In a Streetwise Professor blog post titled, “A Matter of Magnitudes: Making Matterhorn Out of a Molehill,” University of Houston finance professor Craig Pirrong discussed the CFTC civil complaint in the Nav Sarao case, along with the affidavit by Cal-Berkeley’s Terrence Hendershott.
According to Dr. Pirrong, instead of supporting the CFTC’s claims that Sarao’s actions had a large impact on contributing to the Flash Crash, Hendershott’s report “undermines” the CFTC’s claims. Rather, Hendershott’s two analyses estimate small price impacts from Sarao’s activity that are minuscule compared to the price effects that the CFTC asserts. Dr. Pirrong goes on to say that he is “deeply disturbed” by the complaint’s and Hendershott’s “sample days” concept which Dr. Pirrong likened to “cherry picking.”
Furthermore, Dr. Pirrong pointed out that the DOJ, the CFTC, and Hendershott all state that Sarao turned the layering algorithm on and off, which caused prices to “rebound by approximately the same amount as turning it on caused prices to fall.” Dr. Pirrong argued that this is “directly contrary” to the consistent insinuation that Sarao was driving down prices. Instead, Dr. Pirrong reasoned that Sarao caused price “oscillations.” Additionally, Dr. Pirrong asserted that the CFTC complaint lacks “actual evidence” in the section labeled “Example of the Layering Algorithm Causing an Artificial Price” that contains no analysis of market price.
Dr. Pirrong contended that if the CFTC tries to prove that Sarao caused or even contributed to the recent “Flash Crash,” “it will face huge obstacles.” He explained that there were many actors in the markets on the day of the Flash Crash, and attributing the huge change in the system to the behavior of any one individual is “metaphysically impossible to prove.” Dr. Pirrong acknowledged that Navinder Sarao’s conduct was “dodgy” and noted there is “a colorable case” that he did engage in illegal spoofing and layering, but concluded that the CFTC’s assertion as to the alleged impact of his conduct and the legal consequences that could arise from his prosecution are “outrageous.”
Lofchie Comment: In light of the writings of Cabinet contributors, including Dr. Pirrong of the University of Houston and Chris Clearfield of System Logic, as well as my own review of the expert testimony filed by the CFTC, it seems unlikely that the CFTC will be able to demonstrate any link, let alone causation, between Nav Sarao’s trading (even if illegal) and the Flash Crash. In fact, based on the material presented by the CFTC to date, the assertion that the CFTC will be able to demonstrate a meaningful link between the two events seems not merely implausible, it seems unserious. At best, the CFTC’s assertions seems an argument of the “butterfly effect“; that because Mr. Sarao’s flapping of his wings (or flipping of his orders) caused a flood of ensuing events. In some philosophical sense it may be true that Mr. Sarao “caused” the Flash Crash, in the sense that every event in the world contributes to every other, but it is not readily demonstrable in any mathematically meaningful way. To take this rhetorical point even further, if Mr. Sarao’s trading in this single instance “contributed” to the Flash Crash, one could reasonably argue that his trading in another 100,000 instances prevented some other Flash Crash that never happened: how could one possibly know?
The extravagance of the CFTC’s assertions in regard to Mr. Sarao’s trading are troubling in at least two ways, one small and one big. The small way (though perhaps not small to Mr. Sarao unless he is of a very Socratic bent) is that it diminishes his right to obtain a fair hearing as to the actual crimes with which he is charged, especially in light of the way that the popular press has highlighted this accusation.
The big way is that it diminishes confidence in the intellectual authority of the government in investigating the reasons why things go wrong. This is, in a nutshell, the problem with Dodd-Frank. On the one hand, no one can doubt the existence of a particular mishap (whether it is in the 2008 market crash or the Flash Crash). But on the other hand, one can very much doubt the causes that the government points to are in the fact the real causes, as opposed to being the politically convenient villains. And if the causes are misidentified, then inevitably the correctives will be wrong, and perhaps even further damaging going forward.
See: Streetwise Professor: “A Matter of Magnitudes: Making Matterhorn Out of a Molehill.”