Hounslow trader is a scapegoat

The idea that a Hounslow-based day trader caused the American stockmarket to drop by 10 per cent in a few minutes on 6 May 2010 is absurd. Even if his actions acted as a catalyst for the drop – itself a questionable claim – they were certainly not the fundamental cause.

Yet it is widely accepted that Navinder Singh Sarao, the trader for whom the American authorities have requested extradition, is partly responsible for the “flash crash”. He is officially charged with devising a computer program that manipulated the futures market and had a subsequent knock-on effect on the stockmarket. In effect he bet that the S&P 500 would fall and allegedly created a program that made it look like prices were likely to drop.

Even assuming the charges are true it is hard to believe a lone trader in a West London semi-detached house could cause a market loss of almost $1trn. Futures contracts would have given him more leverage than investing directly but it is unlikely his actions caused such a huge fall. He may be guilty of market manipulation but, with only a few million pounds at his disposal, he was a relatively small player.

Although some commentaries have expressed cynicism about the case few have asked fundamental questions about why the market is prone to such falls. In particular, how relatively small interventions can appear to have such a dramatic impact.

There are two key factors at work. First, the huge amount of liquidity held in financial assets. This volume has increased sharply over time relative to the size of the economy. The ratio of total debt to GDP in America has risen strongly since about 1980. The stockmarket too has trended strongly upwards.

This massive surge in market liquidity over time is a symptom of underlying weakness rather than strength. It shows, among other things, that firms would rather hold or manipulate financial assets than engage in capital investment. This itself betrays a fearful attitude towards the future.

With so much liquidity around there is more potential for volatility. Many factors could cause waves in the markets under such circumstances. These could include the acts of a dishonest trader or the prospect of the disorderly unwinding of quantitative easing.

But there is an additional key factor besides the sheer volume of liquidity sloshing around. That is the pervasive fear of uncertainty that has long gripped the markets.

Such anxiety should be seen as a particular example of the angst that has permeated society more generally. We seem to live in a time when people are often particularly fearful about the future. This manifests itself in all sorts of areas from reluctance to let children play unsupervised to the obsessive drive to regulate the behaviour of football fans. Any type of action seen as posing a potential risk is viewed with extreme caution.

In the financial markets such free-floating anxiety can manifest itself as a propensity to be easily spooked. The effect of relatively minor developments can be magnified to prompt market turmoil. Small ripples can be transformed into tsunamis.

Such instability points to fundamental weaknesses. Scapegoating a relatively small-scale trader is a way of evading the challenges posed.

This blog post was first published on Fundweb on 28 April.