A trader who operated out of his West London home was arrested by British authorities Tuesday on U.S. charges that he helped cause the Dow Jones Industrial Average to plummet 1,000 points on May 6, 2010, in what came to be known as the "flash crash."
Prosecutors and regulators charged Navinder Sarao with using a souped-up version of commercially available software to manipulate a stock-market index futures contract, laying the groundwork for the index's decline, in which hundreds of stocks momentarily lost nearly all their value.
Authorities said Mr. Sarao, who was 31 years old at the time of the crash, earned $ 40 million in profits from 2010 to 2014 through alleged manipulations, including $ 879,000 on the day of the flash crash. His company, Nav Sarao Futures Ltd., is registered as operating out of a semidetached home in Hounslow, a London suburb close to Heathrow Airport.
Mr. Sarao's alleged conduct highlights the fragility of financial markets and the potentially destabilizing role computerized trading can play.
The Justice Department, in a complaint unsealed Tuesday, said Mr. Sarao manipulated a futures-contract index that mimicked movements in the S&P 500 stock index. Mr. Sarao allegedly placed orders and canceled them just before they were executed in an effort to artificially move prices, an illegal technique known as spoofing or layering.
That trading by a single individual severely exacerbated an imbalance in the S&P 500 E-mini futures contract, which caused a cascade of trades resulting in what the flash crash, said Aitan Goelman, enforcement director for the Commodity Futures Trading Commission, which worked with the Justice Department in the investigation.
"I don't think you could say one individual singularly caused it, but we do believe that Mr. Sarao's spoofing was a contributing factor" to the flash crash, Mr. Goelman said.
Lawyers for Mr. Sarao, who is in the custody of British authorities and is scheduled to appear in a U.K. court Wednesday, couldn't be identified. The Justice Department said it is seeking Mr. Sarao's extradition to face the criminal and civil charges in a Chicago federal court.
The flash crash shocked investors, traders and regulators with its breadth and speed. For a moment, shares in some companies, such as Accenture PLC, traded for one cent, while others soared to absurd highs. Nearly a trillion dollars of value was temporarily erased before being restored by a swing in the opposite direction minutes later.
The event led to a range of market changes, including "circuit breakers" at exchanges that automatically pause trading in stocks that change price rapidly.
The case unsealed Tuesday, nearly five years after the flash crash, marks the first time authorities have cited illicit behavior as contributing to the events of May 6. Previously, a report by regulators said the crash was set off by the activities of a large trader, later identified by news outlets as Waddell & Reed Financial Inc., which sold about $ 4.1 billion of E-mini futures contracts at a moment when the market was already volatile because of unease over European debt issues.
Those sell orders were executed by an algorithm designed to ramp up trading at times when there was greater volume, according to the report. There was a lot of volume at that point on May 6, and the algorithm sent orders very rapidly into the market, which caused a "liquidity crisis," the report said. The firm wasn't accused of wrongdoing, and the company told customers after the flash crash that it didn't believe its trading was the cause. A spokesman declined to comment Tuesday.
Now, Mr. Goelman of the CFTC says the agency believes Mr. Sarao was a major contributor to the E-mini order imbalance identified in the report.
On the day of the crash, Mr. Sarao placed orders representing $ 170 million to more than $ 200 million of "persistent downward pressure" on the price of the E-mini, according to the Justice Department's complaint.
The government's cases were aided by a whistleblower who brought analysis to the CFTC after spending hundreds of hours investigating the Flash Crash, according to the whistleblower's lawyer, Shayne Stevenson.
The case of Mr. Sarao shines a light on manipulation in the financial markets, the whistleblower said in answers provided to The Wall Street Journal by his lawyer, who said his client didn't want to be named.
The whistleblower said his investigation took several years to complete, according to his lawyer.
Mr. Stevenson said his client found evidence of a single trader having a big impact on the markets on the day of the flash crash. The government followed the trail the whistleblower uncovered and validated those findings, the lawyer said.
Prosecutors allege Mr. Sarao tried to cover up his conduct and provided misleading answers when asked about his trades by representatives for his broker and a futures exchange.
Mr. Sarao allegedly said he had canceled large volumes of orders manually, without the help of an automated trading program, the complaint said. In a March 2010 email to exchange and broker representatives, Mr. Sarao said he "was just showing a friend…what occurs on the bid side of the market almost 24 hours a day, by the high frequency geeks," according to the complaint.
Mr. Sarao later told British authorities he was "an old school" trader who had "always been good with 15 reflexes and doing things quick."
But prosecutors allege Mr. Sarao tinkered with commercially available software, creating an automated trading algorithm that allowed him to quickly place, modify and cancel orders.
In their complaint, prosecutors alleged Mr. Sarao set up an offshore entity in Anguilla, in the British West Indies, for what appeared to be tax-avoidance reasons. U.K. filings for Nav Sarao Futures include a July 2014 borrowing agreement between an Anguilla company registered as International Guarantee Corp. and Nav Sarao Futures. Efforts to reach Mr. Sarao or companies associated with him were unsuccessful Tuesday.
Other filings depict Nav Sarao as a company that bled money. Filings show it reported a £4.7 million ($ 7 million) loss for the year that ended Oct. 31, 2013, and a £27 million loss from May 1, 2011, to Oct. 31, 2012.
Prosecutors calculated Mr. Sarao's profits on trading in E-mini futures contracts, not on his overall trading.
The case is part of a crackdown by criminal and regulatory authorities on some tactics used by high-speed traders, including spoofing, which was outlawed in the 2010 Dodd-Frank financial overhaul.
That law was enacted after the flash crash; the CFTC is alleging Mr. Sarao violated the Commodity Exchange Act, which also prohibits manipulative trading. It is also alleging he violated the anti-spoofing law for trading he engaged in beginning in 2011.
Spoofing is an illegal bluffing tactic in which a trader enters large orders to buy or sell a contract in an effort to dupe other traders into thinking the price is rising or falling.
The spoofer then quickly cancels the original orders and places other orders that take advantage of traders who took the bait.
Another trader was criminally charged with spoofing last year, when the U.S. attorney's office charged a New Jersey high-frequency trader, Michael Coscia, with six counts of commodities fraud and six counts of spoofing in 2011. Mr. Coscia has denied the charges in the case.
—David Wighton
contributed to this article.
Write to Bradley Hope at bradley.hope@wsj.com and Jenny Strasburg at jenny.strasburg@wsj.com
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