Oil Bonanza at U.K. Firm Casts Light on Price-Blind Trades
Oil Bonanza at U.K. Firm Casts Spotlight on Price-Blind Trades
(Bloomberg) -- When Chris Cook was responsible for keeping the pit traders in check at the International Petroleum Exchange in London, they used to call the daily crude oil settlement “Grab a Grand.”
Cook worked in compliance at the IPE in the 1990s when the first “Trade at Settlement” contracts were introduced, allowing buyers and sellers to come together and agree to transact at wherever the settlement price ended up that afternoon. TAS was devised to help funds that merely wanted to track the price of oil, but before long some traders figured out that the settlement could be nudged and that there was money to be made by taking the other side of transactions with parties who didn’t much care about the price.
TAS “was a good innovation, but there was always the potential for abuse, which is why the market should have been restricted to funds, producers and end-users and not speculators,” said Cook, who learned of the wrongdoing after leaving the IPE and is now a consultant in the energy industry. “It was blatant, what was going on.”
Now, the Trade at Settlement instrument is under scrutiny once again after a group of independent traders at a small British prop firm called Vega Capital London Ltd. made as much as $500 million on April 20, when oil fell below zero for the first time, settling at -$37.
“The speed at which the oil price fell into negative territory creates the impression of a market susceptible to manipulation and needing additional regulatory safeguards,” Senator Sherrod Brown, the top Democrat on the banking committee, wrote in a letter Thursday to Heath Tarbert, the head of the U.S. Commodity Futures Trading Commission. “These concerns increase when such price swings are potentially attributable to one market participant.”
TAS Contracts
In TAS contracts, one party agrees to sell something, say 1,000 barrels of West Texas Intermediate crude, and another agrees to buy it at whatever the settlement price ends up being, plus or minus a few cents. TAS is found in markets as varied as gas, wheat and cattle and is popular among ETFs and other funds whose priority is to track a market rather than always get the best deal.
Settlement figures are baked into a wide variety of financial instruments and derivatives and are used by funds to value their assets. On NYMEX, where WTI is traded, the settlement is based on a volume-weighted average of all trades occurring between 2.28 p.m. and 2.30 p.m. in New York.
“If something goes wrong in the oil market, it doesn’t stay contained just to the oil financial markets or the energy sector itself, it bleeds through to the entire global economy,” said Justin Slaughter, who was an aide to CFTC Commissioner Sharon Bowen and is now a consultant at Mercury Strategies in Washington. “These TAS contracts seem to merit additional scrutiny”
Vega’s trade involved a dozen or so of its traders hoovering up May WTI contracts in the TAS market throughout the day, then selling outright WTI contracts and related instruments in unison as the settlement window approached, according to people familiar with the matter. The firm’s selling coincided with an exodus of buyers after demand for fuel was decimated by the coronavirus outbreak and storage space in Cushing, Oklahoma, where purchasers take physical delivery of WTI crude, ran out. Oil’s dive below zero meant Vega’s traders ended up being paid both for some of the oil it sold when prices were falling, and for all the contracts it agreed to buy at settlement.
Vega is now being examined by the CFTC and the U.K.’s Financial Conduct Authority to determine what role, if any, its traders played in oil’s collapse and whether they broke any rules on trading around settlement periods, the people said. The regulators’ conclusions are likely to be followed closely by investors and companies around the world that held instruments pegged to the April 20 settlement price and wound up losing billions. One lawsuit has already been filed against Vega in Chicago by Mish International Monetary Inc., a coin dealer that sold 10 futures contracts that day, alleging violations of the Commodity Exchange Act and the Sherman Act.
CFTC spokesman Rachel Millard declined to comment on the TAS trading on April 20 and about concerns that the market is prone to abuse. The agency plans to publish a report on what caused the decline in oil later this year. The FCA declined to comment.
Abuse Potential
It’s no secret that TAS is susceptible to abuse. In 2008, the CFTC charged the Dutch trading firm Optiver BV with manipulating crude oil and gasoline futures by building a position in the TAS market over several hours and then aggressively trading in the opposite direction in the minutes before and during the settlement window. It’s a practice known as “banging the close.”
Optiver’s aim was to buy oil in the TAS market more cheaply than it sold regular contracts for in the lead-up to the settlement, something it described in recordings as “a fun game.” In 2012, the CFTC fined the firm $14 million and banned three of its employees from trading for several years.
The following year, Dan Shak, a hedge fund manager and professional poker player who once sued his ex-wife for 35% of her $1 million shoe collection, was fined $400,000 and prohibited from trading during settlement periods after being charged with abusing TAS. He paid an additional $100,000 after he was found to have traded during the settlement window for gold a year later. He said it was an accident.
TAS’s vulnerability lies in the fact that it allows traders to quietly build a position without affecting the price, according to Craig Pirrong, a professor at the University of Houston who wrote a paper on the subject last year. Normally, when traders start buying, it indicates they are in receipt of valuable information, encouraging other participants to follow suit and pushing up the price, Pirrong explains. But TAS is inhabited largely by the “uninformed,” so trading there doesn’t have the same market impact, and it’s this “asymmetry that makes manipulation possible,” he writes.
As regulators consider whether Vega’s actions constituted an offense, they will be mindful of another high-profile “banging the close” case. In 2013, the CFTC accused Chicago futures legend Don Wilson and his firm DRW Holdings LLC of making $20 million by aggressively bidding for interest-rate derivatives during a 15-minute settlement window to drive up the price. Wilson argued in court that the firm was simply buying an asset before other participants recognized its true value. He won, highlighting the tricky line that exists between savvy trading and manipulation, and the difficulties regulators face in bringing such cases.
All these incidents took place on exchanges owned by CME Group Inc., which is supposed to have a role in ferreting out wrongdoing but benefits from higher trading volumes. Two days after the oil crash, CME Chief Executive Officer Terry Duffy said that the market had “worked perfectly” and that its wild movements were driven by “fundamentals.”
Asked about concerns that the TAS market is prone to abuse, CME spokeswoman Laurie Bischel said: “We continually monitor trading activity in our markets to ensure compliance with our rules.”
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