When Cleverness Becomes Manipulation
(Bloomberg View) -- Manipulation, or not (1).
What is market manipulation? Well I certainly don’t know. From first principles, it seems like it would mean doing something to a market to make the price move, as opposed to just leaving the market alone to work itself out. But in practice, any time you interact with a market, you will do something to it: Any time you buy a thing, you will tend to push its price up; any time you sell it, you will tend to push the price down. Everyone who participates in a market necessarily manipulates it, in the minimal sense. There’s the famous definition given by a cotton trader, that manipulation means “any operation of the cotton market that does not suit the gentleman who is speaking at the moment.”
The Commodity Futures Trading Commission also has a definition, though it is more of a “traditional four-part test” than it is a definition per se:
(1) That the accused had the ability to influence market prices; (2) that the accused specifically intended to create or effect a price or price trend that does not reflect legitimate forces of supply and demand; (3) that artificial prices existed; and (4) that the accused caused the artificial prices.
It’s a start, but it doesn’t necessarily tell you how to handle the interesting cases. The interesting cases are about weird sources of supply and demand, and the interesting question is which sorts of supply and demand count as “legitimate” and which ones don’t.
One interesting case that we’ve talked about a few times around here is the Hovnanian Enterprises Inc. trade, where Blackstone Group LP's credit unit, GSO, offered attractive funding to the company in exchange for its agreement to do a quickie default on some of its debt to trigger credit-default swaps that GSO owns, and to issue weird new bonds to create a large payout on those CDS. (Here I have cut and pasted my most recent description of the trade.) There are those who think that this is a clever trade to create value out of thin air—even, as I once described a similar transaction, a way to “[take] money from an abstract zero-sum derivatives bet” on a company’s creditworthiness “and [turn] it into an actual loan to an actual company that actually needed the money.” There are those who think it is extremely unsporting, and who sued over it, and who think that it may ruin the market for credit-default swaps—that, as I once put it, “after Hovnanian, a CDS contract looks like a derivative that pays off $100 if the company wants it to, and $0 if it doesn't.” It is a controversial transaction.
Is it market manipulation? I would have said no, but I guess the CFTC says yes? Or maybe? It issued this statement on Tuesday:
"Manufactured credit events may constitute market manipulation and may severely damage the integrity of the CDS markets, including markets for CDS index products, and the financial industry’s use of CDS valuations to assess the health of CDS reference entities. This would affect entities that the CFTC is responsible for overseeing, including dealers, traders, trading platforms, clearing houses, and market participants who rely on CDS to hedge risk. Market participants and their advisors are advised that in instances of manufactured credit events, the Divisions will carefully consider all available actions to help ensure market integrity and combat manipulation or fraud involving CDS, in coordination with our regulatory counterparts, when appropriate.”
I mean it doesn’t look like market manipulation. Grant that it is “manipulation,” in the minimal sense of doing something to influence your payoff, rather than just leaving it to fate to work out. But GSO didn’t manipulate a market: It didn’t buy one thing to move the price of another, or pretend to buy when it was selling, or sell a little so it could buy a lot, or do any of the traditional things that one does when one manipulates markets. Its machinations didn’t involve buying or selling or bidding or offering.
It manipulated a company, sure: It went to Hovnanian and offered it cheap financing in exchange for its agreement to do weird stuff with its capital structure. Did that create “artificial prices” for Hovnanian CDS? That is a deep question. If you think that the natural price of CDS is the one that allows you “to assess the health of CDS reference entitites”—that CDS prices should be low for healthy companies and high for companies near default—then what GSO and Hovnanian got up to does look artificial.
But that’s not quite what the documents say. If you think that the natural price of CDS is the price that reflects the actual expected payoff of that CDS given the actual circumstances of the reference company, then Hovnanian’s CDS prices are perfectly natural. Hovnanian is planning to default on some bonds, which under the terms of the CDS contract will trigger a credit event and an auction for its bonds. And it is planning to issue bonds that—due to “legitimate forces of supply and demand”!—should get a very low price in that auction. (Because they are silly bonds and no one should want to pay much for them.) In a sense nothing manipulative has been done to the CDS, which is properly reflecting the very weird circumstances at the company.
I suspect that the real definition of market manipulation is mostly customary: Manipulation is behavior in a market that other market participants do not expect and do not consider legitimate. It will vary between markets; misrepresenting your own position, for instance, seems to be more acceptable in poker than it is in bond trading. Within any particular market, you usually kind of know it when you see it.
But in some markets you don’t. A lot of people look at the CDS market and see a set of incentives whose purpose is to reward clever reading of the documents and clever structuring of transactions. A lot of other people look at the CDS market and see a straightforward way to bet on corporate credit. My own sense is that the first group of people are right, that CDS documents mean what they say, and if you can get them to do what you want by reading them carefully, then you have won, and merited, a prize. But there is a large constituency for the view that CDS documents mean what they are supposed to mean, and if you can get them to do something surprising by reading them carefully, then that is “manipulation.”
Manipulation, or not (2).
The CBOE Volatility Index, the VIX, is a number computed based on the prices of some options on the S&P 500. It is not an actual thing; you cannot buy the VIX. But you can buy the S&P 500 options that go into its calculation. Occasionally you might do that. For instance, if you were long VIX futures, and those futures were expiring, you might "replace" your VIX futures exposure with exposure to the "actual" VIX by buying the options. Being long April VIX futures is a bet that S&P 500 option volatility will be high in April and May. When those futures expire in mid-April, you might still want to see how that bet plays out. So your futures expire and you replace them with S&P 500 index options.
Separately, if you are long VIX futures when they expire in April, you want the settlement price of those futures to be as high as possible, because you get paid that price at the expiration. If VIX is at 15 an hour before the futures expiry, then you will get paid, you know, 15 times $1,000 times the number of your futures. If it then jumps up to 17 in the final auction that determines the settlement price, you will get paid 17 times $1,000 times the number of futures. Seventeen is more than 15, so you want the VIX to jump up right at the expiration. One way to get the VIX to jump up is to buy the S&P 500 options that go into calculating it. One particularly effective way to get it to jump up is to buy options that have a disproportionate effect on the calculation, often thinly traded out-of-the-money options where you can move the price of VIX a lot by buying a relatively small number of options.
If you own VIX futures, and you put in a big order to buy S&P 500 options right at the end of the settlement auction, are you doing that to maintain your exposure, or to push up the settlement price on your futures? It is hard to know this without looking into your heart, but actually there are some pretty good external signs. If you own 1,000 expiring VIX futures, and you buy exactly the set of options that replicate the VIX in exactly the quantity that replicates your 1,000-future position, then it is reasonable to assume that you were innocently trying to roll that position, and not trying to manipulate the settlement. Because, one, that is a sensible way to roll the position, but also, two, that is not a sensible way to manipulate the settlement. If you buy the entire strip of VIX options, in the same quantity as your expiring futures, and at the settlement-auction price, then any profit that you make by pushing the futures higher will be exactly offset by your additional cost of buying the options. If you can buy the replacement options at a 15 VIX, and then the futures expire at a 17 VIX, then you are getting somewhere. But if you buy the options at a 17 VIX in the auction that pushes the VIX up to 17, then your costs and gains cancel and you haven’t accomplished anything.
On the other hand if you own 1,000 expiring VIX futures and you buy only a few out-of-the-money S&P 500 options for a little bit of money, and push the price of the VIX up that way, then that looks more like—but isn't necessarily—manipulation. For one thing, that's not how you'd roll the position; you might independently decide you want a bunch of S&P 500 options, but there's no connection to your futures position. For another thing, that makes sense as manipulation: Spending a little money on one uneconomic trade, in order to make a lot of money on some other derivative trade, is pretty much how manipulation works.
Anyway last week there was some hubbub about the VIX settlement auction in which the VIX spiked a lot from its previous price, due largely to one buyer spending $2.1 million on some far-out-of-the-money S&P 500 put options that had a big effect on the VIX calculation. There were those who thought that might indicate manipulation. I shrugged that “CBOE, the exchange where the VIX futures are traded ... could find out who bought those options and send them a polite note asking what was up,” to clear up the concern. That seems to have happened, and the CBOE is satisfied that there was no intent to manipulate:
During the opening auction on April 18th, a single market participant submitted orders to buy approximately 212,000 SPX options across a wide range of strike prices. Five additional market participants submitted buy orders totaling 20,000 options. The size and structure of these buy orders appeared consistent with the weights prescribed by the VIX Index formula. Offsetting this buy interest were sell orders submitted by nine participants for a total of 118,000 contracts. This left a buy order imbalance of 114,000 SPX options. This buy order imbalance contributed to the opening prices of the option series that were used to calculate the final VIX settlement value. Based on the orders that were submitted, we believe the auction process functioned as intended, notwithstanding that the final settlement value was higher than what market participants may have otherwise expected.
That seems like the right analysis: If someone just bought a random slug of far-out-of-the-money options that moved the price, then that would look like manipulation, but if they bought options “consistent with the weights prescribed by the VIX Index formula,” then that would look like a reasonable hedging/rolling/etc. trade, and probably not manipulation.
Still it is intriguing. Pravit Chintawongvanich of Macro Risk Advisors wrote in a note on Tuesday:
Even though the order was for the entire strip, it had the most impact in the far OTM options that have the heaviest impact on VIX. Although it appears whoever submitted the order was replicating VIX (and not specifically targeting the far downside), this suggests that at least during April settlement, you could have moved VIX by only trading around $2-$3 million in the far OTM options.
The actual trader here seems to have bought the whole strip of VIX options, rather than just the far-out-of-the-money options that moved the price, but a different trader could have bought just those options with the intent of moving the price. The actual trade wasn’t manipulation but it points the way to a possible manipulative trade. That doesn’t necessarily prove a vulnerability in the system, though: If someone had done the manipulative trade, then CBOE could have noticed that—as it noticed and inquired into this apparently legitimate trade—and caught them. The deterrence function of regulatory inquiries is part of the market structure, and it might prevent that sort of manipulation.
Chintawongvanich also adds:
Firstly, why did the order hit just 5 minutes before the 9:20 AM order submission cutoff, when the auction was open since 8:30 AM? Moreover, since there were only 20,000 contracts trading in the auction at 9AM before the order hit, whoever submitted the order for 212,000 contracts must have been aware they would move the settlement, even if they did not intend to. …
Finally, suppose a trader legitimately had need to replace their expiring VIX futures risk, but also had positions in VIX derivatives that would benefit from a higher settle. Would this trader have an incentive to impact the VIX settlement when they replace their risk? It is not difficult to imagine scenarios where this "legitimate trading" excuse could be exploited.
If you own VIX futures and want to replace them with the underlying options, then what you really want is to buy the underlying options at (say) 15 and have the VIX futures expire at (say) 17. Doing exactly what this trader apparently did—replacing your entire position right at the final auction—is not a good way to do that. It is a fine way to exactly match your expiring futures to your replacement position, but not to make a profit on a mismatch. But there are other possible ways to do that. You might buy half of your replacement options quietly in the hours leading up to the auction, trading efficiently to avoid moving the price, and then buy the other half as noisily as possible at the auction, trading inefficiently (say, slamming in all the orders at the last minute) to try to move the price as much as possible. If that works then you will have gotten paid off on your futures position (paid based on the auction) at a high price, and averaged into your new position at a lower price.
I don’t know how possible that is in VIX futures. But it is generally a possibility to consider. The classic recent example is the foreign-exchange fixing controversy, in which banks agreed to sell (say) pounds at the price at a certain fixed time, but then had to go buy pounds at around that time in order to fill the order. Their goal was to buy pounds at a lower price than the fixing. One way to do that is to buy pounds very efficiently at a low price. (That’s good!) Another way to do that is to buy (some) pounds extremely inefficiently right at the fixing time in order to push up the fixing price above your cost. (That’s bad!) It can be hard for an outsider to evaluate which is which. You can do a legitimate trade to hedge or replace a position that also moves the price in order to benefit that position; your intent can be both virtuous and manipulative. The deep problem of market manipulation is that legitimate trading moves markets too, and sometimes it’s even meant to.
What’s Deutsche Bank up to?
Deutsche Bank AG is abandoning its ambitions to be a top global securities firm as it embarks on possibly the most sweeping overhaul yet of its struggling investment bank.
Germany’s largest lender will scale back U.S. rates sales and trading, reduce the corporate finance business in the U.S. and Asia, and review its global equities business with a view toward cutting it back, the bank said in a statement Thursday. The measures will lead to a “significant reduction” in the roughly 97,100-person workforce this year, it said.
A simple model for the last few years in global banking is that there has generally been a modest reward for any particular bank that cuts back its global ambitions and securities business, but there has also been the tantalizing prospect of a very large future reward for any bank that sticks around long enough to be one of the last surviving full-service global investment banks. Someone will have to trade bonds, and if everyone else quits trading bonds then you’ll be great at it, even though the bond-trading business is a rough one for anyone to be in now. And so a few banks have paid very heavy rents in order to keep that option open. But in fact it seems like there are fewer spots in that business than they thought. (There might be none!) And if you throw in the towel late—if you try to make a go of it as a global bond-trading powerhouse all the way through 2018, and then say “never mind”—then you will regret all those years of paying those rents. “There is no time to lose as the current returns for our shareholders are not acceptable,” said Deutsche Bank’s new chief executive officer.
What’s Goldman Sachs up to?
I don’t know, man, I would have assumed that if there are any spots left for full-service trading-focused global investment banks, Goldman Sachs Group Inc. would be a lock to claim one of them. (Disclosure: I used to work there so am a bit biased.) But what is all this then:
Goldman Sachs has partnered with a star from "The Bachelorette." It's the latest sign that the bank is trying to court Main Street borrowers — and in doing so, shape a new image for itself. …
Fletcher will represent the bank's consumer-lending business, Marcus, in a series of promotions, including nearly two dozen appearances on local TV news segments like "Living Oklahoma" and on radio shows, as well as in posts on her Facebook and Instagram pages, where she has more than 2 million followers.
The campaign is designed to target people in middle America where the Goldman Sachs brand may not be as familiar or where consumers may have a negative impression of the bank left over from the financial crisis.
"She can help us reach consumers in unexpected places like consumer, lifestyle, entertainment, and home publications," Dustin Cohn, the head of brand and marketing communications for Goldman Sachs's digital bank, said in an interview.
I am not sure why Goldman needs a reality-television star for this; I feel like Lloyd Blankfein would be a hit on Oklahoma local television, or in the pages of Better Homes & Gardens. Perhaps they are thinking about succession planning and worry that David Solomon would be a bit more jarring as a lifestyle spokesperson.
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Matt Levine is a Bloomberg View columnist. He was an editor of Dealbreaker, an investment banker at Goldman Sachs, a mergers and acquisitions lawyer at Wachtell, Lipton, Rosen & Katz and a clerk for the U.S. Court of Appeals for the Third Circuit.
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