Update: In a quite shockingly fast reaction, WSJ reports that a U.S. regulator is looking into whether prices linked to the widely watched Cboe Volatility Index have been manipulated, according to people with knowledge of the matter.
The Financial Industry Regulatory Authority is scrutinizing whether traders placed bets on S&P 500 options in order to influence prices for VIX futures, the people said.
Proving manipulation is difficult, lawyers and academics say. The regulator must prove that a person or firm had the ability to move prices and did so intentionally. In addition, the regulator must show that the person intended to create artificial prices, said Craig Pirrong, a professor of finance at The University of Houston who has written about futures manipulation.
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As we detailed earlier, we first exposed the “conspiracy fact” that VIX manipulation runs the entire market back in 2015 as the ubiquitous VIX-crushing algo-runs coincided with a non-stop shorting of VIX futures by a seemingly bottomless-pocketed player in the market… which happened to coincide with the arrival of Simon Potter as the head of The New York Fed’s trading desk…
Probably just a coincidence, right?
Then, in May of last year we academic confirmation of the rigged nature the US equity market’s volatility complex, when a scientific study found “systemic VIX auction settlement manipulation.”
Two University of Texas at Austin finance professors found “large transient deviations in VIX prices” around the morning auction, “consistent with market manipulation.”
Griffin and Shams calculate that “the size of VIX futures with open interest at settlement is on average 5.7 times the size SPX options traded at settlement, and it is 7.3 times for VIX options that are in-the-money at settlement.”
So if you are a trader who owns a lot of the market in VIX futures, you could push around a large dollar value of futures by trading a small dollar value in options. This is particularly true because the S&P option volume is divided among many strikes, and the illiquid deep out-of-the-money S&P 500 options have a big influence on the VIX: You can move the price of those options a lot with relatively small trades, and those price changes have a disproportionate effect on the VIX.
While this was immediately played down by CBOE, and the subject quickly disappeared from the headlines – because VIX was dropping incessantly and stocks were going up, up, up – until VIX flash-crashed rather awkwardly into the morning auction settlement in mid-December, bring the chatter of manipulation back to life…
Bloomberg data show that of the 10 biggest gaps between the VIX settlement value and its closing level the night before, five came in 2017, including December’s, which was the biggest discount in 11 years.
On monthly expirations, settlement occurred outside the VIX’s same-day trading range 42 percent of the time last year, the most since 2005. The average occurrence was 15 percent in the decade through 2016.
While a lot of innocent explanations exist, “really, it is a mystery,” said Pravit Chintawongvanich, the head of derivatives strategy for Macro Risk Advisors.
“Some people rightly get confused about why the settle is seemingly out of context with the market.”
It actually seems like VIX manipulation is an inside-joke, as Hennessy of IPS says in a market dominated by professionals, everyone plays at his own risk.
“Like any market it is susceptible to manipulation by large participants but I think that most VIX traders understand that,” he said.
“2017 saw many settlements that came in points away from the previous day’s close value, and at this point you have to understand the risk you are taking on if you choose to let your options/futures position go into settlement.”
But now, Bloomberg reports a whistleblower has come forward telling U.S. regulators that a scheme to manipulate the VIX costs investors hundreds of millions of dollars a month.
In a letter Monday (see below) that his client found a flaw that allows traders “with sophisticated algorithms to move the VIX up or down by simply posting quotes on S&P options and without needing to physically engage in any trading or deploying any capital.” Billions in purportedly ill-gotten profits have been scooped up by “unethical electronic option market makers,” according to the letter.
The client wasn’t identified by name. He’s held “senior positions at some of the largest investment firms in the world,” according to the letter written by Jason Zuckerman of Zuckerman Law, who has appeared on Washingtonian magazine’s list of top whistle-blower lawyers in the nation’s capital.
Crucially, according to the letter, the whistleblower blames this VIX manipulation as the driver of last week’s volatility complex collapse:
“We contend that the liquidation of the VIX ETPs last week was not due solely to flaws in the design of these products, but instead was driven largely by a rampant manipulation of the VIX index,”
CBOE quickly responded with a denial:
“We take our regulatory responsibilities and the oversight of our markets very seriously,”
“This letter is replete with inaccurate statements, misconceptions and factual errors, including a fundamental misunderstanding of the relationship between the VIX Index, VIX futures and volatility” exchange-traded products.
“As a result of these errors, we feel the conclusionary statements contained in this letter lack credibility.”
But, as we concluded previously, you don’t even have to intervene over some long period to keep options prices up; you can just submit bids in the pre-opening auction once a month and move the settlement price for that month.
There is a sort of hierarchy of manipulability in markets. At the top is Libor manipulation: Trillions of dollars of derivatives settled based on Libor, but Libor was calculated by essentially asking banks “what should Libor be?” The banks didn’t even have to do any trading in order to push the number around; manipulation was, in effect, costless. (Later, with the fines, it was costly.)
At the bottom is, like, manipulating the price of a stock by trading that stock. There are cases of it! It’s a thing. But it is a dumb thing; it really shouldn’t work. If you buy a stock, you will push the price up, sure. But to make any money you then have to sell the stock, which should push the price right back down.
But if you are going to manipulate a tradable market — as opposed to a made-up one like Libor — then VIX looks pretty tempting.
The product that you trade (S&P 500 options) is different from the product where you make your money (VIX futures and options), and the trading market is in the relevant sense smaller than the derivative market: You can move a lot of value in VIX products by trading a small amount of value, in a confined period of time, in the underlying market. So you can cheerfully lose money executing the manipulation — trading the S&P options — and make back more in the derivative.
The question is – why did the whistleblower come forward now – a week after the total and utter collapse of XIV and the short-VIX debacle?
Blame-scaping VIX manipulation for ‘volocaust’ but remaining silent during years of VIX-monkey-hammering sounds more like ‘bad-losers’ – no matter how much we believe in the manipulation of this ‘tail’ that inevitably wags the entire market ‘dog’.
As a reminder, it is not just traders that are potentially “manipulating” VIX, The Fed’s new chair Jay Powell admitted in January that they carry a short-volatility position. We wonder if they took the loss last week or unwound the position?
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Full Whistleblower Letter To Regulators: