A whistleblower complaint that “rampant manipulation of the VIX index” was at play in the recent stock market meltdown last week comes at a time when algorithmic factors are underlying market prices at a unique moment in history. The February 12 letter to the Commodity Futures Trading Commission and Securities and Exchange Commission urges the regulators to take swift action “before investors suffer additional losses due to this fraud.”
Volatility professionals were noticing odd market patterns with the VIX and its correlation ratios early last week as the S&P 500 when on a wild nearly 250-point market meltdown. At the time ValueWalk reported the primary issue:
Late Monday afternoon the unwinding of VIX linked short volatility products spilled over into Tuesday morning as market maker liquidity temporarily dried up, according to one market participant.Exclusive: Dan Loeb’s Two New Stock Picks [Q1 Letter]
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Monday’s whistleblower complaint, to a limited degree, detailed how the liquidity issues in question arose:
The flaw allows trading firms 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. This market manipulation has led to multiple billions in profits effectively taken away from institutional and retail investors and cashed in by unethical electronic option market makers.
At play is work by alleged options market makers to “spoof,” or submit false orders to the exchange that have no reasonable intent to be filled. These orders are identified by a mechanism in the algorithmic systems that interprets the orders as indicating the market pricing is about to change, and market makers adjust their pricing accordingly.
In the case of VIX, the pricing method uses thinly traded out of the money S&P 500 options that can be easily manipulated – a flaw well-known to market participants but one that, until recently, was not much noticed until the market meltdown of nearly one week ago.
The complaint adds another level of analysis by targeting exchanges that trade correlated products, potentially setting up a class action lawsuit:
Although it is not surprising that an inverse exchange-traded fund would lose nearly all its value should the underlying security appreciate over 100% rapidly, we contend that market manipulation is playing a significant role in driving the price of VIX ETPs. And as described below in an excerpt from a widely circulated note by hedge fund Artemis capital in Q3 2015, regulators arguably should have taken action to address the reflexive self-fulfilling danger created by inverse VIX ETPs which require the ETP managers to purchase large amounts of VIX futures around market close when the futures rise rapidly, thereby accelerating their own demise. Knowing that there is such danger created by these products, why did the CME Group not implement circuit breakers on the VIX futures just like it exists for S&P futures for example? Given the high correlation between VIX and S&P, by not placing any safeguards around an unstable market structure for VIX products, the exchange exposes the entire equity market to unnecessary systemic risk. The turmoil in financial markets, which cost American and foreign investors several trillions this week, originated from a known flaw in the market structure by most sophisticated practitioners in the field, and the magnitude of losses experienced calls for accountability from both the exchange and market actors who engage in the manipulation of the VIX.
The Chicago Board of Options Exchange, for its part, maintains that its systems operated properly. In a statement to CNBC they said:
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 ETPs, among other things. As a result of these errors, we feel the conclusionary statements contained in this letter lack credibility.
The real question might not be who made or lost money on the market crash – that is the point of a risk management hedge. The real question that could get sticky and expensive is the liability.