Illiquid Assets Manipulation: The Ability To Profit From Derivatives Positions

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Illiquid Assets Manipulation: The Ability To Profit From Derivatives Positions

K. Jeremy Ko

Securities and Exchange Commission

Igor Kozhanov

U.S. Securities and Exchange Commission

Sean Wilkoff

Cornerstone Research

February 24, 2016


We develop a model of manipulation of indexes, whose components are illiquid in that they require fair valuation based on comparable instruments. Such an index may be susceptible to manipulation since distorting the prices of only a few assets could potentially shift its value. Our model provides a measure of the manipulability of an index and identifies which assets are most likely to be manipulated. We apply our model to analyze the manipulability of national municipal bond indexes subject to various bond size thresholds.

Illiquid Assets Manipulation: The Ability To Profit From Derivatives Positions – Introduction

The ability to profit from derivatives positions by manipulating underlying assets has been a longstanding concern of those who oversee and participate in financial markets. Numerous academic studies have articulated concerns regarding manipulation of underlying markets for both physical and cash-settled derivatives. A number of financial institutions have been accused over time of engaging in this type of manipulation. For example, the United Kingdom’s Financial Conduct Authority fined Barclay’s in 2014 for placing manipulative orders during the daily gold price fixing in order to avoid paying out on a derivative position. In the US, the CFTC imposed sanctions in 2001 on the energy trading firm, Avista, for manipulating the NYMEX electricity futures contract. The CFTC stated in its order: “To the extent that Avista Energy’s Traders could distort the price for futures contracts with an order at the Close on Options Expiration Day that was smaller than the positions created by Avista Energy’s OTC derivatives contracts, Avista Energy’s Traders thought that they might be able to profit via an artificially created increase in the value of its OTC derivatives contracts.” Other manipulations of this type have involved firms misreporting transactions and prices to distort derivative settlement values in commodities, interbank lending, and other markets.

The aforementioned examples all involve manipulation of a single reference asset or instrument. Manipulation may also be feasible for derivatives which reference an index of assets when either economic or structural issues make the index vulnerable to manipulation. For example, Dutt and Harris (2005) develop a model of manipulation which they apply to narrow-based index derivatives. Manipulation of a concentrated or narrow-based index may be feasible since the cost of manipulating a small number of assets may be sufficiently low. Our paper examines another setting of such vulnerability, in which the index consists of illiquid assets. We use the term illiquid to refer to assets with two features. First, these assets are costly to trade in terms of market impact, bid-ask, and other transaction costs. Second, they are traded infrequently and, as a result, generally require fair valuation based on similar assets. A trader can, in principle, manipulate an index of such assets by distorting prices in just a few select components of the index. The prices of other assets in the index should shift as a result of this distortion since their prices are linked through fair valuation.

In this paper, we develop a model of such manipulation. We assume that the manipulator holds a derivative position which can be liquidated costlessly. This position can represent a cash-settled or redeemable derivative or liquid exchange-traded product such as an ETF. Prices are distorted either indirectly through trade (as in the aforementioned Barclay’s and Avista manipulations) or directly by misreporting quotes and transactions (as in the LIBOR manipulation). Our model can address two critical questions. First, to what degree is a particular portfolio of illiquid assets manipulable? Second, which assets within such a portfolio are most likely to be manipulated? Addressing the first question will give market supervisors and others information about which derivatives and investment vehicles are prone to manipulation. Addressing the second question can help market supervisors focus their efforts to detect manipulation.

In this paper, we apply our model to assessing the manipulability of fixed-income indexes. Our motivation derives from the growing class of indexed investment funds referencing fixed-income and other illiquid assets. Although these funds can be mutual funds, a growing number are exchange-traded funds (ETFs) that list their shares on national securities exchanges. Exchange proposals to list new exchange-traded products are subject to Sec. 6(b)(5) of the Securities Exchange Act of 1934, which requires, among other things, that the exchange’s rules be designed to prevent manipulative acts and practices.

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