Mark was quoted in the Wall Street Journal on Tuesday concerning the potential for manipulation of spot VIX at the moment VIX Options and Futures expire. The following is a reprint of that article. To see updates to the article, please visit the WSJ’s website.
By Gunjan Banerji
Updated Feb. 13, 2018 8:13 p.m. ET
A U.S. regulator is looking into whether prices linked to the stock market’s widely watched “fear index” have been manipulated, according to people with knowledge of the matter.
The Cboe Volatility Index, known as the VIX, is derived from S&P 500 options prices. The Financial Industry Regulatory Authority is scrutinizing whether traders placed bets on S&P 500 options to influence prices for VIX futures, the people said. Separately, a letter from a law firm Monday representing an unidentified client urged U.S. regulators to investigate VIX manipulation, claiming it has cost investors hundreds of millions of dollars in losses each month.
If evidence of manipulation is found, it would be a black mark for the VIX, which has soared in popularity over the last decade as a hedging tool for investors. The VIX is designed to track investor anxiety and tends to move in the opposite direction of the benchmark S&P 500 index. Investors purchase VIX futures and options to protect against declines in stocks.
Finra is Wall Street’s self-regulator. It isn’t a government entity but is overseen by the Securities and Exchange Commission. It provides oversight to Wall Street firms such as brokerages and exchanges. Finra works with Cboe Global Markets to help with surveillance of its market. It is unclear whether Finra’s activities on the VIX amount to a formal investigation by the organization. Finra could also reach the conclusion that prices for VIX futures haven’t been manipulated.
A probe by Finra or another U.S. regulator would be another setback for Cboe Global Markets Inc. The VIX is Cboe’s marquee franchise, with a slew of products including futures, options and exchange-traded products that track it.
Last week, the resurgence of market volatility triggered a spike in the VIX and the collapse of a widely traded ETP that buys and sells VIX futures. The ETP’s demise helped send Cboe’s shares sliding 18% over the next four days amid speculation that losses like those suffered by the ETP’s investors could lead to greater regulatory scrutiny for the VIX going forward.
“Cboe has a dedicated regulatory department that works with Finra to monitor certain trading activity for our securities markets, including trading activity that could impact the VIX settlement,” said Greg Hoogasian, Cboe’s chief regulatory officer. A spokesman for Finra declined to comment.
Manipulation is a civil and criminal violation under commodities law, said Craig Pirrong, a professor of finance at the University of Houston. It can be harmful to people trying to hedge their portfolios. Investors frequently turn to futures contracts for this purpose. Moreover, distorting prices can undermine the “fundamental purposes of the markets,” he said, creating a situation in which the forces of supply and demand cease to become a reliable indicator of prices.
Here’s how VIX manipulation could occur: Traders trying to move prices for VIX futures and options could achieve this by betting on the options at a special auction that takes place each month to calculate settlement values. Volume tends to spike around the time of the settlement auction and only in S&P 500 options that tend to have an outsize influence on the VIX’s final level, according to research by John Griffin and Amin Shams, professors at the University of Texas at Austin who wrote a paper on the topic in May.
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 Prof. Pirrong. Since the Commodity Futures Trading Commission’s creation in 1975, it has won only one manipulation case against a trader who wouldn’t settle as of late 2016.
Cboe said the University of Texas professors’ research is based on “fundamental misunderstandings” about the VIX and its derivatives. It also said it has safeguards that make it difficult to manipulate the volatility gauge. “The VIX index formula calculation performs exactly as intended, and we do not think that there is a problem with the VIX settlement process,” a Cboe spokesman said in December.
Lawyers from the Washington-based law firm Zuckerman Law said in a letter Monday that a client is urging the SEC and CFTC to investigate possible VIX manipulation. According to the letter, the client found a flaw that 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.”
Some market participants and observers of derivatives markets say VIX manipulation is feasible. More than a dozen traders and brokers told the The Wall Street Journal that they avoid the expiration days for VIX futures or advise their clients to do so, with some citing manipulation fears. “There’s smoke there,” said Prof. Pirrong. “It’s definitely worth further inquiry.”
There have also been at least two crackdowns surrounding volatility products in the past year by Cboe itself, disciplinary filings show. Chicago-based DRW Securities LLC was fined in December for bets on volatility contracts that track oil, Brazilian equities and emerging markets. These derivatives are similar to VIX futures, though not as popular.
“Cboe has consistently denied any validity to our paper…but they recently fined a firm for exactly the same activity we identified in our paper,” Prof. Griffin, one of the authors of the May paper, said in an email.
A DRW spokeswoman said the firm is pleased the matter is resolved and that it takes obligations to comply with regulations seriously. Cboe declined to comment on the DRW fine.
Equitec Proprietary Markets LLC, a Chicago-based trading firm, was fined in April 2017 for options orders it made related to the VIX futures settlement value. Equitec declined to comment.
For now, some market players simply avoid the VIX settlement date. Mark Guthner, an editor at the Options Edge, said he has noticed oddities with how final VIX futures contracts are priced and modified his trading. “I just see some rabbit feet in the snow from time to time,” Mr. Guthner said of the trading patterns. “It looks funny and if you’re an investor, why subject yourself to that?”
Write to Gunjan Banerji at Gunjan.Banerji@wsj.com
Gunjan Banerji
Reporter, The Wall Street Journal
o. 212.416.3692 m. 347.267.2577
@gunjanjs
