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Matthew Hunter Blog
Matthew Hunter Blog
Matthew Hunter Blog

By Matthew Hunter

Manipulation is never a hot topic for compliance specialists as it is the Great Ocean on which they all sail. No single fraud is more important for detection and prevention than open market price manipulation. Market integrity is the bedrock upon which transactional capitalism rests. It is a C-Suite topic that inspires fear, dismay and often raging anger. Everyone wants markets that are free from corruption. Every firm, every bank and every regulated entity states its desire to be compliant with the laws, rules and regulations of their businesses. Businesses seek to be honest, and broadcast their value as trustworthy partners or counter parties. Integrity matters, at least on paper. It costs money to examine internal behaviors in markets. CEOs do not set out to reward law-breakers, though they often do, nor do they set out to permit cultures of deception and of outlaw practices. Immense wealth is spent in providing training of compliance practices and ostensibly of identifying illegal conduct. Generally compliance is viewed as a cost of business rather than a savings practice. Last but not in the least, not paying fines and not suffering reputational risk are worth real money.

What is benchmark manipulation? Quite simply when it comes to benchmarks, it is the injection of trades to influence the price settlement of a speculative position. The foundation of indices are benchmarks. Benchmark prices are deemed to be determined by transactions dependent only upon the fundamentals of supply and demand of the underlying traded commodity or security. Speculative cash settled financial product interests are bets meant to rest upon the outcome of the forces of supply and demand. Speculative interests are not meant to contribute to benchmark price formation. A crude analogy is the sports bet on the winner of a game. If the game is played fairly then the bet will be paid out simply based on which team won. In market interferences participants sometimes apply a legitimating rationale. A participant errs in believing, because they have a financial interest in the outcome of the speculative trade or position, that they can influence the outcome by providing liquidity to correct or change the price of the benchmark. This is no different than saying that because a financial interest exists in a sports bet, a betting party is entitled to inflict an injury on an opposing player or players to insure the outcome of the game.

Benchmark manipulation is the most common and historically least likely market interference to be detected by a regulator. Benchmark manipulation has commanded staggering penalties (hundreds of millions to billions of dollars), though those penalties seem paltry to me as the financial impacts to price formation and therefore costs to end-user consumers are far greater to society than what is clawed back. How do entities view the costs of their uncovered illegal conduct? I’ll answer the question with a question: which board has fired a CEO or other officers for a benchmark manipulation? 

What are the nuts and bolts required for detecting benchmark manipulation? Regulators need access to the full portfolio of all open trades of a participant and their contributing trades to benchmarks. In the commodities space, futures and options on futures, this data for review by the regulator is excellent. But it is only one leg of a three-legged stool called commodity markets. A second leg is trading and positions in swaps and swaptions, and this information’s availability to the regulator is good, but there can be holes. The third leg of the stool consists of the cash market(s) and forward physical positions and transactions, and the availability of this data to a regulator is a desert. There isn’t any centralized collection of physical trades. To understand the trading of any entity and its incentives to inject interference into real supply and demand, the positions and trading information must be complete and linkages fully appreciated. This three-legged stool of information is only available to the commodities regulator through a regulatory channel, either a subpoena or a Special Call. Rebuilding market events, participants’ conduct, and detecting benchmark abuse by any agency requires all three legs of the stool.

A trading company or financial institution has the best data to uncover the entity’s own illegal conduct and benchmark manipulation. An entity’s own data is complete, including those with global trading books or portfolios. Banks and other participants can review their own data and see how their own trades impact price formation, how those position trades and contribution to index trades became part of their portfolio and what benefitting positions from the interference existed. 

This is not hard work. A simple spreadsheet can be created to demonstrate the incentive.  Real cultural compliance with the anti-manipulation regulations only requires a willingness to view trading activities with a skeptical mind and the discipline to internally enforce regulations.

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