Streetwise Professor

May 1, 2018

Begging the Question on VIX Manipulation

Filed under: Derivatives,Economics,Exchanges,Regulation — The Professor @ 9:29 am

Stung by yet another allegation of manipulation of the VIX, Cboe Chairman and CEO Ed Tilly and President and COO Chris Concannon fired off an open letter defending the exchange and VIX.  To say it begs the key questions is an understatement.

Here’s their explanation of the April 18 event:

During the opening auction on April 18th, a single market participant submitted orders to buy approximately 212,000 SPX options across a wide range of strike prices. Five additional market participants submitted buy orders totaling 20,000 options. The size and structure of these buy orders appeared consistent with the weights prescribed by the VIX Index formula. Offsetting this buy interest were sell orders submitted by nine participants for a total of 118,000 contracts. This left a buy order imbalance of 114,000 SPX options. This buy order imbalance contributed to the opening prices of the option series that were used to calculate the final VIX settlement value. Based on the orders that were submitted, we believe the auction process functioned as intended, notwithstanding that the final settlement value was higher than what market participants may have otherwise expected.

Although oddly disconnected from the discussion of the 18 April spike in the VIX, this statement ostensibly directed at the Griffin and Shams paper claiming to find frequent manipulations of the VIX strongly suggests that they are denying there was a manipulation on 18 April as well:

Finally, we would like to again address the claims of possible manipulation of the settlement process. We reiterate that we believe these claims are without merit, and that the academic paper’s analysis and conclusions are based upon a fundamental misunderstanding about how VIX derivatives are traded and settled. The trading behavior the author considered suspicious is
consistent with normal and legitimate trading behavior.

The explanation of what happened a couple of weeks ago begs the question because in no way does it disprove that a manipulation took place.  Indeed, what they describe is exactly how a large trader could and would “bang the auction” to influence the settlement price of VIX derivatives, in order to profit on positions in those derivatives.  What Tilly and Concannon describe involves a single large trader submitting a huge order on one side of a market with liquidity constraints.  That is almost certain to affect the auction price. That’s how that kind of manipulation works.

Note that the order–again, entered by a single participant–represented about 90 percent of the buy side interest, and more than 80 percent of the order imbalance.  Further, Tilly and Concannon’s touting of the Cboe’s efforts to improve liquidity at the auctions (perhaps inadvertently) concedes that the liquidity at the auctions is presently inadequate, which would mean that a huge order imbalance would almost certainly move prices–as occurred on the 18th–and be anticipated to move prices.  “There’s no problem (’the auction process functioned as intended’), but we’re fixing it!” hardly inspires confidence.

Any participant with the heft to enter such a large order would surely be sophisticated enough to know that it would be highly likely to move prices.  Note that non-manipulative traders would typically want to mitigate price impact, not trade in a way that exacerbates it.  So why do this?

Thus, there is evidence to support all of the elements of a manipulation case, but one.  There is evidence for artificial price, causation, and ability to cause.  The missing element is intent.  I’d be open to suggestions as to why this one market participant would enter such a large order but for an intent to distort prices.  Any such explanation would have to show how this was the most economical way of achieving some non-manipulative objective, such as hedging.

Addressing the issue of intent would require knowledge of the large trader’s positions in VIX-related instruments.  Tilly and Concannon are silent on that issue, which makes their confident disavowal of manipulation incomplete and hence unpersuasive.  Discussing the auction alone, disconnected from the VIX derivatives markets tied to the auction, is inadequate to dispel suspicions of manipulation.

Perhaps the exchange execs are right, and this “whale” (as the FT referred to the trader) was not manipulating.  But the information in the public record, including the information in their letter, is not sufficient to demonstrate this claim. The question-begging defense will therefore likely feed suspicions about VIX, rather than lay them to rest, as the letter’s authors intended.

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