Streetwise Professor

December 5, 2018

Judge Sullivan Channels SWP, and Vindicates Don Wilson and DRW

Filed under: Derivatives,Economics,Exchanges,Regulation — cpirrong @ 10:52 am

After two years of waiting after a trial, and five years since the filing of a complaint accusing them of manipulation, Don Wilson and his firm DRW have been smashingly vindicated by the decision of Judge Richard J. Sullivan (now on the 2nd Circuit Court of Appeals).

Since it’s been so long, and you have probably forgotten, the CFTC accused DRW and Wilson of manipulating IDEX swap futures by entering large numbers (well over 1000) of orders to buy the contract during the 15 minute window used to determine the daily settlement price.  These bids were an input into the settlement price determination, and the CFTC claimed that they were manipulative, and intended to “bang the close.”  The bids were above the contemporaneous prices in the OTC swap market.

The Defendants claimed that the bids were completely legitimate, and that they hoped that they would be executed because the contract was mispriced because of a fundamental difference between a cleared, marked-to-market, daily-margined futures contract and an uncleared swap.  The former has a “convexity bias” and the latter doesn’t.  DRW did some IDEX deals with MF Global and Jefferies at rates close to the OTC swap rate, which it thought were an arbitrage opportunity, and they wanted to do more.  And, of course, they  received margin inflows to the extent that the contract settlement price reflected the convexity effect: thus, to the extent that the bids moved the settlement price in that direction, they expedited the realization of the arbitrage profit.

Here was my take in September, 2013:

Basically, there’s an advantage to being short the futures compared to being short the swap.  If interest rates go up, the short futures position profits, and the short can invest the resulting variation margin inflow at the higher interest rate.  If interest rates go down, the short futures position loses, but the short can borrow to cover the margin call at a low interest rate.  The  swap short can’t play this game because the OTC swap is not marked-to-market.  This advantage of being short the future should lead to a difference between the futures yield and the swap yield.

DRW recognized this difference between the swap and the futures.  Hence, it did not enter quotes into the futures market that were equal to swap yields.  It entered quotes at a differential to the swap rate, to reflect the convexity adjustment.  IDC used these bids to determine the settlement price, and hence daily variation margin payments.  Thus, the settlement prices reflected the convexity adjustment.  Not 100 percent, because DRW was trying to make money arbing the market.  But the settlement prices were closer to fair value as a result of DRW’s quotes than they would have been otherwise.

CFTC apparently believes that the swap futures and the swaps are equivalent, and hence DRW should have been entering quotes equal to swap yields.  By entering quotes that differed from swap rates, DRW was distorting the settlement price, in the CFTC’s mind anyways.

Put prosaically, in a way that Gary Gensler (the lover of apple analogies) can understand, CFTC is alleging that apples and oranges are the same, and that if you bid or offer apples at a price different than the market price for oranges, you are manipulating.


The reality, of course, is that apples and oranges are different, and that it would be stupid, and perhaps manipulative, to quote apples at the market price for oranges.

Here’s Judge Sullivan’s analysis:

[t]here can be no dispute that a cleared interest rate swap contract is economically distinguishable from, and therefore not equivalent to, an uncleared interest rate swap, even when the two contracts otherwise have the same price point, duration, and notional amount.  Put another way, because there is some additional value to the long party . . . in a cleared swap that does not exist in an uncleared swap, the economic value of the two contracts are distinct.

Pretty much the same, but without the snark.

But Judge Sullivan’s ruling was not snark-free!  To the contrary:

It is not illegal to be smarter than your counterparties in a swap transaction, nor is it improper to understand a financial product better than the people who invented that product.

I also wrote:

In other words, DRW contributed to convergence of the settlement price to fair value relative to swaps.  Manipulative acts cause a divergence between the settlement price and fair value.

. . . .

In a sane world-or at least, in a world with a sane CFTC (an alternative universe, I know)-what DRW did would be called “arbitrage” and “contributing to price discovery and price efficiency.”

Judge Sullivan agreed: “Put simply, Defendants’ explanation of their bidding practices as contributing to price discovery in an illiquid market makes sense.”

Judge Sullivan also excoriated the CFTC and lambasted its case.  He blasted it for trying to read the artificial price element out of manipulation law (“artificial price” being one of four elements established in several cases, including inter alia Cargill v. Hardin, and more recently in the 2nd Circuit, in Amaranth–a case that was an expert in).  Relatedly, he slammed it for conflating intent and artificiality.  All of these criticisms were justified.

It is something of a mystery as to why the CFTC chose this case to make its stand on manipulation.  As I noted even before it was formally filed (my post was in response to DRW’s motion to enjoin the CFTC from filing a complaint) the case was fundamentally flawed–and that’s putting it kindly.  It was doomed to fail, but the CFTC pursued it with Ahab-like zeal, and pretty much suffered the same ignominious fate.

What will be the follow-on effects of this?  Well, for one thing, I wonder whether this will get the CFTC to re-think its taking manipulation cases to Federal court, rather than adjudicating them internally in front of agency ALJs.  For another, I wonder if this will make the CFTC more gun-shy at bringing major manipulation actions–even solid ones.  Losing a bad case should not be a deterrent in bringing good ones, but the spanking that Judge Sullivan delivered is likely to lead CFTC Enforcement–and the Commission–quite chary of running the risk of another one any time soon.  And since enforcement officials are strongly incentivized to, well, enforce, they will direct their energies elsewhere.  I would therefore not be surprised to see yet a further uptick in spoofing actions, an area where the Commission has been more successful.

In sum, the wheels of justice indeed ground slowly in this case, but in the end justice was done.  Don Wilson and DRW did nothing wrong, and the person who matters–Judge Sullivan–saw that and his decision demonstrates it clearly.

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  1. The scary part is what if it wasn’t Judge Sullivan, but some other judge who didn’t grasp (or try to) the nuances of the convexity effect. This is not totally hypothetical given the erosion of standard in some of the lower courts.

    Comment by Surya — December 5, 2018 @ 3:06 pm

  2. Which office do I go to to get my reputation back?

    Comment by Ray Donovan — December 6, 2018 @ 10:27 am

  3. I’m completely ignorant of this corner of the world. How does a judge become an expert adjudicator on these matters without a background in it? This case seems to require a lot of knowledge in the subject, so I wonder how that works. I understand that many jobs (like my own) may not require a person to be the technical expert, but we can certainly assess truth vs. fiction reasonably effectively. Is this the situation here?

    Comment by Howard Roark — December 6, 2018 @ 11:53 am

  4. @ Howard
    The judge absorbed DRW’s account of its actions, essentially. They put a very lucid case together.

    @ Prof
    I love love love the judges’ remarks about the CFTC and also about its expert witness.

    – “a slogan is a poor substitute for evidence, particularly when the slogan doesn’t fit the facts”
    – [the opinion that he] “clung to as an article of near religious conviction, has no basis in law or logic and was contradicted by the contract’s very terms”
    – “That he could not say whether the settlement prices were
    artificially high or artificially low only underscored the irrelevance of his opinions on the subject”
    – “In contrast to MacLaverty’s sermonizing, Defendants – although not obliged to do so – offered ample and persuasive evidence demonstrating that the Three-Month Contract was not the economic equivalent of an uncleared swap”
    – “the CFTC’s Enforcement Division…has persisted in its cry of market manipulation, based on little more than an “earth is flat” – style conviction”

    You’re right, it was very written!

    Comment by Green as Grass — December 7, 2018 @ 3:53 am

  5. @Howard–This is a major issue in much litigation. The role of expert witnesses is to try to explain the highly specialized analysis to judges (and juries) who are laypeople. But of course, this requires that the judge/jury is able to understand the expert testimony.

    As in all things, there are variations in ability, knowledge, and background, and this injects an element of error/randomness into findings of fact and law. There can also be the issue of precedent, in which earlier findings, which may be quite old and based on now-obsolete understandings of science or economics, may constrain judges and juries.

    In this case, DRW’s experts (whom I know) did a good job, and as @Green points out, the CFTC’s expert (whom I don’t) was humiliated. In a way I feel for him, because he was forced into contortions to defend the indefensible–but this is a risk he assumed, so my sympathies are very limited. I think that the problems with the CFTC’s case were so obvious here that most judges would have arrived at the same conclusion.

    I have seen the challenges in a variety of cases, including manipulation cases, bankruptcy cases, and patent cases. It is a burden on generalist judges to handle such cases.

    Judge Posner (who was on the 7th Circuit Court of Appeals from 1981-2017, and who is a renowned economist, being a pioneer in the field of law and economics) has advocated that judges use “special masters”–individuals with field expertise, and who are hired by the courts and not the parties–to provide (hopefully) unbiased advice and analysis. This has been done in some instances, but it is not a widespread practice, perhaps for budgetary reasons. And even Posner–from the bench–has criticized the use of special masters in some instances.

    For years George Mason University’s law school has been running judicial education programs in economics and statistics, including specialized programs in say finance, statistics, and health care economics. But the training is not universal, and the technical cases that judges must try are not limited to economic issues. Patent cases, to cite a particular example, are highly complex and span a variety of different scientific fields. There’s no way any judge, let alone all of them, could master all of these fields.

    In Europe (and perhaps elsewhere) this is a reason for assigning this kind of litigation to specialized bodies. But that creates its own issues.

    My personal experience is that judges try very, very hard to get it right. But given the mismatch between personal expertise and the matters on which they must rule, it’s inevitable that mistakes occur. The appeals process can mitigate the mistakes–or add to them.

    We live in a fallen world. Perfection is not an option, but the system has recognized the problems, and has evolved to mitigate them.

    Comment by cpirrong — December 7, 2018 @ 5:34 pm

  6. Thanks for the very good answers. I suppose that is what I expected. Out of curiosity, I had looked up this judge’s profile and didn’t see anything in his background that showed he had ever worked in this field. I became impressed with (or suspicious of) his ability to give a good ruling. I’m glad you think that the effort is there and perhaps produces a livable solution. I just wish judges could be as effective with executive orders on immigration as they apparently do elsewhere.

    Comment by Howard Roark — December 7, 2018 @ 5:56 pm

  7. @Howard–you’re welcome.

    These kind of cases are not as politicized as immigration, and are less vulnerable to forum shopping (i.e., looking for a judge who you are sure agrees with your ideological position). On a national issue like immigration, a plaintiff can pretty much choose any judge in the country. In cases like DRW, the case has to be filed where the alleged violation occurred. For cases involving futures, that usually involves the Southern District of New York or the Northern District of Illinois, where the major exchanges are located.

    Comment by cpirrong — December 7, 2018 @ 6:47 pm

  8. @Howard–I should clarify. A plaintiff can’t choose a judge exactly, but it can sometimes choose to file in a district in which it is highly likely that the judge assigned to the case is sympathetic.

    The other issue with immigration cases, and some others like it, is the ability of district court judges to issue national/universal injunctions. So for example a judge in Hawaii can issue an injunction that applies in the entire US. This was an issue in the travel ban case. Justice Thomas attacked the practice, but the Supreme Court did not rule on it. But restricting national injunctions is in play. I wouldn’t be surprised to see it before the court again soon.

    The combination of forum shopping and national injunctions is the real problem. If you can find a sympathetic judge in Hawaii, but his injunctive power applies only in his district–knock yourself out! But if you can find a judge that is highly to likely to rule in your favor, and that decision is leveraged to the entire country–horrible.

    Comment by cpirrong — December 8, 2018 @ 12:44 pm

  9. Gary Gensler is the worst CFTC chair in history

    Comment by Jeff — December 8, 2018 @ 6:59 pm

  10. @Jeff–Without a doubt. His arrogance led him to push completely misguided policies and regulations.

    Comment by cpirrong — December 8, 2018 @ 10:54 pm

  11. I’ve done the witness thing several times, and the advice usually given by counsel is that your testimony should be intelligible to a 14-year-old.

    This is not to denigrate the intelligence of jurors. It reflects the fact that your 14-year-old self already had much the same reasoning and numerical skills that you do. But in many areas, you don’t understand stuff any better now than you did when you were 14. Think of your car. Think of your central heating boiler. Think of the Leavisite view of the novel. Think about why anyone gives a flying fuck about any Kardashian. If you were an expert, and you had to explain any of those to a total noob, would you explain them any differently to an adult noob than to a 14-year-old noob? Not really.

    It looks to me like DRW and their advisers took all that on board, and duly came up with a briefing that made all this clear.

    Something dinned into me in most early employments was this. If you do something complicated, and when you explain it to an intelligent lay person they cannot fathom what you’re on about – this does not mean they are dumb. It means you are (and it may even mean you don’t actually understand what you do). An attribute of very smart people is the ability to break something complex up in a way that it appears simple. The cleverness is in making it seem easy.

    I’ve no doubt the CFTC’s expert had very good reasons for holding the views he did, but what he clearly didn’t succeed in doing was conveying those to the court.

    Comment by Green as Grass — December 10, 2018 @ 5:27 am

  12. Thanks for explaining this clearly.

    Comment by Global Super-Regulator on Lunch Break — December 10, 2018 @ 7:20 am

  13. @Green. As Richard Feynman said: “If you can’t explain something in simple terms, you don’t understand it.”

    Comment by cpirrong — December 10, 2018 @ 8:31 pm

  14. @GlbalSRLB–You’re welcome!

    Comment by cpirrong — December 10, 2018 @ 8:31 pm

  15. wot no posts?

    Comment by Green as Grass — December 17, 2018 @ 3:25 am

  16. @Prof

    I’m late to this post, but found my way here due to the recent news that the CFTC would not appeal this ruling. As you are likely aware, a current focus of FINRA is on traders that engage in potentially manipulative trading activities (layering, spoofing, etc.). Do you believe that this decision could be used as precedent against defending trading activities to regulators in equities markets?

    Thank you!

    Comment by MICHAEL W HANLEY — March 25, 2019 @ 10:30 am

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