Back in 2007, the CFTC filed a complaint against Dutch high-frequency market maker Optiver for manipulating energy futures via a practice known as ‘banging the close’.
In 2008, Optiver was charged in connection with the case, although the case is still ongoing.
A key point in the charges involved Optiver’s use of the ‘Trade at Settlement’, aka TAS, facility to be able to trade large blocks at the settlement price.
As the CFTC’s complaint explained at the time:
TAS contracts are futures contracts, except that the parties determine at the initiation of the contract that the price will be the day’s settlement price plus or minus an agreed differential.
A TAS trade done at the price of 100 will clear exactly at the final settement price of the day.
Because TAS contracts are priced according to the settlement price for the underlying futures, if a trader with a T AS position can successfully trade futures in the opposite direction, such that the average price of its futures trades is equal to the final settlement price, the price of the futures trades would equal the price of the TAS trades – adjusting for any differentiaL.
A trader can profit by buying and selling T AS contracts, making money on the difference in price; this activity is known as “scalping.”
The settlement price, meanwhile, is determined by calculating the volume weighted average of prices — also known as VWAP — which trade from 2.28-2.30 p.m.
The allegation, hence, is that traders can conspire to impact the settlement price to their advantage.
More recently in June, the FSA charged Andrew Kerr, a former broker at Sucden Financial, with a similar scam. This time it involved Liffe Robusta coffee futures and put option trades in 2007, but the idea of influencing VWAP to push other positions into the money was largely the same. As the FSA described:
Whether Client A’s coffee put options would finish in the money (“ITM”) or out of the money (“OTM”) was determined by the coffee options reference price (“CORP”). The CORP is calculated by reference to the volume weighted average price (“VWAP”) of coffee futures trading between 12:29 and 12:30 on the third Wednesday of the preceding month. With respect to the coffee options that expired in September 2007, the CORP was to be determined on 15 August 2007.
Back to TAS though.
This year, the CFTF charged Morgan Stanley and UBS for a TAS-related abuse in the oil futures market in 2009 — in this case holding back on the reporting of a large block trade. The parties agreed to a settlement in April.
At around mid-day on February 6, 2009, Morgan Stanley and UBS, on behalf of its customer, entered into the TAS block by which Morgan Stanley purchased 33,110 March 2009 NYMEX Light Sweet Crude Oil futures contracts and sold 33,110 April 2009 NYMEX Light Sweet Crude Oil futures contracts. Per their agreement, the UBS broker then did not report the existence of the TAS block trade until 2:37 pm, after the market closed, according to the order.
Given TAS is in the spot light, it would be very interesting, we think, to see what proportion of trading goes through the mechanism on a daily basis.
Unfortunately, it’s hard to gauge the popularity and frequency of TAS orders because the data is very hard to get hold of.
One thing we can be sure of, however, is that if any so-called manipulation is going on, those disadvantaged are parties trading TAS without any ulterior motives. Those who take it for what it is.
Hence it’s interesting to note that amongst the biggest users of TAS contracts — currently offered in futures operated by the CME and ICE — are commodity exchange traded funds.
TAS futures, for example, make up the bulk of creation baskets executed as part of the creation/redemption process because of the uniformity of price that can be guaranteed. It’s certainly the case for United States Oil Fund and related products, according to a conversation FT Alphaville had with its chief investment officer, John Hyland.
The offsetting trades then — if you are index-arbitraging ETFs — would however be place in ETF share units, in this case.
We mention this not because we’re suggesting there’s some sinister manipulation across the asset classes and ETFs. Rather, given the propensity for TAS contracts to be influenced by large or “block trades” (as above) it is reasonable to suggest that large orders of any kind might have some type of unexpected market impact — especially when equity markets (via ETFs) become tied with commodity ones.
With this in mind we refer to the Wall Street Journal, which observed the other day to what degree increased market correlations are being impacted by ETF index arbitraging processes.
As the paper noted, for example:
The market’s flock-like behavior is one more reflection of the growing influence of investors using broad-based strategies to buy and sell large blocks of stocks. Instead of picking individual stocks to hold over a period of time, they trade in and out of the market using broad indexes.
Often, these investors use exchange-traded funds, which trade as easily as a single stock but contain many different stocks that may belong to the S&P 500, the Nasdaq 100 or another index.
Heavy trading in exchange-traded funds means more stocks are likely to move in the same direction on any given day. Analysts call that correlation, a mathematical term meaning similarity of behavior. Correlation is on the rise, to the frustration of investors who are trying to analyze stocks based on their underlying strengths and weaknesses.
Oil market Olivier Jakob at Petromatrix has been observing the trend for a while, especially cross-asset class. He’s also one of the proponents of the notion that large index funds may have been partially front-run in the commodity market due to their size and nature of trading – hence disrupting fundamentals.
What’s worrying, he says, is that if these processes continue it might eventually spell the end of the diversification role of commodity investments completely. As he noted to FT Alphaville on Thursday:
Passive investors have been buying commodity indices for diversification, but diversification has disapeared as they have transformed oil into a macro asset class.
HFT will win in an environement of low diversification as they will always win on the speed of the execution. The higher the correlation between markets the better the market for HFT and as HFT gains market share it then also increases the correlation, until the point when the market becomes irrelevant for price discovery of the underlying fundamentals.
Today we do not know may oil traders that are trading flat price of crude oil without looking at the S&P, the Dollar Index and the VIX. That was not the case five year ago.
In which case, it’s not so much that index funds are running up prices in commodity markets, but rather they’re helping to assimilate returns with other asset classes. Which obviously means fundamentals have become increasingly irrelevant for all — be it in equity markets or commodity markets.
The following chart (dated from June) from Jakob expresses the point nicely:
Products like TAS and now the new Trade at Index Close offered by ICE (yet to see any meaningful volumes though), potentially and subconsciously facilitate the assimilation, we would argue.
Related links:
Is something really scary coming in October? - FT Alphaville
A GLD contango strategy – FT Alphaville
The problem with commodity ETFs – FT Alphaville