May 4, 2015 11:28 am
Exchanges urged to do more to oust tricksters
Philip Stafford in London and Gregory Meyer in New York
The renowned freewheeling and aggressive environment of futures trading is now firmly under the microscope with the industry keen to show it can still police itself. The arrest of UK trader Navinder Singh Sarao for four years of alleged market manipulation of equity futures has shone a fierce spotlight on the dubious trading practices known as spoofing and layering, and done little to improve the reputation of markets.
The crackdown was reinforced last Thursday by the 60-day banning of two traders from the United Arab Emirates on the Chicago Mercantile Exchange for alleged gold futures manipulation. Now traders are being reminded of the need to not only have adequate financial resources, but also exhibit “good moral character, a good reputation and business integrity,” as the CME’s rules state.“Market developments [in recent years] both from the futures and equities market have opened the door for questionable market activities,” says Matt Simon, senior analyst at Tabb Group, a US capital markets consultancy. “For others that follow Mr Sarao, there’s likely to be a big legal fight over what constitutes spoofing.”
A broader question for both futures and equity exchanges is whether dubious trading is isolated or far more prevalent, requiring a stronger response from these self-regulated entities.
As the world’s largest futures exchange, the CME oversees trading across a range of contracts that provide hedge funds, banks, asset managers and others with an opportunity to buy and sell exposure to oil, agricultural products, interest rates and equity markets such as the S&P 500.
Like other bourses, it has had to adapt to the advent of sophisticated high-speed computerised trading systems allowing investors around the world to trade futures, cash equities, currencies and US government bonds.
The Department of Justice investigating Mr Sarao alleged he was able to manipulate the e-mini S&P 500 index futures contract from 6,000 miles away using tactics intended to draw out offers from other traders without showing one’s own hand.
Spoofing is bidding or offering with the intent to cancel the bid or offer before execution. Layering is a more elaborate version, supplying the market with lots of orders that create the illusion of a healthy market. Without establishing intent, traders say it can make it difficult to distinguish it from legal tactics.
Others point out the structure of contract encourages certain types of trading. “What’s key to this is that the e-mini market is a ‘FIFO’ market — ‘first in, first out’,” says one trading executive who declined to be identified. “It encourages you to put in orders when you’re away from the market so that when the market moves closer to your price, you’re closer to the front of the queue.”
Indeed, traders’ complaints about spoofing are legion. The customisation Mr Sarao asked for to his trading software “shouldn’t be difficult to do”, he wrote, “since there are people using these matrices in every market I have traded so it is fairly common”.
Some argue that distinguishing from legitimate trading is difficult, especially when activity is dominated by rapid-fire computers that spit out numerous prices instantly.
For some, the main difference between Mr Sarao and other traders was not his tactics or technology, but the size of his trades and the risk he took that he would not be able to buy or sell in the market.
Regulators argue spoofing is a traceable crime. An academic paper from 2011, co-authored by the Commodity Futures Trading Commission’s then chief economist, Andrei Kirilenko, argued it was a commonly observed form of manipulation used in high-frequency trading that existed in both equities and futures.
Earlier this year HTG Capital, a Chicago proprietary trading firm, sued an unnamed trader for spoofing the US Treasury futures market on CME, arguing his behaviour “eliminates the possibility that this pattern was anything other than orchestrated”. HTG has also brought a CME arbitration case involving spoofing against rival firm Allston Trading.
The big US futures exchanges, CME and Intercontinental Exchange imposed new rules banning disruptive trading. Both have brought punishments against recklessly disruptive conduct in the last three years.
Yet for all their efforts at enforcing discipline, questions are being asked about an exchange’s dual role of running a profitable enterprise while also being responsible for making sure trading does not transgress acceptable practices. As a CME member, Mr Sarao had to meet certain criteria but in return he received price discounts for trading in volume.
But others say competition keeps them honest. “For-profit exchanges can lose customers and volumes — along with investor trust — by tolerating spoofing,” says Neal Wolkoff, former chief executive of the American Stock Exchange and former chief operating officer of the New York Mercantile Exchange.
“In 2010 systems to detect spoofing, and even a definition of what it was, were in infancy. Looking back years to reveal practices and attitudes of exchanges today will give a skewed and inaccurate picture,” he says.
Hang Seng warrants: traders complain; In 3 letters to SGX and MAS, they allege Macquarie’s pricing is “unfair” and “erratic”, with warrants often not moving in line with underlying index
R Sivanithy , Hang Seng warrants: traders complain
4 May 2015
Business Times Singapore
In 3 letters to SGX and MAS, they allege Macquarie’s pricing is “unfair” and “erratic”, with warrants often not moving in line with underlying index
A GROUP of professional traders has complained three times over the past six months to the Singapore Exchange (SGX) and the Monetary Authority of Singapore (MAS) about the market-making activities of Macquarie Capital Securities (MCS) for the Hang Seng Index (HSI) warrants issued by Macquarie Bank (MB).
In complaints dated Nov 12, 2014, Dec 22, 2014 and March 8, 2015, the traders alleged that the warrants often did not move in accordance with the underlying index and the theoretical pricing model. They listed dozens of instances, illustrating situations where call warrants fell instead of rising when the HSI rose, and where put warrants also fell when the HSI dropped.
MCS is the designated market maker (DMM) for warrants issued by MB, which means that MCS is obliged to provide constant buy-and-sell prices throughout each trading session.
For example, according to the latest batch of HSI call warrants issued in April, the term sheet specified that the maximum bid-offer spread was 10 times the minimum permitted price movement in the warrants or S$0.20, whichever was greater.
The complaints alleged that MCS’s pricing was “erratic” and “unfair”. Between Dec 22, 2014 and March 8, 2015, the complainants claimed to have recorded 66 instances of “erratic price behaviour”, including alleged odd delays in MCS’s automated price quoting system which proved detrimental to the complainants’ trading positions.
When contacted, an SGX spokesman said it had received the complaints and was looking into them but could not comment on specific cases. BT understands MAS is awaiting SGX’s findings since it is the exchange which supervises DMMs.
Meanwhile, an MCS spokesman said it had been notified of the complaints but could not comment as it had not received details yet.
Warrants are derivative instruments that derive their value from an underlying asset. Call warrants give holders the right to buy the asset at a fixed price within a specified time frame and so rise when the underlying asset rises, while put warrants give holders the right to sell the asset at a fixed price within the stated time period and therefore gain value when the underlying asset falls.
Structured warrants differ from company-issued warrants in that they are offered by financial institutions (usually banks like MB) when there is demand for such instruments.
Upon expiry, warrants that are “in the money” are settled in cash by issuers – that is, calls whose exercise prices are below the actual price of the underlying asset or puts whose exercise prices are above the market price.
Warrant pricing typically uses an option pricing formula that incorporates five variables: time to expiry, the underlying asset’s price, the exercise price, the risk-free interest rate, and expected future volatility.
In order to ensure a profitable business, issuers actively hedge their positions, usually by buying or selling the appropriate quantity of over-the-counter options or the underlying asset itself.
In theory, because of their hedging, issuers are directionally neutral, and so are thought to be largely indifferent to the direction of the underlying asset. However, they are exposed to the volatility of the underlying asset. So in times of great volatility, issuers face higher hedging costs.
MB is the market leader in the local market for HSI structured warrants with an estimated 90 per cent market share.
A group of professional traders has complained three times over the past six months to the Singapore Exchange (SGX) and the Monetary Authority of Singapore (MAS) about the market-making activities of Macquarie Capital Securities (MCS) for the Hang Seng Index (HSI) warrants issued by Macquarie Bank (MB).