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Learning Our Lessons:

A Short History of Market Manipulation

And The Public Interest


Randall Dodd

Derivatives Study Center


Jason Hoody

Derivatives Study Center


April 9, 2002



Executive Summary:

·          It is in the public interest to protect the integrity of prices in derivatives markets by establishing an anti-fraud and anti-manipulation authority.  Derivatives prices are "affected with a national public interest.  The prices in such transactions are generally quoted and disseminated throughout the United States... for determining the prices to producer and consumer of commodities and the products and by-products thereof and to facilitate the movements thereof in interstate commerce.”

·          Fraud and manipulation are an ever present danger in these markets and should not be recklessly assumed away.

·          One common strategy to manipulate market prices is through the use of derivatives markets, especially non-transparent over-the-counter derivatives markets, because a large position can be amassed and unwound without being observed by the overall market.



Lest we forget….


Congress is beginning to develop the statutory changes needed to address the regulatory gaps and short-comings in federal financial regulations that have been brought to light by the collapse of Enron. 


The Feinstein Amendment is designed to establish anti-fraud and anti-manipulation authority over OTC derivatives contracts in energy and metal commodities.  Some may not appreciate why this is so important, while others many not remember how ever-present the danger of fraud and manipulation is to these markets.  This Special Policy Brief is intended to help inform the public policy debate by providing background information about the issues of fraud and manipulation, and providing a brief record of the cases that underlie the debate about fraud and manipulation.


What are the public interest concerns with fraud and manipulation?


1)  Protecting the integrity of market prices.


Before it was amended in the landmark deregulation bill entitled, “The Commodity Futures Modernization Act,” the Commodity Exchange Act contained a prescient statement of the economic justification for the government’s role in the economy.  In Section 3 of the Act entitled, “Necessity for Regulation,” it stated that futures are "affected with a national public interest."  "The prices in such transactions are generally quoted and disseminated throughout the United States... for determining the prices to producer and consumer of commodities and the products and by-products thereof and to facilitate the movements thereof in interstate commerce."


In short, these prices are important because they are used not only by those directly involved in the market but also by producers and consumers throughout the economy.  Fraud and manipulation are therefore a matter of pubic interest – not just a problem for those who are defrauded or suffer the losing end of the manipulation – because they threaten the integrity of the markets i.e. of the price discovery process. 


2)  Providing a safe and sound market for risk management.


Derivatives markets provide economically useful tools for hedging and risk management.  The extent of their use depends on their affordability, and leverage contributes to their affordability.  Leverage also encourages speculation and greater risk taking.  Capital and collateral (called margin for exchange traded derivatives and securities) requirements are the pillars of financial market safety and soundness.  They function by providing a buffer against losses and a disincentive for excessive risk taking.  Like securities markets and the banking sector, a well regulated derivatives market should have capital and collateral requirements that are commensurate with the level of exposure to market risk and credit losses.  While this will increase the cost, i.e. lower the affordability of OTC derivatives, the market should benefit overall from the improved investor confidence in the marketplace.


3)  Small distortions in market prices can have a large impact on the economy.


Keep in mind that manipulation does not have to be grand in the old fashion way, but can consist of small changes in prices.  If prices of winter wheat are off only 3 cents a bushel, and U.S. farmers produce and sell at home and for export 1,612 million bushels, then it will be a $48.36 million cut in income for the farmers on the winter wheat crop alone.  That same 3 cents applied to the 9.5 billion bushels of corn would affect income by $285 million – almost six times the impact.  That small price change would equal 1% of the nation’s net farm income for all crops.  Similarly, consider a manipulation of 3 basis points (0.03%) on Treasury securities.  If that has to be paid by the government on all outstanding Treasury securities held by the public, then it would cost the Treasury and hence U.S. taxpayers about $1 billion annually.


The ability of the government to detect and deter fraud and manipulation is dependent on the reporting requirements of market participants.  Market prices, trading volume, open interest and larger trader positions are the minimum information needed to maintain adequate market surveillance.  This is the standard for exchange traded derivatives and is similar for the stock and government bond market. 


How does market manipulation occur and what can be done about it? 


Information-based manipulation:

This involves insider trading or making false reports on the market.  An example of the former is the manner in which Enron executives made early moves to cash out their employee stock options and sell their security holdings.  An example of the latter is illustrated by the way Wall Street firms associated with Enron made “buy” recommendations to their customers and the wider market while enhancing their firms’ profits from holding Enron securities, underwriting and other business relationships.


Action-based manipulation:

       This involves the deliberate taking of some actions that changes the actual or perceived value of a commodity or asset.  For example, managers of a firm short the firm’s stock and then announce the loss of an important contract or the closing of factories.  After they profitably cover their short positions by buying at lower prices, they negotiate new contracts or reopen the factories.  Note that these two examples show that action based manipulation can be combined with insider trading.  Similarly, but without insider information, investors may take a position on the stock and then pursue legislation or regulatory changes that might be passed to change the value of the assets.


Trade-based manipulation:

       This is the classic case of either unexpectedly amassing a large position in the market, or more likely using one market to capture the gains from creating a price distortion in another interrelated market.  How does this work?  In the latter case, a manipulator acquires a large long position in the derivatives market in crude oil by entering forward or swap contracts for future delivery or future payments based on the future price of oil.  If the derivatives positions were transacted through the OTC market, then neither the government nor any other market competitor would be able to observe the total position of the manipulator.  Then the manipulator goes into the spot or cash market for crude oil and amasses a large enough inventory of oil (and also contracts to sell it to buyers who will not resell it) in order to push up the present oil price.  This raises the value of the long derivatives positions so that they can be offset or unwound profitably.  Then if the manipulator can sell off the amassed inventory without incurring substantial losses, the manipulation will be successful.  Keep in mind that the manipulator does not have to buy all the oil in the world, but merely that portion that is to be delivered in the market that is linked to the derivatives contracts.  (See the oil price manipulation case below.)




A Few Cases of Market Manipulation


·            Electricity Price Manipulation


       The Commodities Futures Trading Commission charged Avista Energy and several former Avista traders with manipulating electricity prices and won a $2.1million settlement against Avista Corporation and $160,000 against the traders.  The company was charged with manipulating electricity futures prices on the New York Mercantile Exchange (NYMEX) in order to profit from over-the-counter options contracts that were priced off the settlement price in that futures market.  The manipulation occurred between April and August of 1998 and involved Avista entering bids at the end of the trading day that were far below (and at other times far above) the prevailing market prices in order to influence the closing price.  In addition, Avista traders manipulated the prices through non-competitive trading. The company also failed to keep an adequate record of the positions established through its OTC derivatives contracts.



·            More Electricity Price Manipulation


       In May 1998, the Enron Corporation paid a fine of $25,000 to the California Power Exchange for violating rules designed to prevent the manipulation of electricity prices on California’s day-ahead electricity exchange.  Although the violation occurred in the cash market for electricity, efforts to manipulate the cash market price can generate enormous potential gains in derivatives positions. 



·            Oil Price Manipulation


       Tosco won a settlement claiming that Arcadia Petroleum (a British subsidiary of the Japanese firm Mitsui) engineered an elaborate scheme to manipulate oil prices in September of 2001 through the use of OTC derivatives and a large cash market position to corner the market in Brent crude oil.  (Brent is a blend of crude oils pumped out of the North Sea and shipped from a terminal at Sheffield Island off Scotland).  As a result, the price of Brent Crude soared between August 21st and September 5th and pushed its price to a premium over West Texas Intermediate crude oil (WTI).   WTI, which is a higher quality oil, is normally priced about $1 above Brent, but during this period Brent sold for more than $3 above WTI.  This artificial price hike occurred at a time of widespread strikes and social protest in Europe. 


       The following section in italics is taken from the Dow Jones Newswire:


Dated Brent, which acts as a price marker for many international grades, is physical crude traded on an informal market, rather than a regulated futures exchange. This lack of regulation poses problems for oil producers and consumers seeking a fair price, said Robert Mabro, director of the Oxford Institute for Energy Studies and a leading Brent expert.


"There are regular squeezes in the Brent market," Mabro said. "In the trading community, people are fed up. This general view that you can do whatever you like in an informal market is okay, as long as you regulate the market a bit. But if it's a free-for-all, you're back to the cowboy age."


A typical Brent squeeze involves a company quietly building a strong position in short-term swaps called contracts for difference, or CFD's, for a differential not reflected in current prices. The company then buys enough cargoes in the dated Brent market to drive the physical crude price higher, which boosts the CFD differential, Mabro said.


The company may lose money on the physical side, but it's more than compensated from profits on its offsetting paper position in the short-term swaps market, Mabro said.


"The whole trick is to collect more money in CFDs than you lose on the physical squeeze," Mabro said. "People seem to do it in turn. It depends on who's smart enough to move in a way that nobody notices until it happens."


·            Bond Price Manipulation


       The CFTC charged two futures traders with manipulating the futures and options market for U.S Treasury bonds in October of 1992.  The two sold 13,000 bond futures contracts (roughly $13 billion in notional value) and bought 31,000 put options (roughly $31 billion in notional value).  The traders were arrested on the trading floor, expelled from the Chicago Board of Trade, fined $2.25 million by the CFTC  and faced criminal charges. 


·            Soybean Price Manipulation


       In the summer of 1989, concerns about possible price manipulation in soybeans and soybean derivatives led to charges that the Italian agribusiness and financial firm Ferruzzi was engineering a classic short squeeze by acquiring a large portion of the cash market while holding about 50% of the open interest in the July 1989 futures market (estimated to be 30 million bushels of actual soybeans including a majority of the 13 million bushels of soybeans in Chicago Board of Trade approved warehouses).  Prior to being ordered by the CFTC to liquidate their position, the July futures contract traded at $ 7.26 a bushel, compared with $ 6.90 for August, $ 6.64 for September and $ 6.51 for November.  The liquidation turns into a route and Ferruzzi ends up losing $17 million and paying a fine of $2 million plus legal costs.



·            U.S. Treasury Securities Price Manipulation


       In June of 1993, the CFTC charged that the financial firm Fenchurch used exchange traded derivatives called futures in conjunction with a large share of the cash market to manipulate the interest rate on special collateral repurchase agreements on 10-year U.S Treasury notes and profit by forcing short position holders to deliver a more expensive Treasury security to fulfill the futures contract.  Towards the expiration date of the futures contract, Fenchurch held a long futures position of 12,700 contracts (approximately $12.7 billion in notional value) or 76% of the open interest in the market.  The repo rate on the 10-year note fell below 0%, i.e. reached negative interest rates, as an indication of the squeeze caused by the Fenchurch strategy.  The CFTC sought a fine of $600 million for the violation.




·            Copper Manipulation


       The CFTC charged the Japanese bank Sumitomo and chief trader Yasuo Hamanaka with manipulating copper prices through an elaborate series of trades using OTC derivatives, exchange traded futures and options on the London Metal Exchange and the cash market for copper in 1995 and 1996.  By the fall of 1995, Sumitomo controlled 100% of the copper in LME approved warehouses.  As a result, the prices of copper futures contracts, copper spread price differentials, and the prices of cash or physical copper – both in the United States and abroad – reached artificially high levels  This enabled Sumitomo to capture large profits by allowing it to liquidate, lend or roll forward its large position at a higher price or price differential.


       In addition to Sumitomo, the CFTC charged that Merrill Lynch knowingly and intentionally aided, abetted, and assisted the worldwide manipulation and attempted manipulation of copper prices by providing large sums of credit and finance (reported to have exceeded $0.5 billion).  Merrill Lynch benefited from the manipulation through, among other things, its own proprietary trading in the copper market, which was conducted based upon knowledge of the manipulative actions.  They ended settling for a fine of $15 million.


       Just this April, it was reported J.P. Morgan Chase recently paid $125 million to settle a suit filed by Sumitomo charging that the bank had entered into a series of OTC derivatives contracts that created an off-balance sheet loan to Hamanaka in order to help him finance his trading loses.


       According to the CFTC: The impact on prices and markets in the United States from Sumitomo's conduct was direct and flowed from the well-established and well-known pricing relationships that exist between the LME and the U.S. cash and futures markets. First, the trading on Comex [NYMEX] was directly affected. This was particularly true once the LME established its warehouse in Long Beach, California. During those periods of time when the LME price was manipulated into a premium over the Comex price, stocks in the United States were drawn away from Comex-designated warehouses (principally in Arizona) to LME warehouses (principally in Long Beach, California). Most importantly, the artificial prices and backwardation of prices on the LME also caused prices on the Comex to become similarly distorted and artificial as arbitrage trading between the LME and the Comex brought Comex prices higher than they otherwise would have been. Moreover, because copper contracts are generally priced by reference to the LME price or the Comex price, Sumitomo's conduct caused distorted and artificial pricing of copper, including throughout the United States cash market.




·            U.S. Treasury Securities Price Manipulation


       In 1991, Salomon Brothers, the most prestigious bond trading investment bank at the time, was found to have on at least four occasions violated anti-manipulation laws in the U.S. Treasury securities markets.  It also arranged $1.1 billion in questionable repurchase agreements with customers in an apparent attempt to “park” certain securities to keep them out of the market.  (Repurchase agreements are transactions that are structured like foreign exchange swaps in which the security or currency is sold today on condition that it be bought back for a certain price in the future.)

       The U.S. Treasury securities market was $2.2 trillion at the time, but each security auction is no larger than $14 billion or so.  Anti-manipulation rules prevented any one dealer from purchasing more than 35% of any one auction.  Instead, Salomon Brothers bought or bid for 57%, 46%, 44% and 85% at four of the auctions between December 1990 and May 1991.  Estimates are that other bond market traders lost between $50 to $200 million in just one of the auctions.

       The investigation extended to a hedge fund, Steinhardt Partners, that also purchased a large share of at least two of the auctions.  There were similar concerns about using repurchase agreements to place recently auctioned securities in foreign banks that would not likely put the securities back into the cash market.