Prof. Jayanth R. Varma's Financial Markets Blog

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Prof. Jayanth R. Varma's Financial Markets Blog, A Blog on Financial Markets and Their Regulation

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Tue, 31 Jul 2007

Manipulating Closing Prices: The randomization antidote

Manipulation of closing pricing appears to be happening in some of the most liquid markets in the world, and randomization might be the most effective antidote to the problem. I blogged about Amaranth’s manipulation of Nymex natural gas closing prices last week. Dealbook talks about an episode in Blackstone’ shares:

Units of Blackstone ... nosedived for much of the day, dipping as low as $23.27, down 8.8 percent from Wednesday’s close of $25.51, by mid-afternoon. But a mysterious frenzy of trades just before the market’s close helped erase the entire day’s losses and push the stock up to $25.70.

Starting in the last 10 minutes, a series of rapid-fire buy orders helped push up the stock’s price. Among them was a block trade of 114,000 units, which was one of the biggest trade of the day. The time? It was executed at 3:59:55 p.m.

Averaging the last few minutes of trading helps but not completely because the manipulator knows the averaging algorithm used by the exchange. The key insight in my view is to think of this as a game between the exchange and the manipulator in which the exchange moves first and the manipulator can decide his response accordingly.

Game theory would suggest that the exchange use a mixed strategy involving randomization of the time slots over which averaging is done. This neutralizes the advantage that the manipulator has in the current system of moving second. The random time slots could be chosen by sampling from say a beta distribution with shape parameters alpha>1 and beta=1 that produces an increasing probability density function. This would ensure that most time slots would be from the final minutes of trading, but occasionally, there would be a time slot from earlier in the day.

Using public key encryption technology, it is possible for the exchange to announce the actual time slots resulting from the random sampling in advance in a manner which is verifiable ex post but not readable ex ante. This ensures that the exchange cannot manipulate the sample either.

Posted at 14:24 on Tue, 31 Jul 2007     View/Post Comments (3)     permanent link

Thu, 26 Jul 2007

Amaranth Natural Gas Manipulation

The civil complaint filed by CFTC against Amaranth has a fascinating description of how Amaranth allegedly manipulated the settlement price of natural gas futures. The most interesting part is Exhibit C which contains the letter that Amaranth wrote to the exchange explaining its unusual trading in the final minutes of trading on expiry day. It tells a story of Amaranth trying to reduce its calendar spread position by first reducing the far month position and then reducing the near month position by the same amount. Amaranth argued that the near (expiring) month trades took place in the last few minutes because that was when the extent of reduction in the far month position became clear.

The CFTC complaint contains a whole set of instant messages (IM) exchanged by Amaranth’s traders about the manipulation that they were attempting. What is interesting about many of these instant messages is that they also show the IM Administrator sending messages to all participants stating “Note: This session is recorded and this recording is the sole property of Amaranth”. This does not appear to have deterred the traders from talking of their manipulation quite explicitly.

Posted at 16:26 on Thu, 26 Jul 2007     View/Post Comments (1)     permanent link

Thu, 19 Jul 2007

Regulation of Clearing Corporations

Last month, the Ministry of Finance in India put out a discussion paper on the regulatory framework for clearing corporations, but I got around to reading this only now.

The discussion paper says that the exchanges should have only trading members and the clearing corporation should have only clearing members. This seems to imply that the clearing members should all be professional trading members that clear for others but not for themselves. I do not see the logic for such a requirement. The large trading members would normally want to clear their own trades.

The regulatory framework is perhaps hobbled by the enabling legislation itself, but I think there is a clear need for clearing corporations to provide clearing services for a wide range of contracts including not only equities and bonds but also derivatives on equities, interest rates, currencies and commodities. The discussion paper seems to have a different take on this:

Since CCs need to have dedicated resources to meet the exigencies of settlement, it would not ordinarily undertake any other activity which can have contagion effect on the adequacy of its resources. However, it may be allowed to take up other activities not related to securities settlement with prior approval of SEBI.

Finally, the rationale for the clearing corporation to be 51% owned by exchanges is not clear. First of all, exchanges in the context of SCRA probably means only stock exchanges and thus the proposal rules out major participation by commodity exchanges. Secondly, this legislates the “silo” model of clearing and trading that is quite controversial today. It appears to rule out user owned clearing corporations. This provision could also impede competition among exchanges by not allowing an upstart exchange to gain ground by using the services of an established clearing corporation.

Posted at 06:53 on Thu, 19 Jul 2007     View/Post Comments (0)     permanent link

Wed, 04 Jul 2007

SEC and IFRS - Embrace, extend and extinguish?

The US SEC yesterday released the proposed rules allowing foreign issuers to file their financial statements using the International Financial Reporting Standards (IFRS) issued by the International Accounting Standards Board. This proposal is certainly welcome, but one consequence of this is likely to be the emergence of a US flavour of IFRS.

Many countries that have adopted IFRS as their national accounting standard have effected some carve-outs or made some modifications in the interpretation of these standards. When foreign issuers file under IFRS, the US SEC reviews the financial standards for conformity with the original IFRS and not with the jurisdictional variant followed in the issuer’s home country.

Moreover, IAS 8 “Accounting Policies, Changes in Accounting Estimates and Errors,” suggests that when the IASB’s standard or interpretations do not address a matter, issuers should look to the most recent pronouncements of other standard-setting bodies. The SEC’s proposal states (page 61-62):

An issuer using IFRS as published by the IASB, although not required to follow U.S. GAAP guidance, may find reference to FRRs, ASRs, SABs, and Industry Guides and other forms of U.S. GAAP guidance useful in the application of IAS 8.

In addition, the SEC states (page 61):

We believe that a company that would no longer be required to reconcile its IFRS financial statements to U.S. GAAP under the proposed amendments, and its auditor, would continue to be required to follow any Commission guidance that relates to auditing issues.

In addition, foreign private issuers are required to have audits conducted in accordance with the Standards of the PCAOB (U.S.)/U.S. Generally Accepted Audit Standards regardless of the comprehensive basis of accounting they use to prepare their financial statements.

The SEC also points out (page 79) that under current PCAOB standards when SEC filings are audited by foreign audit firms, these audit firms must have policies that provide for review of these filings by persons knowledgeable in accounting, auditing and independence standards generally accepted in the United States.

What all of this means is that the US which has not adopted IFRS at all might still be able to create a US variant of the IFRS. Over time, this variant (more rule based than principles based) may become highly influential and could even become the dominant flavour of IFRS. If this happens, the SEC’s stance could begin to resemble the “Embrace, extend and extinguish” strategy long associated with Microsoft.

Posted at 13:36 on Wed, 04 Jul 2007     View/Post Comments (0)     permanent link