Market Quality and Trader Behavior in a Manipulated Market

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					 Market Quality and Trader Behavior in a
Manipulated Market: Anatomy of a Squeeze



         John J. Merrick, Jr. (Baruch College)
      Narayan Y. Naik (London Business School)
     Pradeep K. Yadav (University of Strathclyde)

                     June 2003
A futures delivery squeeze example of
        market manipulation
•   We study the six-month period of an attempted delivery
    squeeze in the March 1998 long-term UK government
    bond futures contract (LIFFE Long Gilt futures).

•   We employ a highly unusual data set of bond and futures
    market trades by all major players provided to us by the
    UK Financial Services Authority (FSA).
    Previous empirical research on bond
           market manipulation
•   Treasury Bond squeeze of 1986 (Cornell and Shapiro,
    1989).

•   Salomon US Treasury 2-Year Note squeeze (Jegadeesh,
    1993; Jordan and Jordan, 1996).

•   These studies focus only on price distortions. Our paper
    is the first to investigate both the price distortions and
    the trading positions of major market participants.
                 Plan for today

• A brief look at normal pricing of futures at delivery.
• Delivery date futures pricing during a squeeze.
• “Squeeze Potential”
• Examine the cash market pricing distortions.
• Trace the positions taken by the major players
  (dealers & customers) during the squeeze.
         Some interesting insights

•   We identify a key market microstructure
    element that supports the squeezer.

•   Provide two types of evidence for our
    explanation:

      * A shift in cash-futures arbitrage pricing.
      * A “natural experiment” conducted by BOE.
                         Lessons
•   Squeezes are accompanied by severe price distortions and
    some erosion of market depth.

•   Delivery nonperformance penalties in bond futures
    markets create conditions that favor squeezers.

•   Exchanges may need to "mark to market" the conversion
    factors of their contracts more frequently.

•   Regulatory reporting should flag forward term repo
    positions to paint the full picture of cash market
    positioning by individual firms.
   March 1998 Gilt Futures Delivery Date “No-
  Squeeze” Futures Pricing for 2 key issues @ 6%
Coupon       Maturity     CF                  Mod. Dur.            Yield        Delivery Date
9.00%        10/13/2008 0.9999442               7.02               6.00%        03/09/1998

             Issue Price Forward Price               Forward Price/CF           Net Basis
             123.28         123.27                   123.27                     0.00      Cheapest

---------------------------------------------------------------------------------------------------------------

Coupon       Maturity     CF                  Mod. Dur.            Yield        Delivery Date
8.00%        09/25/2009 0.9291579               7.59               6.00%        03/31/1998

             Issue Price      Forward Price          Forward Price/CF           Net Basis
             116.50             116.40               125.28                     1.86      2nd cheapest
   March 1998 Gilt Futures Delivery Date “Full-Squeeze”
   Futures Pricing: 9% 2008 Price Impact = +2% of par.

Coupon       Maturity     CF                  Mod. Dur.            Yield        Delivery Date
9.00%        10/13/2008 0.9999442               7.02               5.777%       03/09/1998

             Issue Price      Forward Price          Forward Price/CF           Net Basis
             125.28             125.27               125.28                     0.00      Co-Cheapest

---------------------------------------------------------------------------------------------------------------

Coupon       Maturity     CF                  Mod. Dur.            Yield        Delivery Date
8.00%        09/25/2009 0.9291579               7.59               6.00%        03/31/1998

             Issue Price      Forward Price          Forward Price/CF           Net Basis
             116.50             116.40               125.28                     0.00      Co-Cheapest
Market Yield Levels vs. the Contract’s 9% Notional Yield
Contract’s Squeeze Value (Fs - Fns) increased as yields fell
    Squeeze causes significant price distortions

   Value the 9% 2008 Gilt vs. the discount factors
    derived from the BOE’s Gilt term structure model
    (e.g., use a typical discounted cash flow bond
    valuation approach).

   But “fair” pricing in this typical no-arbitrage sense
    means a “free squeeze option.”

   Traders begin to bid this cdi1 higher in October 1997.
    It begins to look “rich” in the market.
“Richness” of the 9% 2008 vs. Gilt term structure
Implied Squeeze Probability:
   p = (F0 – Fns)/(Fs – Fns)
    The participants and strategies
   Squeezers – customers or dealers?

   Use of forward term repo trades through the
    delivery date

   Contrarians
Par Value Positions (cdi1 & futures) of the First 3 Squeezers

                                    3a. Inventories of First Three Squeezing Customers

                                    1250                                                                        1.25
 Par value of position (in £ mns)




                                    1000                                                                        1.00




                                                                                                                       Price Distortion (%)
                                     750                                                                        0.75


                                     500                                                                        0.50


                                     250                                                                        0.25


                                       0                                                                        0.00
                                           01- 16-   01-   16-   31- 15- 30- 15- 30- 14-          29- 13- 28-
                                           Sep Sep   Oct   Oct   Oct Nov Nov Dec Dec Jan          Jan Feb Feb                         SC1

                                                           Time Period (Sep 1, 97 to Mar 4, 98)                                       SC2
                                                                                                                                      SC3
                                                                                                                                      Price Distortion
                                          Positions of 2 late entrant Squeezing Customers
                                                    3c. Inventories of Squeezing Customers
                                                                 (Late Entrants)

                                   1000                                                                               1.25
Par value of position (in £ mns)




                                                                                                                      1.00
                                    750




                                                                                                                              Price Distortion (%)
                                                                                                                      0.75
                                    500
                                                                                                                      0.50
                                    250
                                                                                                                      0.25
                                      0
                                                                                                                      0.00
                                        01-   16-    01-   16-   31-   15- 30- 15- 30-     14-   29-    13-     28-
                                   -250 Sep   Sep    Oct   Oct   Oct   Nov Nov Dec Dec     Jan   Jan    Feb     Feb
                                                                                                                      -0.25

                                   -500                                                          SC5                  -0.50
                                                                                                 SC6
                                                    Time Period (Sep 1, 97 to Mar 4, 98)         Price Distortion
                                    A Dealer (#1) learns from trades with “smart” customers

                                                  4a. Inventory of Squeezing Dealer 1

                                   1800                                                                         1.20
Par value of position (in £ mns)




                                   1500                                                                         1.00

                                   1200                                                                         0.80




                                                                                                                        Price Distortion (%)
                                    900                                                                         0.60

                                    600                                                                         0.40

                                    300                                                                         0.20

                                      0                                                                         0.00
                                        01- 16-   01-   16-   31-   15-   30- 15- 30-     14-   29-   13-   28-
                                   -300 Sep Sep   Oct   Oct   Oct   Nov   Nov Dec Dec     Jan   Jan   Feb   Feb -0.20

                                                                                                              SD1
                                                   Time Period (Sep 1, 97 to Mar 4, 98)
                                                                                                              Price Distortion
                                           Cash Gilt & Futures positions of Squeezing Dealer (#2)

                                                                4 b . In v e n to ry o f S q u e e zin g D e a le r 2
                                           1730                                                                                                                 1 .2 0



                                           1480                                                                                                                 1 .0 0
In v e n to r y le v e ls ( in £ m n s )




                                           1230
                                                                                                                                                                0 .8 0




                                                                                                                                                                         Pr ic e D is to r tio n ( % )
                                            980

                                                                                                                                                                0 .6 0

                                            730

                                                                                                                                                                0 .4 0
                                            480


                                                                                                                                                                0 .2 0
                                            230



                                            -20                                                                                                                 0 .0 0
                                                  01-   16-   01-   16-    31-       15-        30-        15-        30-    14-    29-    13-        28-
                                                  Sep   Sep   Oct   Oct    Oct       Nov       Nov        Dec        Dec     Ja n   Ja n   Fe b       Fe b


                                                                           T im e Pe r io d ( 1 S e p 9 7 to 4 M a r 9 8 )                    S D2

                                                                                                                                              P ri c e D i sto rti o n
                                   2 Squeezing Dealers exit early (take some profits in Dec.)

                                                    4c. Inventories of Squeezing Dealers
                                                               (Profit Takers)
                                   1500                                                                                  1.25


                                   1200                                                                                  1.00
Par value of position (in £ mns)




                                                                                                                                Price Distortion (%)
                                    900                                                                                  0.75


                                    600                                                                                  0.50


                                    300                                                                                  0.25


                                      0                                                                                  0.00
                                        01-   16-    01-   16-   31-   15-   30-   15-   30-   14-   29-    13-   28-
                                   -300 Sep   Sep    Oct   Oct   Oct   Nov   Nov   Dec   Dec   Jan   Jan    Feb   Feb -0.25
                                                                                                      SD3
                                                Time Period (Sep 1, 97 to Mar 4, 98)                  SD4
                                                                                                      Price Distortion
     Dealers Learn from Observing Trade Flows

•   Cash Bond trades
         One dealer “learns” from intermediating the position
    accumulations of the 9% 2008 cash bond by the first two squeezing
    customers. This dealer then begins to accumulate a long position in the
    9% 2008 too.

•   Forward Term Repo trades
          One dealer is the “uninformed” counterparty to forward term
    repo trades by squeezing customers (who buy for settlement date
    February 20, 1998 and sell back for March 20, 1998). Soon afterwards,
    this dealer goes the same way in both the repo market and then goes
    long in both the cash and futures markets!
“Contrarians” appear in size after cdi1’s price shifts +0.60%
   and bet heavily that the Squeeze will ultimately fail.

                                            8b. Inventories of Contrarian Customers & Dealers

                                       0                                                                        1.20
                                          01- 16-    01-   16-   31-   15- 30- 15- 30- 14-   29- 13- 28-
 Par value of position (in £ mns)




                                    -1000 Sep Sep    Oct   Oct   Oct   Nov Nov Dec Dec Jan   Jan Feb Feb 1.00




                                                                                                                       Price Distortion (%)
                                    -2000                                                                       0.80


                                    -3000                                                                       0.60


                                    -4000                                                                       0.40


                                    -5000                                                                       0.20


                                    -6000                                                                       0.00
                                                                                             CC-ToT
                                                    Time Period (Sep 1, 97 to Mar 4, 98)     CD-ToT
                                                                                             Price Distortion
      The Squeeze and Market Depth

•   We run regressions relating daily cdi1 price
    changes to dealer inventory changes.

•   Kyle’s Lambda is significantly positive during
    squeeze phases III, IV and V on days when there
    were net customer buys.

•   Public traders attempting to buy cdi1 during these
    times faced perceptibly higher market impact
    costs.
Asymmetries in Settlement Nonperformance Penalties

 •   Cash Bond and Bond Repo Markets permit trades to
     “fail” – the implicit cost is overnight interest charge.

 •   Futures Exchanges impose substantial fines on contract
     shorts that fail to make a timely delivery.

 •   Squeeze’s endgame: In a delivery squeeze showdown
     between a credible squeezer and contract shorts, the
     contract shorts blink first.
Shift in Marginal Financing Rate for Cash-Futures
          Arbitrage Pricing Relationship
The BOE’s Feb 16, 1998 “natural experiment”

•   “Bank of England is prepared to make supplies of the stock available
    from 23 February, on overnight repo only, to any gilt-edged market
    maker (GEMM) who has been subject to a failed return or delivery of
    stock, or has a customer who has been subject to a failed return or
    delivery of stock.”

•   This subtle action by the BOE removed the fear of failing
    against the futures contract. The pricing distortions
    collapsed immediately.

   The reaction was consistent with the nonperformance
    asymmetries explanation as the key market microstructure
    support for the squeeze attempt.
                       For review
•   Squeezes are accompanied by severe price distortions and
    some erosion of market depth.

•   Delivery nonperformance penalties in bond futures
    markets create conditions that favor squeezers.

•   Exchanges may need to "mark to market" the conversion
    factors of their contracts more frequently.

•   Regulatory reporting should flag forward term repo
    positions to paint the full picture of cash market
    positioning by individual firms.