After years of steady growth, the resurgence of stock market volatility has propelled the CBOE Volatility Index, also known as the VIX or, more colorfully, as the "fear gauge," into the spotlight. The press has been
awash with stories of traders with flamboyant monikers like the "VIX elephant" and
Cent" reaping profits of tens, if not hundreds, of millions of dollars from shrewd
trades with minimal outlay.
One hedge fund reportedly made an 8,600% return on
a $200,000 investment.
Even Uber drivers and Target store logistics managers are
getting in on the act and recommending investments in VIX-linked products.
But not everyone is happy. Retail VIX investors recently endured "Black Monday"
and two banks pulled their VIX-linked exchange traded note programs due to
VIX luminaries such as, Robert E Whaley5, Dan Galai
are dismayed by many of the products linked to the index. One VIX
founder, Devesh Shah, lamented that even in his "wildest imagination" he cannot
justify "why these products exist. "
Even worse, suspicions abound that the VIX has
been manipulated by unscrupulous traders to the tune of hundreds of millions of
dollars per month, and we can be sure that regulators are paying close attention.
Indeed, this past week a whistleblower approached both the SEC and the CFTC
with claims of "rampant manipulation of the VIX index" and reports of a nascent
FINRA investigation have surfaced.
Market integrity issues have been a regulatory
priority in recent years, and the reported losses suffered by retail investors here
(whether caused by manipulation or genuine market forces) are potentially more
tangible than those in other recent benchmark cases. It does not take great
powers of foresight to predict that an uncompromising set of regulatory
investigations is on the way, closely followed by legions of plaintiffs' lawyers (but
that is a topic for another day).
There are many basic questions about the looming VIX
investigations that are surprisingly hard to answer. Is this
an SEC or a CFTC case? What elements need to be
proved to establish manipulation or attempted
manipulation? Do the anti-manipulation provisions of
the securities and commodity laws lead to the same
answer in cases like this, or will the race to the
courthouse determine the ultimate outcome?
WHAT IS THE VIX?
The VIX is an index that measures the expected volatility
of the stock market. More precisely, it is "a key measure
of market expectations of near-term volatility conveyed
by S&P 500 stock option prices. "
The index is
calculated from the market volatility implied by SPX
options with a 30 day maturity date. The VIX is
sometimes called the "fear index" because volatility is a
product of investor uncertainty. When markets fall, the
VIX typically rises, and vice versa. Over a twelve year
period, the VIX moved in the opposite direction to the
S&P 500 about 80% of the time.
Volatility trading is a recent darling of the financial
markets, but it has made up for its late start. The VIX
debuted in 1993, and the first VIX-related instruments,
VIX futures, were launched in 2004. VIX options followed
in 2006 (VIX futures and options are often collectively
called "VIX derivatives ").
Since then, VIX exchange
traded products (ETPs) such as exchange-traded funds
(ETFs), exchange-traded notes (ETNs), and commodity
pools have proliferated. These instruments generate
additional complexity because they are typically keyed
off VIX derivatives - not the index - and are often highly
leveraged. ETPs are problematic for retail investors and
other unsophisticated market participants because they
are unsuited to "buy and hold" strategies and "are
virtually guaranteed to lose money though time[.]"
Some also claim that VIX trading insidiously injects
volatility into the S&P 500 itself.
HOW DOES THE VIX SETTLEMENT
The details of the VIX derivatives settlement process and
the underlying math are complex. The key concept is
that the monthly settlement value of VIX futures and
options is determined by a "tradable settlement
process" based on the opening prices of SPX options
that expire 30 days later than the VIX settlement date.
The SPX option opening prices are calculated from a
universe of out-of-the-money SPX puts and calls through
an automated auction.
In other words, market participants have a "mechanism
to buy and sell SPX options at the prices used to
calculate the final settlement value for VIX derivatives
Crucially, this means that the CBOE wants, expects,
and incentivizes traders with expiring VIX derivatives to
trade the underlying SPX options during the settlement
process (something the CFTC has looked askance at in
ISDAFIX). This methodology, the CBOE argues,
promotes two important objectives. First, it allows
market participants to replace hedges that will be lost
when the VIX derivative expires. Second, the CBOE
believes that "because a market participant is converting
vega exposure from one instrument (expiring VIX
derivative) to another (portfolio of SPX options expiring
in 30 days), the market participant is likely to be
indifferent to the settlement price received for the
expiring VIX derivative."
Responding to the recent
manipulation allegations, the CBOE has doubled down
on the sanctity of the settlement process, claiming not
only should market participants be indifferent to the
settlement price, but that there are also sufficient
structural safeguards in the process to prevent
WAS THE VIX MANIPULATED?
These days, once trading in a settlement period, a close,
or a fix of some kind that contributes to a benchmark is
identified, the topic alleged of manipulation inevitably
arises. Questions about potential VIX manipulation have
been simmering for a while. In May 2017, Professors
Griffin and Shams of the University of Texas at Austin
published a paper that found that "at the exact time of
monthly VIX settlement, highly statistically and
economically significant trading volume spikes occur in
the underlying SPX option" but "only in the [out-of-the
money] SPX options that are included in the VIX
Further, the professors did not see a
similar spike in in-the-money options (that are not
relevant to the index) or in S&P 100 Index options or
SPDR S&P 500
options. They argue that "if traders
sought to manipulate the VIX settlement, they would
want to move the prices by optimally spreading their
trades across the SPX strikes and increasing the number
of trades in the deep [out-of-the-money] put options
consistent with the VIX formula." They find that
"[t]rading volume at settlement follows this pattern,
whereas normally deep [out-of-the-money] options are
rarely traded." The paper also claims that there are
other suspicious patterns; for example, certain SPX
options with outsized impact on the VIX settlement have
similar trading spikes.i" The authors consider whether
these observations are consistent with innocent
explanations (such as hedging and the settlement
attracting "pent-up" liquidity), but ultimately conclude
that "the most natural explanation for these patterns
appears to be attempted manipulation."
A letter was sent last week by a lawyer for an anonymous
whistleblower to the CFTC Director of Enforcement and
the Co-Directors of the SEC's Division of Enforcement.
The anonymous whistleblower is said to have held
"senior positions at some of the largest investment firms
in the world." The whistleblower alleges a manipulative
scheme that has caused approximately $2 billion in gains
The letter builds on the article by Griffin and
The whistleblower attacks a so-called "pervasive flaw" in
the VIX settlement process that "allows trading firms
with sophisticated algorithms to move the VIX up or
down by simply posting quotes on S&P options and
without needing to physically engage in any trading or
deploying any capital." The heart of the problem,
according to the whistleblower, is that "the VIX is a
theoretical index, which does not rely on trading activity
but mid-prices, that can be moved up or down by
posting quotes without any physical trading taking
It is of course too early to tell whether any of these
manipulation claims have legs. Certainly, the CBOE is
aggressively countering these allegations and defending
the integrity of its processes, pointing to the structural
safeguards in the VIX settlement and its robust trading
surveillance program. Others are skeptical that the
alleged manipulation could have had such an impact.
The complexity of manipulation cases cannot be
overstated. If the past is any guide, a great deal of data
will be crunched, staggeringly high volumes of trader
communications will be parsed, and many experts in
fields ranging from economics to esoteric trading
instruments will be consulted. Investigations of this kind
are never quick, easy, or cheap. In addition to the
undoubted factual complexity, manipulation cases raise
many complicated legal issues. Indeed, in the case of
the VIX, it is not straightforward even to identify the
appropriate regulator and the controlling law.
WILL THIS BE AN SEC OR CFTC
I NVESTI GA Tl ON?
It is interesting that the whistleblower letter was
delivered to both the CFTC and SEC. Sending the
letter to both agencies speaks strikingly to the lurking
jurisdictional issues. The resolution of these supposed
threshold issues could significantly influence the ultimate
disposition because it is not a foregone conclusion that
the SEC and CFTC will apply similar legal standards in
trading manipulation cases.
In other recent financial index cases (such as the ISDAFIX
and Libor matters), the CFTC has taken the lead and the
SEC has been nowhere to be found. The CFTC has
rationales of varying strengths for its assertion of
jurisdiction in these cases. For example, the CFTC
alleged in Libor that a benchmark is itself a
"commodity" (an argument that has split courts in civil
). The CFTC asserts jurisdiction in the ISDAFIX
cases primarily through a circuitous and little-known
exception in the commodity laws that it believes caused
the relevant swaps market to have been regulated under
the Commodity Exchange Act prior to Dodd-Frank.
Whatever arguments there may be about the CFTC's
jurisdictional bases in the Libor and ISDAFIX cases, the
absence of the securities regulator from the scene at
least makes sense.
The VIX is different, and has always threatened being
caught in a tug-of-war between the securities and
commodity laws. It is an index of the kind the CFTC
typically believes should fall within its bailiwick. Yet it is
an index based on securities-instruments that are firmly
in the SEC's wheelhouse.
To be fair, the SEC and CFTC have a record of some
cooperation in this area. However, the limited
cooperation thus far may only muddy the waters further.
The SEC and CFTC have overlapping jurisdiction over
futures contracts on single securities and futures on a
"narrow-based security-index" (also called "security
futures"). On the other hand, the CFTC has exclusive
jurisdiction over futures on a "broad-based security
index." In a series of Joint Orders, the CFTC and SEC
have agreed that the CFTC has exclusive jurisdiction to
regulate VIX futures because they are not futures on a
narrow-based security-index. But in the same breath,
the agencies also agreed that the SEC has exclusive
jurisdiction over VIX options.
This unwelcome complexity is only the beginning of the
analysis. Here, there are no allegations yet of
manipulative trading of VIX futures or VIX options.
can there be any manipulative trading of the VIX itself; as
the whistleblower points out, the VIX itself is not traded.
Rather, the immediate concern is that individual SPX
options underlying the VIX are being traded (or more
accurately, offered or bid) in bad faith to affect the
settlement price of VIX futures and VIX options, before
flowing into VIX ETPs and retail investors. All that can
truly be said at this stage is that this is a jurisdictional
knot that will take time to untangle.
WHAT ARE THE KEY LEGAL ISSUES? DO
THE SEC AND CFTC SPEAK WITH ONE
VOICE ON ANTI-MANIPULATION LAW?
Apart from the potential negative consequences of
multiple regulators "piling on" to investigate the same
conduct, why does it matter whether the CFTC or the
SEC leads the VIX investigation? One answer is the
potentially different definition of manipulation in the
commodities and securities contexts.
As reported, The VIX allegations bear some parallels to
the ORW CFTC enforcement action that is pending in
the Southern District of New York.
At the summary
judgment stage, the CFTC argued that the intent
requirement for an attempted manipulation claim is
merely trading with intent to affect a price. The judge
disagreed with the CFTC's interpretation of the law and
held that the law requires intent to cause an artificial
price. The standard sought by the CFTC is thought by
most to represent a significant lowering of the bar to
bringing attempted manipulation cases. Despite its
summary judgment setback, the CFTC continued to
litigate the case aggressively and has signaled its
determination in other matters to water down what is
needed to establish manipulation liability.
In ORW, the CFTC claimed that the defendant
attempted to manipulate the price of the IDEX Three
Month Interest Rate Swap Futures Contract by placing
bids during the settlement period for the purpose of
affecting the settlement price. Over a period of
approximately six months, the defendant placed many
electronic bids during the settlement period, none of
which resulted in a consummated trade (though one
trade was almost completed, the other party ultimately
backed out). These bids caused the settlement price to
rise higher than similar instruments in the OTC market.
The email record established that the defendant knew
that the bids influenced the settlement price. DRW
argued, however, that the IDEX and OTC products were
not perfectly correlated and that there was a pricing
differential caused by convexity, meaning that the IDEX
bids were actually closer to the instrument's true price.
In substance, the defendant admitted bidding to affect
the settlement price in a beneficial direction, but denied
intending to cause an artificial price. The judge denied
the CFTC's summary judgment motion, and decided
that a reasonable jury could find that the defendant
believed that the IDEX instruments were undervalued
and that the bids were a legitimate source of supply and
demand. This case proceeded to a bench trial over a
year ago in front of another judge. A decision has not
yet been rendered, though the Court expressed
skepticism over the CFTC's arguments about price
It is likely that the eagerly-awaited ORW
decision will be seized on by those analyzing claims of
VIX manipulation, as well as many other pending
Notwithstanding the judicial pushback in ORW, there are
strong signals that the CFTC is still trying to mold anti
manipulation law in its own image. In other cases, the
CFTC has concluded in speaking settlement orders that
otherwise economically rational and legitimate market
transactions in which a trader traded no more than
necessary to achieve an unquestionably legitimate
outcome (e.g., hedging or to meet physical sale
obligations) are transformed into attempted
manipulation solely upon the serendipitous discovery of
communications suggesting the trader also thought or
hoped that the price at which he or she traded would be
reflected in an index.
It is not hard to see the
unfortunate implications of this for traders of SPX
options caught up in any VIX probe as the CFTC is sure
to look beyond the VIX whistleblower's claims to
scrutinize consummated transactions that were
encouraged by the very structure of the CBOE's
settlement process. Under the CFTC's likely approach,
even completed trades that are economically rational
are likely to be attacked if accompanied by any
language or thoughts that the CFTC does not like.
It is unclear whether the securities laws would support a
CFTC-like approach to manipulation, or whether the
SEC as an institution would have litigated like the CFTC
been a securities case. Some Circuits have
adopted positions under the securities laws that are not
inconsistent with the CFTC's preferred position under
the commodity laws. But others, such as the Second
Circuit, have required "something more" than bad
intent in an open market trade of the kind likely to be
seen in any VIX investigation.
Much of the law remains
to be written and Wall Street's fear gauge may leave a
lasting legacy for how we think about and litigate
alleged market manipulation.