“Banging the close” is a practice in which traders place a large volume of orders just before the close of an exchange. The practice, often with the aid of high-speed computers and sophisticated algorithms, attempts to influence the settlement price of the day with the accumulated large positions.
In a 50-page complaint filed in federal court in New York in 2008, the CFTC alleged that Optiver, a Dutch high frequency trading firm, engaged in “banging the close” on 19 different occasions in 2007 in connection with crude oil, heating oil, or gasoline contracts. According to the CFTC, the firm affected prices on at least five occasions, and reaped a profit of approximately $1 million. Optiver’s strategy, the CFTC charged, was to execute approximately 20 to 30 percent of the firm’s futures trades just before the close and the remainder during the close. Because the futures contracts traded offset the Trade At Settlement contracts, Optiver would profit if it could trade such an amount of its futures contracts before the close.
Optiver’s colorful language, in recorded telephone conversations and emails, gave the government an easy target. The firm developed what it called the “Hammer,” the aptly-named, secretive trading software that allows its users to rapidly enter orders and even jump to the head of the trading queue, which operates on a “first in, first out” basis. Putting your orders first in line makes it possible for “bullying” and, thus the subtle price manipulation, to work in your favor. But perhaps the most damning pieces of evidence in Optiver’s case were emails and phone recordings involving three Optiver employees (also named as defendants in the complaint) discussing building up positions in order to “bully” the market, referring to the scheme as a “fun game” and, in some cases, even bragging about the profits generated. In one recorded conversation, the CEO of Optiver US told a trader, “…you should milk it for right now because you never know how long it’s going to last.” To make matters worse, Optiver employees made false statements to NYMEX compliance officials in order to conceal their manipulative intent.
Optiver’s antics aside, the question is what really constitutes price manipulation? Traditionally, price manipulation allegations have been exceedingly hard to prove, and most of the cases brought by the CFTC are settled, making it difficult to find widespread agreement on standards of proof. While courts differ considerably on what these standards should be, the Southern District of New York1 tends to more or less use the following elements: (1) the defendant possessed the ability to influence market prices; (2) an artificial price existed; (3) the defendant caused the artificial price; and (4) the defendant specifically intended to cause the artificial price. Whether or not the CFTC could prove these elements about Optiver is debatable.
The CFTC would probably take a broader view, that any scheme such as “banging the close” amounts to manipulation, whatever the outcome. So is an attempted manipulation against the law, like attempted murder? As interesting a question though it may be, that is a topic for another day.
Even without going to trial, though, Optiver’s circumstances painted a noticeably unflattering picture of company in the public eye and, not surprisingly, Optiver agreed to a settlement with the CFTC, which included a $13 million fine and disgorgement of its alleged $1 million profit.
But beyond just the legal implications, the Optiver case has also become an argument in the political arena focused on two issues: the high prices of gasoline and “excessive” market speculation. In fact, just two days before the announcement of the Optiver settlement, President Obama called on Congress to increase civil and criminal penalties on speculators that artificially manipulate markets and drive gasoline prices higher. Regardless of the reasons behind such rhetoric, the argument seems somewhat disingenuous as, in actuality, high gas prices have very little to do with market manipulation and everything to do with oil supply and disruptions, unrest in the Middle East, lack of alternative energy sources and global politics in general.
The other issue that the Optiver case brings to mind is the effort to curb market speculation, especially with respect to the energy markets. The CFTC’s approval of position limits last October is just one example of the government’s intent to accomplish this. But, the truth is that speculation and manipulation are often confused with one another and this perpetuates widespread misunderstanding. Healthy market speculation is vital to the economy and provides short-term and long-term benefits, including accurate pricing information and, more generally, enables risk transfer and better hedging and financial outcomes for producers and consumers.
The benefits of high-frequency trading (HFT) are harder to discern. In a way, HFT is the new Wild West of the financial markets, with regulators struggling to keep up with constantly advancing technology aimed at finding new ways of turning profits. What is clear is that HFT firms like Optiver have attracted some of the brightest minds in finance and, thus, are at the forefront of innovative technology. But, precisely because the technology is so advanced, HFT has naturally also attracted considerable scrutiny and with it increased suspicion, especially with respect to the real function and objectives of such practices. If the motive is a quick profit and the methods turn out to be primarily front running, bullying, scalping and sub-pennying as opposed to genuine speculative market activity (e.g., market making), then regulators will have a much easier time deciding which side of the speculation-manipulation spectrum HFT falls under, and a much greater inclination toward heavier regulation and enforcement.
In re Natural Gas Commodity Litigation, 337 F.Supp.2d 498, 507 (S.D.N.Y. 2004).