A short history of market misconduct techniques

Financial frauds and market abuses appear to be unique acts. In fact, they often follow recognisable patterns, Gerry Harvey explains

It is said that there is nothing new under the sun – this is true of market misconduct.

In 1814, Charles de Berenger landed in Dover disguised as a Bourbon officer. He and his associates widely proclaimed the death of Napoleon, including in a letter transmitted to the Admiralty in London, using the latest modern technology – the semaphore telegraph.

The group had bought gilts in the weeks before and made £0.5m (some £70m today) in profit as the market rose on the news. The conspirators were prosecuted and their case set a precedent and established the offence of common law conspiracy to defraud.

Thomas Hayes was prosecuted under this same law for Libor manipulation in 2015.

Has this technique for manipulating markets been repeated? Do people dress up to manipulate markets in the modern world?

The surprising answer is yes. In 1987, FBI agents disguised themselves as traders to gain entry to the Chicago futures pits to uncover trading frauds. They were so successful that two years later, a group of con men copied the ploy.

They disguised themselves as traders and, wearing fake trader jackets and identity flashes, they managed to trade fraudulently in the pits for over a year.

The ploy has been more recently adapted. In 2015, James Craig used the modern disguise of identity theft and social media to carry out the same manipulative strategy as de Berenger in 1814: publishing false market information. He imitated the Twitter accounts of two genuine broking houses to post false corporate information, causing rapid share price falls.

Craig bought near the lows and sold on the market retracement.

Under review

A key problem in managing conduct risk is its potential scope. Many people assume that the range of potential malpractice in markets is limitless; in the words of the judge in a now-famous US enforcement case: “The methods and techniques of manipulation are limited only by the ingenuity of man.” Cargill, Incorporated v Hardin (1971)

However, analysis of the behavioural patterns in actual cases of misconduct establishes that the number of malpractice techniques is more limited.

At the Fixed Income, Currencies and Commodities Markets Standards Board (FMSB), we call this behavioural cluster analysis. It demonstrates that the same market abusive techniques are repeated and adapted, and it is reasonably rare that a genuinely new ploy is invented.

This methodology is simple. Enforcement cases are reviewed to ascertain the pattern of malpractice behaviour indicated. These are then compared to determine whether the same behaviours repeat or are unique or different in each case.

 Identifying malpractice techniques is the essential first step to forestalling them, in particular if there is a more limited core group of identifiable practices 

The FMSB has reviewed more than 400 cases from 19 countries over a 200-year period in all of the main asset classes. We found that just 26 patterns of behaviour repeat over time and across markets, asset classes and jurisdictions.

This is the first time that analysis of this type has been undertaken with cases collated in a single place as a point of reference for, and as an input to, governance and oversight structures and methodologies.

The use of disguises in the cases of de Berenger and the Chicago markets is a somewhat peculiar example, but this type of analysis has a serious application in today’s markets.

Conduct risk is now systemic in scale. In the past five years, banks globally have paid some $375bn in conduct fines, and misconduct has damaged trust in financial services. Identifying malpractice techniques is the essential first step to forestalling them, in particular if there is a more limited core group of identifiable practices.

As to the patterns, some are more common, others more intermittent. The list of 26 includes wash trades, the manipulation of closing and reference prices, ramping, layering and spoofing, market corners, front-running, insider dealing and client confidentiality breaches.

An exposition of each pattern is a considerable essay, but a description of some of them is set out below.

Bag of tricks

One of the most common and resilient patterns is wash trading. A typical wash trade involves a purchase and sale of securities that match in price, size and time of execution, and which involves no change in beneficial ownership or transfer of risk.

Wash trades are fictitious transactions used to give a false impression of price or market activity. Their history in the 20th century starts with the boom in railroad stocks in the US in 1908, but they have also been used to manipulate government bonds, floating rate notes, oil and even sunflower seed futures. We find them used more recently in the Libor problems.

Market corners and squeezes have been attempted in commodities markets and more recently in bond markets.

A corner arises where a party attempts to achieve a dominant controlling market position to dictate price.

A squeeze arises where a party does not seek dominance, but attempts to gain control of sufficient amounts of a commodity or security to impact prices.

Many commodities markets have suffered corners and squeezes. Twentieth-century cases include Soybeans (1941), Silver (1947), Butter (1947), Eggs (1947), Oats (1951), Potatoes (1955), Cattle (1979), Wheat (1991), Copper (2001) and Cocoa (2010).

A famous event arose when two onion traders, Vincent Kosuga and Sam Siegal, cornered the onion futures market on the Chicago Mercantile Exchange between 1952 and 1954.The resulting scandal led to the passing of the Onion Act in 1958, which bans the trading of futures on onions in the US. The ban remains in effect.

The first-ever issue of US treasury bonds was the subject of a corner attempt in 1792. More recent attempts have been made. In 1991, two dealers used unauthorised trades on client accounts to exceed limits on purchases in treasury auctions to attempt a squeeze on two US treasury issues.

Two years later, in June 1993, Fenchurch Capital Management attempted a classic squeeze by acquiring a large long position in treasury note futures contracts and gaining control over the supply of the cheapest-to-deliver treasury notes as the futures moved to expiry.

Similar tactics are possible in the corporate market. In 2013, Harbinger Capital created a short squeeze in a small distressed debt issue. Harbinger purchased 113% of the issue notional and then refused to lend bonds to short sellers. The price doubled.

Spoofing prices

Patterns of malpractice repeat, but they also adapt to new market structures. Some people have hoped that the mandated move to screen-based trading under the legislative initiatives that followed the 2008 credit crisis will provide a solution to misconduct – that human misconduct can be ‘coded out’.

A note of caution is required. Many of the repeat clusters evident in traditional markets have already been adapted to technology. Technology does not eradicate human intervention in markets. It transfers it to another type of human – a computer programmer.

In 2011, Michael Coscia manipulated futures markets in energy products, metals, agricultural markets, currencies and indices by engaging in a practice called spoofing. Spoofing is the placing of orders with the intention to cancel them prior to their being filled, and thereby ramp or depress prices.

Coscia employed a technologist to develop a program that would place spoofing orders, execute trades at artificial prices and cancel the spoof orders as soon as his winning trades were completed. These sequences were timed to take place in milliseconds.

There are similar examples of technological applications that have been designed to manipulate electronic markets – in effect, misconduct has been coded in.

The FMSB will publish its work in this area later this year. However, while the case history is fascinating in itself, the objective of this exercise is not academic. It is practical.

If we can identify the horizon of repeat abusive techniques, then more effective pre-emptive responses to misconduct become possible and we perhaps begin to curb the market aberrant application of the ‘ingenuity of man’.

About the author

Gerry Harvey is the chief executive of the FMSB.

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This article was taken from the Sep/Oct 2017 issue of The Treasurer magazine. For more great insights, log in to view the full issue or sign up for eAffiliate membership

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