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

Abstract

This paper investigates the trading behavior of major market participants - both dealers and customers - during the six-month period of a well-publicized market manipulation episode: an attempted delivery squeeze in a bond futures contract traded in London. The analyses are based on a rich dataset on the spot and futures trades and inventories reported to the chief governmental regulator by different individual dealers and the Exchange. This simultaneous investigation of price distortions and trading positions of participants are of significant interest to both academics and market regulators. From an academic perspective, this paper provides, inter-alia, empirical evidence on how learning takes place in the market place and on the strategic behavior of major market participants, both dealers and public traders, in a market manipulation setting. It also shows that prices respond selectively to the trading actions of only the group of selected market participants that are relevant at that time. From a regulatory perspective, this paper has several messages. First, regulators and exchanges need to be very concerned about ensuring that squeezes do not take place since they are accompanied by severe price distortions and significant erosion of market depth. Second, exchanges should "mark to market" the specifications of their contracts more frequently, so that the term structure which underlies the calculation of conversion factors does not become dramatically different from the prevailing term structure. Third, regulatory reporting should ask for flagging of possession oriented trades like forward term repos: these trades can currently go un-noticed since they require virtually no regulatory capital. Fourth, and very importantly, delivery non-performance penalties in bond futures markets should be changed to conform to the cash market and the repo market conventions for settlement nonperformance.

Keywords: Price manipulation, Futures markets, Squeeze

JEL Classification: G10, G20, G24