June FTSE Settlement

[stevespray]

Peterpr…

I agree with you 100% and I think I stated something very similar at the weekend.

Others…

I would pose the following questions and would be grateful if someone with a genuine insight might be able to provide the answers.

1) Why does the exchange find it necessary to create an environment (ie this mid morning auction business) in which to determine the settlement figure – why can’t normal market trading be used to produce such a figure? – I pose this question because it appears reasonably obvious to me that it is far easier for someone to manipulate this auction (which leads to the settlement figure being established over a very short time period – 2 minutes or so). It would be far harder for someone to manipulate the market as a whole which is what they would have to do if settlement prices were established using the underlying market on which the derivative is based.

2) Why does the exchange choose a method, to establish final settlement, which effectively limits market participation? – The method used effectively disengages the derivative being settled from other derivatives based on the same underlying (for example, on Friday, the June Futures broke away from the September Futures). It stands to reason that this method of settlement is going to potentially make the settlement period much more unstable – The method has effectively removed the markets ability to arbitrage between the market being settled and (the much bigger) market as a whole. It this ability to arbitrage which keeps many markets stable. Effectively the market being settled loses its ‘anchor’.

3) When the exchange used the ‘old’ method of settlement they used to send out warnings, in the run up to the settlement date, warning customers of potential volatility. Given the comments made, both now, since and before the changes to settlement procedures, it appears that the exchange is trying to achieve a situation where settlement is less volatile than it used to be. Is it perhaps possible that the exchange is seeking to find and implement the impossible? Settlement periods are notoriously volatile in exchanges all over the world. Is this just not the nature of markets? When many people trade markets get more volatile and swing more violently.

Steve.

 

[kriesau]

Peterpr…

I agree with you 100% and I think I stated something very similar at the weekend.

Others…

I would pose the following questions and would be grateful if someone with a genuine insight might be able to provide the answers.

1) Why does the exchange find it necessary to create an environment (ie this mid morning auction business) in which to determine the settlement figure – why can’t normal market trading be used to produce such a figure? – I pose this question because it appears reasonably obvious to me that it is far easier for someone to manipulate this auction (which leads to the settlement figure being established over a very short time period – 2 minutes or so). It would be far harder for someone to manipulate the market as a whole which is what they would have to do if settlement prices were established using the underlying market on which the derivative is based.

They changed the EDSP system in Nov 04. Previously it was based upon 81 readings of the FTSE Index between 10.10 and 10.30. Now it's based upon an auction of the component stocks at 10.15. The reason for changing was due to volatility between 10.10 and 10.30 as cash positions that hedge derivatives were unwound. There was a case in Sept 02 when the FTSE went up by over 200pts in this timeframe but that was largely due to a mistake made by a dealer. Both the old system and new system are vulnerable too manipulation by big hitters.

However under the old system the process was transparent and as a result an option holder at least had the opportunity to hedge his position if it was vulnerable. Also the EDSP was based upon the continuing movement of the FTSE Index as the underlying instrument.

Under the new system there is an opaque auction of the constituent parts with a 3% margin limit on the bid or offer with reference to the last automated trade. This effectively creates a temporary rump index that is divorced from thr FTSE Index for a few minutes and the results are not reflected by the FTSE Index. That is why it is ill conceived and inferior to the prior system.

2) Why does the exchange choose a method, to establish final settlement, which effectively limits market participation? – The method used effectively disengages the derivative being settled from other derivatives based on the same underlying (for example, on Friday, the June Futures broke away from the September Futures). It stands to reason that this method of settlement is going to potentially make the settlement period much more unstable – The method has effectively removed the markets ability to arbitrage between the market being settled and (the much bigger) market as a whole. It this ability to arbitrage which keeps many markets stable. Effectively the market being settled loses its ‘anchor’.

Absolutely right !

3) When the exchange used the ‘old’ method of settlement they used to send out warnings, in the run up to the settlement date, warning customers of potential volatility. Given the comments made, both now, since and before the changes to settlement procedures, it appears that the exchange is trying to achieve a situation where settlement is less volatile than it used to be. Is it perhaps possible that the exchange is seeking to find and implement the impossible? Settlement periods are notoriously volatile in exchanges all over the world. Is this just not the nature of markets? When many people trade markets get more volatile and swing more violently.

Steve.

For all of its faults the prior system was more logical, transparent, credible and less iniquitous than the existing auction. I do not think that current system is capable of being sustained. The fall out from Friday has been huge and they are going to have to take some action over this for the future.

 

[Rognvald]

Kriesau and peterpr

It would appear from what you both say that you are adapting quickly. A I said, "a choice is available to us" - you have made yours. Presumably the "awful lot of pissed people" (your words - not mine) have made theirs too. The environmental change took place late in 2004 and the adaptations are starting now.

 

[Mr. Charts]

Rognvald,
Good to see you posting again
Richard

 

[qazwsxedc]

Well clearly, with only a 3% margin either side of the last automated price, there is obviously no scope for anyone to try to manipulate the final EDSP !

Just in case you're not being sarcastic, 3% of the FTSE is 150+ points at present. Last Friday's shenanigans clearly were within that limit

 

[kriesau]

Just in case you're not being sarcastic, 3% of the FTSE is 150+ points at present. Last Friday's shenanigans clearly were within that limit

I'm was not being sarcastic as the content of my original post clearly indicates.

The fact of the matter is that the FTSE did not go above 5100 until mid morning yesterday after the BOE minutes were released, which clearly prompted the rise. That is virtually 3 clear sessions after the EDSP was declared and the BOE minutes did not pre-empted the EDSP of 5138 last Friday morning. Furthermore, 4 days later, the index high (this morning) of 5122 is still well short of 5138 last Friday morning !

Your point about the current price being within the 3% margin is irrelevant since you are referencing a level that was only reached 3 days later or are you suggesting that it took the Exchange 3 full days to execute orders placed around 10.15am last Friday (now that's sarcasm) !

 

[animal]

The following circular was issued to members of the exchange - obviously they are looking closely at what went on.
Of course identifying the culprits and proving "naughty intent" are very different issues


From Liffe/Euronext - 23 June 2005
LONDON CIRCULAR No. 05/14
FTSE 100 INDEX FUTURES AND OPTIONS CONTRACTS EXPIRY OF THE JUNE 2005 CONTRACT MONTH

Executive Summary
This Circular comments upon the calculation of the Exchange Delivery Settlement Price in respect of the June 2005 contract month of the FTSE 100 Index Futures and Options Contracts.
**************************************************************************************************************

1. The Exchange Delivery Settlement Price (“EDSP”) in respect of the June 2005 contract month of the FTSE 100 Index Futures and Options Contracts (“the Contracts”) was calculated on Friday 17 June 2005 as 5138.0. This figure is final and binding.

2. On the Last Trading Day of the Contracts, an intra-day auction on the London Stock Exchange (“LSE”) is used to derive the price of each component stock of the FTSE 100 Index. Such prices are subsequently used to derive the Expiry Value of the FTSE 100 Index on which the EDSP of the Contracts is based. The intra-day auction process was introduced in November 2004 following extensive consultation with the market and discussion between the Financial Services Authority, LSE and LIFFE.

3. In light of the significant difference between the EDSP on 17 June 2005 and the value of the FTSE 100 Index immediately before and after the intra-day auction, the two Exchanges are carefully examining the activity surrounding the expiry. While it is too early to predict the outcome of that analysis, if any further changes to the EDSP mechanism are considered desirable, then these will be the subject of market consultation.

 

[kriesau]

The following circular was issued to members of the exchange - obviously they are looking closely at what went on.
Of course identifying the culprits and proving "naughty intent" are very different issues


From Liffe/Euronext - 23 June 2005
LONDON CIRCULAR No. 05/14
FTSE 100 INDEX FUTURES AND OPTIONS CONTRACTS EXPIRY OF THE JUNE 2005 CONTRACT MONTH

Executive Summary
This Circular comments upon the calculation of the Exchange Delivery Settlement Price in respect of the June 2005 contract month of the FTSE 100 Index Futures and Options Contracts.
**************************************************************************************************************

1. The Exchange Delivery Settlement Price (“EDSP”) in respect of the June 2005 contract month of the FTSE 100 Index Futures and Options Contracts (“the Contracts”) was calculated on Friday 17 June 2005 as 5138.0. This figure is final and binding.

2. On the Last Trading Day of the Contracts, an intra-day auction on the London Stock Exchange (“LSE”) is used to derive the price of each component stock of the FTSE 100 Index. Such prices are subsequently used to derive the Expiry Value of the FTSE 100 Index on which the EDSP of the Contracts is based. The intra-day auction process was introduced in November 2004 following extensive consultation with the market and discussion between the Financial Services Authority, LSE and LIFFE.

3. In light of the significant difference between the EDSP on 17 June 2005 and the value of the FTSE 100 Index immediately before and after the intra-day auction, the two Exchanges are carefully examining the activity surrounding the expiry. While it is too early to predict the outcome of that analysis, if any further changes to the EDSP mechanism are considered desirable, then these will be the subject of market consultation.

Well why have they declared the EDSP as 'final and binding' before they have completed their investigation into the reasons for 'the significant difference between the EDSP on 17 June 2005 and the value of the FTSE 100 Index immediately before and after the intra-day auction'

If it is 'too early to predict the outcome of that analysis' then it must also be too early to conclude whether or not the EDSP of June 17 was derived from any manipulation of the process.

So what happens to those investors, who lost money against this EDSP figure, if any form of manipulation of that price is subsequently uncovered ?

 

[danfreek]

I think the reason they're leaving it as final and binding is because they don't want anyone to have any financial concern in the result of the investigation. The EDSP process was known in advance, and if it hasn't worked properly this time (as it clearly didn't) then they will fix it in the future. They don't want the hassle of compensating anyone for the loss if it does turn out to be manipulation, however it is they would do that.

 

[Windlesham1]

As the FSA urinate in the same vessel as the perpetrators,it's such a bunch of nonsense. As usual the public gets shafted by the Old Boys' Club. How many people have had financial dealings and can honestly say they were given good value? I'll buy that person their own planet!
PS The americans think our regulation is like the Wild West

 

[kriesau]

I think the reason they're leaving it as final and binding is because they don't want anyone to have any financial concern in the result of the investigation. The EDSP process was known in advance, and if it hasn't worked properly this time (as it clearly didn't) then they will fix it in the future. They don't want the hassle of compensating anyone for the loss if it does turn out to be manipulation, however it is they would do that.

Are you saying that their position is therefore 'tough luck' where investors are concerned should any manipulation be uncovered.

Also I don't understand your last sentence.

 

[danfreek]

Yes, unfortunately, for some people it is just tough luck, I'm not saying that that's the right stance, but it seems to be the one they are taking.

All I meant by my last sentence is that I dont know how they would manage any compensation for people adversly affected by any manipulation, and I think that it is a problem that they just don't want to get involved with. again, I'm not saying that that is right, it's just the way it is.

 

[stevespray]

If anyone is sat at home thinking that the settlement price is going to altered then they clearly living in 'cloud cuckoo land'.

I'm pretty sure that the people investigating already know 99% of what went on but I doubt if they would reveal that. My understanding is that audit trails at electronic exchanges are comprehensive to say the least. I'm fairly certain that the 'manipulators' in question could be traced very quickly - most likely within a matter of minutes.

The thing I laugh most at is that way that they say they 'consulted the market' when they introduced the current settlement process. To be frank, any experienced market participant can see the massive weak spot in the process which was introduced. Any settlement procedure which effectively dis-engages the market being settled from the underlying market is going to be open to potential abuse because the differences can not be arbitraged. They must think we are idiots!

Steve.

 

[kriesau]

If anyone is sat at home thinking that the settlement price is going to altered then they clearly living in 'cloud cuckoo land'.

I'm pretty sure that the people investigating already know 99% of what went on but I doubt if they would reveal that. My understanding is that audit trails at electronic exchanges are comprehensive to say the least. I'm fairly certain that the 'manipulators' in question could be traced very quickly - most likely within a matter of minutes.

The thing I laugh most at is that way that they say they 'consulted the market' when they introduced the current settlement process. To be frank, any experienced market participant can see the massive weak spot in the process which was introduced. Any settlement procedure which effectively dis-engages the market being settled from the underlying market is going to be open to potential abuse because the differences can not be arbitraged. They must think we are idiots!

Steve.

Very interesting viewpoint. Could you perhaps elaborate a bit further on the comment in your last sentence where you state that the differences (presumably between the last preauction traded price and the actual auction price) cannot be arbitraged.

 

[animal]

I think that the EDSP was established correctly ie the auction process worked as published in advance.
There is no reason to change it on that basis.

Because of the allowed 3% movement in constituents an opportunity to exploit came along for someone with deep pockets and a view that they were underwight on oil because of its rising price.

No doubt they bought a load of cheap index options and futures the day before
On auction day they could have bought twice as many BP (say) as they needed during the auction with programmed buying at upto 2.9% above the pre auction price.
Shift the index, clean up big time by cashing in the futs and options and then dump half of the shares that they didn't need to normalise the market a bit.

All within the rules?
A tricky call, if they manage to prove a deliberate market fixing operation, they can fine the player.
If that happens, those of us who lost out can then mount a class action to recover the losses in court

Public vs "Old Boys" ?
I'd suggest that there are quite a few institutional "old boys" lining up with the small fry on this one. Various banks etc are big players in the affected markets.

 

[stevespray]

Kriesau…

I’d be more than happy to elaborate.

In simple terms Futures and Options are derivative products based on an underlying market. In the case we are discussing we are talking about the FTSE100 Cash Index being the underlying market. It’s therefore fairly important that the expiry price of the derivatives fairly reflect the ‘true value’ of the market on which it is based.

Arbitrage is a massive element of all global trading – Alan Greenspan actually made that comment recently.

Arbitrage effectively ties markets together. Some arbitrage is complicated and some is simple. In the case we are discussing it is simple. The ‘auction method’ removes the markets ability to arbitrage the instrument being settled with other derived markets based on the same underlying market – the nature of the ‘auction method’ means that there is a chance that the settlement price will not reflect the real level of the underlying (or other derived markets).

For example, look at the prices for the FTSE Dec Future and the FTSE Sept Future – The Dec contract is obviously worth slightly more (due to interest rates x time until expiry) but they move in kilter with each other. If September goes up 15 points then so does December. If September went up 20 points and December only went up 5 then people would buy December and sell September until both contracts reflected the same size change (that situation will never occur because traders will spot the potential differential in value long before it got so big). Buy selling the Sept and buying the Dec you are arbitraging – you are making the trade because you know that sooner or later the two contracts will come back into line.

With the ‘auction method’ of settlement there is no such guarantee of the contract being settled returning to the true level of the ‘real’ market because the end of the auction signals the expiry of the contract.

What you are then left with is a situation where the potential manipulator only has to manipulate the short term price within the auction. In essence he isn’t manipulating the whole market, only the bit that matters and inside a much smaller controlled envioriment. If the settlement was based on the actual prices of the FTSE100 Cash Index (between two points in time) then the manipulator would have a much harder job because he would have to manipulate the whole market. If he wanted to move the expiring June contract upwards by 80 points then he’d also have to move the Sept and Dec as well and therefore he would be subject to the selling forces from within those contracts. (This assumes that even the manipulation of a stock would be reflected in the all the futures markets – something which doesn’t always happen with the auction business).

Feel free to question.

Steve.

 

[stevespray]

Animal..

Good post.

I’d agree with you – it does look like a classic set up.

All within the rules? I’d say so. Looks to me like a classic British **** up. If someone was clever enough to think up the idea and then even cleverer in pulling it off then good luck to him.

As normal, in these situations, the real issue is one of responsibility. The exchange are the ones who make the rules. They are the people who thought up this obviously flawed settlement procedure. They need to take responsibility for that. If this was the US then heads would roll – mostly likely on prime-time financial TV!

However, this is Britain and the old school tie shall prevail – close ranks and cover each others arses!

In the end nobody will take responsibility. Already the exchange has issued a statement say that the settlement procedure was established after consultations with the market and therefore one can already detect that the exchange is trying to distance themselves from blame.

Rule Britannia!

Steve.

 

[peterpr]

Animal..
Good post.

Lots of good stuff. IMHO though, there are two fundamental issue at stake, the one following from the other:

1. The auction process was presumably designed to avoid overt manipulation. To manipulate the price requires that the manipulator have an accurate take on precisely when the stocks being used for the manipulation leave the auction. As I understand it, that is not at the end of the auction period but at any time during the auction when certain technical conditions have been met. He can not rely on the SETS price alone because that is determined purely by transaction flow through the order book, whether or not the stock is still 'in the auction'. ie if he bid up the price, then sold it down before the technical conditions were met, he would achieve nothing. He has to bid up the price whilst the stock is in the auction and sell it down ONLY when it leaves. To do that he has to KNOW that the stock has left the auction. The ability of a trading party to ascertain precisely when it has left (or at least estimate with a high degree of confidence) is the achilles heel of the process.

2. The technical spec allows for a 3% discrepancy, which rather suggests that its designers recognised the theoretical potential of manipulation. However, regardless of the spec, a settlement like the one we witnessed in June clearly undermines confidence in the product.

 

[animal]

Steve - broad agreement

Good luck to them - well in general I agree but when it comes to shifting markets, some are more equal than others. Also those that are more equal are normally subscribed to exchanges with codes of conduct etc so that they can lose profitable privileges

In these public revelations its all about boiler plate on bums, this is one where a good bit of investigative journalism would be a really good thing and a public service for once. There will be loads of pensions etc affected albeit indirectly.

Unfortunately it is usually the case that the scapegoat is the one who pointed out the weaknesses of the system and embarassed the establishment rather than the bad guy who made off with the goodies (possibly to private applause)

One can be cynical about the consultative process but when the change was last made there were discussions and published resposes. Some are still in the Liffe site archives.

The main problem to my mind is that the markets need the big players as much as the players need the market. Nobody wants a confidence issue to arise so there will be no chest baring.

The outcome is likely to be one of "mutually assured survival" in which creativity is respected, mild admonishments accepted so that the music can go round and round, principally paid for by the small guys which is after all their right and duty.

 

[animal]

Getting an even break?

All sorts of ideas are being bandied about and it is an enormously complicated thing.

Hitherto, when we had averaging, big players definitely tried to move the market so in a sense nothing is new except the degree
It has been possible to get some clue about the likely movement from the open interest on the Ftse index option contracts

The most unpleasant aspect to this last expiry was the speed at which the EDSP was settled.
Things were so volatile for such a brief time that any avoiding action was impossible
The raid came out of a clear blue sky for most.

One idea is that the EDSP is established over a longer period such as 3 hrs
This would at least allow players to manage their risk more effectively