Will Settlement Manipulation Kill the ‘Golden VIX’ Futures Market?

One of the recent success stories for new financial instruments is the CBOE’s VIX futures market. The VIX is a measure of expected S&P 500 stock index volatility – sometimes known as the ‘fear index’. Because the VIX is calculated using a complex formula and scores of Put and Call options, the VIX itself can neither be bought nor sold. CBOE’s VIX futures market partially solved this problem by offering futures linked to the VIX. Investors are able to take positions in the VIX without having to construct the physical portfolio of options. The market’s appetite for a volatility hedging instrument is so great that the VIX futures now trades over 100,000 contracts per day, and the CBOE is about to offer the contract on a 24 hour basis…

The VIX futures market is only a partial solution to the lack of an investible underlying VIX portfolio. Since the VIX does not exist, physical delivery is not possible and therefore the market is cash settled. For VIX futures to have credibility, they must be closely tied to the VIX itself. Theoretically, forcing the VIX future to expire at the same price as the VIX should achieve this goal but there is potential for unscrupulous traders to manipulate closing VIX prices for personal gain in the VIX futures settlement process.

The CBOE knows that this is a weakness, and so they have instituted a procedure to protect market participants using a ‘Special Opening Quotation’ system to calculate settlement prices. The problem is that the SOQ doesn’t work – in fact, the process invites manipulation of settlement prices by (i) separating the SOQ price from the actual VIX and (ii) providing unscrupulous traders with pinpoint accuracy as to the timing of their bogus bids or asks that drive the SOQ calculation.

For example, the October 2012 VIX settlement price was announced last Wednesday to be 15.96. However, simultaneously, the actual VIX was quoted at 15.35 having never been above 15.60 during the opening of the S&P 500 options market and the SOQ process. How could the settlement price be 15.96 when the VIX itself never reached anything like this level? This settlement price affected 60,000 open futures positions as well as 3.15M option contracts. The economic implication of the overstatement of settlement price amounts to at least USD 27.6M in favour of the longs versus the shorts futures holders, and more if we factor in the call option holders.

The potential gains from manipulating the SOQ settlement price are clearly large, and this threatens the viability of the VIX futures market. The CBOE needs to act quickly to redesign their settlement price determination process. An effective way to think about a new framework is to create one where the costs of manipulation become large relative to the benefits.

One way to increase the cost of manipulating prices is to create uncertainty in the timing of the futures expiry. It is one thing to enter a bogus bid or ask price for a once-off SOQ calculation, quite another to be forced to defend that bogus price for minutes, hours or even a full trading day. Eating the cost of bidding USD 1 higher for 1000 option contracts is palatable if a trader can materially influence the settlement price, but holding that USD 1 overbid for an hour is potentially ruinous.

This is the solution that First Degree has put forward to the CBOE following Wednesday’s skulduggery. There may well be other solutions. One thing is certain, however. If settlement manipulation continues then the VIX futures market will shrink and die.