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January 17, 2018
Brattle Economists Author Article on Derivatives' Roles in Manipulation

Brattle Principal Shaun Ledgerwood and Senior Associate Jeremy Verlinda have authored an article published in the October 2017 issue of The Journal of the Law of Investment & Risk Management Products Futures & Derivatives Law Report, which discusses the role derivatives play in market manipulation.

The authors explain that market manipulation occurs when an economically rational actor deliberately uses false information to cause demand or supply to deviate from underlying economic fundamentals in order to benefit from that deviation. Financial derivatives often serve as the means through which such benefits are derived, as the enforcement actions brought by the Commodity Futures Trading Commission (CFTC) and other U.S. regulators attest. Since the CFTC has moved resources from its Division of Market Oversight into its Division of Enforcement, it has expressed interest in pursuing major violations of its market manipulation rules.

With the CFTC’s heightened surveillance, the authors aimed to address the following questions:

  • Should derivative traders be concerned that they might have civil liability if they hold positions that benefit from another market actor’s manipulation?
  • Is there a way to proactively distinguish legitimate trading from manipulative behavior?
  • For traders who held derivatives positions injured by manipulative behavior, what recourse is available to address their harms?
  • Do the antitrust laws provide an additional source for liability for or recovery from manipulative behavior?

The article also presents a framework that can be used to distinguish legitimate behavior from manipulative trading. The authors explain that if a derivatives holder trades in the market for the underlying product or contract (a “trigger”) in a manner that could alter the market price (a “nexus”) and favorably affect the value of the derivatives (the “target”), the question then turns to whether the revenues produced from the target are sufficiently large to more than compensate any losses and expenses incurred in the triggering trades (“leverage”). If the revenues from the derivatives exceed the losses incurred by the trades that “triggered” the chain of events, then the derivatives could be viewed as a speculative position that might have been positioned as a leveraged target for manipulation, a determination that then hinges upon the intent of the actor. Conversely, if revenues from the derivatives are less than or equal to any losses in the triggering trades, the derivatives act as a hedge consistent with the legitimate use of such instruments.

The article, “Derivatives’ Roles in Manipulation,” is available for download below.