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September 28, 2012
Brattle Economists Publish Academic Paper Supporting a Generalized Analytical Framework for Proving or Disproving Market Manipulation

An article authored by Brattle economists Shaun Ledgerwood and Paul Carpenter was published in September 2012 in the Review of Law and Economics.

The article, “A Framework for the Analysis of Market Manipulation,” explains that the acts which could be considered manipulative remain poorly understood despite statements from enforcement agencies as to the behavior forbidden. This is due in part to the historical precedent set by previous manipulation cases which provide a patchwork of specific types of behaviors determined to be illegal, with no functional linkage to a common economic logic across the cases tried by each agency, much less across agencies. Previous academic literature on point likewise fails to provide a generalized approach to defining manipulative behavior.

Drs. Ledgerwood and Carpenter provide mathematical proof supporting the elements of an analytical Framework that describes price-based manipulation as an intentional act (the “trigger”) made to cause a directional price movement (the “nexus”) to benefit financially leveraged positions that tie to that price (the “target”). This approach is shown to apply generally to a broad range of behavior identified previously by the FERC, CFTC, SEC and DOJ to be manipulative, including acts involving uneconomic trading (e.g., Amaranth [natural gas index], Constellation [electricity prices], Optiver [“banging the close” of NYMEX crude futures using algorithmic trading]; outright fraud (e.g., false reporting of load in RTOs, statements designed to create a “pump-and-dump” scheme), or market power (e.g., U.S. v. KeySpan Corp.).

The authors assert that the Framework is sufficiently flexible to apply to a variety of settlement mechanisms where prices are determined, including indices (such as the LIBOR), auctions, and other points where the security or commodity traded is marked-to-market. Likewise, the Framework can adapt to evaluate manipulative behavior that is not necessarily price-based, such as wash trades and other acts designed to bias market volumes without necessarily affecting price. This could simultaneously improve market liquidity and compliance by providing definitional and analytic certainty concerning what behavior does and does not constitute a market manipulation.

“As the U.S. and Europe implement broad anti-manipulation rules, a more consistent and logical approach to the detection and analysis of manipulation is warranted,” said Shaun Ledgerwood, co-author of the paper and a senior consultant at Brattle. “To this purpose, the framework we propose could clarify what does and does not constitute manipulation for both market participants and enforcement agencies. Such certainty would ultimately improve market efficiency through improving market liquidity and reducing bid-ask spreads.” The citation for the article is Review of Law & Economics, Volume 8, Issue 1, Pages 253–295, ISSN (Online) 1555-5879, DOI: 10.1515/1555-5879.1577, September 2012.