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March 02, 2011
Brattle Report Proposes Definition of Market Manipulation that Would Improve Market Efficiency and Harmonize Federal Enforcement Actions

A report released today by economists at The Brattle Group proposes a framework for defining, detecting, and analyzing manipulative behavior that would offer market participants and regulators a clearer, more concrete standard by which to identify or refute market manipulation. In the discussion paper, “Losing Money to Increase Profits: A Proposed Framework for Defining Market Manipulation,” Brattle economists Shaun Ledgerwood, Gary Taylor, Romkaew Broehm, and Dan Arthur expand upon their recently submitted comments to the Commodity Futures Trading Commission (CFTC) in response to the Notice of Proposed Rulemaking (NOPR) on Market Manipulation. In their comments, they proposed a practical definition of manipulative behavior: intentionally losing money on transactions that set (or make) a price to benefit the value of related positions that tie to (or take) that price. The Securities and Exchange Commission, Federal Energy Regulatory Commission, Federal Trade Commission, and CFTC have similar statutes prohibiting market manipulation through the use of fraudulent methods. Because the definition proposed by Brattle characterizes manipulation as a type of transactional fraud actionable under all of these statutes, adoption of this definition could harmonize enforcement actions across agencies, cases, and statutes. Market participants will benefit from the resulting certainty and consistency, as will the practitioners who can unify their practices to support a common framework for compliance. This could save the scarce resources of enforcement agencies and the internal compliance divisions of market participants. It will also promote clarity with respect to the legitimacy of transactions in the normal course of business, improve compliance, and increase the liquidity and efficiency of the markets over time. In the coming months, the CFTC is expected to issue final rules concerning multiple provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act, including Rulemaking 23, which addresses market manipulation. Whether this rulemaking places the Commission in a more or less aggressive position concerning future enforcement actions is not as relevant as the fact that private manipulation-based litigation under the new provisions will be possible. “Irrespective of the agency’s ultimate rules, market participants must be aware that they can potentially be found liable for damages under the new fraud-based anti-manipulation provisions,” said Shaun Ledgerwood, co-author of the paper and a senior consultant at Brattle. “Our framework is based on a straightforward economic model that demonstrates the mechanics of how a market manipulation can be defined, analyzed, and detected or refuted,” he added. The paper also identifies differences in the CFTC’s legal standard for proof of a manipulation before and after passage of Dodd-Frank; provides examples of loss-based manipulation and discusses why such activities are appropriately categorized as fraud; describes the inefficiencies created by market manipulation; and addresses the implications that the proposed framework would have on legal practitioners.