Market Quality and Trader Behavior in a Manipulated Market: Anatomy of a Squeeze

1
Market Quality and Trader Behavior in a
Manipulated Market Anatomy of a Squeeze

• John J. Merrick, Jr. (Baruch College)
• Narayan Y. Naik (London Business School)
• Pradeep K. Yadav (University of Strathclyde)
• June 2003

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A futures delivery squeeze example of market
manipulation

• We study the six-month period of an attempted
  delivery squeeze in the March 1998 long-term UK
  government bond futures contract (LIFFE Long Gilt
  futures).
• We employ a highly unusual data set of bond and
  futures market trades by all major players
  provided to us by the UK Financial Services
  Authority (FSA).

3
Previous empirical research on bond market
manipulation

• Treasury Bond squeeze of 1986 (Cornell and
  Shapiro, 1989).
• Salomon US Treasury 2-Year Note squeeze
  (Jegadeesh, 1993 Jordan and Jordan, 1996).
• These studies focus only on price distortions.
  Our paper is the first to investigate both the
  price distortions and the trading positions of
  major market participants.

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Plan for today

• A brief look at normal pricing of futures at
  delivery.
• Delivery date futures pricing during a squeeze.
• Squeeze Potential
• Examine the cash market pricing distortions.
• Trace the positions taken by the major players
  (dealers customers) during the squeeze.

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Some interesting insights

• We identify a key market microstructure element
  that supports the squeezer.
• Provide two types of evidence for our
  explanation
• A shift in cash-futures arbitrage pricing.
• A natural experiment conducted by BOE.

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Lessons

• Squeezes are accompanied by severe price
  distortions and some erosion of market depth.
• Delivery nonperformance penalties in bond futures
  markets create conditions that favor squeezers.
• Exchanges may need to "mark to market" the
  conversion factors of their contracts more
  frequently.
• Regulatory reporting should flag forward term
  repo positions to paint the full picture of cash
  market positioning by individual firms.

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March 1998 Gilt Futures Delivery Date
No-Squeeze Futures Pricing for 2 key issues _at_ 6

• Coupon Maturity CF Mod. Dur.
  Yield Delivery Date
• 9.00 10/13/2008 0.9999442 7.02
  6.00 03/09/1998
• Issue Price Forward Price Forward
  Price/CF Net Basis
• 123.28 123.27 123.27
  0.00 Cheapest
• --------------------------------------------------
  --------------------------------------------------
  -----------
• Coupon Maturity CF Mod. Dur.
  Yield Delivery Date
• 8.00 09/25/2009 0.9291579 7.59
  6.00 03/31/1998
• Issue Price Forward Price Forward
  Price/CF Net Basis
• 116.50 116.40 125.28 1.86 2nd
  cheapest

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March 1998 Gilt Futures Delivery Date
Full-Squeeze Futures Pricing 9 2008 Price
Impact 2 of par.

• Coupon Maturity CF Mod. Dur.
  Yield Delivery Date
• 9.00 10/13/2008 0.9999442 7.02
  5.777 03/09/1998
• Issue Price Forward Price Forward
  Price/CF Net Basis
• 125.28 125.27 125.28
  0.00 Co-Cheapest
• --------------------------------------------------
  --------------------------------------------------
  -----------
• Coupon Maturity CF Mod. Dur.
  Yield Delivery Date
• 8.00 09/25/2009 0.9291579 7.59
  6.00 03/31/1998
• Issue Price Forward Price Forward
  Price/CF Net Basis
• 116.50 116.40 125.28 0.00
  Co-Cheapest

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Market Yield Levels vs. the Contracts 9
Notional Yield
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Contracts Squeeze Value (Fs - Fns) increased as
yields fell
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Squeeze causes significant price distortions

• Value the 9 2008 Gilt vs. the discount factors
  derived from the BOEs Gilt term structure model
  (e.g., use a typical discounted cash flow bond
  valuation approach).
• But fair pricing in this typical no-arbitrage
  sense means a free squeeze option.
• Traders begin to bid this cdi1 higher in October
  1997. It begins to look rich in the market.

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Richness of the 9 2008 vs. Gilt term structure
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Implied Squeeze Probability p (F0 Fns)/(Fs
Fns)
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The participants and strategies

• Squeezers customers or dealers?
• Use of forward term repo trades through the
  delivery date
• Contrarians

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Par Value Positions (cdi1 futures) of the First
3 Squeezers
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Positions of 2 late entrant Squeezing Customers
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A Dealer (1) learns from trades with smart
customers
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Cash Gilt Futures positions of Squeezing Dealer
(2)
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2 Squeezing Dealers exit early (take some profits
in Dec.)
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Dealers Learn from Observing Trade Flows

• Cash Bond trades
• One dealer learns from intermediating the
  position accumulations of the 9 2008 cash bond
  by the first two squeezing customers. This dealer
  then begins to accumulate a long position in the
  9 2008 too.
• Forward Term Repo trades
• One dealer is the uninformed counterparty to
  forward term repo trades by squeezing customers
  (who buy for settlement date February 20, 1998
  and sell back for March 20, 1998). Soon
  afterwards, this dealer goes the same way in both
  the repo market and then goes long in both the
  cash and futures markets!

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Contrarians appear in size after cdi1s price
shifts 0.60 and bet heavily that the Squeeze
will ultimately fail.
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The Squeeze and Market Depth

• We run regressions relating daily cdi1 price
  changes to dealer inventory changes.
• Kyles Lambda is significantly positive during
  squeeze phases III, IV and V on days when there
  were net customer buys.
• Public traders attempting to buy cdi1 during
  these times faced perceptibly higher market
  impact costs.

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Asymmetries in Settlement Nonperformance
Penalties

• Cash Bond and Bond Repo Markets permit trades to
  fail the implicit cost is overnight interest
  charge.
• Futures Exchanges impose substantial fines on
  contract shorts that fail to make a timely
  delivery.
• Squeezes endgame In a delivery squeeze showdown
  between a credible squeezer and contract shorts,
  the contract shorts blink first.

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Shift in Marginal Financing Rate for Cash-Futures
Arbitrage Pricing Relationship
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The BOEs Feb 16, 1998 natural experiment

• Bank of England is prepared to make supplies of
  the stock available from 23 February, on
  overnight repo only, to any gilt-edged market
  maker (GEMM) who has been subject to a failed
  return or delivery of stock, or has a customer
  who has been subject to a failed return or
  delivery of stock.
• This subtle action by the BOE removed the fear of
  failing against the futures contract. The pricing
  distortions collapsed immediately.
• The reaction was consistent with the
  nonperformance asymmetries explanation as the key
  market microstructure support for the squeeze
  attempt.

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For review

• Squeezes are accompanied by severe price
  distortions and some erosion of market depth.
• Delivery nonperformance penalties in bond futures
  markets create conditions that favor squeezers.
• Exchanges may need to "mark to market" the
  conversion factors of their contracts more
  frequently.
• Regulatory reporting should flag forward term
  repo positions to paint the full picture of cash
  market positioning by individual firms.