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

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Title: 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

2
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.

4
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.

5
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.

6
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.

7
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

8
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

9
Market Yield Levels vs. the Contracts 9
Notional Yield
10
Contracts Squeeze Value (Fs - Fns) increased as
yields fell
11
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.

12
Richness of the 9 2008 vs. Gilt term structure
13
Implied Squeeze Probability p (F0 Fns)/(Fs
Fns)
14
The participants and strategies
  • Squeezers customers or dealers?
  • Use of forward term repo trades through the
    delivery date
  • Contrarians

15
Par Value Positions (cdi1 futures) of the First
3 Squeezers
16
Positions of 2 late entrant Squeezing Customers
17
A Dealer (1) learns from trades with smart
customers
18
Cash Gilt Futures positions of Squeezing Dealer
(2)
19
2 Squeezing Dealers exit early (take some profits
in Dec.)
20
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!

21
Contrarians appear in size after cdi1s price
shifts 0.60 and bet heavily that the Squeeze
will ultimately fail.
22
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.

23
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.

24
Shift in Marginal Financing Rate for Cash-Futures
Arbitrage Pricing Relationship
25
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.

26
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.
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