Fixed income - A precursor
Over the last couple of years, fixed income spoofing has dominated market abuse complaints and prosecutions. Historically, spoofing in the fixed income asset class has been focused on single-instrument manipulation, but as detection technology has improved, cross-asset cases have begun to feature more heavily. This trend seems likely to continue over the next few years.
The fixed income trading arena is particularly at risk of this type of abuse for several reasons. In particular, the fact that many different instruments can be used to express the same risk (bonds, bond futures and swaps are all expressions of interest rate expectations) means that influencing the price of one instrument will move the price of all other related securities. Additionally, in the same context, relative value trading occurs throughout this space, such as trading on-the-run versus off-the-run bonds.
However, fixed income is far from unique in this regard. Indeed, several commodity markets trade in comparable ways and are, therefore, similarly exposed to the risk of this sort of market manipulation, with oil and gas trading being perhaps the most pertinent example.
According to a recent McKinsey report1, the commodity trading industry made record estimated profits of $104 billion last year, even as market volatility decreased and earnings at some of the biggest groups fell. The surprise increase from 2022, when the fallout from the war in Ukraine pushed up prices and supercharged profits, was driven by a wave of new entrants into the sector, including tech-focused traders and hedge funds and rising returns from power trading activities.
Relative value trading
The process of fractional distillation converts crude oil into a series of useable products (fractions), including jet fuel, gasoline, gasoil, benzene, propane and some others. Please see the diagram on the next page for more information. These fractions are produced in broadly similar ratios in each refinery. The price of crude oil coupled with refinery costs will drive the production price of each of these fractions. This calculation, complex though it may be, roughly presents an arbitrage condition limiting how high or low the price of each of these fractions can be compared with the price of crude oil.
Of course, demand factors will drive the prices of these fractions higher or lower, but the arbitrage condition presents limits to how far prices can deviate from the norm. Moreover, if the price of one particular fraction becomes significantly out of line with the price of other fractions, the process of cracking can be used to convert the longer chain fractions (e.g. fuel oil) into shorter chain ones (e.g. jet fuel), thus creating additional supply of the more expensive fraction. This ability to convert one fraction into another creates a further arbitrage condition.
These two conditions will tend to limit how far prices for different fractions can deviate from each other and mean that the prices of each fraction should tend towards the arbitrage level.
As a result, fractions can be traded against each other and/or the price of crude oil as part of a relative value strategy. In one strategy version, a trader could (in theory, at least) buy crude oil, secure refinery capacity, and forward sell all of the fractions (in the correct ratios); if this left a profit, then the strategy would be worth pursuing.
Whilst this approach is rarely of practical use, the relationship between the crude price and the price of the fractions can be used to build a hedging strategy. This general approach could be used to hedge illiquid positions in fractions using highly liquid products as an initial hedge followed by a series of spread trades to gradually reduce the basis risk inherent in the initial hedge.
Hedge trade example
In late 2023, Bank XYZ enters into an Over-the-Counter (OTC) trade and agrees to sell 5 million barrels of jet fuel to an Asian airline for delivery in 2026 into Singapore.
This is a substantial position and executing the exact opposite trade in the interbank market will either be impossible or will likely cost the entire bid/offer spread made on the trade.
As described above, the best approach is, therefore, to apply an initial hedge in a highly liquid instrument with broad market risk overlap to nullify most of the directional risk associated with the general price of oil and then execute a series of spread trades to increasingly reduce the residual risk.
Spoofing in oil and gas markets
Importantly, the strategy of executing a series of spread trades provides an immoral trader with a series of cross-instrument spoofing opportunities, which until recently may have been considered beyond detection.
Historically, complaints and prosecutions in the oil and gas markets have focused on single-instrument spoofing. For example:
More recently, the complexity of spoofing cases has increased. United States versus Logista Advisors LLC and Andrew Harris Serrota is an ongoing case brought by the CFTC in July 2023, in which the alleged spoofs were in spread trades. For example, the defendants are alleged to have attempted to manipulate both:
If proven, both of these were single-venue cross-asset spoofs based on the same underlying commodity, the spoof being designed to influence the spread between two contracts based on a single commodity (WTI in the former and Natural Gas in the latter).
However, the defendants are also alleged to have executed a more sophisticated two-commodity cross-asset spoof. In this case, the spread between the price of April 2020 ICE Brent Crude and April 2020 WTI Crude which further increases the complexity of the alleged manipulation.
A further level of complexity would still be one where the spoof order is placed on a different exchange from the bona fide order. We have not seen any complaints or prosecutions related to that scenario as yet, but as detection technology improves, such actions could follow.
Reference price transactions
In reality, outside of WTI, Brent and a few of the front-month contracts for various fractions, most of the futures contracts are extremely illiquid and trade infrequently. Most of the large transfers of risk in the oil and gas markets, therefore, happen via OTC transactions; this presents an opportunity for an unscrupulous trader to manipulate perceptions of fair price in order to generate additional profits on an OTC transaction.
For example, a trader negotiating a sale of a large amount of 2026 Singapore Jet Fuel (as in the example above) could aggressively buy Jet Fuel futures just before quoting the OTC price to the customer. A small amount of buying in the highly illiquid Jet Fuel back month futures contracts could easily move the price upwards. The customer on the other side of the OTC trade might see these inflated prices and assume that either (1) the fair market price is higher than it actually is or (2) the price is moving rapidly upwards. In either case, this might spook the customer into agreeing on the OTC trade at a higher price than is fair.
This type of manipulation is akin to the cases of primary market manipulation that we described in our earlier articles exploring a range of fixed income manipulation case studies. In the second of those articles, we explained that, in the case of primary market manipulation,
“The problem actually relates to a wider set of problems: those of all financial market transactions where a private fixing is involved."
“In this case, the term private fixing relates to any case where a transfer of risk off-exchange takes place between parties at a price determined by reference to a screen price."
“Expressed as a general principle, the problem arises when a large volume of risk is priced over the counter with reference to a screen, where the contemporaneous volumes may be much lower. The issue is particularly acute where the reference instrument (i.e., the instrument whose price is displayed on the screen) generally trades in low volume and whose price is volatile.”
This is very much the case here; a large risk transfer is occurring via an OTC transaction whose price is determined with reference to screen prices of instruments where the contemporaneous volumes may be much lower (i.e., illiquid futures contracts with infrequent and sporadic trading).
The tip of the iceberg
Recent enforcement cases have begun to demonstrate that manipulation in the commodities markets goes beyond the single asset spoofing cases that were historically the sole source of complaints.
It is our opinion that, as advanced detection technology is more widely implemented, enforcement against cross-venue, cross-asset abuse will increase dramatically, just as it has in the fixed income markets over the last few years.
We also believe that manipulation is likely to occur in the OTC space, where the price of futures contracts may be squeezed just ahead of agreeing prices for large OTC transactions. Until now, no major prosecutions have occurred in this arena. However, as mentioned above, advanced detection technologies have rarely been employed in this space; this is changing rapidly and we again believe that enforcement actions will follow the implementation of sophisticated trade surveillance tools aimed at detecting such abuse.
Market abuse case studies
Please access the following links to learn more: