The Role of Cash Settlement in Market Manipulation
and in the Panic of 1987
( Author wishes to remain anonymous – 2007 )
posted by Charleston Voice [you may find easier reading the PDF version links at end of post]
Edited for post by Charleston Voice
Edited for post by Charleston Voice
I
We have been alarmed by the recent behavior of our financial markets. Our concern is not so much with market volatility but rather with market combustibility. It is not random wildness that troubles us but the markets susceptibility to specific stimuli which are controlling the short and intermediate pricing of equities, futures and options.
We are concerned that the regulators have allowed the development of a market mechanism that they neither understand nor can control. More, we contend that the US equity markets are now sullied by an extensive on-going manipulation of unprecedented proportion.
Our securities industry takes space travel and genetic engineering for granted yet continually succumbs to the rhetoric of “random walk" and “no one is bigger than the market.”
In the wake of the 1987 market break, regulators and scholars have been asking the “right” wrong questions. Leading us astray they raise the classic moot issues, like margin requirements and market limits, which evoke fervent debate simply because those elements,
though debatably irrelevant, are easy to understand. Moreover, the brute-force actions of
trembling margins and imposing 50 point limits are sure to have some noticeable impact.
Many of the academics/ rhetoricians consulted following the October ‘87 crash are or have been in the paid service of interested parties. They have massaged data to show that what we see is just illusion and that our markets are not being controlled.
At the root of the current confusion is an often ignored, little-understood feature of the new derivative instruments. It is called “cash settlement," and it functions to undermine fair
markets.
II
What is "cash settlement”? It is the feature of certain options and futures which specify that they be settled only in cash at (or sometimes before) maturity at the existing price of the underlying security.
"Cash settlement” instruments are synthetic devices. They have no other purpose than to transfer cash from one entity to another by manipulating an underlying index number from
one moment to the next, one month to the next.
Nothing REAL is produced, created or even traded. On expiration, money is just transferred automatically into or out of accounts of those who have placed their bets. No more, no less.
2
While the mechanics of “cash settlement” index options and futures are simplicity itself (a bookkeeper’s dream), these insidious instruments impact the market with great complexity.
To begin with, disposal of these instruments exerts no buying or selling pressure on the market.
It is difficult to imagine any legitimate product on security where buying and selling in massive quantity doesn’t impact price. With “cash settlement” that is what we have. There is no balancing mechanism as there is with any normal product, commodity, stock, bond or standard option and future.
In normal markets, unwinding positions will stabilize rather than destabilize by precisely counteracting the initiating transactions and returning the market to external supply demand
equilibrium.
On a typical option expiration, those who exercise the usual 150,000 (plus or minus)
in-the-money “cash settlement” index options do not dispose of the $ 5 billion worth of stocks which ostensibly underlies these options. NOTHING really underlies these options; only cash changes hands; the game is repeated the following month.
The buyer of a “cash settlement” index future is NOT buying an underlying basket of
stocks for future delivery, no matter what the “efficient market” rhetoricians claim. The “cash settlement” future is mathematically different from every other future in that it is really a hybrid OPTION, not a future.
At expiration, the so-called index future affords the holder no ownership, but an
OPTION to take or not to take delivery of the underlying stock basket. This fundamental aspect of “cash settlement”, and how it impacts the market, is little understood.
To illustrate, consider the holder of 10,000 standard futures contracts on silver at maturity. If this holder does not choose to own the metal, the equivalent of 50 million ounces must be sold into the open market. This order to sell, taken by itself, is likely to depress the market price for the metal. The seller has an incentive to sell as carefully as possible as the more the price is depressed, the less the proceeds will be. Such a seller is likely to begin the process of liquidation well before maturity; he has a disincentive to disrupt market price.
In contrast, the holder of 10,000 S&P futures owns contracts which settle for cash.
Disposing of these contracts puts no downward pressure on the market whatever. They just turn to cash. Where the holder of these contracts chooses to take delivery of the underlying stock baskets, it may be done without market risk, as follows: At expiration, stock baskets are
purchased “at the market.” Any higher cost which results from this buying pressure is exactly
offset by the higher “cash settlement” proceeds from the expiring futures.
This “cash settlement” futures holder has no incentive to tread carefully on the market.
Quite the contrary; there is an incentive to cause as much disruption as possible. Consider the operator who is long the futures and short stock baskets against them. Knowing in advance that he and his associates will cover short stocks aggressively at predetermined moments (and thus drive the market upwards), they all buy “cash settlement” call options (and/or sell puts) in advance to profit from upward movement that they THEMSELVES will generate. Note that the simple act of covering short stocks at or near 3 expiration is all that is necessary to create the profit and close ALL positions. Various labels, including “front-running,” have been applied to this strategy. The key to a successful “cash settlement” manipulation is power and organization. The market must be overwhelmed at distinct points in time. Profit without risk can be achieved so long as domination can be achieved. If no greater opposing force appears or, if none exists, the market can be controlled.
We must recall the Hunt Brothers’ failed attempt to corner the silver market in 1980.
What doomed that organized scheme from the out-set was that the Hunts actually OWNED
something that they themselves would not consume, a physical commodity, which would have to be sold to complete the transaction to create the profit.
Thus, as in all fair markets, the simple round-trip action of one non-consuming group
counteracted itself. As the Hunts were unable to convince or coerce others to take them out of their positions in the physical silver, the futures or options, the price of silver wound up where it started.
Now, consider the logical outcome had the Hunts been holders of “cash settlement”
calls and futures on silver (which did not exist at the time). If they would have timed their
buying of the physical to achieve the desired price rise through hypothetical “cash settlement” expiration dates (or “triple witching hours” as the press calls it), they would have been cashed out of option and futures positions automatically, for cash, without selling silver and depressing its price. They may have become masters of the financial world, using the EXACT mechanism which others are currently using to dominate today’s equity markets.
In theory, “cash settlement” was created to facilitate operations and to allow participants of any size to move easily in and out of the marketplace. As October, 1987 demonstrated, precious few were able to find liquidity when it was needed most.
We believe that a PROPER analysis of the existing marketplace will demonstrate that
a group, a Cartel, now exists and that it has been using the “cash settlement” mechanism to
profit from its ongoing manipulation of the New York Stock Exchange. We likewise believe
that there is no other group substantial enough to oppose this Cartel and unless it is dismantled, fair capital markets will cease to exist altogether in this country.
III
It is folly that regulators who do not fully understand or appreciate the key and subtle
features of "cash settlement” futures and options are judging the viability of a marketplace
driven and controlled by this instruments.
In our discussions of "cash settlement" with various regulators, we have yet to
encounter a single one who begins to understand the mathematics of the mechanism which now dominates our markets.
Our regulators must first acknowledge that they require the input of impartial scholars
who can explain that the owner of a “cash settlement” index option or future holds a highly
complex instrument the market impact of which they have yet to determine.4
Advertisements, such as the following, five years old, from BARRON'S, should also
intrigue our regulators:
Securities firm employing sophisticated arbitrage strategies and
proprietary valuation models for the investment of private funds in the
convertible securities and options markets seeks Ph D. level
mathematician to join its research staff.
Experience in securities analysis is not necessary.
Academic specializations of interest are stochastic control theory,
dynamic programming, numerical analysis of PDE’s*, and optimal
stopping theory.
Box S-687, BARRON’S
This ad says a lot. What it doesn’t say is that stochastic control theory, optimal
stopping theory, superb organization and a few $ Billion may be sufficient to corner our "cash settlement” markets. It is possible that some operators have transformed the US equity markets into a well-oiled machine. Push a button for a specific, predetermined response; stop the market in its track, turn it on a dime once option positions are established, then race it the other way.
Our deregulating SEC and CFTC have allowed the complexities of "cash settlement”
to be foisted on an unsuspecting public. It is remarkable that in the wake of a global market
panic precipitated by the "cash settlement” mechanism, the Commissions do not appreciate
what has happened, and do not know where to look.
IV
Despite all rhetoric, there is no evidence that the existing market is any more efficient
now than ever before. Much of the heavy volume does not reflect any genuine change of
ownership. Baskets of stock traded back and forth without risk against futures and options add nothing to the economy or to the equity markets. Such positions are established and
subsequently unwound strategically to EXCITE the market to profit of "cash settlement”
options. The premise that derivative instruments add liquidity is a myth.
The formal studies of the October crash, notably that of The Brady Commission, contend that market volatility has not increased. To quote that prejudiced report: "recent volatility is not particularly high when viewed in a broad historical context."
For calendar year 1987, that analysis fails the sanity test and the flaw is obvious: only
day-to-day closing prices were used. The wild INTRA-day swings, so characteristic of the precrash environment, were ignored. DAYS where the market traveled THREE HUNDRED Dow Jones points, in violent fifty point swings, to close up or down only ten points just don’t show up.
* Partial Differential Equations 5
The Brady analysis concerns itself only with NET daily price changes.
Curiously, the Brady Commission did not acknowledge what every professional trader
knows: the venerable New York Stock Exchange is being dragged around daily by a new
mysterious force.
While 60% of those polled by the Brady Commission agreed that the three "cash settlement” trading strategies (portfolio insurance, index arbitrage and program trading) were “principal factors” contributing to the October, 1987 world market panic, Brady doesn’t follow its own nose to explore how these strategies INTERACT as a mechanism to manage markets.
We have not seen a single published analysis of the crash which has broached even the
POSSIBILITY that a market control mechanism exists. Market studies which have received
attention have been directly or indirectly sponsored and we cannot ignore the singularity of
interest between those who are manipulating and those who have been called on to “analyze” it.
With key data available to the regulators and with scholarly effort, the market control
mechanism can be laid bare. It will be possible to demonstrate how the "cash settlement” index option is utilized as the primary profit generator in a rigged marketplace driven by highly managed tape painting. Institutional money is used to move the markets to achieve portfolio managers' specific personal short-term trading objectives in the form of "cash settlement” index option profits.
V
Today's investors must navigate within a marketplace which includes an odd array of players,
some of whom are familiar while others are new, unusual and confusing:
A) THE NAIVE GAMBLER: Speculators who try to profit on short-term
market moves. Known collectively as “the public”, then often buy
"cash settlement” OEX puts and calls. These players and their brokers
are substantial net losers but are drawn back to the market repeatedly
by the lure of quick “unlimited profit with limited risk”.
As public players become increasingly experienced they realize, much
the way casino gamblers do, that the game is not “fair”. Unlike roulette,
blackjack and craps however, the OEX game odds are not yet regulated
and the house is still unknown.
B) THE NAIVE HEDGER: Institutions and individuals with large portfolios which try to use futures and options to hedge volatile markets and even participate in “index arbitrage.”
If they do not rely on “pros” to manage their hedging programs, they do not succeed. The “pro” is given total control over the short-term trading of these portfolios (with which to help move markets) in exchange for a share of incremental performance.
As an example, Wells Fargo Bank handles the daily index trading for 6 such august entities as the Rockefeller Foundation and the General Motors Pension Fund (source: Futures Magazine, WSJ).
While Wells Fargo clients were major sellers during the panic of 1987, we have seen no analysis which lays to rest the burning possibility that Wells Fargo or key personnel held short positions in "cash settlement” instruments in personal accounts and were using institutional money to drive the market down.
We have seen no attempt to analyze personal trading patterns of fiduciaries who surrender control of institutional portfolios used to create specific market combustibility.
C) MAJOR TRADING FIRMS: Experts who handle the enormous wave of stock “buy and sell programs" which rock the market. These players act both as agent and as principal and enter into quasi-legal profit sharing agreements with institutional clients (source: WSJ) to
orchestrate buy and sell orders.
While there is little evidence to indicate that all of these major firms act independently, regulators have sufficient data to determine the level at which they DO act in concert.
To date, apparently, the regulators have chosen not to perform this analysis although some interesting tidbits are emerging. It seems that at least Salomon Brothers and Morgan Stanley (two key contributors to the Brady Commission, no less) were subsequently identified by the
SEC as illegal short-sellers into the 1987 panic.
Initially, the trading firms used program trading to manipulate the market only in the moments immediately preceding option expirations. The level of short-term market control has since developed extensively as the Cartel has reaped $ Billions of profits both on and offshore.
Program trading is now the single dominant market mover on a day-today basis and is understood only as a system where "the computers make the buy and sell decisions.”
Regulators, by their inaction, are entrenching this mysterious system and are forcing the public to compete against informed traders who “run ahead” with stock, futures and option orders just prior to their own organized prearranged short-term market moves.
Buried away (Appendix 3, figure 12) in its report, without any cross reference, the Brady Report discloses that the twenty largest trading firms’ principal accounts were net SHORT $200 million of stocks coming into the crash.
This is simply the tip of the iceberg as it does NOT include the short futures and long put positions of either the firms OR their partners’ and principals’ personal accounts, onshore and offshore.7 .... finish reading PART I on the uploaded PDF file
PART II can be read HERE
