Gary Gensler, show here standing in front of a place card with his name on it, runs the CFTC. Photographer: Andrew Harrer/Bloomberg.
Gary Gensler, show here standing in front of a place card with his name on it, runs the CFTC. Photographer: Andrew Harrer/Bloomberg.

Yesterday DRW Investments LLC, a Chicago proprietary trading firm, filed a weird lawsuit against the Commodity Futures Trading Commission to try to stop the CFTC from filing an enforcement action against DRW for market manipulation. The supposed manipulation, in addition to probably not really being market manipulation, is an absolute treat, so I'm going to tell you about it.

The story starts in 2008, when the International Derivatives Clearinghouse and Nasdaq OMX got together to build an interest rate swap futures contract. This made a lot of sense: Over-the-counter derivatives like swaps are evil weapons of mass destruction that destabilize the financial system, etc., while cleared exchange-traded derivatives like futures are safer and more transparent, etc., so moving OTC derivatives onto exchanges is the wave of the future, favored by the Dodd-Frank Act, etc.* Interest rate swap futures are the most straightforward way to move the swaps -- the biggest pool of OTC contracts -- onto exchanges.

But not that many people used the IDCH/Nasdaq interest rate swap futures contract, for reasons having to do with territoriality (no bank wants to give up its lucrative OTC swap business to trade exchange-traded products) and with the fact that the contract was terrible. The terribleness was that the contract was meant to, and IDCH/Nasdaq advertised that it would, exactly replicate the value of an over-the-counter interest rate swap. But it didn't. IDCH/Nasdaq just designed it wrong, so its value was slightly but meaningfully different from the value of a swap with the same terms. What they got wrong isn't exactly rocket science but it's, let's say, footnote science, so.**

Eventually, though, IDCH and Nasdaq convinced Jefferies to trade the contract, starting in 2010. This worked because Jefferies did not have a significant incumbent OTC swap business to protect, so it was open to exchange-based trading, and also because Jefferies was dumb and didn't realize the contract was terrible. It missed the same thing that IDCH and Nasdaq missed, and just believed IDCH and Nasdaq when they said that the futures and swaps were equivalent.

Meanwhile, folks at DRW Investments also started trading the contract, because they were smart and saw that Jefferies were dumb. Basically, Jefferies took one side of a bunch of these contracts (receiving fixed), and DRW took the other on all of them (paying fixed). The contracts were systematically mispriced: The fixed payer systematically should have paid more than it would under an equivalent swap, but since Jefferies believed that the futures and swaps were identical, it was willing to do the trades at the same rate as an equivalent swap. So DRW obliged (and, one assumes, entered into offsetting swaps, hedging out the interest rate risk and just pocketing the mispricing).

DRW then did two other delightful things. First, it published a white paper pointing out the problem with IDCH's contract. Second, it started posting bids with Nasdaq at what it thought were the right prices. Since the contract was so thinly traded -- basically just Jefferies and DRW!*** -- that moved the price of the contract in DRW's favor, costing Jefferies money in margin postings and making Jefferies angry because its swap futures were not acting like it had expected them to.****

Of course DRW did this. It wasn't trading those futures for the intellectual satisfaction of valuing them correctly.***** It bought a bunch from people who valued them wrong, then went out telling everyone how to value them correctly. Then it made money. That was its job. Jefferies, of course, was free to release its own white papers and post its own bids to try to convince everyone to value the futures the way it wanted them valued. It didn't do that because it was wrong. You win some, you lose some.

Then you sue over the ones you lose! Jefferies sued Nasdaq and IDCH for misleading it into doing these trades. Here is Jefferies's complaint, which is genuinely embarrassing both for Jefferies and for IDCH/Nasdaq. I guess they realized that, because the case eventually moved to arbitration.

But yesterday DRW sued the CFTC because the CFTC has apparently been telling DRW that it's going to bring an enforcement action claiming that DRW manipulated the market for these swap futures. We only have DRW's side of the story, from its (appropriately) self-serving complaint, but the story sounds pretty silly. Basically the CFTC seems to think that when DRW posted orders in the market at what it deemed to be the "correct" prices -- prices that were meaningfully different from prices in the OTC swap market -- it was doing so to manipulate the market rather than for economic reasons.

It's worth saying that this sounds maybe a little true: The market was pretty illiquid, and nobody seems to have traded with DRW's orders,***** meaning that the main effect of those orders was to move the settlement price (which IDCH calculated based on orders in the market, in the absence of trades) rather than to actually do more trades. You could understand the CFTC being a bit peeved about DRW entering a bunch of orders that weren't executed but that did move the settlement price in its favor.

But still my biases are pretty firmly with DRW here. Those bids they posted may not have been executed, but they were legitimate. As they put it:

because subsequent events demonstrate that DRW was correct in its analysis of the valuation of the IDCH Contract vis-à-vis the valuation of an uncleared OTC swap, and because the CFTC did not dispute that there was any indication that DRW’s orders were otherwise not made in good faith or otherwise not based on a fair and reasonable value of the IDCH Contract, there was no basis for contending that those orders were in any way manipulative and intended to lead to an artificial price.

DRW saw a mispriced asset -- an asset that was mispriced due to bad contract design rather than economic facts in the world. They took advantage of that mispricing. And then they did everything in their power to call attention to the mispricing, so it would vanish and they could book a profit. It all worked perfectly. That's just arbitrage. It's totally legitimate, it leads to greater efficiency, etc. etc. etc.

But it also means someone gets hosed, and that someone complains to the regulators, and the regulators are inclined to find that it looks fishy. The CFTC is not alone in this: JPMorgan just paid a $410 million fine to the Federal Energy Regulatory Commission for too bloodthirstily exploiting the fact that it understood the California electricity market's rules better than the people who wrote those rules. All markets rely on participants trying to exploit better knowledge and analysis of economic facts in the world, but they're less comfortable with participants who try to exploit better knowledge and analysis of the market's own rules. Even if that's not actually market manipulation -- and here it probably isn't -- to some people it sure feels like cheating.

* That's all debatable -- some people worry about too-big-to-fail clearinghouses, etc. -- but let's not let that detain us.

** Actually your best bet is to read either this post from yesterday by Craig Pirrong (which is where I learned about this story), or this actually very clear 2011 white paper from Rama Cont, Radu Mondescu and Yuhua Yu. But the gist is pretty simple which is that:

  • in both OTC and cleared contracts, the side that is out-of-the-money generally posts collateral (margin) and the side that is in-the-money generally receives collateral (margin); but
  • in OTC swap contracts the side that posts collateral normally gets paid interest on the cash or bonds that the post; while
  • in cleared futures contracts the side that receives margin normally gets to keep the interest on the margin.

This creates convexity and NPV effects which you can read about at your leisure but the point is: Those are different things. Some interest-rate futures have valuation adjustments to reflect this difference. The IDCH/Nasdaq contract did not.

*** I'm abstracting a bit. According to Pirrong actually MF Global was pretty involved too (on Jefferies's side).

**** There's a bit more to that actually. If you read Jefferies's complaint, the mechanism that IDCH/Nasdaq used to determine the settlement price of its contract was sort of:

  • whatever they like, but
  • probably look at actual trades if there are any (there aren't), and
  • if there are no trades, look at posted bids/offers if there are any, and
  • if there are no trades or posted markets, just use OTC swap rates.

So you see, when there are no other trades or bids, IDCH/Nasdaq will just pretend that their contract is equivalent to an OTC swap, and Jefferies can go to bed each night thinking that it hasn't lost any money: that the thing it owns is worth as much as the swap it thought it owned. But when DRW posts a bid -- at the correct price! -- then IDCH/Nasdaq will dutifully use actual "market" prices for the contract, and Jefferies will go to bed each night with a mark on its future that makes it clear it's worth less than the swap it thought it was buying.

***** That statement is like 30% wrong. People like valuing things correctly.

****** DRW says "all of DRW’s orders were firm and transparent, and each of DRW’s orders was posted for more than sufficient time for trades to occur;" which is sort of a backhanded way of saying "... but they never actually led to any trades."