A while back we talked about a lawsuit in which Chicago proprietary trading firm DRW Investments LLC had sued the Commodity Futures Regulatory Commission because it was afraid that the CFTC was going to sue it for market manipulation and, apparently, thought there was a rule that whoever sues first wins. Nope, not a rule. Today the CFTC sued DRW for market manipulation. One lesson here might be, don't sue your regulator to stop them from suing you, they are not fond of that sort of thing.

Back in September I was pretty sympathetic to DRW and after reading the CFTC's complaint. I'll double down on that. What happened is that International Derivatives Clearinghouse offered a new interest-rate swap futures contract that was meant to be economically equivalent to an interest rate swap. It was not. Its margining rules made it more favorable to the long (pay-fixed) side, so it should be worth more than a swap. Everyone seems to agree on this point now, but they didn't always, and since DRW noticed it before everyone else, they got long a ton of these futures when everyone was willing to sell them at swap-equivalent prices. Then they went around publishing white papers about how those prices were wrong, which is pleasingly obnoxious.

So far so good. The problem is that the extra value came from the margining rules, but the futures were valued each day for margining purposes like so:*

1. If there were trades in a 15-minute settlement period at the close, the trading price set the value.

2. If there were no trades, but there were bids and/or offers, the bids and offers set the value.

3. If there were no trades, no bids and no offers, the swap curve set the value.

If this future market became a robust efficient market, then there would be lots of trades, and those trades would be arbitraged up to the theoretically correct price, which would be higher than the equivalent swap price because, remember, the futures are not really equivalent to the swaps. If on the other hand it was a ghost town with no trading, then the prices would default to the (incorrect!) equivalent swap prices.

It was a ghost town. Nobody traded, so it defaulted to the swap prices. This left DRW feeling aggrieved: Their brilliant trade wasn't working out for them for stupid reasons. They could prove that this futures contract was worth more than the equivalent swap, but in the absence of trading the stupid valuation rules just said that it was worth the same as the swap.

You could pause here to question the nature of that proof but let's barrel right along.

Anyway, DRW thought to themselves -- over email, alas** -- well, this stupid system is gaming us, but it really is a stupid system, so what if we gamed it instead. That was a productive line of inquiry. Their game was just to submit bids during the settlement period, which is a pretty simple game. Those bids were higher than the equivalent swap curve, but they were -- according to DRW's own lawsuit, and the CFTC doesn't actually dispute this -- theoretically correct. DRW was bidding perfectly reasonable prices.

And since it was a ghost town, nobody ever traded on their bids, nobody submitted other bids or offers, just crickets all round. So DRW's bids became the official valuation price.***

I find it very hard to object to that! The CFTC finds it easier to object to it, despite its budget cuts, remember that this case is a priority and the London Whale guys are not. I do not understand the theory at all. Like, here:

1. There was a market with no trades.

2. The market had a clear, published, mechanical set of rules to set prices for margining purposes.

3. Before DRW's "manipulation," those rules set prices that were theoretically "wrong" and not based on trades. (Because there were no trades.)

4. After DRW's "manipulation," those rules set prices that were theoretically "right" (I guess, so DRW says, and no one disagrees) and not based on trades. (Still no trades!)

The CFTC seems to think that state 3 is fine and state 4 is illegal but I do not know why. They're equally fake, but at least state 4 sort of looks like a market price. Nobody would trade these futures at the swap price, but somebody would trade them at DRW's price: DRW! The thing about DRW's manipulation is that if you think their bid prices are too high you could always hit the bid: DRW left their bids up for at least a little while, and according to them anyway they'd have been happy to trade there. Sure it was an illiquid market, but the fact that nobody traded with them in at least 118 days of them putting up supposedly egregious bids suggests that nobody found those bids all that off-market.

Manipulation is a funny thing. It's not illegal to trade at a price you like, or even a price you don't like; it's not illegal to post bids or offers, even if you don't trade on them. It's illegal to do that stuff with evil in your heart, and that's why the CFTC is coming after DRW. But evil in hearts is hard to identify, especially in these times of reduced regulatory budgets. DRW will tell you that the intent was to make these futures markets more, not less, accurate and transparent. Of course their goal was to make money -- the goal is always to make money -- but the effect probably was to improve an already broken market. Seems a bit harsh to call that manipulation.

* This slightly oversimplifies; cash flows were valued on a curve based built from 14 maturities, in which each maturity was priced based on that waterfall.

** Or something: "On November 3, 2010, the unlawful plan was explained by one DRW trader to a colleague: 'I think what we will have to do is at 10:00am send our offers to IDCG directly to move the 10am settles and then do the same at the close'." There's not actually a 10 a.m. settlement; he was just confused.

*** From the CFTC complaint:

Wilson and DRW had the ability to affect the Three Month Contract due the fact that very few of these contracts were executed on the NFX. On at least 118 trading days that DRW manipulated the daily settlement rates, there was not a single consummated on-exchange trade of the Three-Month Contract, and DRW alone, placed 100% of the electronic bids for long positions during this period; there were no offers for short positions placed at all. Wilson and DRW were well aware of these facts as they inserted bids to affect the settlement rate. As in the words of one DRW trader, the Three-Month Contract was the "ultimate of illiquid products."

Also fun:

After the PM Settlement Period each day, DRW would regularly cancel its bids, which avoided the possibility that DRW would actually have to enter into a futures contract and pay the higher rates that it bid. In fact, none of DRW's electronic bids were accepted or "hit" to consummate an actual transaction. Yet, all of its bids during the PM Settlement Period pushed the Three-Month Contract settlement prices higher than they would have been in the absence of DRW's bids.