The Curious Case of Our Regulatory Environment (Part II), or Why the Earth Isn’t Flat.

By Carl Gilmore

Carl Gilmore is president of Integritas Financial Consulting, and has been in the financial services space for 25 years.

Two years ago I wrote about the Commodity Futures Trading Commission enforcement action against Don Wilson and his company DRW Investments alleging price manipulation in certain financial instruments. Back then, I (along with many other industry participants) suggested that DRW’s trading activity not only wasn’t manipulative, but that DRW’s discovery of pricing discrepancies in the relevant instruments that resulted from convexity bias, and DRW’s subsequent market activity actually corrected artificial prices rather than created them.

Yesterday in New York, U.S. District Court Judge Richard Sullivan dismissed all claims against Wilson and DRW, issuing an opinion that could be described as a CFTC “spanking.” In the case, the CFTC Division of Enforcement alleged, among other things, that Wilson and DRW attempted to create artificial prices by submitting bids near the close that the CFTC described as inflated and artificial. Wilson and DRW argued throughout the litigation that the prices they submitted weren’t artificial, that they stood ready to transact business at those prices and that they had identified a discrepancy in the valuation of those instruments that created an arbitrage opportunity.

The judge agreed with Wilson and DRW, writing that “it is not illegal to be smarter than your competitors, nor is it improper to understand a financial product better than the people who invented that product.” Wilson and DRW believed that they had figured out how to value the instruments in question better than anyone else. And guess what? They were right! The judge found that Wilson developed a trading strategy based on his conclusions and put DRW’s money at risk to test his theory. According to the judge, Wilson didn’t need to manipulate the market and the judge found absolutely no evidence that he ever did so.

So what does all of this mean? It struck me as important that Judge Sullivan quoted from a previous case in the 2nd Circuit that sets forth the elements needed to prove market manipulation. That case is In Re Amaranth. Judge Sullivan quoted that “As long as a trading pattern is supported by a legitimate economic rationale, it cannot be the basis for liability under the CEA.”

What could be a more legitimate economic rationale than discovering a mis-pricing, developing a trading strategy to take advantage of the mis-pricing, and betting your own money on that strategy? That is what price discovery and free markets are all about. Wilson didn’t conceive a clever plan to manipulate the market, he figured out a clever way to take advantage of a mis-priced market.

Some commenters will inevitably suggest that as a result of this decision it will be harder for the CFTC to bring market manipulation cases. I’m not sure that will be the case. I’ve known many of the people at the CFTC and they are by and large hard working and have the best interests of the public and markets in mind. They still have significant and robust tools for bringing enforcement actions and those haven’t gone away. This ruling may make them more thoughtful about which cases they bring, but they will keep bringing them. And if someone is truly manipulating the market, I want them to bring those cases. This decision means that, like everyone else, the CFTC will have to prove its case. I suspect there are still market manipulators out there and there are market manipulation schemes we haven’t heard of yet. This just isn’t one of them.

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