Commodity Futures Manipulation: Theory, Evidence, and Regulatory Implications

Abstract

This thesis is a collection of four separate papers with a core theme: commodity futures manipulation. It aims to answer three important questions. How vulnerable are futures markets to manipulation? What are the effects of manipulation? How should futures markets be regulated? We first set up a one-shot game-theoretical model (Chapter 2) with certain classes of heterogeneously informed traders to consider how vulnerable a futures market to manipulation is, what influences this vulnerability and how manipulation affects the functioning of the market. This model predicts that futures manipulation may occur in equilibrium with a positive possibility if the deliverable supply is less than perfectly elastic, and the large trader possesses a certain amount of private information (here relating to his "type"), and more important, the functioning of futures markets is adversely affected by manipulation. In Chapter 3, we attempt to extend the above analysis into a dynamic context with a slightly modified market structure with the purpose to show how a large trader can manipulate a market through dynamically strategic trading when the hedger trades rationally, observes contract delivery process and may opt out of futures trading. This model also predicts a positive probability of manipulation in equilibrium. One interesting result from this model is that the adverse effects of manipulation may be lessened due to the introduction of exogenous uncertainty in a futures market. This may justify certain types of regulation against manipulation initiated by exchanges or regulators, such as trading for liquidation only, emergency price or position limits, etc. Chapter 4 moves to investigate empirically the economic effects of the alleged Sumitomo manipulation on the London Metal Exchange (LME). The results support our theoretical analysis. We find the evidence that the manipulation not only reduced the accuracy of "price discovery", but also influenced the basis and basis risk in the futures market. Thus the functioning of the LME was undermined. Furthermore, by comparing the actual LME cash price with a VAR forecast, we find that the LME cash prices were generally above the forecast prices during the period of alleged manipulation, but not significantly. Finally, we discuss the regulatory implications of futures manipulation in Chapter 5, and argue that manipulation should be one of the major concerns for futures regulation. We also undertake a comparative study of futures regulation in the US and the UK, and propose specifically how cost-effective futures (derivatives) regulation may be achieved in the UK.