For the last couple of years, there have been intense allegations of manipulation in the Brent (NYSEARCA:BNO) market. These claims came into particular focus yesterday, with a lawsuit being filed by Brent crude futures traders against BP, Statoil, Shell and Morgan Stanley.
This article will explain why, although any market can be manipulated, the Brent futures are particularly vulnerable to such action. And with the mechanism being so obvious, it's likely that someone has already taken advantage of it. The article will also cover stock index futures, as they are exposed to the same vulnerability.
The main difference
Brent, along with WTIC crude (NYSEARCA:USO), is one of the main benchmarks for crude prices around the world. But when trading Brent or WTIC futures, there is one massive difference. The difference is that while WTIC futures traded on Nymex settle physically, Brent futures traded on IntercontinentalExchange settle in cash.
This difference is gigantic for someone trying to manipulate prices. If prices are being taken up, whoever is buying WTIC futures would have to at some point take delivery of all that crude. If prices are being taken down, whoever was selling would at some point have to deliver all of that crude: 1000 barrels per contract, delivered to Cushing, Oklahoma. This poses two problems:
First, the possibility of moving and storing all that crude, or finding all that crude to deliver, has physical limits;
Second, whoever manipulates the market still has an asset he needs to liquidate, so is still exposed to losing its gains from the manipulation.
On the other hand, someone driving Brent crude upwards would just need deep pockets. On the day those futures matured, he's be out of the position with his gains settled in cash. If he was driving Brent down, the result would be the same: the position would go away and the gains would be settled in cash.
This is obviously tremendous. The case can be made for a tactical strategy by a group of collusive actors where if they all took the same side of the market, they could drive the price of crude one way into expiry, and just pocket the gains upon maturity. No such thing is possible with WTIC since at the end of such move, the group would still either have a large holding of crude to liquidate, or a massive quantity of crude needed for delivery.
What this means is that Brent is intrinsically easier to manipulate than WTIC.
This applies to stocks, too
Ironically, the same logic can be applied to S&P500 (NYSEARCA:SPY) or Nasdaq 100 (NASDAQ:QQQ) futures. They, too, settle in cash. So there, too, it's possible for a collusive group to take one side of the market and force that side right into the expiry of a futures contract. Here, this is intrinsically easier to do than the same manipulation in a single stock.
The reason is the same. If a collusive group chooses to drive a stock artificially higher or lower, at the end of that action it still either holds a massive long or short inventory which it has to close, risking market impact which might wipe out its collusive gains.
No such problem exists with the futures settled in cash, because at the end of the collusive move into expiry the contracts disappear and are settled in cash. If the group drove prices up artificially, at the end of the move it doesn't have anything to sell. If the group drove prices down artificially, at the end of the move it doesn't have anything to buy - it just pockets the gains.
It would be better both for commodity futures and for stock index futures to always settle physically. How could stock index futures settle physically? They could settle in ETF units, for instance.
Such a change would make the markets much less vulnerable to collusive manipulation. As it stands, Brent crude futures or stock index futures are prime grounds for large, well-financed manipulators. The tactic is simple, and in the markets when there are schemes which can make money easily they always get taken advantage of, so it's near certain that the schemes described in this article have been used and continue to be used.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.