A whistle-blower told U.S. regulators that a scheme to manipulate the VIX, the volatility gauge thrust into the spotlight last week during a wild trading session, costs investors hundreds of millions of dollars a month.

A Washington-based lawyer told the Securities and Exchange Commission and Commodity Futures Trading Commission -- the nation’s top markets regulators -- in a letter Monday that his client found a flaw that allows traders “with sophisticated algorithms to move the VIX up or down by simply posting quotes on S&P options and without needing to physically engage in any trading or deploying any capital.” Billions in purportedly ill-gotten profits have been scooped up by “unethical electronic option market makers,” according to the letter.

The client wasn’t identified by name. He’s held “senior positions at some of the largest investment firms in the world,” according to the letter written by Jason Zuckerman of Zuckerman Law, who has appeared on Washingtonian magazine’s list of top whistle-blower lawyers in the nation’s capital.

Use of VIX derivatives has surged as money managers look for ways to hedge gains during the bull market. The gauge, which measures the cost of using S&P 500 options as insurance against stock swings, has gained widespread use especially since 2004 when Cboe began introducing futures and later on options tied to the index. Those products unleashed a new kind of hedging instrument into the financial system, allowing investors to make bets on market volatility.

“We take our regulatory responsibilities and the oversight of our markets very seriously,” Cboe, the Chicago-based exchange that controls the VIX, said in a statement. “This letter is replete with inaccurate statements, misconceptions and factual errors, including a fundamental misunderstanding of the relationship between the VIX Index, VIX futures and volatility” exchange-traded products. “As a result of these errors, we feel the conclusionary statements contained in this letter lack credibility.”

Spokespeople for the regulators didn’t immediately respond to a request for comment.

The central role of the VIX was underscored last week, when it more than doubled in a single day, a record surge. Some exchange-traded products that held VIX futures plunged, and Credit Suisse Group AG decided to liquidate one of them. Billions of dollars were wiped out.

“We contend that the liquidation of the VIX ETPs last week was not due solely to flaws in the design of these products, but instead was driven largely by a rampant manipulation of the VIX index,” according to the letter.

A central question for anyone alleging traders decided to drive up the VIX with manipulative trades on Feb. 5 is: why? By 2:30 p.m. in New York that day, the index had already roughly doubled from its level the previous Thursday. Anyone making bets it would rise was already enjoying some of the biggest profits in two years.

Last year, an academic study asserted that the process through which VIX futures are settled is subject to manipulation. Cboe has said those claims are baseless.

Source:
courtesy of BLOOMBERG

by Brian Louis and Nikolaj Gammeltoft

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