VIX manipulation probes sow angst around Wall Street fear gauge

The world got a stomach-churning lesson in the risks of trading volatility after the VIX swung wildly in February.

Now, traders are experiencing another gut check as market regulators look into allegations that the index is being rigged.

News broke Thursday that the U.S. Securities and Exchange Commission and Commodity Futures Trading Commission opened probes into the VIX, one of Wall Street's most widely used benchmarks. One area of investigation is the monthly auction that determines the price of futures contracts tied to the VIX, people familiar with the matter said.

"If they find something that is untoward, that's a big deal," said Amy Wu Silverman, managing director and equity derivatives strategist at RBC Capital Markets. "VIX has become an industry standard, it's almost synonymous to volatility. Questions like 'What exactly is going on?' make people nervous."

The development is a blow to Cboe Global Markets, which compiles the so-called fear gauge. Not only has the company been stung by the recent bouts of turbulence, but its crown jewel, the VIX, has become the focus of intense scrutiny after a 2017 research paper alleged its process is vulnerable to being manipulated.

In a statement, Cboe expressed confidence in its market oversight. It has said that allegations of manipulation are unfounded.

Preventing Misconduct

A sign anxiety is rising: Cboe officials have been leaning on compliance departments at firms that trade VIX options and futures, asking what they're doing to prevent misconduct among customers, according to a person whose company has been queried. The inquiries began about a week ago, said the person, who asked not to be named.

While Cboe officials have repeatedly dismissed the claims as baseless, traders seem less certain. Punished first in February by concern that month's histrionics would dent its volatility franchise, Cboe's stock is down 15% in 2018, after rising 27% annually since the end of 2010 and never posting a down year. It's fallen in four of the past five weeks.

While trading in VIX options set a record high during the first quarter, as did related S&P 500 contracts, investors have liquidated positions in VIX futures, with open interest sinking to the lowest levels in about two years. Volume slowed in April to the lowest level in more than a year, according to data compiled by Bloomberg.

Cboe owns the intellectual property underlying the VIX and charges money to use VIX-related products it created. If you buy an options or futures contract, you usually pay a transaction cost that the Cboe collects, while VIX-related exchange-traded notes and funds owe a licensing fee. Trading fees from VIX futures and options, added together, make up roughly 25% to 30% of the Cboe's revenue, depending on the quarter, according to Christopher Allen, senior research analyst at Rosenblatt Securities.

Over the years, allegations of VIX rigging have occasionally surfaced, though were seldom taken seriously by professionals. The latest claims have piqued more interest among traders who have been baffled as settlement values increasingly occurred far away from prevailing market prices.

Research published by Bloomberg News in January showed that of the 10 biggest gaps between the VIX settlement value and its closing level the night before, five came in 2017, including December's, which was the biggest discount in 11 years.

Leaders of the exchange, among the most respected in the industry, are on the defensive, assuring traders in a letter last week that no manipulation has occurred while at the same time vowing to improve the process by which the auction is conducted. It was signed by Ed Tilly, the chief executive officer, and Cboe President Chris Concannon, once an SEC lawyer.

In response to news of the probe, the company said in a statement that it is "confident of our regulatory program, and that of our regulatory services provider, FINRA." The reference is to the Financial Industry Regulatory Authority, which Cboe hired to help police its markets.

"Both our regulatory program and FINRA maintain surveillance programs and dedicated teams of staff that surveil and monitor the trading activity and review every settlement across our futures and securities markets," according to the statement.

"The VIX and the VIX-related products have been in the spotlight," Mr. Allen said. "It's obviously important."