The Law and Economics of Benchmark Manipulation

The following post comes to us from Andrew Verstein, Assistant Professor of Law at Wake Forest University School of Law. It is based on his recent article, “The Law and Economics of Benchmark Manipulation,” which is forthcoming in the Boston College Law Review and is available here.

This is a period of unremitting market manipulation. Allegations have rocked the markets in interest rates, foreign currency, gold, palladium, milk, oil, biofuels, natural gas, and aluminum, to say nothing of the inexorably rising tide of stock price manipulation. By all accounts, manipulation is in its season.

The abundance of market abuse could be surprising given the daunting challenges scholars believe manipulative traders must overcome. Here is a quick version of one skeptical argument: to drive up the global price of an asset – say, silver – you have to buy a truly enormous amount. But you can’t get rich unless you can sell at the inflated price, and whatever forces raised the price while you bought will reverse when you try to sell. In theory, the plummeting price should precisely evaporate your profits. In the meantime, you had to pay to transport and store a quarter of the world’s silver. If theory predicts that it is hard to manipulate prices, then why is manipulation so widespread?

In an article forthcoming in the Boston College Law Review, I argue that manipulation scholarship and law both reflect an outdated view of markets. Both are fixated on prices. The reality is that markets care relatively little about prices. Instead, markets care about price benchmarks, and so do the manipulators who prey upon them.

Price benchmarks are institutions that represent prices. For example, the Dow Jones Industrial Average approximates the stock market, just as the Consumer Price Index summarizes the cost of living. Markets are far too vast and complex, and the notion of “price” far too elusive, for anyone to actually do much with prices. Toyotas are sold and resold all around the country, with different features and quality levels. No rational person would try to discover and analyze all this data. But no one wants to overpay either. Instead, one might rationally consult the Kelley Blue Book for its price assessment for the car in question. The Kelley Blue Book is a price benchmark that compiles market data and distills it into a single comprehensible number.

Benchmarks serve us well, but their rise is a mixed blessing. Our increasing reliance on benchmarks has made them an attractive target for manipulation. We trust these benchmarks enough to write them into contracts, administrative regulations, and statutes. Once the benchmark is hardwired into legal relationships, manipulating the proxy pays off just as much as manipulating the underlying reality. For example, if the manipulator has agreed to sell oil at the benchmark price, tampering with the benchmark has the same effect as moving the worldwide supply of oil.

At the same time, it is considerably easier to bias a benchmark than the “real” market price. By their nature, benchmarks describe a market based on some small slice of it. Careful manipulators can bias that slice.  It is a daunting task to corner the world currency market, but it may be less daunting to corner the 2% of the market whose price is considered by the leading benchmark. By shrinking the domain over which the manipulator must exercise influence, benchmarks manipulation circumvents the principal challenges to manipulation identified by scholars.

As a result of widespread hardwiring of benchmarks into legal relationships, as well as their susceptibility to influence, market manipulation is increasingly synonymous with benchmark manipulation. This is true in currency markets, commodity markets such as the trade of crude oil, and even equity securities. Indeed, properly understood, most equity market manipulation can be characterized as benchmark manipulation.

This realization is significant for regulators who would reduce the incidence and damage of market manipulation. For decades, our market abuse laws have fixated on manipulation-by-fraud. Yet fraud requires reasonable reliance upon a misstatement. Worryingly, benchmark manipulation can proceed without anyone making a fraudulent statement or trade, as the manipulator understands and exploits the benchmark’s rules. And because of hardwiring, manipulation can pay even if the victim knows the full truth about all of the relevant facts. A contract calling for payment at the benchmark price calls for that level of payment even if the benchmark price looks pretty screwy. Benchmark manipulation fits poorly in our dominant manipulation enforcement paradigm. Instead, our market abuse regime should proscribe manipulation of benchmarks as its own distinct harm.

Yet where regulators do seek to directly engage with benchmarks, they must do so with a sophisticated understanding of how benchmarks work and how they are used, or else may threaten to increase both risks and costs. Unfortunately, the European Commission did not demonstrate such understanding in its Proposed Regulation of Benchmarks. Among other faults, the EC proposed increasing the “objectivity” of benchmarks. While objectivity is superficially desirable, foreign exchange benchmarks are relatively objective, and yet they have been the site of what Britain’s chief market regulator recently called the “biggest series of quantifiable wrongdoing in the history of our financial services industry.” Clear, mathematical methodologies give regulators a sense of comfort but they give manipulators a blueprint for market abuse. Appropriate regulation of the benchmark space must preserve subjectivity and flexibility, while giving good incentives for robust benchmarks.

In the end, there are tradeoffs between benchmark robustness, accuracy, cost and other values underlying benchmarks’ usefulness. However, a better balance can be struck if benchmarks’ manipulative potential is better understood.