Equity Index Futures: A Mature Market with Unresolved Regulatory Challenges

Equity index futures are futures contracts written on equity indices such as the S&P 500 or the Dow Jones Industrial Average. Deriving values from the underlying indices, index futures offer expedience to investors interested in a broad economic sector or geographical region represented by the indices without taking a position in each constituent stock. Equity index futures started trading in the U.S. on the Chicago Mercantile Exchange (CME) in 1982 against the S&P 500 index.  Today, equity index futures are one of the most actively traded financial derivatives in the U.S., with almost 400 million index futures contracts traded on the E-mini S&P 500 alone in 2019.[1]

The marketplace for index futures is mature, with state-of-art trade execution facilities and sophisticated risk-management apparatuses. Regulation has been improving since the equity index future contract’s inception through a concerted effort of federal agencies, financial industry self-regulators and trading exchanges. Important milestones have been reached in transparency, execution efficiency, international co-operation, investor protection, and market integrity. Regulatory scrutiny has produced a reliable trading environment where disruptive behaviors are, for the most part, kept under control.

Nonetheless, challenges remain with respect to three issues:

  • Corroborated wash trades
  • Spoofing
  • Flash crash induced by automated trading

Corroborated wash trades are trades submitted to the exchange’s trading system to be matched with a pre-arranged person (e.g., another trader employed by the same firm or a sibling firm) rather than a random counterparty.  Trades are recorded as consummated at the noted prices and quantities without real changes in the ownership of the contracts. Market manipulators utilize such fictitious trades to falsely signify hyperactivity in a financial instrument, leading to over-reactive trading that benefits their own positions. Wash trades are also employed in money laundering to move illicit money from the “buyer” to an affiliated “seller” through the cleansing effect of apparently legitimate market transactions.

Regulation requires all trades in exchange-listed futures contracts to be consummated in an open and competitive manner. Pre-arranged trades are generally prohibited, although there are a few narrow exceptions wherein they may occur but only by following stringent procedures. CME, where the vast majority of the futures contracts based on U.S. equity indices are traded, imposes a mandatory waiting period between two legs of pre-arranged orders so independent orders, if they exist, have an opportunity to interject. To prevent inadvertent self-matching, CME has provided the optional GLOBEX Self-Match Prevention. A broker who opts for this functionality is assigned an identification number that accompanies each order he submits to CME’s trading system. Orders on the opposite side with the same identification number are prevented from execution.

Intentional wash trades placed at close price-ranges by collaborating traders can elude CME’s detection prior to execution. An examination of recent enforcement actions shows that pre-arranged trades account for a substantial portion of disciplined trading activities and that all violations were discovered after they were executed.  In some cases, disciplinary actions lagged the offenses by a few years. Without any effective pre-screening mechanism, regulators must rely on the deterrent power of penalties to enforce compliance. What level of penalty is appropriate needs to be carefully assessed.

Spoofing involves submitting orders to the exchange with an intention to cancel them before execution.  Such a practice is motivated by distorting the public’s perception of the supply and demand balance to trigger panic trading in the direction desired by the spoofer.  When the price moves into an anticipated range, the spoofer submits market orders to take profit and cancels the original spoofing orders. Although regulation has imposed a position limit on the total number of open futures contracts a person can hold, the limit does not apply at the order-entry stage. That is because some orders may end up not being executed or are part of a legitimate hedging strategy. Finance theory and empirical evidence have shown that spoofing can be successful at generating lucrative profits for the spoofer. Indeed, spoofing played a substantial role in the Flash Crash on May 6, 2010.[2]

Spoofing is effective if the order book is fully transparent. While U.S. exchanges have taken pride in providing a real-time, full view of their limit order books, the merit of complete transparency is questionable in light of the damaging effect of spoofing. The Hongkong Exchange, for example, provides a restricted view of only the best-10 bid and ask quotes.

Automated trading (also called algorithmic trading) uses a computer program to detect trading opportunities based on pre-defined strategies and feed orders at a high frequency automatically into the exchange’s trading system. On the day of the Flash Crash of 2010, a severe order imbalance kickstarted an automated algorithm that was established by a major mutual fund. The algorithm targeted an execution rate without regard to the execution prices, so the computer continuously fed sell orders in E-mini S&P 500 futures contracts. About 75,000 contracts (valued at approximately $4.1 billion) were executed in 20 minutes. The selling pressure quickly spilled over to the stock market through index arbitrage activities. The rapid decline in prices prompted some liquidity providers to suspend trading in apprehension of a possible meltdown. The reduced buy-side liquidity caused trades to be executed at irrational prices as low as one penny or as high as $100,000.[3] The exchanges cancelled more than 20,000 trades to avoid catastrophic losses for many traders.

In the wake of the Flash Crash, regulators implemented tighter price bands for circuit breakers at the NYSE and NASDAQ. CME also linked the circuit breaker for the S&P 500 futures to that for the underlying index. In October 2012, the Commodities Futures Exchange Commission (CFTC) introduced rules that require clearing members to design and implement volume or margin-based limits on customer orders.[4] CFTC decided not to impose any specific pre-screening measures so that each clearing member can customize mechanisms befitting its unique circumstances.

The efficacy of this principle-based pre-screening obligation as a preventative tool against algorithm-induced crashes is questionable. First, pre-screening was already required by the National Futures Association – the self-regulatory organization for firms and individuals participating in the futures industry – when the 2010 Flash Crash happened. NFA Compliance Rule 2–9 requires each NFA member to ‘‘diligently supervise its employees and agents in the conduct of their commodity futures activities for or on behalf of the Member.’’[5] The NFA issued Interpretive Notice 9046 in 2002 (and a revised version in 2006)  under this rule to provide that NFA members ‘‘must adopt and enforce written procedures to examine the security, capacity, and credit and risk management controls provided by the firm’s automated order-routing systems (AORSs).’’[6] Among other requirements, the Interpretive Notice states that ‘‘An AORS should allow the member to set limits for each customer based on commodity, quantity, and type of order or based on margin requirements. It should allow the Member to impose limits pre-execution and to automatically block any orders that exceed those limits.’’[7] CME rules effective at the time of the Flash Crash also contained similar provisions.[8]   Second, financial institutions tend to use multiple clearing members to clear large trades. In absence of a coordinated pre-screening mechanism in which clearing members widely participate, orders that satisfy the limits of individual clearing members may nonetheless aggregate to a disruptive quantity if they are placed simultaneously or within a short time span.  Given the idiosyncrasy and complexity of firms’ order processing systems, there is no clear path to achieving coordinated pre-screening in the foreseeable future.

ENDNOTES

[1] Jennifer Rudden, Leading global equity index futures and options contracts traded 2019, by volume, Statista (Aug. 18, 2020), https://www.statista.com/statistics/380482/leading-equity-index-futures-options-by-volume/.

[2] See Department of Justice, Futures Trader Pleads Guilty to Illegally Manipulating the Futures Market in Connection With 2010 “Flash Crash”, Press Release No. 16-1314 (Nov. 9, 2016), https://www.justice.gov/opa/pr/futures-trader-pleads-guilty-illegally-manipulating-futures-market-connection-2010-flash.

[3] Id. at 8.

[4] Customer Clearing Documentation, Timing of Acceptance for Clearing, and Clearing Member Risk Management, 17 C.F.R. Parts 1, 23, 37, 38 & 39 (2012).

[5] National Futures Association, Part 2 – Rules Governing the Business Conduct of Members Registered with the Commission (1991), https://www.nfa.futures.org/rulebook/rules.aspx?Section=4&RuleID=RULE%202-9.

[6] National Futures Association, 9046 – Compliance Rule 2-9: Supervision of the Use of Automated Order-Routing Systems (2002), https://www.nfa.futures.org/rulebook/rules.aspx?RuleID=9046&Section=9.

[7] Id.

[8] Chicago Mercantile Exchange, CME Rulebook, Chapter 9, Rule 982, https://www.cmegroup.com/content/dam/cmegroup/rulebook/NYMEX/1/9.pdf. See also letter from CME Group Market Regulation Department, to Members, Member Firms and Market Users, CME and CBOT Rule Changes in Connection With NYMEX Rulebook Harmonization, (Nov. 28, 2008) (modifying Rule 982 with regard to subsection A.1 and A.4 without changing other parts of the rule), https://www.cmegroup.com/tools-information/lookups/advisories/market-regulation/SER-4789.html.

This post comes to us from Professor Lynn Bai at the University of Cincinnati College of Law. It is based on her recent article, “The Regulation of Equity Index Futures,” available here.

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