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Security Market Manipulations and the Assurance of Market Integrity

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Security Market Manipulations and the Assurance of Market Integrity By Shan Ji Supervisor: Professor Mike Aitken Co-supervisor: Professor Frederick H. deB. Harris This thesis is presented for the degree of Doctor of Philosophy in Finance At The University of New South Wales Banking and Finance Australian School of Business 2009 Abstract This dissertation is motivated by two major factors. First, there have been no direct studies conducted for the relationship between market integrity and market efficiency and the driving forces behind the cross-sectional variations in market quality. Second, a better understanding the relationships among market integrity, market efficiency and other mechanism design factors for securities exchanges will facilitate securities exchanges achieve a satisfactory level of market quality. This dissertation consists of three chapters. In Chapter 1, a review of literature on market manipulation will be given. A series of common securities market manipulation strategies and corresponding market surveillance alerts will be explained and defined. In Chapter 2, we develop a testable hypothesis that market manipulation as proxied by the incidence of ramping alerts would raise transaction cost for completing larger trades. We find ramping alert incidence positively related to effective spreads in 8 of 10 turnover deciles from most liquid to thinnest-trading securities. The magnitude of the increase in effective spreads when ramping manipulation incidence doubles is economically significant, 30 to 40 basis points in many moderate liquidity deciles. This compares with an average effective spread of 72 basis points for index-listed securities in the most efficient electronic markets worldwide. In Chapter 3, In Chapter 3 of this thesis, we test the correlation between the levels of market integrity as proxied by the incidence of ramping alerts and a combination of proxies for factors from the following four potential drivers deciding the market quality across securities exchanges: • Securities Markets Trading Regulations • Securities Markets Technologies • Securities Market Infrastructure • Securities Market Participants The model we developed to test the correlation between the proxies for level of market integrity and seven proxies for the four potential drivers were estimated with Ordinary Least Square (OLS) and Two-stage Least Square (2SLS) error structures assumed, respectively to learn the most about the possible endogeneity of spreads and volatility. By performing Hausman-Wu specification tests, we concluded that simultaneity bias in the thickly-traded deciles is not material for the AI-Volatility and AI-Spread equation pairs. Subsequently, we used the PROBIT model to analyse the probability of adopting RTS across the 240 securities exchange deciles and the likelihood proves to be systematically related to four determinants in our sample. Finally we estimate the structural equations to investigate possible cross-equation correlation of the disturbances with either seemingly unrelated regression (SURL) estimation. Our findings are three-fold. Firstly, in the moderately-traded deciles, we find that the presence of a closing auction (CloseAucDum) reduces the incidence of ramping alerts. Trade-based manipulation proves more difficult when a manipulator’s counterparties can use closing auctions to unwind their intraday exposures. The RTS dummy variable is significantly positively related to alert incidence. In the absence of any panel data on the dynamic effects of adopting RTS, what we are observing in cross section is the perceived vulnerability of certain exchanges to manipulation and their consequent adoption of RTS plus the regulatory regimes required to have a salutary effect on market integrity. Second, in the moderately-traded deciles, we find that the closing auctions and more regulations in pursuit of market integrity lower quoted spreads. RTS and a regulation specifically prohibiting ramping indicate in cross- section the perceived likelihood of more ramping. Thirdly, in terms of the probability of the deployment of a real-time surveillance system, the estimations again differ by liquidity decile grouping. In the moderately-traded deciles, higher alert incidence, the presence of DMA, and higher FDI again increase the likelihood of adopting a real- time surveillance system. iii Our findings have a couple of policy implications for many securities exchanges in terms of market design and market surveillance. First, the exhibited relationship between alert incidence and effective spreads indicates trade-based manipulation has a significant impact on execution costs. Therefore, the prevention of securities market manipulation not only serves the indirect purpose of improving an exchange’s reputation for market integrity but also contributes directly to achieving a more efficient marketplace. Second, our results indicate that some market design changes can enhance the regulatory efforts to prevent securities market manipulations. For example, to prevent manipulators from marking the closing price, some exchanges could choose to adopt a closing auction or a random closing time, which would make manipulation more costly. Nevertheless, no securities exchange can be designed perfectly. Consequently, exchange and broker-level surveillance backed by effective regulatory enforcement is a necessary and pivotal complement to good design choices. iv Table of Contents ABSTRACT ............................................................................................................................................ II TABLE OF CONTENTS ...................................................................................................................... V CERTIFICATION ............................................................................................................................. VIII ACKNOWLEDGEMENTS .................................................................................................................. IX LIST OF DIAGRAMS ........................................................................................................................... XI LIST OF TABLES ............................................................................................................................... XII CHAPTER 1 ............................................................................................................................................ 1 MANIPULATION: A SURVEY AND LITERATURE REVIEW .................................................................................. 1 1.1 INTRODUCTION ................................................................................................................................................. 1 1.2 LITERATURE REVIEW ....................................................................................................................................... 4 1.2.1 THE EXISTENCE OF MANIPULATION IN SECURITIES MARKET .................................................. 5 1.2.2 THE FORMS OF SECURITIES MARKET MANIPULATION ............................................................... 7 1.2.3 VOLATILITY, SPREAD AND SECURITIES MARKET MANIPULATIONS ......................................... 9 1.3 SECURITIES MARKET MANIPULATIONS ....................................................................................................... 12 1.3.1 RAMPING .......................................................................................................................................... 12 1.3.2 UNUSUAL EXPIRATION DAY ACTIVITY ....................................................................................... 13 1.3.3 MISLEADING ORDER AND TRADING STRATEGIES .................................................................... 13 1.3.4 WASH TRADES ................................................................................................................................. 15 1.3.5 DERIVATIVE-UNDERLYING PRICE MANIPULATION ................................................................. 15 1.3.6 LAYERING THE ORDERBOOK ....................................................................................................... 16 1.3.7 CHURNING ....................................................................................................................................... 17 1.3.8 CORNERING THE MARKET ............................................................................................................ 18 1.3.9 SQUEEZING THE MARKET ............................................................................................................. 19 1.3.10 FRONT RUNNING ............................................................................................................................ 19 1.4 ALERTS FOR SECURITIES MARKET MANIPULATIONS ................................................................................ 21 1.4.1 INTRODUCTION ............................................................................................................................... 21 v 1.4.2 THE MARKING THE CLOSE ALERT .............................................................................................. 22 1.4.3 REVERSAL THE NEXT TRADING DAY .......................................................................................... 23 1.4.4 THE BAIT AND SWITCH ALERT ..................................................................................................... 24 1.4.5 WASH TRADE ..................................................................................................................................
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