DRW Defends CFTC Claim It ‘Banged the Close, Day After Day’by
Regulator alleges firm used false bidding to boost profit
DRW says its placed bids for undervalued swaps futures
DRW Holdings Inc. rigged an interest-rate benchmark to juice profits on a trade, U.S commodities regulators told a federal judge in a high-stakes case marking their first courtroom attempt to prove manipulation in a decade.
Trading firm DRW and founder Donald R. Wilson used artificial bidding near the end of the trading session to boost the price of futures on interest-rate swaps in a technique known as "banging the close," a lawyer for the Commodity Futures Trading Commission said.
“When the three-month contract didn’t trade at the price they wanted, they took matters into their own hands," CFTC attorney Daniel Ullman said Thursday in federal court in Manhattan. “How did they do it? They banged the close. Day after day."
While the CFTC maintains Chicago-based DRW submitted false, above-market bids for the contracts offered by Nasdaq Inc., Jonathan Cogan, lead defense attorney for DRW and Wilson, said the bids were actually below the true economic value of the contracts.
DRW’s "bids were real bids," Cogan said. “They stood ready, willing and able to transact."
Both sides agree on many of the facts in the case, including that DRW submitted bids that increased the settlement price of the contracts and boosted its profits. The CFTC is seeking a lifetime trading ban against the defendants.
The first witness in the case, DRW trader Brian Vander Luitgaren, acknowledged under questioning from CFTC lawyer Traci Rodridguez and U.S. District Judge Richard Sullivan that he knew the bids he submitted would raise prices and that it would enhance the firms profits. He reviewed e-mails he sent to colleagues, including one that talked of a strategy to "move" settlement prices and another in which he referred to the firm’s counterparties as "suckers."
A Nasdaq exchange executive, John Shay, testified that officials grew concerned about DRW’s bids shortly after they began because they were out of line with the rest of the market. He said exchange executives called DRW and told them to stop. "It raised a few eyebrows," he said of DRW’s tactics.
To win the case, the CFTC must show that the firm crossed the line from shrewd trader to manipulator of prices of financial contracts. It will be a high bar.
“Proving actual manipulation is a difficult task, which is why so very few such cases have been proven to date," said Rosa M. Abrantes-Metz, an adjunct professor at New York University’s Stern School of Business and an expert on market manipulation. She’s not involved in the case.
“It can be difficult to distinguish between someone who affects prices in a legitimate way simply because they are a large trader, versus someone who purposely moves prices away from market fundamentals while fooling the rest of the market,” she said.
DRW placed inflated bids in an effort to drive up the settlement price of the contracts to benefit a $350 million position, the regulator claims, making $13 million in ill-gotten gains.
DRW and Wilson, the firm’s chief executive officer, argue that the trades were based on a good-faith belief that the contracts were mispriced and the market would rise, according to court records.
The contract, a three-month future on interest-rate swaps, allowed buyers to receive a fixed interest-rate payment, while paying an adjustable floating rate to the seller. A trade would be profitable for a buyer if the fixed rate stayed predominantly higher than the floating rate.
DRW’s position, comprising thousands of contracts and maturities, was exclusively on the fixed side of the market. Those trades generated modest profits in the initial months, but authorities allege the firm grew frustrated when prices didn’t rise to the level where it believed they should be.
So beginning in January 2011, according to the CFTC, the firm began “banging the close” by placing bids in the market that were 17 percent to 30 percent higher than where the market was trading. The bids, almost 3,000 in all, were placed during the final minutes of the trading session, when settlement prices are calculated, and were only left out for brief periods and never resulted in a completed trade, the agency says.
DRW and Wilson argue that the contracts failed to account for a phenomenon known as convexity bias, in which prices for interest-rate futures should be a certain amount different from interest-rate swaps. DRW and Wilson said they believed prices on the contracts would rise as traders recognized the flaw and corrected their pricing.
Sullivan will decide the lawsuit without a jury. The trial, which is expected to last a week, is a rare test of the CFTC’s ability to prove a manipulation claim. The agency hasn’t tried such a lawsuit since 2005. Most settle with the payment of a fine and without a defendant’s admission of wrongdoing.
The case is CFTC v. Wilson, 13-cv-07884, U.S. District Court, Southern District of New York (Manhattan).