Recent sharp declines in U.S. equities markets have drawn renewed attention to the Chicago Board Options Exchange (CBOE) Volatility Index (VIX), and to financial products that are linked to the index. On February 6, 2018, the VIX spiked to an intraday high of 50.30. It was reported that following this market volatility and related VIX spike, a whistleblower filed complaints with the U.S. Commodity Futures Trading Commission (CFTC), U.S. Securities and Exchange Commission (SEC), the Financial Industry Regulatory Authority (FINRA) and the CBOE, that alleged manipulation of the VIX. Recent research and market commentary have also raised concerns regarding the susceptibility of the VIX to manipulation. CBOE has dismissed allegations of VIX manipulation, however, given the public nature of the current complaints, it is probably safe to assume that one or more of these regulatory bodies will launch a thorough investigation into possible VIX manipulation.
VIX-linked products have become increasingly prevalent among today’s trading and investment community, and trading volume in such products has grown considerably since CBOE created the VIX in 1993. A variety of trading and risk management strategies center around taking positions that provide either long or short exposures to market (or asset) price volatility. Such strategies typically involve trading options, VIX futures and options, volatility-based ETFs and ETNs, or combinations of these instruments.
Because of the growing popularity of VIX-linked products and renewed concerns around the potential for manipulating the VIX itself, some trading firms and investment management firms may have increased exposure to regulatory inquires. Even if the VIX is not being manipulated, responding to regulatory inquiries is both time consuming and expensive. To efficiently respond to regulators and to effectively manage increasing regulatory risks, any trading operation or investment management firm with significant holdings in VIX-linked products, or those engaged in volatility trading strategies involving the S&P 500, should assess their programs for monitoring, identifying and investigating potential attempts at manipulation or disruptive trading. This article offers some things to consider for those responsible for managing trading, risk and compliance around volatility strategies.
What is the VIX?
The VIX is an index that was developed and is administered by CBOE. The index is meant to represent the 30-day implied volatility of the S&P500 Index (SPX). The value of the index is derived, primarily, from the average weighted prices and strike prices of out-of-the-money SPX options with maturities between 23 and 37 days in the future.
CBOE lists a range of VIX derivatives, including weekly and monthly VIX futures and options on the CBOE Futures Exchange (CFE).
How might the VIX be manipulated?
While it should be noted that allegations of large-scale VIX manipulation have not been supported by regulatory findings, CFE has recently sanctioned a market participant for violating CFE Rules 608 and 620. The description of the conduct at issue in this case is consistent with the general theory of how one might manipulate (or at least impact) the VIX. In short, it is alleged that the market participant traded in deep out-of-the-money options in such a way as to move the VIX level, by impacting option prices or to meet minimum bid requirements in otherwise unquoted strike prices. If such activity was designed to benefit expiring listed VIX derivatives, the options trading would need to take place during the Special Opening Quotation (SOQ) period.
With this overly simplified example of possible VIX manipulation in mind, it must be noted that there are many legitimate business reasons for trading and having positions in both VIX derivatives and SPX options. Additionally, there are legitimate reasons why market participants would have expiring VIX derivatives positions and be trading in SPX options around the time of derivative expiration. Neither of these scenarios alone serve as evidence of manipulation. As in any manipulation investigation, additional facts and circumstances, and evidence of trader intent, must be examined to distinguish legitimate market activity from fraudulent or manipulative activity.
What steps can market participants take to identify and mitigate regulatory risks around SPX volatility trading?
If regulatory bodies undertake a large-scale VIX market investigation, many conscientious and law-abiding firms and traders may find themselves responding to requests for data or for explanations of certain market activity. Although these interactions with regulators are never completely avoidable, there are things trading firms can do to better know when they are taking on additional regulatory risk, and to be prepared for efficient dialog should market regulators come calling. Listed below are five relatively straightforward steps that trading management, risk, and compliance professionals can take to understand and manage regulatory risks associated with VIX trading:
- Practical market conduct training – Most, if not all, trading organizations will have some form of compliance training in place that addresses manipulation and disruptive trading. However, many of these trainings don’t go much beyond sharing what the rules are and the expectation that traders follow the rules. A trader or portfolio manager will certainly know if they are attempting to manipulate a market. However, it is often less obvious to traders when their normal trading may have the appearance of manipulative activity when reviewed by market regulators. Trainings should be sufficiently tailored to the business strategies in place so as to provide examples of when additional care should be taken in trade execution.
- Targeted position and risk reporting – For many firms, daily risk reports are the primary data source available to compliance personnel for monitoring trading activity. However, depending on the nature of the trading, a risk-only view of the business may not be sufficient for compliance purposes. A business that is engaged in volatility trading will likely generate daily risk reports that are highly detailed and perhaps quite complicated. This is, of course, appropriate for managing a volatility portfolio, but it is highly unlikely that market regulators will take such a sophisticated view of the portfolio. Generally speaking, regulators will look at positions (e.g. number of contracts, notional value, etc.) when assessing market activity rather than aggregate portfolio risk. This can create a disconnect between the business view and what might be drawing the attention of regulators. To address this, compliance personnel should have tools or reports for viewing “positions” in the same manner that regulators would, to better understand how their market activity might be viewed if scrutinized.
- Know the strategy before the trade – Whether reviewing the activity of existing traders, or approving new strategies, management and control personnel should be able to obtain a clear description of the strategies and trading tactics that are at issue. Traders or portfolio managers should be able to articulate strategy objectives and provide examples of how execution of the strategy may unfold. One example relevant to VIX trading could be when a trader wants to replicate the implied volatility risk of VIX futures and to take that exposure into the last 30 days before option expiration. Management and compliance should seek an understanding of how that would look, what options might be traded, and in what proportions? Also, what market factors may cause these things to vary? There are many reasons why a trader or portfolio manager might want or need to trade in out-of-the-money SPX options during VIX settlement. A conversation about when and how that might appear should be had with trading management, risk and compliance before such activities take place.
- Benchmarking market behavior – When evaluating any individual market event for potential compliance issues, lack of context can obscure the true nature of the trading. Analyzing past trading and outcomes for particular strategies to establish benchmarks of “normal” activity can provide important context. Benchmarking characteristics of trading behavior can be useful in quickly identifying outlier behavior. Although trading activity will likely vary over time, it may be useful to describe characteristics such as:
- Typically, how large are the trader’s positions?
- How close to expiration does the trader enter or exit positions?
- Do SPX volatility traders typically use VIX contracts, SPX options, or both?
- Are SPX volatility exposures carried beyond the VIX expiration (i.e., closer to SPX option expiration)?
- Challenge the initial trading thesis in periodic reviews – It is important to periodically look back at VIX related trading activity to evaluate how well actual trading outcomes align with expectations. As discussed above, trading management, risk and compliance personnel should have an understanding of when and how a trader or portfolio manager would expect to be trading SPX options around VIX expirations. Periodic reviews of trader behavior in both VIX derivatives and SPX options may identify instances in which the timing of trading or the relative notional values appear to be inconsistent with expectations. These situations present opportunities for continued discussion with traders or portfolio managers to better understand the circumstance around the trades, and to better understand any nuance or changes in trading strategies.
If financial market regulators begin investigating VIX derivatives users, or volatility trading more generally, there will likely be many trading and investment management firms that find themselves producing documents and answering questions. These firms should expect that the regulators they are interacting with will need a significant amount of education on the strategies and trading that are under review. The better prepared management and control personnel are within these firms, the easier these conversations will likely be. Unfortunately, it is too often the case that the level of business knowledge and monitoring capabilities within trading compliance organizations are not as robust as they should be.
Volatility trading strategies can be complex, and this may result in greater gaps in business knowledge within important control functions. Working with traders and portfolio managers to close these gaps will allow for better implementation of basic oversight actions, such as those described above. This, in turn, will better protect firm capital and the careers and reputations of individual employees.
 https://www.reuters.com/article/us-usa-stocks-volatility-manipulation/whistleblower-alleges-manipulation-of-cboe-volatility-index-idUSKBN1FX0ES; https://www.wsj.com/articles/wall-street-regulator-probes-alleged-manipulation-of-vix-a-popular-volatility-gauge-1518547608.
 Griffin, John M. and Shams, Amin, Manipulation in the VIX? University of Texas at Austin. May 23, 2017.
 For a comprehensive presentation of the VIX calculation methodology, see, The CBOE Volatility INDEX – VIX, Chicago Board Options Exchange White Paper. 2014.
 The CBOE Futures Exchange is a CBOE entity that is registered with the CFTC as a Designated Contract Market, and is the venue on which VIX futures and options trade.
 CFE Rule 608 prohibits “any act detrimental to the exchange, in conduct inconsistent with just and equitable principles of trade or in abusive practices, including without limitation, fraudulent, noncompetitive or unfair actions. CFE Rule 620 states, in part, that, “No Trading Privilege Holder nor any of its Related Parities shall engage in any trading, practice or conduct on the Exchange or subject to the Rules of the Exchange that…demonstrates intentional or reckless disregard for the orderly execution of transaction during the closing period.”
 See, CBOE Case No. 20150448574.