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Price Manipulation Risk – The Big Unknown

Despite efforts to strengthen controls, the Libor scandal and recent valuation problems with JP Morgan's "London Whale" trade point out that banks still have exposure to price manipulation risk.

The risk of price manipulation of securities is likely the top risk for banks that is least understood by the layman. Indeed, at first blush, the sin of deliberately mispricing a security does not appear the most egregious. Yet, as we have seen with the Libor scandal, it can lead to very significant market distortions and huge penalties from the regulators. Understanding the reason why that is so and what can be done to mitigate the risk is one of the most urgent issues for risk managers today.

So how does it happen that traders are able, on occasion, to manipulate the price of a traded security? In general of course, trading in marketable securities happens when people can agree on a price to execute a transaction. Most of the time that price is broadly determined by an exchange and can be tested by analysts and traders on the basis of easily observable data in the market.

Transparency is thus facilitated by an exchange and pricing data available to all market participants. Certain securities, however, are valued on the basis of price information that is not so transparent to others. Pricing may,in fact, be dependent on expertise or market data available to a restricted number of persons. Transactions in such securities may also occur not on an exchange but on the basis of a bi-lateral agreement between two parties. Structured notes, collateralized debt obligations and credit default swaps have been typical of such transactions up to now, (though of course this is now changing for some credit default swaps under Dodd-Frank).

Banks also provide valuation expertise and pricing information that becomes an input into valuation of securities and assets. The interest rates at which banks lend to one another and use as benchmarks for other transactions are an example of such valuation services. Libor (London inter-bank offered rate) is the most well-known of these but there are many others.

[For more on The Ten Most Significant Operational Risks of 2012, see Andrew Waxman's related story.]

It turns out then that banks run several risks in this area. First, in the case of transactions in securities that are hard to value, banks run a risk that is hard to measure when they lack an independent and authoritative valuation source for a given security. In such cases, traders may be able to, if they so choose,tempted by opportunities, for example, to improve their earnings for the year, manipulate favorably the price of said security. Such activity was alleged to have occurred at Credit Suisse in 2007 leading to its re-statement of $1.3 billion in bond valuations in 2008 and criminal charges issued against three traders from that time.

Second, in the case of valuation services, banks are at risk of introducing distortions into the market place if they fail to provide objective valuation data. In the cases of Barclays, for example, under the terms of the LIBOR settlement between it and the United States Department of Justice, the Bank formally admitted that “the manipulation of the (rate) submissions affected the fixed rates on some occasions”. (US DoJ Statement of Facts – 26 June 2012). It is as well to point out that the foregoing examples were not isolated to Credit Suisse and Barclays but have likely occurred at every bank on the street that participates in fixed income trading.

Andrew Waxman writes on operational risk in capital markets and financial services. Andrew is a consultant in IBM's US financial risk services and compliance group. The views expressed her are those of his own. As an operational risk manager, Andrew has worked at some of the ... View Full Bio

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