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A whistleblower complaint that “rampant manipulation of the VIX index” was at play in the recent stock market meltdown last week comes at a time when algorithmic factors are underlying market prices at a unique moment in history.

The February 12 letter to the Commodity Futures Trading Commission and Securities and Exchange Commission urges the regulators to take swift action “before investors suffer additional losses due to this fraud.” Cited in the whistleblower letter is volatility trader Chris Cole of Artemis Capital Management, who is firing back as well.

Volatility professionals were noticing odd market patterns with the VIX and its correlation ratios early last week as the S&P 500 when on a wild nearly 250-point market meltdown. At the time ValueWalk reported the primary issue:

Late Monday afternoon the unwinding of VIX linked short volatility products spilled over into Tuesday morning as market maker liquidity temporarily dried up, according to one market participant.

Monday’s whistleblower complaint, to a limited degree, detailed how the liquidity issues in question arose:

The flaw allows trading firms with sophisticated algorithms to move the VIX up or down by simply posting quotes on S&P options and without needing to physically engage in any trading or deploying any capital. This market manipulation has led to multiple billions in profits effectively taken away from institutional and retail investors and cashed in by unethical electronic option market makers.

At play is work by alleged options market makers to “spoof,” or submit false orders to the exchange that have no reasonable intent to be filled. These orders are identified by a mechanism in the algorithmic systems that interprets the orders as indicating the market pricing is about to change, and market makers adjust their pricing accordingly.

In the case of VIX, the pricing method uses thinly traded out of the money S&P 500 options that can be easily manipulated – a flaw well-known to market participants but one that, until recently, was not much noticed until the market meltdown of nearly one week ago.

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