Modern Market Manipulation

by Mike Riess  

as presented at the International Precious Metals Institute 27th Annual Conference, 
16 June 2003 , San Juan , Puerto Rico

  Here’s a question I hear often: Why worry about market manipulation—it happens all the time?

The reason we have markets is price identification.  By knowing the price, you know the value of your asset and you can use the value to plan and make decisions.   Market manipulation subverts the whole purpose.  It wrecks markets and puts everyone but the manipulator at a disadvantage.  That’s why market manipulation is a felony, punishable by 5 years in prison and a $1 million fine.

I’m going to use the Sumitomo copper manipulation as an example throughout this talk.  By way of background, Sumitomo was a major factor in the copper market in 1986 when Yasuo Hamanaka became Sumitomo’s chief copper trader.  He attracted allies, took over the copper market and then, for 10 years, he gamed the public, the regulatory agencies and even his own management.  He was joined in 1991 by Charles Vincent and Ashley Levett, who formed Winchester Commodities to execute the trades for the manipulation. It all unraveled in 1996.  

Sumitomo represented the Japanese Smelter Pool, a cartel that collectively bought copper concentrate at a forward price and sold refined copper prompt.  It liked high prices, but what it really needed was a consistent backwardation.  This chart of prices and the backwardation shows just how successful they were: 

The CFTC’s definition of manipulation is:

a.       A planned operation that causes or maintains an artificial price,

b.      Unusually large purchases or sales in a short period of time in order to distort prices, and

c.       Putting out false information in order to distort prices.

In many cases, the ways markets are manipulated haven’t changed much over the centuries.  But in others, they have changed dramatically, even in the last 10 or 20 years.  I’d single out these 3:

1. The layers of leverage associated with futures markets, and the importance of futures markets in industry pricing.

2. The size of market participants compared to the raw material markets.  Also the diversity of the players and their potential to do harm..

3. National regulatory bodies with international challenges.
   

Let me elaborate on each of these three areas: 

1. Vulnerability of futures markets:  If you are going to manipulate a market, the futures market is the place to begin.  We routinely use formulas based on COMEX or the London Fix as an index to set the price of physical purchases and sales—even if we do no business directly on the exchange.  So, if you control the futures price you control the price at which the whole industry does business. 
   
   At the same time, futures markets are especially vulnerable to manipulation.
   
   The amount of deliverable metal on the futures exchange varies substantially compared to the physical volume of the commodity produced.  In normal times, it might range from 5% to 10% percent.  Original margin requirements run about 5% of the value of a contract, so it’s cheap to carry a large futures position relative to the amount of material that can be delivered, and certainly compared to production.  As first notice day and the delivery period approach, prices of nearby material will be pressured up if it appears the long isn’t going to liquidate.
   
   

2. The size and diversity of the market participants has changed and has increased the markets’ vulnerability to manipulation. 

a.       Financial institutions have become major players in the metals markets. So, the potential to finance a market operation is much closer at hand.   To manipulate a market, you need to control deliverable metal, which requires funding.  The metal-dealing units of the major financial houses are natural financiers, and the Sumitomo manipulation would not have worked without them. 

Hamanaka had authority to trade copper but not to borrow money.  The metal dealing divisions of financial institutions have the same limits:  they borrow and lend metal, but not money. 

One way to solve Hamanaka’s financing problem within everyone’s constraints was metal swaps.  The dealers bought Sumitomo’s inventory and sold it back for forward delivery.  This was an off-balance sheet metal financing transaction that gave Hamanaka the liquidity he needed to buy more metal, it didn’t affect the parent’s borrowing capability, and it gave the dealers an annualized yield said to be as high as 40%.  Everyone stayed within the letter of their corporate authorities and everyone violated the law.

We are not talking about a few isolated cases.  Here is a partial list of companies, the damages they paid to Sumitomo and the fines they paid:

The list is partial because it does not include settlements that were sealed. 

The list also highlights the inadequacy of regulatory censure.  Million pound or million dollar fines are huge for the exchanges, but the companies are so large that a seven digit fine is just a bad hair day.  It is only through the courts that the penalties reflect the scale of the players. 

b.      The financial houses are large fish in a very small pond. As we have evolved from an industrial to a service and information economy, the raw material markets, including the metals markets, have become relatively less important.  Metals companies have consolidated and concentrated, and our industry seems to get smaller every year. 

Meanwhile, the financial markets have enjoyed explosive growth, and the financial services organizations have ballooned with them.   

Today, it isn’t just the little markets like palladium, platinum or the exotic metals that are vulnerable to manipulation.  If copper can be manipulated for 10 years, so can silver, and maybe even gold. 

c.       Before the ‘80’s, there were just us traders.  Rogue traders arrived on the scene with the large institutional participants, both private and public.  Today’s companies and government marketing boards are large enough for senior management to distance itself from controversy, including market manipulation. 

In a competitive, amoral environment, middle managers in these mega-organizations have the authority to hijack an institution’s reputation and the financial clout to manipulate the market—and they do.  As long as they succeed, they enjoy promotions and perks and, sometimes, the fruits of embezzlement.  If the manipulation unravels, the company denies any knowledge and hangs the rogue out to dry.  We’ve seen this over and over again, most recently with D’Avila and Codelco, Hamanaka and Sumitomo, Leeson and Barings and Tsuda and Daiwa Bank.

d.      Commodity funds and hedge funds are new and important factors.  It’s not unusual for a fund group to have assets of over $1billion.  That is significant power.

Some funds colluded directly with Sumitomo to manipulate the copper market. 

In other cases, Hamanaka manipulated the funds to orchestrate market moves.  Most large funds use mathematical, statistical and technical trading systems.  Sophisticated manipulators can, and do, figure out the funds’ trading patterns.  Hamanaka and his UK associates, Winchester Commodities, used the funds’ trigger points to accelerate market moves. 

e.       We’ve had a great deal of press in the last ten years about derivatives and how they undermine the markets.  Futures and options were traded in Amsterdam in 1650, so derivative products are hardly new to the commodity markets. 

What is new is the scope.  Sumitomo engineered a 1 million ton option strategy to control the LME copper stocks, which were about 500,000 tons at the time.  The face value of the underlying long was about $2 billion.  This was known as the RADR transaction and might have been the largest futures or raw material position ever.  RADR was risk-neutral, so its only economic purpose was to funnel $50 million to Winchester .

f.        There’s also nothing new about disinformation in the market place.  But again, the scale was unprecedented.  Sumitomo moved hundreds of thousands of tons copper out of European LME warehouses to make inventories look like they were disappearing.  Meanwhile, the material was afloat or lodged in a warehouse not registered with the LME.   A Chinese Government trading company took 100,000 tons off the market;  when prices dropped, it became a “national stockpile.”  Some was parked in Singapore and Korea .

Market economies and democracies work because a variety of forces automatically reach out to bring the outliers and aberrations back into line.  A successful manipulation overwhelms the tug of moderating market forces.  That leaves the regulators and courts as the last line of defense:

3. Regulators with international challenges:  The Sumitomo situation cried out for international regulatory cooperation.  Instead, the problem was perpetuated and even fueled by turf wars between exchanges and regulatory bodies.
   
   The LME based its reactions on the marketplace.  When the backwardation exceeded a certain level, it intervened.  COMEX looks to position size, particularly as a delivery approaches maturity.  Another difference was that U.S. regulators insist on knowing the beneficial owner of a position; the U.K. did not. 
   
   But the overriding mandate is to keep markets orderly and prevent manipulation.  To that end, both the U.S. and U.K exchanges and regulatory agencies have broad emergency powers.  They can limit business to liquidating trades only, or even close the exchange entirely.  So, the core issue is not the regulations:  it is the will of the leadership. 
   
   The decisions that need to be made are always fraught with conflicts and political pressure.  The exchanges’ immediate constituencies, both in the U.S. and in London , are its members.  Most of these are traders and brokers.  Manipulations generate excitement and market activity, the lifeblood of traders and brokers, so the exchanges can be reluctant to intervene. 
    
   The LME chose a policy of benign neglect.  After all, Sumitomo was the industry leader, and it’s comfortable to believe that big strong companies are also virtuous.  And business on the exchange was booming.  So, when David Threlkeld blew the whistle on Hamanaka in 1991, the LME banned him from the exchange, and it accepted Sumitomo’s assurances until the very end that all was right with the world.
   
   The U.S. picture was quite different.  COMEX and the CFTC rightfully earned high marks for leadership, but their job was much easier: 

1. Sumitomo had focused on the LME.  COMEX had not benefited from the volume and didn’t have much to lose..

2. The strongest part of NYMEX’s constituency was in the energy contracts, and the exchange was not about to tolerate a manipulation in metals that might jeopardize its energy business. 

3. The LME had to stand alone, whereas NYMEX had the proactive support of the CFTC in resisting the wash over from London to New York .

Typically, the manipulators have a head start and the regulators have to play catch up.  In 1993, when the LME finally limited the daily backwardation, COMEX and the CFTC anticipated that the manipulation might shift to the U.S.    They knew what was coming, so they could immediately pressure Hamanaka and Winchester with position limits and disclosure requirements.  And, for the most part, the U.S. regulatory bodies kept Hamanaka in London . 

With Hamanaka’s focus back in London , the LME went to a twelve cent premium over COMEX.  This was in an arbitrage that typically ranges between two cents over or under.  The copper price at the time was about $1.00 so you had a 10% move attributable solely to the turf war between the regulatory bodies. 

The CFTC took the position that, even though the activity was mainly on the LME, the arbitrage between London and New York was causing COMEX to be manipulated.  It demanded extensive information on LME customer activity from U.S. brokers.  Those that held back information were subject to fines and censure.  None of this made the LME very happy.

Hamanaka had never been able to control the COMEX inventories, even though they are normally only about a tenth of the LME’s.  In early 1995, when Sumitomo proposed LME warehouses located in the U.S. , the LME’s management jumped at the chance to put a thumb in COMEX’s eye.  At a 12Ë LME premium, deliverable stocks flew out of the COMEX warehouses and into the new U.S. LME warehouses.  COMEX stocks went as low as 3000 tons, when typically they run over 50,000.  In the end, Sumitomo controlled over 80% of the U.S. LME warehouse warrants. 

Late in 1995, when the CFTC began to contact non-U.S. companies with LME positions, the LME finally began cooperating, and in the beginning of ’96 Hamanaka’s manipulation was stopped.  It’s unclear whether it ended because of the regulators, or because Hamanaka ran out of credit lines, or as Sumitomo claims, they found an accounting error that finally revealed all.

I mentioned earlier that it is only through the judicial system that large companies can be fined in proportion to their size.  Our civil courts are still our best line of defense.  That’s because:

1.      Civil court actions are driven by self interest. 

2.      So, the reaction is reliable and almost inevitable.

In the Sumitomo case, it was the class action and contingency attorneys that served the public interest.

There are copper consumers that lost millions of dollars buying copper at high prices and hedging copper into a backwardation.   In their books and in their minds, they wrote off the loss.  Individual lawsuits made no economic sense against the juggernaut of Sumitomo lawyers.  But as part of a class, many of them recaptured their losses.

As to contingency lawyers, major law firms surf the net and scan the financial news routinely looking for corporate hiccups that violate the law.  Anti-trust activity in restraint of trade and activity in violation of the RICO statutes carry triple damages, so they are especially attractive targets.  If the attorneys win, they can win very big; if they lose, they sacrifice years of time, effort and foregone fees.  For a plaintiff, this is a very comfortable arrangement.  And for the industry and society, it’s important to have an automatic reaction to a crime.

The criminal courts are not as reliable because there’s nothing automatic about prosecution.  The threat of prison time should be a powerful deterrent.  But as a practical matter, prosecutors don’t seem very much concerned with white collar crime.  Only one person, Hamanaka, was prosecuted in the Sumitomo case and that was in Japan .  Since criminal prosecution is only a remote threat, and since the fines and damages are generally paid by the companies, not by the individuals, the question is: what’s to keep a Sumitomo from happening again, perhaps in precious metals?