Cboe exchange turns to machines to police
its 'fear gauge'
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[September 20, 2018]
By John McCrank and Saqib Iqbal Ahmed
NEW YORK (Reuters) - Hard pressed to quash
allegations that its popular "fear gauge" is being manipulated, Cboe
Global Markets <CBOE.Z> is turning to artificial intelligence to help
put those concerns to rest.
The exchange, which owns the lucrative volatility index the VIX <.VIX>,
has taken several steps to confront manipulation claims that have helped
drive the Cboe's stock down about 15 percent this year, putting it on
pace for its worst year ever.
In its latest effort to police trading tied to the index, the Cboe is
working with FINRA, its regulatory services provider, to develop machine
learning techniques to tell whether market conditions surrounding the
VIX settlement are potentially anomalous, the exchange told Reuters.
"Incorporating the use of machine learning and AI (Artificial
Intelligence) is a logical part of the ongoing enhancement of our
overall regulatory program," Greg Hoogasian, Cboe chief regulatory
officer, said in an emailed statement.
Cboe declined to elaborate on when it began using machine learning
techniques to monitor VIX settlements.
Any steps, however, may take a while to change investors' minds on the
"Any time you see controversy over manipulating markets and it involves
a company, there are people who will walk away from the stock," said
Peter Tuz, president of Chase Investment Counsel in Charlottesville,
"It ends up tarnishing the company and subjecting them to legal risk
that is very hard to quantify," he said.
Tuz said Chase Investment Counsel, which owned nearly 19,000 Cboe shares
in mid-2017, began selling its stake early this year, shedding the last
of it on May 21.
Cboe's stock performance this year has lagged that of other major
exchange operators. Shares of Nasdaq Inc <NDAQ.O> are up about 17
percent, Intercontinental Exchange Inc's <ICE.N> is up about 10 percent
and CME Group Inc <CME.O> shares have risen 18 percent.
Concerns the index was being manipulated surfaced last year after John
Griffin and Amin Shams of the McCombs School of Business at the
University of Texas, Austin wrote an academic paper that noted
significant spikes in trading volume in S&P 500 index options right at
the time of settlement.
The paper also compared the value of the VIX at settlement with its
value as calculated from S&P 500 options right after the settlement, and
showed the two tend to diverge.
Instances of big deviations are taken as evidence by some that
unscrupulous traders have been deliberately moving the settlement price.
A stock market fall on Feb. 5 that caused the VIX to surge the most in
its 25-year history brought further scrutiny to the index, and led to
dozens of lawsuits and ongoing probes into the matter by the U.S.
Securities and Exchange Commission and the Commodity Futures Trading
The regulators have yet to comment on the matter and Cboe has denied the
manipulation accusations, citing liquidity problems and legitimate
hedging activity as reasons for unusual moves on settlement days.
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People walk by the Chicago Board Options Exchange (CBOE) Global
Markets headquarters building in Chicago, Illinois,
U.S., September 19, 2018. REUTERS/Michael Hirtzer
"Only a forensic analysis of those episodes can confirm or refute
such a claim," said Kambiz Kazemi, partner at Canadian investment
management firm La Financière Constance.
Meanwhile, the steps Cboe has taken to address the claims of
manipulation are going in the right direction, said Kazemi.
The exchange operator recently overhauled the technology behind the
auctions, improved the speed with which it sends alerts about
auction imbalances, and sought to increase the number of market
makers that provide buy and sell quotes for the auction.
POLICING THE FEAR GAUGE
Orderly VIX settlement auctions over the last few months have helped
take some of the pressure off the Chicago-based exchange operator.
"I think we all will be observing the effects of the Cboe measures
in the next few months," Kazemi said.
VIX and associated products accounted for roughly a quarter of
Cboe's 2017 earnings, analysts estimate, and the controversy around
the product has spooked some stockholders.
While financial firms have been using artificial intelligence
software for everything from compliance to stock-picking, a growing
number of firms have started to use it for market oversight.
Given the huge amount of data involved in market surveillance,
machine learning algorithms can be far more efficient than humans in
rooting out potential market manipulation, said Richard Johnson, a
market structure and technology consultant at Greenwich Associates.
"It's going to be a must have," he said.
FINRA, which already monitors Cboe's market on the company's behalf,
confirmed it was working on machine learning to enhance surveillance
of the VIX settlement auctions, but would not offer specifics.
More generally, the Wall Street watchdog is working to use
artificial intelligence to catch nefarious activities more quickly,
including schemes that may have previously been unknown to
regulators, said Tom Gira, who oversees FINRA’s market regulation
He said FINRA has begun using machine learning to scan for illegal
activities across stock and options exchanges and is in the process
of adding a feedback loop to the software that would regularly
incorporate analysts' data and allow the machines to detect
ever-changing manipulation patterns.
(Reporting by John McCrank and Saqib Iqbal Ahmed in NEW YORK;
Additional reporting by Michelle Price in WASHINGTON; Editing by
Megan Davies and Tomasz Janowski)
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