Evidence of market manipulation in the financial crisis

📝 Abstract

We provide direct evidence of market manipulation at the beginning of the financial crisis in November 2007. The type of manipulation, a “bear raid,” would have been prevented by a regulation that was repealed by the Securities and Exchange Commission in July 2007. The regulation, the uptick rule, was designed to prevent manipulation and promote stability and was in force from 1938 as a key part of the government response to the 1929 market crash and its aftermath. On November 1, 2007, Citigroup experienced an unusual increase in trading volume and decrease in price. Our analysis of financial industry data shows that this decline coincided with an anomalous increase in borrowed shares, the selling of which would be a large fraction of the total trading volume. The selling of borrowed shares cannot be explained by news events as there is no corresponding increase in selling by share owners. A similar number of shares were returned on a single day six days later. The magnitude and coincidence of borrowing and returning of shares is evidence of a concerted effort to drive down Citigroup’s stock price and achieve a profit, i.e., a bear raid. Interpretations and analyses of financial markets should consider the possibility that the intentional actions of individual actors or coordinated groups can impact market behavior. Markets are not sufficiently transparent to reveal even major market manipulation events. Our results point to the need for regulations that prevent intentional actions that cause markets to deviate from equilibrium and contribute to crashes. Enforcement actions cannot reverse severe damage to the economic system. The current “alternative” uptick rule which is only in effect for stocks dropping by over 10% in a single day is insufficient. Prevention may be achieved through improved availability of market data and the original uptick rule or other transaction limitations.

💡 Analysis

We provide direct evidence of market manipulation at the beginning of the financial crisis in November 2007. The type of manipulation, a “bear raid,” would have been prevented by a regulation that was repealed by the Securities and Exchange Commission in July 2007. The regulation, the uptick rule, was designed to prevent manipulation and promote stability and was in force from 1938 as a key part of the government response to the 1929 market crash and its aftermath. On November 1, 2007, Citigroup experienced an unusual increase in trading volume and decrease in price. Our analysis of financial industry data shows that this decline coincided with an anomalous increase in borrowed shares, the selling of which would be a large fraction of the total trading volume. The selling of borrowed shares cannot be explained by news events as there is no corresponding increase in selling by share owners. A similar number of shares were returned on a single day six days later. The magnitude and coincidence of borrowing and returning of shares is evidence of a concerted effort to drive down Citigroup’s stock price and achieve a profit, i.e., a bear raid. Interpretations and analyses of financial markets should consider the possibility that the intentional actions of individual actors or coordinated groups can impact market behavior. Markets are not sufficiently transparent to reveal even major market manipulation events. Our results point to the need for regulations that prevent intentional actions that cause markets to deviate from equilibrium and contribute to crashes. Enforcement actions cannot reverse severe damage to the economic system. The current “alternative” uptick rule which is only in effect for stocks dropping by over 10% in a single day is insufficient. Prevention may be achieved through improved availability of market data and the original uptick rule or other transaction limitations.

📄 Content

Evidence of market manipulation in the financial crisis∗ Vedant Misra, Marco Lagi, and Yaneer Bar-Yam† New England Complex Systems Institute 238 Main Street Suite 319, Cambridge, Massachusetts 02142, US (Dated: October 29, 2018) Abstract We provide direct evidence of market manipulation at the beginning of the financial crisis in November 2007. The type of market manipulation, a “bear raid,” would have been prevented by a regulation that was repealed by the Securities and Exchange Commission in July 2007. The regulation, the uptick rule, was designed to prevent market manipulation and promote stability and was in force from 1938 as a key part of the government response to the 1929 market crash and its aftermath. On November 1, 2007, Citigroup experienced an unusual increase in trading volume and decrease in price. Our analysis of financial industry data shows that this decline coincided with an anomalous increase in borrowed shares, the selling of which would be a large fraction of the total trading volume. The selling of borrowed shares cannot be explained by news events as there is no corresponding increase in selling by share owners. A similar number of shares were returned on a single day six days later. The magnitude and coincidence of borrowing and returning of shares is evidence of a concerted effort to drive down Citigroup’s stock price and achieve a profit, i.e., a bear raid. Interpretations and analyses of financial markets should consider the possibility that the intentional actions of individual actors or coordinated groups can impact market behavior. Markets are not sufficiently transparent to reveal or prevent even major market manipulation events. Our results point to the need for regulations that prevent intentional actions that cause markets to deviate from equilibrium value and contribute to market crashes. Enforcement actions, even if they take place, cannot reverse severe damage to the economic system. The current “alternative” uptick rule which is only in effect for stocks dropping by over 10% in a single day is insufficient. Prevention may be achieved through a combination of improved transparency through availability of market data and the original uptick rule or other transaction process limitations. ∗A report on preliminary results from this work was transmitted to the House Financial Services Committee and sent by Congressman Barney Frank and Congressman Ed Perlmutter to the SEC on May 25, 2010. † Corresponding author: yaneer@necsi.edu 1 arXiv:1112.3095v3 [q-fin.GN] 3 Jan 2012 I. INTRODUCTION TO BEAR RAIDS AND MARKET MANIPULATION On July 6, 2007, the Securities and Exchange Commission (SEC) repealed the uptick rule, a regulation that was specifically designed to prevent market manipulations that can trigger market crashes. While it is widely accepted that the causes of the crash that began later that year were weaknesses in the mortgage market and financial sector, the close proximity of the repeal to the market crash suggests that market manipulation may have played a role. Here we present quantitative evidence of a major market manipulation, a “bear raid,” that would not have been possible if the uptick rule were still in force. The timing of the bear raid, in autumn 2007, suggests that it may have contributed to the financial crisis. Bear raids are an illegal market strategy in which investors manipulate stock prices by collectively selling borrowed shares. They profit by buying shares to cover their borrowed positions at a lower price. While bear raids are often blamed for market events, including financial crises [1, 2], this paper is the first to demonstrate the existence of a specific bear raid. The sale of borrowed shares, called short selling, is a standard form of market trading. Short sellers sell borrowed shares, then buy them back later and return them to their owners. This practice yields profits when prices decline. In a bear raid, investors engage in short selling with the addition of market manipulation. Instead of profiting from a natural decline in the fundamental value of a company stock, the executors of a bear raid themselves cause the price to decline. Large traders combine to sell shares in high volume, “driving” the price down [3, 4]. A bear raid is profitable if other investors are induced to sell their shares at the lower price. This may happen for two reasons: margin calls and panic. Margin calls occur when brokerages force investors to liquidate their positions. Investors who are confident in the rising price of a stock may buy shares on borrowed funds, called “buying on margin,” using the value of the shares themselves as collateral. When prices decline, so does the value of the collateral and at some point brokerages issue “margin calls,” requiring shares to be sold even though the owners would prefer not to. Panics occur when investors, fearing further losses, sell their shares. The executors of a bear raid profit from the price decline by buying back the shares they bor

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