Strategic trading and manipulation in trade at settlement contracts

• Published date: 01 May 2023
• Author: Craig Pirrong
• Date: 01 May 2023
• DOI: http://doi.org/10.1002/fut.22401

Received: 4 January 2023

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Accepted: 6 January 2023

DOI: 10.1002/fut.22401

RESEARCH ARTICLE

Strategic trading and manipulation in trade at settlement

contracts

Craig Pirrong

Bauer College of Business, University of

Houston, Houston, Texas, USA

Correspondence

Craig Pirrong, Bauer College of Business,

University of Houston, 4800 Martin

Luther King Dr, Melcher 240B, Houston,

TX 77204, USA.

Email: cpirrong@uh.edu and

cpirrong@gmail.com

Abstract

Trade at settlement (“TAS”) contracts are widely employed by futures

exchanges. They are an example of a “derived pricing”mechanism that

reduces the transactions costs of uninformed traders. However, TAS

contracts are susceptible to strategic, and indeed manipulative, trading by

large intermediaries. Those with large TAS positions can profit from

trading strategically/manipulatively, and this trading tends to cause

excessive price movements. Moreover, some of the price impacts of such

strategic trading are permanent. The severity of strategic/manipulative

trading and its effects depends on the concentration of TAS positions, and

information on concentration and price movements can be used to detect

such trading.

KEYWORDS

futures markets, manipulation

1|INTRODUCTION

“Trade at settlement”(“TAS”) is a ubiquitous form of trading in futures markets. In a TAS contract, before the

settlement period on a given day, a trader agrees to buy or sell a futures contract at the settlement price established

later in the day. Pirrong (2020) demonstrates that TAS contracts reduce transactions costs for uninformed traders (e.g.,

hedgers or commodity‐based exchange‐traded funds [“ETFs”]): when some information is short lived, or competition

among informed traders is intense, the uninformed can signal their lack of private information by trading TAS rather

than the underlying futures contract and thereby reduce their executions costs.

Pirrong (2020) shows how TAS contracts can also create opportunities for manipulation. Indeed, there are

instances in which TAS trading has been implicated in alleged manipulations, including the notorious episode of

negative crude oil futures prices on April 20, 2020, and the Optiver case from 2008. More generally, former

Commodity Futures Trading Commission (CFTC) commissioner Dan Berkovitz raised questions about the

potentially adverse consequences of TAS trading:

The CME Group contract markets have recognized the potential for market abuse and distortion through the

use of TAS, warning market participants that “any trading activity that is intended to disrupt orderly trading or

to manipulate or attempt to manipulate a settlement price to benefit a TAS position will subject the member

and/or the market participant to disciplinary action.”Further, “[t]o prevent these abuses …the CME/CBOT has

limited TAS trading in agricultural commodities to only the most liquid commodities, and only in the most

liquid contract months.”

J Futures Markets. 2023;43:615–634. wileyonlinelibrary.com/journal/fut © 2023 Wiley Periodicals LLC.

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In this article, I examine the impact of TAS on strategic trading in the presettlement and settlement periods. In

particular, using a modification of microstructure models of Kyle (1985), Admati and Pfleiderer (1988), and Osler

and Turnbull (“OT”)(2016), I show that imperfectly competitive TAS market makers have an incentive to trade

the underlying futures contract strategically before and during the settlement period. That is, these market makers

exercise market power that distorts prices. Moreover, the strategic trading depends on the concentration of the

market makers.

This model has several implications. First, strategic trading leads to excessive movements in the settlement

price: some TAS market makers profit from these excessive movements. Second, there can be “overtrading”:that

is market makers may trade more underlying futures contracts than necessary to offset their TAS exposure.

Third, price impacts tend to be greater, the more concentrated the TAS market makers. This higher

concentration can result from a smaller number of equally sized market makers, or the presence of a single large

market maker and some smaller market makers. Fourth, although a portion of the price impact of the strategic

trading is transitory, some is permanent because of the inability of market participants (and notably market

makers in the underlying future) to distinguish the uninformed trading of the TAS market makers from

informed trading.

The remainder of the article is organized as follows. Section 2briefly describes the futures settlement mechanisms

and TAS contracts. Section 3outlines the model. Section 4explores the predictions of the simplest model where there

are

N

imperfectly competitive, identical TAS market makers. Section 5extends the model to the case of a single large

market maker and a “fringe”of imperfectly competitive smaller market makers. Section 5considers the case where the

amount of concentration varies randomly over time. Section 6summarizes.

2|FUTURES SETTLEMENT AND TRADE AT SETTLEMENT

Futures exchanges establish daily settlement prices that are used to determine mark‐to‐market values, and hence

variation margin payments, on a daily basis. For actively traded futures contracts, the settlement price is usually

derived from transaction prices from a period beginning a few minutes before the close of trading and ending at

the close. For example, for New York Mercantile Exchange (NYMEX) Light Sweet Crude Oil Futures, the

settlement price for the “active”contract (the front month contract until two days before expiry) is the volume

weighted average price (“VWAP”) rounded to the nearest tick during the period 14:28:00–14:30:00. For other

heavily traded contracts other than the active contract, the settlement price is based on the active contract VWAP

and the VWAP of spread trades between the active contract and the contract of interest, again during the

14:28:00–14:30:00 interval.

On the various Chicago Mercantile Exchange (CME) Group exchanges (CME, Chicago Board of Trade, and

NYMEX) market participants can enter into TAS contracts throughout the day, starting with the preopening period and

continuing until the end of the settlement period related to the contract. The price paid/received by a TAS participant is

the final settlement price plus or minus a differential. Exchange rules limit the maximum differential (e.g., plus or

minus 10 ticks for crude oil). For example, the buyer of a TAS at a differential of 2 pays the final settlement price plus

two ticks (e.g., 2 cents/barrel for crude oil).

3|THE MODEL

In this model, trading takes place as follows:

•At T1

−

, some uninformed traders submit TAS orders to TAS market makers. Market maker

d

receives orders

FF=˜+ϵ

d

d

. The variance of

F

˜is

σ

S

2

and the variance of

ϵ

d

is

σ

ϵ

2

for all

d

. The common component

F

˜could be driven,

for example, by an imbalance of flows into/out of ETFs holding the underlying future, or an imbalance of hedgers

rolling positions into a deferred month.

•At T

1

, TAS market makers can trade the underlying futures contract. Informed traders and other noise traders (both

described below) can also trade the future.

•At

TT>

s

1

, TAS market makers can trade the underlying futures contract. Informed traders and other noise traders

can also trade. TAS orders are filled at the market clearing price at

T

s

.

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PIRRONG