What is the VIX?
The VIX is a measure of expected volatility of the S&P 500 Index (SPX). It is a leading barometer of investor sentiment in the stock market. The CBOE also publishes several VIX sub-indices, tracking volatility in more narrowly defined markets.
The market for VIX derivatives has grown rapidly. Between 2011 and 2016, an average of $44billion notional VIX futures were traded annually ($700million market-to-market value). These products are increasingly traded by hedge funds, mutual funds and exchange-traded notes (ETNs). On 5 February 2018, Credit Suisse had to liquidate an ETN worth billions of dollars that tracked VIX futures, in response to VIX more than doubling in a single day.
Is the VIX settlement being gamed?
The chart below, which tracks the VIX on 20 December 2017, shows a steep drop between 07:30 and 08:30 (CST). The drop coincides exactly with the CBOE’s hour-long auction window used to calculate the final settlement price for VIX options.
The CBOE has strongly denied that its benchmarks are open to manipulation. However, last year, they fined DRW Securities $1.5m for attempting to manipulate the settlement price for options on three VIX sub-indices, on nine out of fourteen settlement days between February 2014 and March 2015.
Fideres has analysed the main VIX index and settlement for the same period flagged in the DRW fine. For each settlement day, we calculate the difference between the VIX index and VIX settlement. The average discrepancy is 2%.
We have also developed a preliminary model to estimate potential losses for investors in VIX futures, which settled between 2006 and 2017:
Note that the above calculations apply only to VIX futures. Manipulation of the VIX or VIX settlement can cause losses to investors in wide variety of financial products, including but not limited to:
§ VIX options
§ VIX-linked securities or securities that track the performance of VIX e.g. VelocityShares Daily Inverse VIX ETN (XIV)
§ Investors in algorithm trading firms that make buy/sell orders based on the movement of the VIX
§ Other financial products and derivatives linked to indices using the same calculation methodology as the VIX – e.g. the Cboe Russell 2000 Volatility Index
Why the VIX is easy to Manipulate
VIX derivatives that reference the VIX settlement are highly liquid. In contrast, SPX options that drive the value of VIX are not widely traded. As a result, a trader who wants to manipulate the VIX (and by extension VIX derivatives) can do so by placing a relatively small number of SPX option trades. The short settlement auction window also means that the risk of detection and potential costs for manipulators are low. Finally, VIX derivatives are cash settled, meaning that traders receive the cash value of their positions, even if they have deviated from their ‘true’ value.
The CBOE’s formula for calculating the VIX is also open to manipulation. It uses prices from a selection of out-of-the-money (OTM) SPX options, whose weighting in the formula increases the more OTM they are. A recent University of Texas study, using data from 2005 to 2015, showed that trading in deep OTM SPX options disproportionately increased during settlement auctions, in comparison to other similar products. This trend, they argue, cannot be explained by unrelated market events on the SPX.
Who may Manipulate the VIX?
The flaws in the design of the auction system make the VIX fix susceptible to manipulation by individual players. This presents a challenge for private claimants, as unlike previous financial manipulation cases (eg: LIBOR), identifying a small group of market participants with the same incentive to manipulate is not straightforward.
 Although the DRW case concerned a VIX sub-index and not the main index, we believe this assumption is reasonable. All VIX-related indices and settlements are calculated using similar methodologies.
 Source: CBOE, Fideres’ calculations.