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US financial regulators are investigating a claim by an anonymous whistleblower that the VIX volatility index at the centre of last week's stock market sell-off has been manipulated by rogue option market makers.
The VIX is commonly known as the 'fear' index because it measures changes in stock market volatility implied by the prices of financial options, which give their holders the right, but not the obligation, to buy or sell a security at a set price.
Volatility - the amount by which asset prices move up and down in trading - increases at times of market tension.
After a year of registering low volatility during a long period of unusual stock market calm, the VIX fear gauge shot up at the start of last week as unexpectedly strong US wage data spooked investors into believing that more interest rate rises would be needed to combat inflation, a move with huge implications for bond and share prices around the world.
The dramatic spike in the VIX index caused at least two exchange traded products betting on a continuation of low volatility to close with massive losses to their investors.
In an echo of the price-fixing scandals in recent years involving the Libor inter-bank lending rate and currency markets, the whistleblower, who purports to have held senior positions in several big investment companies, alleges that the VIX is subject to 'rampant manipulation'.
In a letter to two of America's most important financial regulators, the US Securities and Exchange Commission and Commodity Futures Trading Commission, the individual claims that a 'pervasive flaw' in the VIX enables sophisticated algorithm traders to move the index by simply posting quotes on options on US stocks without needing to trade or deploy capital.
'This market manipulation has led to multiple billions in profits effectively taken away from institutional and retail investors and cashed in by unethical electronic option market makers,' the whistleblower claims in the letter from Zuckerman Law in Washington.
The person accused the Chicago Board Options Exchange, where US options trade, of risking financial contagion by not placing safeguards around VIX products, given the correlation between the fear gauge and the S&P 500, the main US stock market index.
'The turmoil in financial markets, which cost American and foreign investors several trillions this week, originated from a known flaw in the market structure by most practitioners in the field, and the magnitude of losses experienced calls for accountability from both the exchange and market actors who engage in manipulation of the VIX,' the letter states.
CBOE rejected the claims: 'This letter is replete with inaccurate statements, misconceptions and factual errors, including a fundamental misunderstanding of the relationship between the Vix Index, Vix futures' and related exchange-traded products, it said in a statement reported by the Financial Times.
However, it also said it was working with the Financial Industry Regulatory Authority, a self-regulatory body for brokers and financial advisers overseen by the SEC, which is investigating the allegations.
'CBOE has a dedicated regulatory department that works with Finra to monitor certain trading activity for our securities markets, including trading activity that could impact the Vix settlement,' said Greg Hoogasian, CBOE's chief regulatory officer in a statement reported by the FT.