When Theory Meets the Market – Part 1: Did the Trading Actually Move the Market

 

In many market abuse cases concerning alleged closing price manipulation and benchmark distortion, early attention is often directed towards motive. That is understandable. If a trader stood to benefit from a particular closing price, and traded shortly before the close, the circumstances may warrant investigation.

But motive and market impact are different things. 

The fact that somebody wanted a price to move does not establish that their trading actually moved it. In cases where a particular market effect is alleged, that is something which can and should be examined separately. 

 

Putting the trading into context 

The size of a trade on its own tells us surprisingly little. 

A purchase of £5 million of shares might be very significant in one security and relatively insignificant in another. What matters is the relationship between the trading and the market in which it took place. That means looking at matters such as normal trading volumes, liquidity and the timing of the orders. It also means looking at what everybody else was doing. If the market was already moving before the disputed trading began, or if substantial buying by other participants was taking place at the same time, those facts are relevant to any assessment of the effect attributable to the trades under examination. 

The same applies to the period selected for analysis. A trade may represent only a small proportion of the day’s total volume but a much larger proportion of the trading during a particular period around the close. Alternatively, presenting the trade as a large percentage of a narrowly selected period may exaggerate its importance when viewed against the trading day as a whole. 

There is no universally correct measure. The important point is to use the measure which actually helps explain what was happening in the market. 

 

What happened before and afterwards? 

Price behaviour around the trades can be particularly informative. 

If a security was already rising before the relevant orders arrived, continued to rise while they were being executed and remained at the higher level afterwards, it may be difficult to attribute the movement solely to those orders without further evidence. The position may look rather different if an order enters a relatively quiet market, consumes the liquidity available at several price levels and the price subsequently falls back once that buying ceases. 

Neither pattern proves or disproves manipulation. But they are very different pieces of market evidence. 

This is why simply placing a chart of the trades next to a chart of the price can be misleading. Two things happening at approximately the same time does not establish that one caused the other. The underlying trading needs to be understood. 

 

Market structure matters 

It is also important to understand how the particular market operates. 

Continuous order-book trading, closing auctions and benchmark calculations do not work in the same way. Nor do equities, FX, futures and less liquid instruments. A volume which might have little effect in one market can be significant in another. 

Closing auctions are a good example. An order submitted into an auction interacts with the other orders present and with the mechanism used to determine the uncrossing price. Looking only at the disputed order, without considering the other buying and selling interest in the auction, can give a misleading impression of its effect. 

The mechanics are therefore not a technical detail. They are part of the evidence. 

 

The problem with the counterfactual 

The obvious difficulty is that we cannot rerun the market without the disputed trades. We will never know with certainty where the price would have been if a particular order had not been entered. That limitation should be acknowledged rather than disguised by increasingly elaborate analysis. 

What can often be done, however, is to look at the available evidence and assess whether the proposed explanation is consistent with it. That may include the behaviour of the security before and after the trades, movements in related securities or indices, contemporaneous news, the orders of other market participants and the liquidity available at the relevant time. 

The result may be a range of plausible outcomes rather than a single alternative price. That does not make the analysis less useful. In my view, recognising that uncertainty is preferable to presenting a degree of precision which the market evidence cannot support. 

 

Motive is not a substitute for market evidence 

None of this means that motive is unimportant. In some cases it may be highly relevant. 

The point is simply that evidence of motive should not be allowed to answer a different question. 

If it is alleged that trading moved a market, there should be some analysis of whether the trading was capable of producing the effect alleged and whether the contemporaneous market evidence is consistent with that explanation. Sometimes it will be. Sometimes the evidence will show that the disputed trading was sufficiently large, sufficiently concentrated and executed in market conditions where an effect would be expected. 

In other cases, the wider market evidence may provide a much less straightforward explanation. 

That distinction can matter considerably in financial litigation. The narrative surrounding a transaction may be compelling, particularly when viewed many years later. But markets leave records, and those records providean opportunity to test the narrative against what was actually happening at the time. 

 

That, essentially, is what I mean by When Theory Meets the Market. 

 In the next article I will look at a different problem: why an individual trade can appear very different once it is considered as part of the wider transaction, strategy or portfolio to which it belonged.