Standard II(B) – Market Manipulation

CFA Institute members and candidates are prohibited from engaging in tactics that artificially increase trading volume to deceive market participants under the Integrity of Capital Markets, Market Manipulation policy.

Application 1: Manipulation of Model Inputs

Andy Knoxville is the head of structured products at Kings Investment Bank. As the structured products team leader, he is responsible for creating new and creative products that attract potential investors. He notices that there is substantial interest in low-volatility products. Consequently, Knoxville creates “low-vol” products that contain inputs intended to suppress the negative impact of higher volatility in the market. A part of Steven’s compensation is directly linked to the number of clients that purchase these “low-vol” products. In periods of low volatility, clients that bought these products were extremely successful. Since the beginning of the coronavirus epidemic, high levels of volatility have led to numerous defaults.

Has Knoxville violated Standard II(B) – Market Manipulation?

1. No, clients should be aware of the complexity of the “low-vol” structured product.
2. No, he did not artificially manipulate any stock’s price, volume, or volatility.
3. Yes, intentionally manipulated the inputs of the model to conceal the effects of higher volatility on the returns of the product.

Solution

The correct answer is C.

Steven violated Standard II(B) – Market Manipulation. Intentionally manipulating model inputs is considered a form of information-based manipulation. Steven’s manipulation was intended to attract more business and increase his compensation. His actions would cause investors to lose trust in capital markets and poorly reflect the investment profession. 

Application 2: Pump-Primping Strategy

John Reynolds, CFA and CEO of Naxis Future Exchange (NFE), introduces a new equity index futures contract into the market. In an attempt to attract individuals and major brokers to trade on its exchange, Naxis offers significant discounts on its trading fees. To be eligible for the reduction in trading fees, firms must agree to a minimum trading volume of the new contract over the next six months. Naxis hopes that the demonstration of consistently large liquidity will attract new brokerages and retail traders to its exchange.

Are Reynolds’s actions in conflict with Standard II(B) – Market Manipulation?

1. No, Reynolds is allowed to offer discounts on trading fees.
2. No, the firms or retail traders who engage with Reynolds’ exchange on this offer are in violation.
3. Yes, because Reynolds is attempting to mislead investors about the liquidity of the contract.

Solution

The correct answer is C. 

Investors may be misled by the artificial liquidity generated by Naxis through the discounts offered. The expiry of the discount after six months could potentially reduce the liquidity of the contract. Because Reynolds failed to disclose this agreement with all its clients and potential clients, he has violated Standard II(B) – Market Manipulation. Disclosure of the arrangement to all investors would comply with Standard II(B) – Market Manipulation.

Application 3: Market Manipulation

Larry Linkard, CFA, is a public relations and investment strategist at VCX securities, the leading investment bank in an IPO of a telecommunication service provider that has been performing well recently. VCX is finding it difficult to sell the IPO due to the recent negative publicity the telecommunication company has received due to management misconduct. The management of the telecommunication company is currently under investigation by the regulator.

Larry released a statement to the public to sell the IPO, implying that the telecommunication management has been cleared of any wrongdoing. Under the CFA Code and Standards, Larry:

1. violated the Code and Standards.
2. did not violate the Code and Standards as no investors were harmed.
3. did not violate the Code and Standards as the company’s performance is exceptional.

Solution

The correct answer is A.

Larry violated the CFA Institute Code and Standards because he attempted to manipulate the demand for the shares of the telecommunication company. Standard II(B) prohibits members and candidates from engaging in tactics that artificially increase trading volume to deceive market participants.

B is incorrect. The fact that Larry is deceiving the public into buying the shares of the telecommunication company is a violation of the CFA Institute Code and Standards whether investors are harmed or not.

C is incorrect. The telecommunication company’s performance should not be used as an excuse for Larry to deceive investors.

LOS 3(a): Evaluate practices, policies, and conduct relative to the CFA Institute Code of Ethics and Standards of Professional Conduct.

LOS 3(b): Explain how the practices, policies, or conduct does or does not violate the CFA Institute Code of Ethics and Standards of Professional Conduct.