The option exchange TOM has been gamed by a trader. The case came the light last week, after a string of suspicious trades in AEX index options. The exchange hasn’t lost any money on the (alleged) manipulation. The burden was for the market makers. It’s a bit of a complicated story for outsiders, I’m afraid.

Basic background

On the multilateral trading facility TOM (“The Order Machine“), options are listed on Dutch stocks and the AEX index. The same options are also trading on Euronext. In other words, there are usually two markets for the same option at the same time. A third option exchange, Eurex, doesn’t play a role in this story.

Stat trades

Banks like ABN AMRO and brokers like Binck are connected to TOM. There is a kind of monopoly, as all orders from these connected brokers are routed to TOM. There can be a better market on the Euronext market in an option. TOM guarantees best execution. It compares the price on their own trading platform with Euronext. TOM explains it like this.

If the client sends a market buy order in an option, and the price on Euronext is lower – it get’s executed on TOM against Euronext’s price. What happens is this:

  1. TOM Broker buys the lower offer on Euronext
  2. TOM Broker gives this Euronext trade to a market maker
  3. TOM Broker executes the client buy order against the market maker on TOM MTF (Multilateral Trading Facility)
  4. Market maker ends up with a long position on Euronext, and short position on TOM MTF in the same instrument. Matched against the same price. Market maker gets a small rebate for this service.

We call this a “stat trade“.

Opt out

The next step was to allow market makers to opt out of the automatic hedge on Euronext. Market makers can say, “if there’s a better price for the retail customer on Euronext, we are willing to trade against the customer. No matter the price on Euronext“.

This makes sense. TOM can execute everything on their own platform. Market makers get the trades, and have the possibility to decide between scratching the trade on Euronext or to keep the trade.

As a result, less volume will move to Euronext. The market maker on Euronext with tight quotes will do less trade volume on his quotes. In practice, this isn’t much of a problem for market makers. Apart from All Options, every market maker is active on both exchanges. Euronext isn’t happy.

The manipulation

Jerry gives a sharp offer in an option on Euronext. Then Jerry logs in into his Binck or ABN retail account, and gives a buy order with the same price as his own offer on Euronext. His buy order will be executed on TOM against a randomly assigned market maker. Jerry’s offer on Euronext remains untouched. Jerry quickly withdraws his offer on Euronext.

This is what happened in the AEX options on TOM. Longer dated AEX options have wider spreads. More possibility to game the opt out system. Market surveillance at TOM noted the strange trades last week. They switched off the Opt Out functionality completely.

Where is the money?

How does Jerry make money with this? He could to the same trick the other way around. Scalping a few cents profit. Alternatively, he could game the market makers and the exchange for more advanced strategies. Building a more complex option position against profitable prices.

It’s not easy to make a substantial profit with this manipulation. The fake order on Euronext can’t be too sharp – your order may be executed at a bad price. Only options with a large bid/ask spread can be used. Regular stock options have very tight option quotes, which make them almost impossible to manipulate.

Smoking gun

TOM can only suspect manipulation and report it to the regulator. For evidence, you need the full cooperation of two exchanges and at least two brokers. One of the brokers may be located in another country. Time-consuming.

But there is a smoking gun. According to an official statement from TOM, the manipulation was done while concealing the ownership of the transactions involved. The Dutch watchdog AFM is involved in the matter. Expect follow-up news from the AFM after they identified the manipulator.

Statement from TOM

This isn’t just speculation and gossip. Thursday July 7th there was an official statement from TOM – confirming the issue.

Recently we detected cross market manipulative behavior which could only take place by making use of the specifics of the TOM STAT Opt out functionality and trading access to and knowledge of the Dutch derivatives markets where options with the same contract specifications are traded (i.e. Euronext and TOM MTF). The recent case involved entering orders without a bonafide intention to trade and with the purpose of improperly influencing pricing across markets. This was done in a structured manner, potentially by one or more persons acting in concert, whilst concealing the ownership of the transactions concerned.

Small time crooks

The whole thing with concealing the ownership gives it a weird touch. After all, we’re not talking about millions here. Market makers losing money on strange trades, they will be fast to discover what’s going on. Yes, ripping a few market makers for a few thousand euro a day is possible. But it won’t last long. Concealing identity is a difficult thing to do, especially when there’s money involved.

I know the small time crooks involved will be reading this. The AFM is after you, and I guess you have a few weeks left. Take the plane to South America while you still can. Buy a new identity. Alternatively, you could stay and gamble on the Dutch court failing to understand “opt out” trades.

Disclaimer : the description of stat trades, and especially “best execution” is kept simple on purpose.