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EXHIBIT 66
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UNITED STATES DISTRICT COURT
SOUTHERN DISTRICT OF NEW YORK
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UNITED STATES COMMODITY
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FUTURES TRADING COMMISSION,
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:
Plaintiff,
:
:
-against :
:
DONALD R. WILSON AND DRW
:
INVESTMENTS, LLC,
:
:
Defendants.
:
:
:
:
:
:
:
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Civil Action No.: 13-CIV-7884
ECF CASE
REBUTTAL REPORT OF ROBERT M. MacLAVERTY
PREPARED AT THE REQUEST OF PLAINTIFF
UNITED STATES COMMODITY FUTURES TRADING COMMISSION
August 18, 2015
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Table of Contents
A. Qualifications .......................................................................................................................... 2
B. Summary of Opinions.............................................................................................................. 3
C. Summary of Scope of Assignment .......................................................................................... 3
D. Background.............................................................................................................................. 5
E. Analysis & Conclusions ........................................................................................................ 12
F. Concluding Remarks ............................................................................................................. 43
G. Documents Considered .......................................................................................................... 43
H. Exhibits .................................................................................................................................. 44
I. Appendices ............................................................................................................................ 44
1
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A. Qualifications
1. My name is Robert M. MacLaverty and I am a Managing Director with Berkeley
Research Group, LLC (“BRG”), providing financial and economic consulting
services to law firms, banks, insurance companies, pension funds, endowments and
foundations. Prior to joining BRG, I was a Managing Director with FTI Consulting.
2. I have nineteen years of experience trading and advising on various securities and
derivatives including interest rate swaps, futures, exchange-traded and over-thecounter options, residential mortgage-backed securities, commercial mortgage-backed
securities, asset-backed securities, cash and synthetic collateralized debt obligations,
credit default swaps, total return swaps and other structured products.
3. I also have thirteen years of experience providing consulting services to institutions,
private banking clients, and various regulatory bodies. I have worked with both
investors and issuers in matters involving structure, liquidity, suitability and pricing.
4. My resume and testimony history are attached as Appendix A.
5. BRG is being compensated for the time I spend on this matter at its usual and
customary rate of $650 per hour, plus expenses. In preparing this report, I have been
assisted by staff working for BRG who worked under my supervision and control.
BRG is also being compensated at its usual and customary rates, plus expenses, for
the time and expense incurred by others working for me and at my direction on this
matter. I have no financial stake in the outcome of this litigation and the conclusions
of this report are in no way dependent on the compensation paid to BRG.
2
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B. Summary of Opinions
i. The opinions outlined in my Initial Report are well-supported by facts:
a. DRW’s bids had an impact on daily settlement prices similar to a “manipulating the
close” scenario.
b. The Three-Month Contract would have defaulted to Corresponding Rates in the
absence of DRW’s bids.
c. DRW’s bids drove daily settlement prices above a level they would have been priced
in the absence of those bids and caused artificial prices on the NFX.
d. The Initial Report clearly distinguishes between potential convexity bias and
convexity effect.
e. The Initial Report does not conflate illiquidity and artificiality concepts.
f. DRW’s bids did not constitute price discovery.
ii. The opinions reached by Matthew A Evans are flawed:
a. Evans’ conclusion that DRW’s bids were a legitimate part of the price discovery
process is unsubstantiated.
b. The criteria used by Evans for price discovery is unsupported by facts.
c. “DRW’s stated strategy” used by Evans for price discovery is theoretical.
d. Evans’ conclusion that DRW’s bids have no economic analogue to “banging the
close” cases is incorrect.
e. Evans does not fully understand the connection between illiquidity and artificiality in
this matter.
3
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iii. The opinions reached by Jeffrey H. Harris are flawed:
a. The assumptions made by Harris are theoretical.
b. Harris’ price discovery opinions are not based on the reality that existed on the NFX.
c. Harris mischaracterizes DRW’s bidding behavior.
d. Harris’ conclusions about DRW’s profits are oversimplified.
e. Harris’ conclusions about market knowledge are overreaching.
C. Summary of Scope of Assignment
6. On June 19, 2015, I submitted a report (“Initial Report”) in which I provided a
general discussion of interest rate swaps, interest rate swap futures contracts, the
trading of interest rate swaps and interest rate swap futures contracts, clearinghouses
and other related entities, contract markets, margin and also a discussion of financial
products and their purpose in the marketplace generally. I also analyzed and
discussed the conduct of Donald R. Wilson (“Mr. Wilson”) and DRW Investments,
LLC (“DRW”), DRW’s contract positions and reviewed DRW’s trading activity to
assess its impact on the IDEX Curve,1 including issues of convexity bias. In addition,
I contrasted this conduct to other contracts such as the Eurodollar Futures Contract
and performed an analysis of the IDEX USD 3 Month Interest Rate Swap Futures
Contract (“Three-Month Contract”), the United States Commodity Futures Trading
Commission (“CFTC”)-regulated NASDAQ OMX Futures Exchange (“NFX”), the
International Derivatives Clearinghouse (“IDCH”), the IDEX Curve and the IDCH’s
Rulebook with respect to the Three-Month Contract, as well as conduct on the
exchange.
1
The IDEX Curve is a compilation of the daily settlement rates of the Three-Month Contract on various tenors.
4
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7. Finally, I expressed opinions on DRW’s knowledge, means and ability to influence
daily settlement prices of the IDEX USD 3 Month Interest Rate Swap Futures
Contract (“Three-Month Contract”) thus creating artificial prices on the NFX. Also, I
expressed opinions on the artificiality of these prices due to behavior based on
DRW’s self-serving actions and not on basic forces of supply and demand. These
actions caused artificial prices or price trends on 117 trading days and resulted in a
net gain for DRW.
8. I have been asked by counsel to review and respond to the opinions in the expert
reports submitted by Matthew A. Evans (“Evans”) and Jeffrey H. Harris (“Harris”) to
the extent these reports address the opinions, analyses, and conclusions in my Initial
Report.
D. Background
i.
Interest Rate Futures Contracts
9. A futures contract is an exchange-listed contract between two parties to buy or sell a
particular commodity or other underlying asset in the future. Performance on the
contract may require either delivery of the underlying asset or cash payment. In the
case of an interest rate futures contract where two parties have an agreement to make
cash payments, one party is the purchaser (takes a “long” position), agreeing to make
fixed payments and to receive floating payments and hence would benefit from rising
interest rates, and the other party is the seller (takes a “short” position), agreeing to
make floating payments and receive fixed payments and hence would benefit from
interest rates decreasing.2
2
Initial Report at ¶ 15.
5
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ii.
Interest Rate Futures Contracts on the NFX
Overview of Interest Rate Futures Contracts on the NFX
10. Interest Rate Futures Contracts must be listed and traded on Designated Contract
Markets (“DCMs”) that must operate under the rules and regulations of the CFTC,
based upon the Commodity Exchange Act (“CEA”).3 The NFX, a DCM, offered
trading of various futures contracts including the Three-Month Contract.4
11. The Three-Month Contract was listed by the IDCG, a Derivatives Clearing
Organization (“DCO”) that was regulated by the CFTC. This contract was traded on
the NFX, with the primary function of serving as an interest rate hedging, speculation
and/or general financial tool for trading fixed payment streams versus floating
payment streams with respect to fluctuations in interest rates.5
Price Alignment Interest in the Three-Month Contract
12. The Three-Month Contract differed from some other interest rate futures contracts as
it contained no Price Alignment Interest (“PAI”),6 an adjustment method sometimes
used to counter realized convexity bias7 pricing differentials. The lack of PAI is not,
in and of itself, an impediment to the viability of a futures contract. DRW thought it
could acquire the Three-Month Contract at relatively low prices considering the
absence of PAI and as a result, benefit over time.8
3
Initial Report at ¶ 22.
4
IDCH Rulebook, September 1, 2010, pages 94-126. IDCG00010738-70.
5
Initial Report at ¶ 22.
Price Alignment Interest (“PAI”) – “A cost of funding adjustment that is calculated off-line using the appropriate
interest rate for the IRS transaction. These rates are based on the underlying currency of the transaction and the
central counterparty.” BNY Mellon (June 2013). Cleared Swap Handbook, page 6.
6
7
Convexity bias refers to the potential benefit a party with a long fixed-rate position in a cleared swap or futures
contract has over the party with a short position in a rising rate environment when margin is made by delivering
cash as opposed to securities. Initial Report at n. 23.
8
Deposition of Brian Vander Luitgaren, November 19, 2014 (67:2-13).
6
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DRW’s Activity in the Three-Month Contract
13. In 2010, DRW, along with other market participants, obtained interest rate futures
contracts on the NFX by means of bilaterally agreed upon transactions. DRW
acquired long positions in the Three-Month Contract through NewEdge USA, LLC
(“NewEdge”), a brokerage services firm, which served as the Futures Commission
Merchant (“FCM”) for DRW’s trades on IDCH. By September 30, 2010, DRW had
acquired a net9 long position of around 3,500 contracts with a total net notional value
of $350 million, shown in the figure below.10
Figure 1 – DRW’s Three-Month Contracts11
Trade #
EffDate
ExpDate
B/S
1974
8/17/2010
8/17/2012
B
$5,000,000
Notional
Rate
0.7300
1980
8/18/2010
8/18/2012
S
$5,000,000
0.7075
2018
8/26/2010
8/26/2011
B
$25,000,000
0.4100
2095
9/15/2010
9/15/2020
B
$50,000,000
2.7340
2103
9/16/2010
9/16/2040
B
$25,000,000
3.4400
2127
9/22/2010
9/22/2040
B
$50,000,000
3.5420
2134
9/23/2010
9/23/2040
B
$50,000,000
3.5010
2142
9/24/2010
9/24/2020
B
$50,000,000
2.5940
2170
9/30/2010
9/30/2020
B
$100,000,000
2.5000
Total Net Notional Value: $350,000,000
9
DRW acquired one short position in August of 2010 for a notional amount of $5,000,000.
10
“IDCH Fut Daily EOD Report,” IDCG00012181, 12189, 12237, 12342, 12350, 12382, 12390, 12398 and 12432.
11
Initial Report at ¶ 42.
7
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iii.
IDCH’s Use of Over-The-Counter (“OTC”) Interest Rate Swaps
14. The IDCH utilized “interest rates in corresponding bilateral interest markets”12
(“Corresponding Rates”), that is, interest rates from the OTC market, to determine
daily settlement prices in the absence of bidding during 2:45 and 3:00 PM (the “PM
Settlement Period”) on the electronic exchange of the NFX.
Overview
15. An OTC swap is a privately negotiated agreement between two parties (called a
“bilateral transaction”) speculating on changes in interest rates where fixed interest
payments are exchanged for floating interest payments. OTC pricing is known only to
the two parties of the negotiation and is not reported in the public domain. The most
common type of OTC interest rate swap is a fixed versus floating interest rate swap
(sometimes called a plain vanilla swap).
Figure 2 – Plain Vanilla Interest Rate Swap
12
Complaint for Injunctive and Other Equitable Relief and for Civil Monetary Penalties under the Commodity
Exchange Act filed in United States Commodity Futures Trading Commission v. Donald R. Wilson and DRW
Investments, LLC (Civil Action Number: 13 Civ. 7884) (“Complaint”) at ¶ 3.
8
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16. OTC interest rate swaps are traded by market participants over-the-counter using a
standardized International Swaps and Derivatives Association (“ISDA”) Master
Agreement13 and swap confirmation.14 A central element of the OTC interest rate
swap market in this matter relates to its robust pricing verification from a large
volume of actual, consummated transactions. As of December 2012, there was
approximately $372 trillion notional outstanding in the OTC interest rate swap
market.15
17. These benchmark rates are referred to as Corresponding Rates within this case and
were used by the IDCH to determine closing prices, in the absence of market activity.
Description of Corresponding Rates
18. The Corresponding Rates are defined as ‘prevailing interest rates in corresponding
bilateral interest markets specified in IDCH’s rules.16 The Corresponding Rates used
by the IDCH are based upon rates from Bloomberg.17 I have used Bloomberg and
Thomson Reuters to confirm that Tullett Prebon, ISDA, ICAP, and Thomson Reuters’
rates reflect similar rates to those identified as Corresponding Rates within the IDCH
Curve Interpolator Data.18
13
The ISDA Master Agreement is a standard agreement that outlines the terms for OTC transactions between
counterparties. This agreement is published by the ISDA with the aim of providing both parties clear definitions of
contract terms. Once the two parties agree to these contract terms, they do not have to re-negotiate each time a new
transaction is entered into.
14
A swap confirmation refers to a legally binding document that contains a record of agreements made by
counterparties to the terms and conditions of a swap transaction. A confirmation is created when an acknowledgement
is signed (manually, electronically, or by some other legally equivalent means) by the receiving counterparty.
15
http://www.bis.org/statistics/dt1920a.pdf
16
Initial Report at ¶ 30.
17
Deposition of Gerard Kopera, April 2, 2015 (21-24).
18
Initial Report at ¶ 30.
9
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Importance of Broker Markets
19. Demand represents the quantity and price for a willing buyer in the marketplace,
while supply represents the quantity and price for a willing seller in the marketplace.
When price is agreed upon for a given quantity by both buyers and sellers,
equilibrium is established at that moment in time, and the price discovery process is
complete. When there is only one party to any bid or offer in a marketplace, there is
no price discovery as there are no consummated trades.
20. Broker markets represent transactions by interdealer brokers such as Tullett Prebon,
ISDA, ICAP and Reuters that display the bid and offer rates in their respective
displays to dealer customers and are reflective of actual trading levels and levels of
liquidity. Although not all interest rate swap trades occur through brokers, the
information garnered from dealers reflect general levels of activity and is based on
actual trades reflecting supply and demand.
10
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iv.
Pricing models
21. When a price trades on a given market, that information becomes an indication and
basis for pricing the next trade for that instrument. However, there are times when
market specific trading information is unavailable. Under such circumstances, traders
then rely on a model to quantify anticipated price levels for a given series of inputs.
Among these inputs, it is important that the model be calibrated to actual, not
theoretical, transactions which occurred in that market.
22. When one uses a model for trading or hedging purposes, the model necessarily
includes inputs, such as pricing inputs from the market it attempts to price.19 In other
words, calibration to the market of the actual instrument is required for establishing a
mark on that instrument in that market.
23. Given that trades entered into by DRW in the Three-Month Contract with other
market participants were executed within a few basis points of the market rate
curve,20 DRW’s model, to the extent it used one for valuing future Three-Month
trades, should have been calibrated to those initial transactions and marked as such.
Traders of interest [rate] derivatives “usually have some expectation about the market of the products they are
dealing with.” Traders “require their pricing models to reflect the realities of the market segments underlying to their
products…There usually exist several model parameters which must be calibrated such that certain related
‘observable’ constants really take their actually observed values.” Rainer, Martin (2009). “Calibration of Stochastic
Models for Interest Rate Derivatives.”
19
20
Initial Report at ¶ 66.
11
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E. Analysis & Conclusions
i. The opinions outlined in my Initial Report are well-supported by facts:
a. DRW’s bids had an impact on daily settlement prices similar to a “manipulating the
close” scenario.
“Other than being broadly about settlement prices, DRW’s actions in this matter have
no economic analogues to “Bang The Close” cases”21 (Evans)
24. Although no bid or offer was ever acted upon, the manipulative effect of DRW’s
bidding was exhibited through increased settlement prices and artificial fixing of the
IDEX Curve from what had traded in the market previously. Thus DRW’s bidding
activity did have an impact on daily settlement prices similar to a “manipulating the
close” scenario. Evans also claims that “Other ‘Bang The Close’ allegations revolve
around using overwhelming trade volumes.”22 The fact that the volume of DRW’s
bids may not have been overwhelming hardly excuses the behavior and its effect on
settlement prices, especially given that this was a market which had a daily volume of
zero.
21
Evans at ¶ 75-82.
22
Evans at ¶ 78.
12
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25. As outlined in my Initial Report, “The 1,470 bids placed or left open during the PM
Settlement Period and cancelled during or after the PM Settlement Period included
1,467 bids that were greater than Corresponding Rates. Among the 1,467 bids that
were greater than Corresponding Rates, 1,024 bids ultimately affected daily
settlement prices.”23 The group of 1,024 bids did have an impact on daily settlement
prices similar to a “banging the close” 24 scenario, or more precisely a manipulating
the close scenario, because doing so was known to be an integral component of the
settlement pricing protocol of the exchange.
Figure 3 – DRW Order Timing25
23
Initial Report at ¶ 59.
“Banging the Close: A manipulative or disruptive trading practice whereby a trader buys or sells a large number
of futures contracts during the closing period of a futures contract (that is, the period during which the futures
settlement price is determined) in order to benefit an even larger position in an option, swap, or other derivative
that is cash settled based on the futures settlement price on that day.”
http://www.cftc.gov/consumerprotection/educationcenter/cftcglossary/glossary_b
24
25
IDCH Data Feed. DRW-IDCG-0000001.
13
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b. The Three-Month Contract would have defaulted to Corresponding Rates in the
absence of DRW’s bids.
“Mr. MacLaverty assumes that, absent DRW’s bids, the Three Month Contract’s
daily settlement prices would have been set at the Corresponding Rates”26 (Harris)
26. As outlined in my Initial Report, the IDCG has a process to create the inputs for the
IDEX Curve in its internal pricing documents, “When there was electronic exchange
activity, IDCH used in order of precedence, (i) the mid-point of relatively tight
bids/offers; (ii) the recent transaction history of tight bids/offers (i.e. an observed
consummated trade); (iii) and where there were only bids/offers, these bids/offers
would be used, to establish daily settlement prices.”27 According to the testimony and
deposition transcripts of IDCG officials, daily settlement prices would default to
Corresponding Rates in the absence of actual electronic exchange activity.28
26
Harris at ¶ 118.
27
Initial Report at ¶ 29.
28
Deposition of Brian Vander Luitgaren, November 19, 2014 (63:1-8).
Testimony of Donald R. Wilson Jr., April 2, 2013 (30:3-14).
Deposition of Yuhua Yu, March 3, 2015 (41:25-42:4).
Deposition of Michael K. Dundon, April 1, 2015, Exhibit 13. IDCG 00005319.
“Filtering, Prioritizing, & Modification of IDCG Data Feeds” IDCG, 2008. IDCG00009826-8.
14
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c. DRW’s bids drove daily settlement prices above a level they would have been priced
in the absence of those bids and caused artificial prices on the NFX.
“No Justification for Finding Artificial Prices”29 (Harris)
27. The artificial settlement prices created on the NFX were due to DRW’s illegitimate
bidding activity on the electronic platform of the NFX and served the purpose of
increasing its position in the Three-Month Contract. The artificial prices created by
DRW were not based on basic forces of supply and demand and consummated trades
on the NFX. As shown in my Initial Report, the price trend created by DRW is almost
exactly equivalent, if not the same, as the close prices on the NFX. This can also be
seen in Exhibits 7A – G of Harris’ Expert Report. A sample of days is shown in the
figures below. These rates are also in great excess to the Corresponding Rates, which
represent actual consummated trades and where trades initially took place on the
NFX.
Figure 4 – Sample of Days: Corresponding Rate vs. Close Rate (Artificial Prices)30
29
Harris at ¶ 121.
30
IDCH Curve Interpolator. DRW-IDCG-0000003.
15
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16
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d. The Initial Report clearly distinguishes between potential convexity bias and
convexity effect.
“Mr. MacLaverty’s claims that DRW allegedly profited from a “potential convexity
bias” reflect a complete misunderstanding of the NPV and convexity effects.”31
(Harris)
28. In my Initial Report, I explain “Convexity bias32 in the Three-Month Contract [as] a
term which describes the potential for longs to make more by investing the variation
margin in a rising interest rate environment than shorts can make by investing its
variation margin in a declining rate environment. Mr. Wilson has asserted that this
potential benefit shows up as an effect if there is a correlation between variation
margin and changes in interest rates.”33 That is, both parties stand to make a profit
when the market moves in their favor, however the long has the potential to make
more based on convexity bias. In addition, I explain DRW’s assumptions relative to
convexity bias, “Additionally, DRW asserted that this phenomenon could cause the
party seeking a short position to demand that the party seeking a long position pay a
higher fixed rate on IDCH swaps than prevailing rates in the OTC market.”34
Although this phenomenon “could” happen, it does not necessarily mean that it
“would” happen. In fact, as discussed below, the expected pricing differential due to
convexity bias never occurred.35
31
Harris at ¶ 131.
32
Convexity bias refers to the potential benefit a party with a long fixed-rate position in a cleared swap or futures
contract has over the party with a short position in a rising rate environment when margin is made by delivering cash
as opposed to securities. Initial Report at n. 23.
33
Initial Report at ¶ 39.
34
Initial Report at ¶ 40.
BRG understands that DRW’s March 14, 2011 Whitepaper (“Final Whitepaper”) references an earlier paper titled
“Mondescu, R., Wilson, J. and Yu, Y., Central Clearing of Interest Rate Swaps: a Comparison of Different Proposals
- Part II, Working Paper, January 25, 2011.” For purposes of my Rebuttal Report, I refer to the January 25, 2011
paper as “Draft Whitepaper.”
35
Initial Report at ¶ 64.
17
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29. DRW assumed that there should be a price premium based upon convexity bias in the
Three-Month Contract, but that effect was never observed on the NFX in the form of
trades at wider spreads to Corresponding Rates i.e. the basic forces of supply and
demand never verified DRW’s assumed price premium based on convexity bias.
30. For a given change in interest rates, the beneficiary of that change also benefits from
being about to invest cash margin and earn interest income -- referred to as the Net
Present Value (“NPV”) effect. This interest income or expense is a potential
component of the profitability from margin on a Three-Month Contract that is
generally not present in an OTC swap. The fact that the all-in payoff may be
potentially more favorable for a long position, on a given trade under a given interest
rate scenario, than for a short position, does not change the fact that there is still a
benefit from the NPV effect for either party.
31. In addition, the potential NPV effect is the cumulative interest on variation margin
over the holding period of the position. However, there are other factors that drive the
NPV effect, including changes in values of other independent variables. The NPV
effect had no benefit to DRW when the market is moving against it, i.e. in a declining
rate environment. In other words, every basis point that DRW bid over Corresponding
Rates served to buffer DRW’s variation margin whenever the market moved against
it.
32. Moreover, the NPV effect was never observed on the NFX in the form of trades at
wider spreads to Corresponding Rates i.e. the basic forces of supply and demand
never verified a price premium based on the NPV effect.
e. The Initial Report does not conflate illiquidity and artificiality concepts.
“Plaintiff’s Expert conflates illiquidity and artificial price concepts.”36 (Evans)
“MacLaverty also alleges that DRW “disproportionately” affected the IDEX
settlement price curve.”37 (Evans)
36
Evans at ¶ 87-94.
37
Evans at ¶ 95.
18
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33. In my Initial Report, I clearly distinguish between concepts of illiquidity and
artificiality. In addressing the former, I wrote “The lack of liquidity of the ThreeMonth Contract allowed a single participant to have greater control over daily
settlement prices than in a more robust marketplace such as the Eurodollar Futures
Contract. DRW was aware that the Three-Month Contract was an illiquid product and
went so far as to call it the “ultimate of ill-liquid products.””38 With respect to the
latter, I address artificiality by saying “I have read Judge Torres’ Memorandum and
Order in United States Commodity Futures Trading Commission v. Donald R. Wilson
and DRW Investments, LLC and understand that the legal definition of an artificial
price is one that “does not reflect basic forces of supply and demand” and that
“market manipulation in its various manifestations is implicitly an artificial stimulus
applied to (or at times a brake on) market prices, a force which distorts those prices, a
factor which prevents the determination of those prices by free competition alone.”
Based on my analysis of the electronic platform of the NFX to follow, DRW caused
artificial daily settlement prices on the NFX.”39
34. To clarify the difference, one might say the absence of liquidity enhances the
condition from which an artificial price is created. There was a period during which
limited, off-exchange, liquidity existed on the NFX and where trades were marked
accordingly. Subsequently, the market became illiquid and no price discovery
occurred. Artificiality is thus a spillover effect from DRW’s entry of bid levels into
an illiquid market. Illiquidity alone does not create artificial prices, but when
combined with activity, such as DRW’s illegitimate settlement period bids, artificial
prices resulted on the Three-Month Contract.
35. The same can be said with respect to the IDEX Curve. As DRW kept widening its
spreads, between the end of 2010 to August of 2011, disproportionate to any
identifiable input changes or market changes, the aggregate artificiality of the ThreeMonth Contracts underpinning the IDEX Curve did so as well.
38
Initial Report at ¶ 52.
39
Initial Report at ¶ 56.
19
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f. DRW’s bids did not constitute price discovery.
“DRW’s bids provided market liquidity and contributed to price discovery.”40
(Harris)
“Whether or not a counterparty hit them, DRW’s bids were invaluable for, and a
legitimate source of price discovery.”41 (Harris)
36. In the case of the Three-Month Contract, DRW only entered bids which were not
consummated. Although it is true that a bid can serve as price discovery when it is
entered along with other market bids at the same level, or at new higher prices within
a previously existing bid-offer spread, this was not the market condition in the ThreeMonth Contract. Not a single offer was elicited on the NFX from January 24, 2011
through August 12, 2011 (the “Relevant Period”). As explained by Michael K.
Dundon during his deposition, “…if you’re aware that no other entity is participating
on the – on the exchange, there would be no other reason to submit bids other than to
affect the [settlement] curve.”42 Absent consummated trades, the bids had no meaning
for price discovery purposes.
37. DRW supplied 100 percent of the bids posted on the electronic exchange of the NFX
during the Relevant Period. A one-sided market does not constitute price discovery or
an accurate reflection of actual supply and demand. Further, DRW was aware of the
illiquidity that existed on the NFX and as such, that its bids would affect settlement
prices.43
38. In sum, no actual prices could be deemed “discovered” as a result of DRW’s bids.
40
Harris at ¶ 108-110.
41
Harris at ¶ 71-95.
42
Deposition of Michael K. Dundon, April 1, 2015 (168).
43
Testimony of Craig Silberberg, February 2, 2012 (96).
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ii. The opinions reached by Matthew A Evans are flawed:
a. Evans’ conclusion that DRW’s bids were a legitimate part of the price discovery
process is unsubstantiated.
39. Evans states that “DRW’s electronic bids were a legitimate part of the price discovery
processes that underlie the IDEX USD Interest Rate Swap Futures (“IDEX” or the
“Three Month Contract”) daily settlement price curve.”44
40. While it may be true that electronic bids, among other market based data, i.e. trades
that occurred, are all parts of a price discovery process, bids on a standalone basis
under the market conditions of this case are not a legitimate part of a price discovery
process.
41. In particular, price discovery does not occur in an illiquid marketplace. Evans states
“Price makers in such illiquid markets…aid in price discovery.”45 Price makers in
illiquid markets may provide information about the bids themselves, however due to
the nature of an illiquid market, price makers do not supply information about the
offer and thus do not supply information about the price globally. DRW’s bids were
thus theoretical given the illiquidity of the market.
42. Further Evans claims “The market as a whole benefits…when qualifying bids or
offers enter the market.”46 This may be true in other markets where both qualifying
bids and offers exist, however, in the case of the Three-Month Contract, DRW only
entered bids, which were not consummated, and thus provided no benefit to the
market, only to DRW. There was no change in volume in the Three-Month Contract.
The volume remained at zero. Despite DRW posting bids, doing so never created an
offer, and thus does not contribute to price discovery.
44
Evans at ¶ 10.
45
Evans at ¶ 51.
46
Evans at ¶ 28.
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43. Evans states that “unfilled limit orders placed in the marketplace, sometimes called
‘resting orders,’ are an important part of price discovery.”47 He also quotes the U.S.
Securities and Exchange Commission (SEC) in saying that “displayed limit orders are
the primary source of public price discovery.”48 These statements made by Evans
have no contextual background and assume a liquid marketplace.
44. Limit orders that do not “make the market”49 are by definition “off-market.” This
does not apply to limit orders that are entered inside a previously existing bid-ask
spread. Given this context, Evans’ statements about price discovery may hold true for
liquid markets. However, in an illiquid market such as the one that existed on the
electronic platform of the NFX, limit orders are not a component part of the price
discovery process.
47
Evans at ¶ 14.
48
Evans at ¶ 15.
49
Competitive open markets defines parameters for “make the market” as the highest bid and the lowest offer.
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45. Evans also places importance on the “busted,” off-exchange trade with MF Global on
February 2, 2011.50 In fact, the exchange describes this as a “DK’ed” trade.51 The
difference can sometimes be important. A busted trade refers to a cancellation of a
recorded trade and can be cancelled for a variety of reasons. A “DK’ed” trade has
been ruled by the exchange to not have occurred. For this reason, it is clear that there
is no price discovery in a “DK’ed” trade. Since this “DK’ed” trade was negotiated
off-exchange and not by on-NFX electronic bids and offers, other market participants
were not involved and did not compete in an open and free market to reverse this
“DK’ed” trade. This was a “DK’ed” trade and its reversal does not provide legitimacy
as a consummated trade in the context of price discovery. In emails between IDCG
and MF Global on February 2, 2011, regarding the “DK’ed” trade, Laurie Ferber of
MF Global states that “We believe you [IDCG] have a serious issue with the prices
being shown, and potentially market manipulation….”52
46. Another way in which Evans attempts to validate DRW’s bidding activity is by
claiming that “The surge in trading volume in the settlement period can be many
times the volume of other periods of the trading day.”53 Under ordinary circumstances
of a competitive and liquid marketplace, one would expect differences in volume
throughout different times of a given trading day. However, there is no rationale for a
market that never trades to follow that trading pattern. The only known result from
end of day bidding by DRW was incorporation of those bid levels into the IDEX
Curve for settlement purposes. There were never any known offers from any market
participants during the Relevant Period. The settlement effect was of equal or greater
value to DRW than an executed price. Thus, Evans’ comparing two vastly different
market conditions of liquidity to claim greater likelihood of execution tied to order
entry timing is disingenuous at best.
50
Evans at ¶ 53.
51
Testimony of Gerard Kopera, February 29, 2012 (24-25).
Email from Laurie Ferber to John Shay, Lauren Cantor, John Young, Jack Mahoney, Re: “We have an issue,”
February 2, 2011. MF046116.
52
53
Evans at ¶ 49, Exhibit 1.
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b. The criteria used by Evans for price discovery is unsupported by facts.
47. Evans qualifies DRW’s bids as orders that should be used in the daily settlement
process, “DRW’s electronic bids for the Three Month Contract were executable
orders. These orders met the criteria54 typically used in the industry to determine if an
order qualifies for inclusion in the daily settlement price process.”55
48. Evans makes this assertion based on the unsubstantiated criteria that it is necessary,
but not comprehensive, for placing orders during the settlement period. While the
criteria is logical, bids are only one of several elements of the criteria used in the
industry for inclusion.
49. There is no support for why these three criteria are consistent with custom and
practice, particularly within the circumstances of this case. A fourth criterion that
would be relevant, but not mentioned by Evans, is the determination of whether there
even was a possibility that someone would respond to DRW’s bids. DRW placed
2,405 unanswered bids for a total of 120 trading days, yet continued to put in similar
bids regularly. Not a single offer ever materialized on the NFX from January to
August of 2011.
50. Finally, Evans states that bids must be of enough volume to transfer risk and later
states that “DRW’s bids were large enough volume orders to confer risk.”56 Evans
does not recognize that it is impossible to have a transfer of risk in a market that does
not trade.
54
Evans at ¶ 27.
55
Evans at ¶ 10.
56
Evans at ¶ 42.
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c. “DRW’s stated strategy” used by Evans for price discovery is theoretical.57
51. Evans attempts to prove the legitimacy of DRW’s bids for use in price discovery by
comparing them to DRW’s theoretical price based strategy, “DRW’s electronic bids
were consistent, and conservatively placed, with respect to DRW’s stated strategy.”58
52. The stated strategy that Evans considers, and uses as a basis for his conclusions,
involves a lack of calibration to the only trades that actually occurred (a spread of flat
to OTC rates) and the negotiated reversal of trades on the NFX that occurred in
August 2011. The relevant analysis is to compare DRW’s bids to Corresponding
Rates, rather than “DRW’s stated strategy”. I believe that DRW’s bids were not
“conservatively place[d]” based on my analysis comparing DRW’s bids to
Corresponding Rates, which were used as settlement prices in the absence of
electronic bids.
53. Further, DRW did not “conservatively place[d]” bids according to the change in
spread relationship between the end of 2010 when trades were consummated at levels
close to OTC rates and the reversal of DRW’s trades with Jefferies in 2011.
Figure 5 – DRW’s Jefferies Trades59
EffDate
9/15/2010
9/16/2010
9/22/2010
9/23/2010
Contract
Tenor
10
30
30
30
Last Statement Date
8/11/2011
8/11/2011
8/11/2011
8/11/2011
57
Spreads at trade
initiation
-0.026%
0.010%
-0.008%
0.001%
Spreads at trade
unwind
0.495%
0.132%
0.233%
0.192%
Evans states that DRW allegedly placed its bids consistent with its model. Evans did not verify that. In fact, Wilson
testified that DRW placed bids at the “price we [they] were willing to pay.” Testimony of Donald R. Wilson Jr., April
2, 2013 (91:14-22). See also n. 80.
58
Evans at ¶ 10.
59
IDCH Data Feed. DRW-IDCG-0000001; New York FRB, Table H.15.
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54. Evans asserts “An analysis of periodic fair valuation model data show DRW’s
electronic bids were consistent with, or lower than, DRW’s measurement of fair value
for the Three Month Contract.” Similar to his comparison of DRW’s bids to “DRW’s
stated strategy,” Evans’ conclusions comparing DRW’s bids to “DRW’s
measurement of fair value” is not relevant in determining a fair mark-to-market
because no trades observed were consistent with DRW’s measure of fair value.
55. DRW’s bids are not consistent with properly calibrated mark-to-market levels which
are more appropriate inputs for IDCG’s IDEX curve. Valuation for relative value is
different than mark-to-market, particularly when there is no market.
56. Evans attempts to rationalize DRW’s behavior by claiming “An analysis of DRW’s
changes to its electronic bids shows that changes occurred slowly through time,
moved with conservatism, and in general moved in ways that are inconsistent with
how a manipulator would act in seeking the maximum settlement price increases.” 60
57. In fact, DRW did behave how Evans expects that a manipulator would act by placing
bids during the settlement period which became de facto settlement prices of the
Three-Month Contract. The bids entered by DRW were the single greatest influence
on settlement prices as they were the only party providing them. These, in the face of
market changes that were intermittently adverse to DRW’s underlying long position
in the Three-Month Contract, are not what one would expect for those market
changes. These changes included market metrics such as yield compression,61
volatility, interest rates and roll-down effect which would not have justified the extent
of DRW’s bidding at spreads to Corresponding Rates.
60
Evans at ¶ 10.
See Exhibit 3 – Treasury Yields for detail on yield compression during the Relevant Period. Market yields between
the 30-year and 2-year treasury yield curve dropped from 3.9% to 3.52%, indicating a yield compression of 0.38%.
As spreads across tenors collapse in this manner, absolute spreads of tenors to the curve would be unlikely to widen.
61
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d. Evans’ conclusion that DRW’s bids have no economic analogue to “banging the
close” cases is incorrect.
58. Evans claims that “DRW’s bidding activities were not consistent with a “Bang The
Close” allegation.” 62 However, the impact of DRW’s bids entered or maintained
during the settlement period created a condition that better served the purpose of
favorable settlement rates than it would have for other times during the trading day.
As stated in my Initial Report, the behavior would and did manipulate the close.
59. The actions of DRW had the impact of a “banging the close” scenario (that is,
influencing pricing by DRW’s actions on the close) which could or more precisely be
labeled a “manipulating the close” scenario.
60. Evans claims that “It is expected and rational behavior when traders, DRW traders in
this matter, place qualifying orders into the settlement procedure in an effort to make
settlement prices more demonstrable, and thus reliable…”63 While it may be rational
for traders to analyze their positions in which they have open positions and be
concerned about settlement prices affecting open positions, and thus to affect
settlement prices, that does not mean that it is appropriate conduct. The illiquid nature
of the NFX did not allow DRW to place bids at theoretical levels.
62
Evans at ¶ 10.
63
Evans at ¶ 31.
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61. In his conclusions, Evans refers to “overwhelming trading volumes,”64 which has no
place in this matter as no trades were ever consummated on the electronic exchange.
He also classifies DRW’s bids as “not designed to affect settlement price curves
through subversive means,”65 when in fact, DRW’s bids did affect settlement prices
by and through illegitimate bids. Finally, Evans claims that DRW’s bids “represented
where execution could take place.” 66 However, by that same logic, execution could
have taken place anywhere. Again, this was a market that did not trade, no offers ever
materialized, no “resting orders” or bids from any other market participant existed,
and no prices outside of initial positions ever cleared the market.
62. Further, Evans attempts to justify DRW’s conduct by stating that it “potentially
lowered settlement prices.”67 However this comes from a theoretical model producing
a theoretical price. One does not know about the relevance of DRW’s bid levels with
respect to potential settlement prices.
e. Evans does not understand the connection between illiquidity and artificiality in this
matter.
63. Evans does not understand the distinction I have made between illiquidity and
artificiality, “Plaintiff’s expert MacLaverty conflates illiquidity and artificiality
concepts. He also erroneously concludes that DRW’s impact on IDEX settlement
prices was “disproportionate” while the contemporaneous data demonstrate a
proportionate impact at most.”68 As explained in section E.i., the spreads kept
widening over the Relevant Period disproportionate to any identifiable input changes
or market changes. Also, an uncleared bid does not reflect supply and demand by
definition. This necessarily takes into account illiquidity in the Three-Month
Contract.
64
Evans at ¶ 78.
65
Evans at ¶ 84.
66
Evans at ¶ 84.
67
Evans at ¶ 31.
68
Evans at ¶ 10.
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64. Evans’ conclusion that bids demonstrate a “proportionate impact at most,” is
incorrect. The spread based on the DRW’s bidding of the 30-year continued to widen
and reached approximately 90 basis points over the Corresponding Rate curve by the
time DRW ceased bidding on the exchange in August of 2011. In other words, DRW
made the curve steeper than it would have been. DRW took proactive action in more
meaningful tenors (and the tenors in which DRW had open positions), to aggressively
bid in the 30-year portion of the curve.
iii. The opinions reached by Jeffrey H. Harris are flawed:
a. The assumptions made by Harris are theoretical.
65. According to Harris’ own statement about interest rate model methodology, results of
any model are by definition subject to choices about assumptions and data inputs.69
Harris himself is no exception to making theoretical assumptions about the ThreeMonth Contract and its relationship with OTC swaps, “The rates that represent fair
value on the cleared Three Month Contract are higher than rates on non-cleared OTC
interest rate swaps with similar terms due to cash flows from daily variation margins
applied on the cleared Three Month Contract. These higher rates stem from interest
rate volatility and an upward sloping yield curve over the term of the swap.”70 The
assumptions and methodology71 behind Harris’ conclusions are incomplete. For a
given tenor of a swap, an upward sloping yield curve by definition brings roll-down
effect into pricing assumptions as well, which Harris fails to address.
66. Although I agree generally that the NPV effect is one component of the difference in
value between the two instruments, there are other components which, depending on
market conditions, may overwhelm the NPV effect. Changes in independent variables
and/or assumptions and changes in market conditions can more than offset the NPV
effect for a given market participant.
69
Harris at ¶ 65.
70
Harris at ¶ 4.
71
Harris at ¶ 65.
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67. Harris also goes through the irrelevant exercise of comparing DRW’s bids to its use
of the Hull-White One-Factor model, just as Evans compared DRW’s bids to its
“stated strategy.” Harris states that “DRW’s bids on the Three Month Contract are
consistent with my calculations of the NPV effect and the convexity effect using the
Hull-White One-Factor model of expected interest rate dynamics applied on data
from January through August 2011 (the “Relevant Period”). Based on this [Harris’]
analysis, DRW bid at reasonable prices which represented legitimate demand for the
long side of the Three Month Contract and not “artificial prices,” as alleged.”72
68. DRW and Harris make theoretical assumptions about the marketplace, but fall short
by not explaining other pertinent characteristics of the actual NFX marketplace.
69. DRW and Harris outline the components for the valuation of IDCG Swap Futures,
however, neither DRW nor Harris include market conditions and observations that
would be relevant to the actual NFX marketplace. First, neither mention that DRW, as
the only market participant bidding on the NFX, was aware of:
(i) the illiquidity that existed on the electronic platform of the NFX; and thus, (ii)
the effect it could have on daily settlement prices and daily variation margin.73
72
Harris at ¶ 4.
The Rulebook’s daily settlement price makes no direct reference to variation margin. That is, the daily settlement
price of the Three-Month Contract does not take into account cash flows from daily variation margin. Initial Report
at ¶ 33.
73
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70. It is important to realize that generally a theoretical model does not predict those
levels at which trading would take place unless it has been calibrated to match market
levels. Market participants may not even agree on which model should be used.
Traders cannot assume that market participants will ever agree that a particular model
will provide the best basis for predicting where trading will occur, notwithstanding
the presence or absence of trading to corroborate a given model. It is clear that the
Hull-White model, supposedly employed by DRW, and Harris, were theoretical and
did not reflect actual pricing of the Three-Month Contract on the NFX. Such a model
can be used to identify expected profits on trades but it is wrong to then use that
model to influence marks.
71. As pointed out by Harris, “…the precise results of my valuation analyses are not
identical to those of Cont et al. (2011). This is not at all surprising or concerning.
Interest rate modeling involves the choice of modeling assumptions and data
inputs.”74 Given the self-described subjectivity of Harris’ interest rate swap model,
and the disparate results that come from such an exercise, it is understandable why
market participants have different views exhibited in the marketplace. As a result,
Harris and DRW reach different results using theoretical models. However, that does
not legitimize the singular production of a mark by any one participant as an absolute
for settlement price purposes.
b. Harris’ price discovery opinions are not based on the reality that existed on the NFX.
72. Harris also attempts to establish the legitimacy of DRW’s bids for price discovery,
“Because DRW’s bids on the Three Month Contract reflected the NPV and convexity
effects, they represent a clear example of legitimate price discovery in the Three
Month Contract.”75 As discussed previously, price discovery is not solely based upon
a limit order or bid and, more importantly, price discovery is not possible in a market
that doesn’t trade.
74
Harris at ¶ 65.
75
Harris at ¶ 4.
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73. At the time DRW established its open positions, DRW was aware of the methodology
adopted by IDCH in settling the Three-Month Contract at Corresponding Rates.76
However, during the Relevant Period, DRW, in effect, overrode the contract
specifications of the Three-Month Contract by placing bids that led to artificial
settlement prices.
74. Harris acknowledges that DRW’s bids represented (only) its demand for the Three-
Month Contract.77 Again, this is indicative of a one-sided market and is not
appropriate for true price discovery. By definition, DRW’s bids only reflect one side
of a market, i.e. demand. Actual price discovery and non-artificial prices must
represent both supply and demand.
75. Harris points out that the value of DRW’s bids were indicative of legitimate supply
and demand. “DRW’s bids on the Three Month Contract offered premium rates
relative to the non-cleared OTC interest rate swap with similar terms and therefore
were more representative of true supply or demand for the Three Month Contract than
were non-cleared prices on OTC interest rate swaps.”78 In other words, Harris
concludes that prices of non-cleared OTC interest rate swaps do not reflect legitimate
supply or demand for the Three-Month Contract, but by inserting bids supposedly
produced by a theoretical model into a market that never traded, DRW’s bids
somehow did. This argument cannot be construed as a basis for value in the open
marketplace.
76. In as much as OTC swap rates were an element of pricing the Three-Month Contract
when they did trade, they would also, absent in any changes in the marketplace
necessarily serve as an element for pricing the Three-Month Contract at a later date
during the Relevant Period.
76
Testimony of Donald R. Wilson Jr., April 2, 2013, Exhibit 4. D0134940.
77
Harris at ¶ 4 and ¶ 121.
78
Harris at ¶ 4.
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77. It is important to highlight that this is an assumed environment based on theoretical
inputs and assumptions. It may be more appropriate to refer to this environment as the
“assumed” environment as it is one in which Harris is supplying the inputs and
assumptions, and one of which does not appear to include calibration to actual market
transactions of the same instrument or contract in a previous period.
78. It is necessary to calibrate a pricing model to actual market transactions when
establishing a mark in that or any prior existing position. Neither DRW’s pricing
model (to the extent it actually used one) and Harris’ pricing model appear to include
calibration to actual market transactions. This final step is essential when using a
model to establish a mark, therefore the results produced by DRW’s and Harris’
models yield incomplete results. These incomplete results were based on a noncalibrated model that was unsuitable for purposes of establishing a mark in a contract
market where the resulting price dissemination was misleading.
79. The calibration of a model is at least as important to its applicability as any of its
individual inputs. Such inputs for a swap model would necessarily include variables
such as volatility and interest rate assumptions.
80. As discussed above, interest rates and volatility are key assumptions that have
significant importance in a swap model. As Exhibit 1A – OTC Swap Rates - 10 v. 30
year (2010-2011) shows, there was an upward trend in swap rates from August 2010
through January 2011. This is consistent with the positive cash flows accruing to
DRW during that period. However, from February through August 2011 (i.e. the
period during which DRW placed bids on the electronic exchange of the NFX), the
swap rates took a downward turn.79 DRW, as a fixed-rate payer (i.e. floating-rate
receiver) in the Three-Month Contract in a declining rate environment, could not have
benefited to the extent to which it did, but for DRW’s bids that led to artificial
settlement prices on the NFX during the Relevant Period.
See Exhibit 1B – Corresponding Rate - 10 v. 30 year (Relevant Period) for more detail on swap rates during the
Relevant Period.
79
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81. Exhibit 2 – 10-year U.S Treasury Note Volatility Index shows the volatility in the 10-
year U.S Treasury Note from July 2010 through December 2011. It is clear that from
January through May 2011, volatility exhibited a downward trend, which goes against
Harris’ rationale for bidding at rates that represented “fair value” in the Three-Month
Contract during that phase in the Relevant Period.
82. The above stated market conditions do not point to a market environment that would
support making a profit from a long position in the Three-Month Contract. Therefore,
one must question how DRW managed to profit on its long positions in the ThreeMonth Contract in market conditions that went against them.
c. Harris mischaracterizes DRW’s bidding behavior.80
83. Harris analyzes DRW’s bidding behavior and describes it as follows, “DRW’s
electronic bids on the Three Month Contract represented true interest to buy at the
posted prices and quantities throughout the trading day because: (a) they were posted
for almost 47 minutes, on average, and thereby, exposed DRW to the risk of one of its
posted bids being hit and (b) they were posted at rates within the range of (or
consistently below) all estimates of fair value.” 81
84. Although, DRW’s electronic bids could have represented “true interest” to buy at the
posted bids, and not “prices” as Harris asserts, they were not based on actual market
activity on the NFX. DRW’s bids, which remained open during the PM Settlement
Period, produced artificial daily settlement prices.
Harris states that DRW’s bids were consistent with its view of fair value of the Three-Month Contract. However,
this statement was not corroborated by Harris. See ¶ 98. As stated earlier, Wilson testified contrary to Harris’
statement by stating that DRW placed bids at the “price we [they] were willing to pay.” Testimony of Donald R.
Wilson Jr., April 2, 2013 (91:14-22).
80
81
Harris at ¶ 4.
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85. In a market that did not trade, and absent any other reference points for establishing
daily settlement prices, even a temporary bid would have a greater effect on daily
settlement prices than some other price derived from a related market, such as the
OTC swap market.82 So too does the timing of such a bid matter with respect to
validation of that bid. In other words, the fact that liquidity and volume is generally
highest during the opening and the close of a trading period for liquid contract
markets, and the fact that DRW’s bids during the PM Settlement Period failed to
flush out any interest by counterparties, DRW’s bids did not reflect basic forces of
supply and demand. As a result, DRW’s bids during the settlement period proved
effective in favorable settlement prices for DRW’s existing positions.
86. Secondarily, I did observe off-exchange negotiated transactions by DRW which
occurred at or near a spread of zero, as outlined in my Initial Report. However,
subsequent bids by DRW did not occur at levels which would be consistent with the
spread of DRW’s initial transactions. That is, when price discovery83 is established
and subsequently disseminated, that becomes a benchmark for establishing value in
that market and in other ancillary markets that may or may not trade. The result is the
establishment of legitimate “value” at a moment in time. On the NFX, the prices
disseminated by DRW’s initial established positions provided benchmarks for value
on the NFX. A better example of fair value pricing in this case would be the pricing
of a bilateral swap that is priced off other contemporaneous bilateral swap trades or
Corresponding Rates as reflected in a more liquid marketplace.
82
The IDCH used interest rates from the OTC swap market (in the absence of electronic bidding activity in the PM
Settlement Period) to determine daily settlement prices of the Three-Month Contract on the NFX. As stated above,
the information from OTC swap markets garnered from brokers reflects actual trading levels.
83
Price discovery cannot be established on the exchange when there are no consummated trades. DRW was aware
that it was the only market participant on the NFX during the Relevant Period. Michael K. Dundon testified that “…if
you’re aware that no other entity is participating on the – on the exchange, there would be no other reason to submit
bids other than to affect the [settlement] curve.” Deposition of Michael Dundon, April 1, 2015 (168).
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87. Thus, if the market was calibrated with market pricing, it could only have done so
where it was trading when positions were initially established and/or closed out in a
competitive open market. The fact that DRW’s bid levels far exceeded Corresponding
Rates during the Relevant Period when nothing traded implies either 1) DRW’s
theoretical model was never actually calibrated on the basis of prior trading activity,
or 2) DRW may not have placed bids in accordance with a properly calibrated
theoretical model.
88. Harris claims that “Contrary to the CFTC’s assertion that DRW’s bids active during
the Three Month Contract’s settlement period (1:45PM to 2:00PM CT, “Settlement
Period”), were withdrawn “shortly thereafter,” I find that DRW’s bids active during
the Settlement Period were posted for more than 17 minutes, on average—longer than
the 15-minute Settlement Period itself—and exposed DRW’s trading interest broadly
to the market.”84 I agree that, overall, DRW’s bids were posted, on average, for at
least 15 minutes, during the PM Settlement Period, which accounts for approximately
3% of the trading day. However, DRW would have had an even greater opportunity
to have its bids matched if these positions were open for anywhere closer to the 630
minutes every day the electronic exchange of the NFX was open. Traders that look to
“expose [DRW’s] trading interest broadly”85 usually enter standing day orders, which
was not what DRW did. This would be more typical for a trader that truly wants to
maximize opportunities of getting filled.
89. In fact, as stated in my Initial Report, “on nine trading days during the Relevant
Period, February 25, May 12, June 7, June 16, June 17, June 24, July 19, July 21 and
July 22, 2011, DRW did not add a single bid until the PM Settlement Period.”86 The
volume and breadth of a sample of these trading days in shown in the figures below.
84
Harris at ¶ 4.
85
Harris at ¶ 4.
86
IDCH Data Feed. DRW-IDCG-0000001.
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Case 1:13-cv-07884-AT-KNF Document 104-75 Filed 10/30/15 Page 39 of 56
90. Finally, Harris states that “40% of [DRW’s] bids, were placed during the fifteen-
minute Settlement Period.” I agree with this statement in terms of DRW’s overall
bidding conduct, yet find an additional 21% of bids that were placed before the
Settlement Period and remained open during the Settlement Period. These “open
bids” affected closing prices in the same manner as the bids that were placed during
the PM Settlement Period.
Figure 6 – DRW Bidding Activity87
87
IDCH Data Feed. DRW-IDCG-0000001.
37
Case 1:13-cv-07884-AT-KNF Document 104-75 Filed 10/30/15 Page 40 of 56
Figure 7 – DRW Bidding Activity on February 25 (A) and July 19, 2011 (B)88
(A)
(B)
88
IDCH Data Feed. DRW-IDCG-0000001.
38
Case 1:13-cv-07884-AT-KNF Document 104-75 Filed 10/30/15 Page 41 of 56
91. As seen from DRW’s bidding activity solely during the PM Settlement Period on the
nine trading days shown above, it is clear that DRW’s bids did not singularly
represent legitimate interest in buying the Three-Month Contract. An e-mail exchange
between Luitgaren and Silberberg further corroborates their desire for settlement in
line with their bidding behavior.89
d. Harris’ conclusions about DRW’s profits are oversimplified.
92. Harris concludes that “DRW’s profits did not depend on DRW’s bids in the electronic
market, as the CFTC alleges, but rather stemmed from interest rate movements and
the fact that DRW entered into a long position in the Three Month Contract at below
fair value. Whether or not DRW or another party posted bids at a premium after
taking a position in the Three Month Contract (which more closely reflected supply
or demand for the Three Month Contract), DRW would have realized substantially
the same stream of cash flows generated by the exchange of variation margin over
time.”90
93. DRW would not have made the same profits holding a long position in the Three-
Month Contract at or near Corresponding Rates. Significantly, based on market
conditions and changes in value of its hedging vehicles of choice, DRW would have
seen potential losses that would most likely be reflected in the profits of those hedges.
DRW managed to minimize that loss (i.e. make a profit) only by placing bids that
created artificial settlement prices, thus affecting the IDEX Curve.
94. Some component of the profit that DRW made on their long positions is due to the
interest on variation margin. The components that go into the calculation of interest
on variation margin are: (i) the purchase price, (ii) the sale price, (iii) gains/losses on
hedges and (iv) the interest embedded on receiving/paying margin.
89
Testimony of Brian Vander Luitgaren, February 1, 2012, Exhibit 20. D0000663.
90
Harris at ¶ 4.
39
Case 1:13-cv-07884-AT-KNF Document 104-75 Filed 10/30/15 Page 42 of 56
95. Further, parties that are long the Three-Month Contract benefit in a rising rate
environment and thus observe an increase in value of their position. I define three
phases for changes in swap rates between August 2010 and August 2011. As Exhibit
1A – OTC Swap Rates - 10 v. 30 year (2010-2011) shows, there was a general upward
trend in swap rates from August 2010 through February 9, 2011 (“Phase I”). During
this time, the Net Present Value of DRW’s 10 and 30-year positions generally grew
favorably for DRW, as reflected in Exhibit 4 – DRW’s Long Positions – 10-year and
Exhibit 5 – DRW’s Long Positions – 30-year. Further, between August 2010 and
January 20, 2011, DRW did not bid on the electronic exchange and thus the Net
Present Value of DRW’s positions was affected solely by the change in
Corresponding Rates.
96. Starting on January 21, 2011, DRW started bidding on the electronic exchange of the
NFX and essentially drove the value of the Net Present Value of its 10 and 30-year
positions. From February 10 to approximately March 19, 2011 (“Phase II”) swap
rates exhibited a general downward trend, and as expected, the Net Present Value of
DRW’s 10 and 30-year positions declined. As shown in Figure 8, DRW bid, on
average, approximately 10 to 40 basis points over the Corresponding Rate curve for
both the 10 and 30-year contract. Further, DRW bid, on average, approximately 0
basis points more on 30-year contracts compared to 10-year contracts in January, 8
basis points more in February and 19 basis points more in March. DRW bid
increasingly higher on the 30-year contract versus the 10-year contract, despite the
fact that the spread between the 30 and 10-year contracts remained virtually flat
during this period.
40
Case 1:13-cv-07884-AT-KNF Document 104-75 Filed 10/30/15 Page 43 of 56
Figure 8– DRW Bid Rates increase over Corresponding Rates (CR)91
Month
Tenor
January
February
March
April
May
June
July
August
10
10
10
10
10
10
10
10
Average
Difference
Between
DRW Bid
Rate and CR
0.12%
0.21%
0.21%
0.26%
0.26%
0.24%
0.25%
0.23%
Tenor
20
20
20
20
20
20
20
20
Average
Difference
Between
DRW Bid
Rate and CR
0.12%
0.29%
0.32%
0.48%
0.48%
0.47%
0.48%
0.53%
Tenor
30
30
30
30
30
30
30
30
Average
Difference
Between
DRW Bid
Rate and CR
0.12%
0.29%
0.40%
0.70%
0.71%
0.70%
0.71%
0.84%
97. Finally, between approximately March 20 and April 8, 2011 (“Phase III”), swap rates
exhibited a general upward trend, and again as expected, the Net Present Value of
DRW’s 10 and 30-year positions grew favorably for DRW. The increase in Net
Present Value of DRW’s 10 and 30-year position on April 7 and 8, 2011 coincides
with DRW bidding approximately 25 basis points over the Corresponding Rate curve
for the 10-year contract and approximately 70 basis points over the Corresponding
Rate curve on the 30-year contract on those days. DRW’s bidding on the 30-year
contract is 45 basis points more than its bidding on the 10-year contract and during a
period that the spread between the 30 and 10-year contracts remained virtually flat.
91
IDCH Data Feed. DRW-IDCG-0000001.
IDCH Curve Interpolator. DRW-IDCG-0000003.
41
Case 1:13-cv-07884-AT-KNF Document 104-75 Filed 10/30/15 Page 44 of 56
98. The Net Present Value of DRW’s 30-year positions reached far greater levels
proportionally than the levels reached on its 10-year positions, as shown in Exhibit 4
– DRW’s Long Positions – 10-year and Exhibit 5 – DRW’s Long Positions – 30-year.
On April 9, 2011, as swap rates started on a downward trend that would exist until the
termination of the position by DRW in the beginning of August 2011 (“Phase IV”),
the Net Present Value of DRW’s 10 and 30-year positions began to decline. However,
because of the Net Present Value level that DRW’s 30-year positions reached, due to
its bidding 45 basis points higher on the 30-year contracts versus the 10-year contract,
the Net Present Value started its decline from a place of higher value, and thus DRW
lost less than it would have otherwise lost, but for its bidding behavior.
e. Harris’ conclusions about market knowledge are overreaching.
99. Finally, Harris assumes that “The shift from International Derivatives Clearinghouse
(“IDCH”) using OTC interest rate swap prices to more appropriate cleared Three
Month Contract specific prices was inevitable. Given the real economic differences
between an OTC interest rate swap and the Three Month Contract, a rate premium
was appropriate for the Three Month Contract.”92 Harris, himself, even admits that
this “rate premium” is theoretical. One fact remains: this price premium never
occurred, or was exhibited, via legitimate forces of supply and demand of the ThreeMonth Contract.
92
Harris at ¶ 4.
42
Case 1:13-cv-07884-AT-KNF Document 104-75 Filed 10/30/15 Page 45 of 56
100. DRW and Harris both incorrectly assume that the marketplace will agree with the
assumptions and outputs of their models (to the extent DRW used a model in placing
its bids), and thus set the IDCG settlement curve to higher rates. DRW also assumes
that this will ultimately validate the rates they assume are “fair” and should be
discovered on the NFX. These assumptions and assertions of “fair” value are
completely theoretical in the absence of a properly calibrated model. DRW’s theories
were never confirmed due to the fact that none of its bids were ever hit, no offers
came into the market and there were no transactions on the electronic platform of the
NFX. The lack of subsequent consummated trades on the electronic exchange
provided DRW with no inputs to adequately calibrate its model, to the extent it used
one, for marking purposes.
F. Concluding Remarks
101. In conclusion, DRW’s bids, supposedly based on a theoretical model that was
uncalibrated to actual market transactions, was a misleading and inappropriate basis
for marking-to-market the Three-Month Contract. DRW’s illegitimate bids, as the
only market participant on the NFX, created artificial settlement prices. The artificial
settlement prices provided DRW with greater economic benefit than it otherwise
would have realized.
G. Documents Considered
102. My opinions have been reached after reading certain case filings, testimony and other
documents produced in this case, reading and analyzing available financial data, and
independent research. A list of the documents I considered is identified in Appendix
B of this report. I reserve the right to alter or modify my opinions as additional
relevant information becomes available.
43
Case 1:13-cv-07884-AT-KNF Document 104-75 Filed 10/30/15 Page 46 of 56
H. Exhibits
Exhibit 1A – OTC Swap Rates - 10 v. 30 year (2010-2011)
Exhibit 1B – Corresponding Rate - 10 v. 30 year (Relevant Period)
Exhibit 2 – 10-year U.S Treasury Note Volatility Index
Exhibit 3 – Treasury Yields
Exhibit 4 – DRW’s Long Positions – 10-year
Exhibit 5 – DRW’s Long Positions – 30-year
I. Appendices
Appendix A – Curriculum Vitae of Robert M. MacLaverty
Appendix B – Additional Documents Considered
Robert MacLaverty
August 18, 2015
44
Case 1:13-cv-07884-AT-KNF Document 104-75 Filed 10/30/15 Page 47 of 56
Exhibit 1A – OTC Swap Rates - 10 v. 30 year (2010-2011)
5.00%
4.50%
4.00%
3.50%
Swap Rates
3.00%
2.50%
10-Year
2.00%
30-Year
10-30
1.50%
1.00%
0.50%
Phase I
Phase II
0.00%
Source: FRB Table H.15
Date
Phase
III
Phase IV
Case 1:13-cv-07884-AT-KNF Document 104-75 Filed 10/30/15 Page 48 of 56
Exhibit 1B – Corresponding Rate - 10 v. 30 year (Relevant Period)
5.00%
Corresponding Rate (10-yr)
Corresponding Rate (30-yr)
5 period Moving Average (10-Yr)
4.50%
5 period Moving Average (30-Yr)
Corresponding Rate
4.00%
3.50%
3.00%
2.50%
Phase II
Phase III
Phase IV
2.00%
Date
Note: The moving average trendline is used to smooth out fluctuations in data and is based upon the average of a specific number of data points. A five period or five
day moving average trendline is shown above.
Source: IDCH Curve Interpolator
Case 1:13-cv-07884-AT-KNF Document 104-75 Filed 10/30/15 Page 49 of 56
Exhibit 2 - 10-year U.S Treasury Note Volatility Index
12
11
Close
10
9
TYVIX
8
7
6
5
4
3
2
Date
Note: TYVIX is the NEW ticker symbol for the CBOE/CBOT 10-year U.S. Treasury Note Volatility Index (Formerly ticker VXTYN).
TYVIX provides a measure of expected volatility specific to the fixed income market.
Source: Chicago Board Options Exchange (CBOE)
Case 1:13-cv-07884-AT-KNF Document 104-75 Filed 10/30/15 Page 50 of 56
Exhibit 3 - Treasury Yields
5.00%
Treasury Yields
4.00%
3.00%
2-Year
5-Year
10-Year
30-Year
2.00%
1.00%
0.00%
Source: FRB Table H.15
Date
Case 1:13-cv-07884-AT-KNF Document 104-75 Filed 10/30/15 Page 51 of 56
Exhibit 4 - DRW's Long Positions - 10-year
4.25
$14,000,000
Phase II
Phase I
$12,000,000
Phase
III
Phase IV
3.75
$10,000,000
$8,000,000
2.75
$6,000,000
2.25
$4,000,000
1.75
$2,000,000
1.25
$-
0.75
$(2,000,000)
Trade # 2170
Trade # 2142
Trade # 2095
10-Year Swap Rates
0.25
$(4,000,000)
Date
Source: New York FRB Table H.15, IDCH Fut Daily EOD Reports
Swap Rates
Net Present Value (NPV)
3.25
Case 1:13-cv-07884-AT-KNF Document 104-75 Filed 10/30/15 Page 52 of 56
Exhibit 5 - DRW's Long Positions - 30-year
$14,000,000
5
Phase I
Phase II
Phase
III
Phase IV
4.5
$12,000,000
4
$10,000,000
$8,000,000
3
$6,000,000
2.5
2
$4,000,000
1.5
$2,000,000
1
$0.5
Trade # 2103
Trade # 2134
Trade # 2127
30-Year Swap Rates
$(2,000,000)
Source: New York FRB Table H.15, IDCH Fut Daily EOD Reports
0
Date
Swap Rates
Net Present Value (NPV)
3.5
Case 1:13-cv-07884-AT-KNF Document 104-75 Filed 10/30/15 Page 53 of 56
Curriculum
m Vitae
Appendix A
ROBERT M.
M MACLAV
VERTY
BERK
KELEY RES
SEARCH G
GROUP, LL
LC
810 Seventh
h Avenue, S
Suite 600
New Yo
ork, NY 100
019
Also resiident in Chiicago
Office: 646.205.93
380
Mobile: 847.902.2
2666
[email protected]
BIO SUMMAR
RY
Robert MacLaverty is a ma
anaging dire
ector with Berkeley
B
Ressearch Group, LLC (BR
RG) providing financiall,
econ
nomic and testifying expert
e
services to the nation’s le
eading law firms, invesstment ban
nks, pension
n
fund
ds, endowments and foundations.
Mr. MacLaverty
y spent the majority off his 18-yea
ar Wall Stre
eet career trrading and in institutio
onal sales of
o
taxa
able fixed-income securrities, deriva
atives and structured
s
p
products. A
After working
g as a finan
ncial analys
st
with Morgan Gu
uaranty Tru
ust Company of New York
Y
(J.P. M
Morgan), he was a trad
der (as princcipal marke
et
makker and/or agent)
a
with CS First Boston
B
(Cre
edit Suisse) , Continenttal Bank (B
Bank of America), Bear
Stea
arns and Mo
organ Stanle
ey. He was
s also an ind
dependent ttrader and sseat owner a
at the Chica
ago Board of
o
Trad
de, while se
erving on nu
umerous co
ommittees of
o the exch ange. His combinatio
on of prior industry and
d
expe
ert experien
nce provides
s a unique breadth
b
to his practice.
His capital markets experrtise include
es, but is not
n limited to, U.S. Trreasury and
d Governm
ment Agency
y
secu
urities, futurres and forw
ward contra
acts, interest rate swap
ps, mortgage-backed ssecurities (M
MBS), assettbackked securities (ABS), exchange-traded and OTC option
ns, securitie
es lending and repo transactions
s,
synthetic assets
s, credit default swaps
s (CDS), cash and syn
nthetic collateralized de
ebt obligatio
ons (CDOs)),
and other struc
ctured produ
ucts. Other investmen
nts markete
ed to familyy offices and foundatio
ons included
d
ate equity and hedge fu
unds.
priva
In M
Mr. MacLav
verty’s capa
acity as a Primary De
ealer marke
et-maker, h
he acted ass principal fulfilling the
e
oblig
gation to pa
articipate in all Quarterrly Refundin
ngs and oth
her U.S. Tre
easury and Federal Re
eserve Bank
k
Systtem activitie
es. Institutio
onal counterparties included foreig
gn central b
banks, soverreign funds, total-return
n
portffolio manag
gers and the
e Federal Re
eserve Bank
k of New Yo
ork.
As a testifying expert,
e
Mr. MacLaverty
M
y has served
d as an exp
pert in nume
erous matterrs including MBS, ABS
S,
CDO
Os, CDS, he
edge funds, auction ra
ate securitie
es (ARS), co
omplex tran
nsactions in
n ponzi sche
emes, back
kdatin
ng of options, internatio
onal bond un
nderwriting//issuance an
nd cross-bo
order transa
actions.
Mr. MacLaverty
y has prov
vided expert testimony
y on behalff of institutions and p
private bankking clients
s,
inclu
uding U.S. regulatory
r
agencies.
a
He
H has worrked with bo
oth investorrs and issue
ers in matte
ers involving
g
struccture, liquid
dity, suitability and pric
cing. He ha
as also bee
en engaged
d in cases w
where econ
nomic crises
s
affecct market performanc
ce. He has testified
d in Federral District Court, U.S
S. Adminisstrative Law
w
Case 1:13-cv-07884-AT-KNF Document 104-75 Filed 10/30/15 Page 54 of 56
Procceedings an
nd before otther Federal administra
ative bodies as an indusstry expert in custom a
and practice
e,
valuation and damages.
ally, Mr. Ma
acLaverty ho
olds an A.B
B. in analyttic philosoph
hy from Bo
oston Colleg
ge, an M.A
A. in analytic
c
Fina
philo
osophy from
m Georgetow
wn University, a post-g
graduate te
erm in intern
national law
w and econo
omics at the
e
Lond
don School of Econom
mics, and wa
as a Ph.D. (ABD)
(
cand
didate in eco
onomics at the Universsity of Notre
e
Dam
me. He also
o held lice
enses for General
G
Securities Re
epresentativve (Series 7), Uniform
m Securities
s
Representative (Series 63)) and Registtered Investtment Advissor (Series 6
65).
LICE
ENSURES HELD
General Securitties Represe
entative (Se
eries 7)
Unifo
orm Securitties Represe
entative (Se
eries 63)
Registered Inve
estment Adv
visor (Series
s 65)
EDU
UCATION
Ph.D
D. (ABD), University of Notre Dame
e, 1983
Postt-graduate, London Sch
hool of Econ
nomics, 198
80
M.A., Georgetow
wn University, 1979
A.B., Boston Co
ollege, 1978
8
SUM
MMARY OF
F PROFESS
SIONAL EX
XPERIENC
CE
Berkkeley Resea
arch Group, LLC
2011-Pre
esent: Mana
aging Direc
ctor
FTI C
Consulting
2009-2011: Managiing Directo
or
Cred
dit Suisse
1987-1989
2008-2009: Vice Prresident
Morg
gan Stanley
y
2004-2008: Vice Prresident
Chiccago Partne
ers (Navigan
nt Economic
cs)
1996-2004: Partnerr
2
Case 1:13-cv-07884-AT-KNF Document 104-75 Filed 10/30/15 Page 55 of 56
J.P. Morgan & Co.
C
1983-1984
1994-1996: Vice Prresident
Bear Stearns
1992-1994: Vice Prresident
Continental Ban
nk (Bank of America)
1990-1992: Vice Prresident
Chiccago Board of Trade
1984-1990: Membe
er
TES
STIMONY EXPERIENC
E
CE
Expe
ert Report and Deposition Testimony of Robert
R
M. MacLavertyy filed in R
Re: Starr IInternationa
al
Com
mpany, Inc. v. United States off America, Case: 1: 11-cv-0077
79 TCW, U
U.S. Court of Claims
s,
Wasshington D.C
C., filed Feb
bruary 7, 2014. Expert Rebuttal Re
eport for the
e same mattter filed Aprril 18, 2014
Expe
ert Report and
a Deposittion Testimo
ony of Robe
ert M. MacLa
averty filed in Re: Liquiid Realty Ad
dvisors, LLC
C
et al. v. Clairvue
e et al. Filed
d May 31, 20
013.
Expe
ert Report and
a
Testim
mony at Arbitration of Robert
R
M. M
MacLaverty filed in Re
e: BNP Parribas S.A. v.
v
OJS
SC Russian Machines. Filed Septtember 28, 2012. Pro ceedings in
n International Arbitration London
n,
Janu
uary 18, 201
13.
Expe
ert Report, Deposition and Trial Testimony of Robert M
M. MacLaverty filed R
Re: U.S. Se
ecurities and
d
Exch
hange Com
mmission v. Brian Stok
ker, 11-cv-7388, U.S. D
District Cou
urt, Southerrn District o
of New York
k
(Man
nhattan), file
ed March 16
6, 2012. Re
ebuttal Repo
ort for same
e matter filed April 6, 20
012.
Expe
ert Report and
a Testimo
ony at Arbittration of Ro
obert M. Ma
acLaverty in
n the matterr of FINRA Departmen
nt
of Enforcement v. Brooksto
one Securities, Inc. Disciplinary Prroceeding N
No. 2007011
141350, filed
d January 4,
4
2011
1. Rebuttal Report for same matte
er filed Janu
uary 19, 201
11.
PRO
OFESSIONAL AFFILIA
ATIONS
Ame
erican Economic Assoc
ciation
3
Case 1:13-cv-07884-AT-KNF Document 104-75 Filed 10/30/15 Page 56 of 56
Appendix B
Additional Documents Considered
Pleadings:
Wells Submission on behalf of DRW Investments, LLC, DRW Holdings, LLC and Donald R. Wilson, Jr.
Expert Reports:
Expert Report of Matthew A Evans, July 27, 2015
Expert Report of Jeffrey H. Harris, July 27, 2015
Depositions/Testimonies:
Wasserman, Robert 2015 04 22 (Condensed Transcript)
Stephenson, Samuel Heath 2015 05 27 (Condensed Transcript)
Books/E-books:
Brigo, D. and Mercurio, F., Interest Rate Models- Theory and Practice, Springer, 2007.
Burghardt, Galen. The Eurodollar Futures and Options Handbook. New York: McGraw-Hill, 2003.
Rainer, Martin (2009). “Calibration of Stochastic Models for Interest Rate Derivatives.”
Hull, John, and Alan White, "Pricing Interest Rate Derivative Securities”, Review of Financial Studies, 3,4 (1990), (573-592).
Web:
CME
CME
BIS
Statement of Financial Accounting Standards No. 157
E-book
Book
Article
Article
https://www.cmegroup.com/trading/interest-rates/files/understanding-eurodollar-futures.pdf
http://www.cmegroup.com/trading/interest-rates/files/IR148_Eurodollar_Futures_Fact_Card.pdf
http://www.bis.org/statistics/dt1920a.pdf
http://www.fasb.org/jsp/FASB/Document_C/DocumentPage?cid=1218220130001&acceptedDisclaimer=true
Data:
Bloomberg
Thomson Reuters
Note:
For all other documents considered, please refer to Appendix B of "Expert Report of Robert M. MacLaverty".