Manipulation or Brilliant Trade? The Curious Case of Don Wilson

When Don Wilson spotted a chance in 2010 to take another bite at a trade that had mostly eluded him as a younger man, he never expected he’d be defending his actions six years later in a Manhattan federal courtroom.

A former pit trader who rose from the floor of the Chicago Mercantile Exchange to create the 700-person derivatives powerhouse DRW Holdings LLC, Wilson is a respected industry executive. Early in his career, the University of Chicago graduate with a toothy smile built quantitative models in the off-hours to guide his trading. That same methodical approach led him to assemble a group six years ago to determine if a pricing mismatch worth tens of millions of dollars was staring them in the face.

What happened next will be heard in a New York courtroom later this year after the U.S. Commodity Futures Trading Commission accused Wilson, 48, and his firm of manipulating markets and illegally earning $20 million along the way. Wilson is fighting the claims and has said he was simply buying an asset ahead of the market recognizing its true value, much like a trade he encountered earlier in his career.

The case strikes at the heart of what can be a slippery definition of swaying markets — the line between manipulation and shrewd trading. The court battle also raises questions about the dual regulation of U.S. derivatives markets by the government and an industry-funded watchdog. Along the way there’s a Chicago blizzard and a cameo appearance by Jon Corzine eight months before his firm MF Global Holdings Ltd. crashed and burned.

Those details came to light in a cache of depositions, recorded phone calls and e-mails made public in October, revealing never-before-seen elements of the case. This story is based on those documents as well as interviews with the people involved.

Moving Prices

The CFTC sued Wilson and DRW in 2013, saying they broke the law by placing orders only to move prices in their favor. The trades were for a new type of interest-rate derivative offered by a futures exchange owned by Nasdaq Inc. The CFTC alleged that DRW bid on contracts during two daily 15-minute windows when prices are set but never intended to buy the assets. That benefited a $350 million position DRW had already established, according to the regulator.

The crux of the civil case may come down to whether the CFTC can convince the court that Wilson and DRW took matters into their own hands, placing increasingly higher bids when the market didn’t move the way they wanted. Wilson has argued that he was trying to buy the contracts before prices moved to the correct level, not manipulate the market.

Wilson “thought it was mispriced, so he bought the contract,” said Craig Pirrong, a finance professor at the University of Houston who is sympathetic to the futures trader’s position. “He was looking for the convergence.”

Steve Adamske, a CFTC spokesman, declined to comment beyond the court filings.

Convexity Bias

To fully understand how Wilson got into this mess, you have to go back to 1992, when the most important futures contract in the world was broken and no one knew it.

Two assets that should have traded in a tight relationship to each other didn’t. The first, a eurodollar futures contract, had been invented in Chicago a decade earlier. The second, an interest-rate swap, is now the world’s largest derivatives market. The beauty of the eurodollar contract was its ability to set prices years in advance for the rate swaps, except in 1992 the correlation was off by a small but significant degree. That difference came to be known as a convexity bias.

When Wall Street messes up, investing opportunities are born. By 1994, Galen Burghardt and William Hoskins at Carr Futures in Chicago had identified one instance where $1.2 million in free money could have been wrung from the trade. “The swaps market has not fully absorbed the implications of this pricing problem,” they wrote in a research note.

That caught the attention of Wilson, who began his career trading eurodollar options. Wilson met with Burghardt and Hoskins to make sure he had the math correct, but he didn’t have relationships with banks to be able to trade the swap leg of the transaction. He made some money, nothing major, and by the mid-1990s the market had corrected for the pricing error.

Undervalued Swaps

Then in 2010, after DRW had become a force in the $30 trillion U.S. derivatives industry, Wilson saw another chance to trade a convexity bias. This time, he didn’t hold back.

His view was that the interest-rate-swaps future offered by Nasdaq’s exchange was undervalued compared with swaps that trade in the private over-the-counter market. He even commissioned a paper to prove his point.

Wilson said in a 2013 deposition in the CFTC case that he uncovered the pricing issue while researching competitors to a futures market he had an ownership interest in, the Eris Exchange, which opened in 2010.

As in the eurodollar-swaps trade, once the rest of the market caught on to the convexity bias on Nasdaq’s market, the contracts he’d already bought — and others he continued to buy — would increase in value to match the OTC swaps. The problem was, no one other than Wilson was trading the contracts.

‘Manipulative Scheme’

DRW’s bids were a “manipulative scheme” intended to influence daily settlement rates “on an exchange where nobody traded” and weren’t intended to be consummated, according to the CFTC. From January to August 2011, the regulator alleged, DRW bought almost 90 percent of all the three-month contracts on Nasdaq’s exchange.

Regardless of how many users are in a market, part of the CFTC’s job is to “protect the market users and their funds, consumers and the public from fraud, manipulation and abusive practices related to derivatives,” according to the regulator’s mission statement.

The CFTC has a bad record when it comes to winning manipulation cases. The commission has had only one court victory since its creation in 1974, in part because its lawyers must satisfy a four-part test to prove manipulation, including that an “artificial price” was created. In the case against Wilson, the commission’s lawyers are arguing they need only show that DRW “intended to affect market prices” to prove attempted manipulation.

Industry groups and futures exchanges accused the CFTC of overstepping its bounds. The court should “retain the well-established legal standard for attempted price manipulation,” CME Group Inc., Intercontinental Exchange Inc., the Futures Industry Association, the Managed Funds Association and the Commodity Markets Council wrote in a friend-of-the court brief filed in January.

Most CFTC enforcement cases are settled before trial with defendants neither admitting nor denying wrongdoing. Several recent cases have involved spoofing, a type of bait-and-switch manipulation where traders enter price quotes into a market and then cancel them without the intention to execute. Enforcement actions usually end with fines and injunctions to cease illegal behavior. In Wilson’s case, the government is seeking possible trading suspensions or an outright ban against him and his company.

Blizzard Trade

One of the more dramatic episodes in Wilson’s case revolves around what happened, or didn’t happen, on Feb. 2, 2011, when one of the worst blizzards to hit Chicago shut down most of the city. Wilson skied to work that day.

Just before 3 p.m., a potential trade came into DRW’s office. On the other side was MF Global, the brokerage headed by Corzine, a former New Jersey senator and governor. Corzine’s personal trader, Lauren Cantor, had been told there was a big buyer in the market, and Corzine could be heard in the background giving her approval to let DRW name how much it wanted to buy, according to court documents. A billion dollars, came DRW’s reply. Too much, Cantor replied, and they settled on $250 million.

The deal was never consummated, Wilson has said, because a risk manager who needed to approve the transaction stayed home that day. The next morning, Wilson tried to find out what happened to what came to be known as the blizzard trade. That drama played out in a phone call with Laurie Ferber, MF Global’s general counsel at the time.

“These prices, the timing of these prices is very smelly,” Ferber told Wilson, according to a transcript of a conversation two days after the busted trade.

“What do you mean by that?” Wilson said.

“You guys have been putting up prices at 2:45 the last several days,” Ferber said.

“Let’s pause here for a minute,” Wilson said. “We’d be happy to trade on any of those prices. All day long.”

‘Stupid Enough?’

A few minutes later, Wilson said it seemed as if MF Global was doing everything it could to walk away from the trade.

“My understanding, and this is pure hearsay, is that MF called up IDCG in the morning and said ‘Get us out of this trade,’” Wilson said, referring to the derivatives clearinghouse that Nasdaq used.

Ferber responded: “That’s not true. First off, even if someone thought that, which is not the case, do you think we’re stupid enough to do that?”

“I have no idea,” Wilson said.

One reason Wilson was angry was the loss DRW had taken hedging the MF Global trade.

“Right now the result is that we don’t have on a trade that we thought we had done, and we are out $1.1 million,” Wilson said to Ferber. MF Global agreed five months later to pay Wilson’s firm $850,000.

Wilson disputed the CFTC’s claim that DRW canceled orders to avoid trading.

“The CFTC knew all along from the evidence it had obtained before it filed its lawsuit that when MF Global saw our bid and called to transact with us during this period, we not only agreed to a transaction, but one 10 times the size of our bid,” he said in an e-mailed statement. “We’re left to question why the CFTC disregarded this evidence and asserted the opposite.”

NFA Report

Wilson, who served on the board of the Futures Industry Association and has been a member of the CFTC’s Global Markets Advisory Committee, plans to use the blizzard trade as proof that DRW was in fact interested in buying contracts in the market. He and his lawyers also point to a report by the National Futures Association, the industry’s self-regulatory organization, that they say shows DRW was interested in actual trades.

At the request of Nasdaq, and unrelated to the CFTC case, the NFA audited DRW’s 2011 trading records from Jan. 24 to Aug. 11, identifying 2,420 orders over 120 days. It found that on 45 of those days DRW placed orders only when the pricing windows were open. Overall, 28 percent of the firm’s orders were made outside those time frames.

The industry group also found that more than 97 percent of DRW’s orders were left exposed to the market for more than one minute. “It appears the orders were entered in a manner consistent with DRW’s claims” and that the exposure the orders had to the market “appears to mitigate the probability of the firm utilizing manipulative order strategies,” the NFA said in its report.

DRW and its attorneys, who include Lanny Davis, a former special counsel to President Bill Clinton, said they weren’t shown the NFA report until after the CFTC sued the firm in 2013.

“It is fair to ask why the CFTC failed to disclose the report, which contradicted or undermined the key assertion in the manipulation case,” Davis wrote in a summary of court documents shown to Bloomberg News.

Aitan Goelman, the CFTC’s head of enforcement, wrote in an Oct. 14, 2015, letter to Davis that the commission can’t unilaterally release confidential information such as the NFA report.

‘Profit Opportunity’

Live bids or offers entered into a market where they can be accepted by other investors represent a risk position, the University of Houston’s Pirrong said.

“In this high-frequency trading world, a minute is an eternity,” he said. The repeated activity over months may also prove hard for the CFTC to counter, Pirrong said. “That’s the kind of thing people can notice and take advantage of. It can create a profit opportunity for someone else.”

In a deposition in the case given in 2013, Wilson was asked by a CFTC attorney about the convexity bias inherent in eurodollar futures. The lawyer asked if Wilson agreed that others in the market have to catch on to convexity bias for the disparity to be corrected.

“I mean, I guess you could say that,” Wilson said. “I think of it just as supply and demand.”