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NEW YORK/BENGALURU, Feb 13 (Reuters) - Wall Street's most widely followed gauge of future stock market volatility is being manipulated, causing billions of dollars in losses a year to unwary investors, a law firm representing an "anonymous whistleblower" alleged in a letter to U.S. financial regulators and released on Monday.
The letter, to both the U.S. Securities and Exchange Commission and the Commodity Futures Trading Commission, was provided by a Washington-based law firm which represents the anonymous person claiming to have held senior roles in the investment business.
Claims in the letter outline how trading firms have taken advantage of the way the Cboe Volatility Index is being calculated in order to manipulate the index. Financial products that track the VIX are at the center of the current stock market ructions that have seen U.S. benchmark equities fall in and out of 10 percent correction territory since late January.
"The flaw allows trading firms with advanced algorithms to move the VIX up or down by simply posting quotes on S&P options and without needing to physically engage in any trading or deploying any capital," Jason Zuckerman of Zuckerman Law said in the letter.
Cboe Global Markets, home to the VIX, pushed back against the allegations.
"This letter is replete with inaccurate statements, misconceptions and factual errors, including a fundamental misunderstanding of the relationship between the VIX Index, VIX futures and volatility exchange traded products, among other things," a Cboe spokeswoman said in a statement.
The VIX estimates the expected near-term volatility conveyed by S&P 500 index option prices. The index relies on mid-quote prices of select out-of-the-money SPX call and put contracts, among other things.
At the time of settlement of VIX futures, the CBOE calculates an official settlement level of the VIX based on a special monthly settlement auction of S&P 500 options.
This settlement price ultimately determines whether large blocks of VIX futures expire worthless or turn a profit.
Zuckerman's letter alleges that trading firms have manipulated the VIX index to their advantage by posting quotes for S&P 500 options, without any actual corresponding trades.
But William Speth, vice president, head of Research at Cboe, said: "There are structural safeguards built into the process of the calculation of the VIX settlement value that would hinder the type of manipulation the letter alleges."
He added that "our regulatory group actively surveils for potential VIX settlement manipulation."
The letter alleges that manipulation of the volatility index also played a role in recent wild price moves of certain volatility-linked exchange traded products (ETPs).
Two banks, Credit Suisse Group AG and Nomura Co Ltd , last week, said they would terminate two ETPs that bet on low volatility in stock prices. The announcements followed dives in the ETP prices as the price of VIX futures soared following a sharp drop in U.S. stocks on Feb. 5.
The SEC declined to comment. The CFTC was not immediately reachable for comment. (Reporting Saqib Iqbal Ahmed; Additional reporting by Rama Venkat Raman in Bengaluru; Editing by Sunil Nair and Daniel Bases)