A scheme to manipulate Wall Street's fear gauge, VIX, poses risk to the entire equity market and costs investors hundreds of millions of dollars a month, a law firm on behalf of an "anonymous whistleblower" told U.S. financial regulators and urged them to investigate before additional losses are suffered.
The Washington-based law firm which represents an anonymous person who claims to have held senior roles in the investment business, told the Securities and Exchange Commission and Commodity Futures Trading Commission on Monday that he discovered a market manipulation scheme that takes advantage of a widespread flaw in the Chicago Board Options Exchange (CBOE) Volatility Index (VIX).
The CBOE Volatility Index measures the cost of buying options and is the most widely followed barometer of expected near-term stock market volatility.
"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," it said in a letter.
Those bets against volatility unraveled last week as the benchmark S&P 500 and the Dow Jones Industrial Average suffered their biggest respective percentage drops since August 2011.
Investors using exchange-traded products linked to the VIX were pummeled and two banks, Credit Suisse and Nomura, said they would terminate two exchange-traded notes that bet on low volatility in stock prices.
Months of extended calm in the stock market has made selling volatility a lucrative affair, with ETPs attracting about $3 billion in investment.
When the VIX futures prices spike, these ETPs lose value, at which time the issuers of these products could liquidate the shares.
"We contend that the liquidation of the VIX ETPs last week was not due solely to flaws in the design of these products, but instead was driven largely by a rampant manipulation of the VIX index," according to the letter from the law firm.
The letter lacks credibility as it has inaccurate statements, misconceptions and factual errors, including a fundamental misunderstanding of the relationship between the VIX Index, VIX futures and volatility exchange-traded products, CBOE said in a statement to Bloomberg.
A Cboe spokesman told CNBC: "We take our regulatory responsibilities and the oversight of our markets very seriously. 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 ETPs, among other things. As a result of these errors, we feel the conclusionary statements contained in this letter lack credibility."
The SEC declined to comment to Reuters and the CFTC was not immediately available for comment.
—CNBC contributed to this report.