CHAPTER 5 Price Manipulation Risk: The Big Unknown

The risk of price manipulation of securities is likely the top banking risk that is least understood by the layman. Indeed, at first blush, the sin of deliberately mispricing a security does not appear the most egregious of financial sins. Yet, as we have seen with the LIBOR scandal, it can lead to significant market distortions, price cheating, and significant penalties from regulators. Understanding the reason why that is so and what can be done to mitigate the risk is one of the most urgent issues for risk managers on Wall Street today.

What catches the headlines is generally the bad actions of a few. However, there are many, many people involved in complex, difficult valuation work that do the right thing every day. Someone wandering through a typical fund accounting operation, for instance, would perhaps be struck by the level of focus and intense effort expended on the activity. Controllers spend a great deal of the day pouring over the valuation of securities in each portfolio. However, any security ultimately depends on there being a market to purchase it. What happens when no one wants to buy the security in question? A precipitous drop in prices can occur. This is what happened to credit securities and subprime securities in the summer of 2007.1

Many traders and many firms at that time were depending on the buoyant market in mortgage securities to drive profits and revenue. Instead, these prices suddenly dropped ...

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