You are on page 1of 36


N O. 3 9 9 / O C TO B E R 2 0 0 4


by Christian Ewerhart,
Nuno Cassola, Steen Ejerskov
and Natacha Valla

N O. 3 9 9 / O C TO B E R 2 0 0 4


by Christian Ewerhart 2,
Nuno Cassola 3, Steen Ejerskov 3
and Natacha Valla 3

In 2004 all
will carry This paper can be downloaded without charge from
a motif taken or from the Social Science Research Network
from the
€100 banknote. electronic library at

1 The authors would like to thank Vítor Gaspar, Hans-Joachim Klöckers, and an anonymous referee for very helpful suggestions.The opinions
expressed in this paper are those of the authors alone and do not necessarily reflect the views of the European Central Bank.
2 Postal address for correspondence: Institute for Empirical Research in Economics,Winterthurerstrasse 30, CH-8006 Zurich, Switzerland;
3 European Central Bank; e-mail:

© European Central Bank, 2004

Kaiserstrasse 29
60311 Frankfurt am Main, Germany

Postal address
Postfach 16 03 19
60066 Frankfurt am Main, Germany

+49 69 1344 0


+49 69 1344 6000

411 144 ecb d

All rights reserved.

Reproduction for educational and non-
commercial purposes is permitted provided
that the source is acknowledged.

The views expressed in this paper do not
necessarily reflect those of the European
Central Bank.

The statement of purpose for the ECB
Working Paper Series is available from the
ECB website,

ISSN 1561-0810 (print)
ISSN 1725-2806 (online)

Conclusion 21 Appendix 22 References 28 Figures 30 European Central Bank working paper series 33 ECB Working Paper Series No. 399 October 2004 3 . Endogenous price effect 16 4. Exogenous price effect in the swap market 9 3. Introduction 6 2.CONTENTS Abstract 4 Non-technical summary 5 1.

The present paper identifies a variation of this type of manipulation that might occur in money markets with an interest rate corridor. corridor system. manipulation ECB 4 Working Paper Series No. 399 October 2004 . JEL classification: D84. a large investor may benefit from building up a futures position first and trading subsequently in the spot mar- ket (Kumar and Seppi. E52 Keywords: Money market. We show that manipulation involving the use of central bank facilities would be observable only sporadically. 1992). The probability of manipu- lation decreases when the central bank uses an active liquidity management. Manipulation can also be reduced by widening the interest rate corridor. Abstract In certain market environments.

The analysis also shows that manipulation becomes less likely in systems with a wider interest rate corridor. 399 October 2004 5 . The strategy is to build up a significant position in short-term interest rate instruments (swaps or futures). Non-technical summary Money markets with interest rate corridors dier institutionally from other markets such as stock markets or markets for fixed income instruments. the likelihood of manipulation decreases with the size of the reaction that the market rate exhibits in response to a strategic recourse to the central bank facilities. the central bank has the means to ensure that attempts to control the market rate will in general not be successful. The paper oers a model that allows to derive the manipulator’s optimal strategy in a market that is aware of the possibility of manipulation. but by a strategic use of the standing facilities of the central bank. with an active liquidity management that neutralizes manipulative actions in due time. In contrast to alternative forms of manipulation. the impact on short- term prices is achieved not mainly by trading activities. and to aect the short-term market rate subsequently using the standing facilities provided by the central bank. This suggest a new theoretical rationale for having the facility rates not “too close” to the target or policy rate. Firstly. Two comparative statics results are obtained. ECB Working Paper Series No. The main prediction of the model is that manipulation in money markets would occur only from time to time. Thus. This paper identifies a kind of manipulation that might occur in such a money market.

on a day-to-day and intra-day basis. Further stabilization of money market interest rates can be achieved by in- troducing a reserve requirement system with an averaging provision. allowing short-term market interest rates to be steered with limited volatility around the desired level. Canada. the European Central Bank (ECB) in the euro area. the case of the Federal Reserve in the US. at a rate some basis points above market rates (lending facility). 1. In a corridor system. More broadly. and the Bank of England in the UK. for example. central banks around the world seem to increasingly attach greater value to stable. by the rates on the standing facilities. day-to-day and even intra- day money market conditions. for example. so-called corridor systems have been adopted. the range of variation of overnight interest rates will be bounded. the euro area. 399 October 2004 . With this aim. By setting a corridor around the central bank target or policy rate. and stands ready to absorb liquidity overnight in unlimited amounts at a rate some basis points below market rates (deposit facility). Under ECB 6 Working Paper Series No. This reduces the noise that short-term liquidity conditions may cause to the signalling of the monetary policy stance (see Woodford [12]). the central bank stands ready to provide overnight liquidity in unlimited amounts. generally against collateral. New Zealand and the US. This is. Introduction Major central banks around the world increasingly focus on steering some short-term money market interest rate in their implementation of the mon- etary policy stance. in Australia. More recently the Bank of England announced that it is also considering adopting such a system (see Bank of England [4]).

this framework. as shown in Quirós and Mendizábal [10]. The stabilization of overnight interest rates works through an arbitrage mechanism. ECB Working Paper Series No. during most of the maintenance period. However. Thus. the reserve account at the central bank can be run down or increased on a daily basis. Furfine [6. The combination of a corridor system with an averaging mechanism provides a powerful framework to stabilize the overnight interest rate. This paper wishes to contribute to the ongoing discussion on the appropriate design of corridor systems by showing that. In fact. it appears that the issue of the appro- priate design of standing facilities is still largely unexplored in the literature. As a tool for liquidity management by commerical banks that is complementary to transacting in the inter-bank market. intuitively speaking. However. from a theoretical perspective. Recently. an individual bank’s demand schedule will be highly elastic around the interest rate level expected to pre- vail at the end of the maintenance period. the demand schedule becomes increasingly inelastic as quantitative targets for reserves must be met. which has to reach a certain value on average over a main- tenance or statement period. temporary or small liquidity im- balances can be absorbed by variations in quantities rather than prices. 399 October 2004 7 . and that a stigma from using the standing facilities may lead to its use being lower than what would be desirable to reduce interest rate volatility. when the end of the period approaches. banks have to maintain a daily positive reserve balance at the central bank. 7] shows how an improper design of the marginal lending facility may lead to its use being greater than what would be expected from the characteristics of the interbank market.

adding value to the red position.4 4 Other more recent forms of manipulation that are currently discussed in the media are so-called market timing and late trading in the context of the funds industry (esp. this strategy could be even more successful when the manipulator builds up a swap or futures position beforehand. In fact. lending the money subsequently out into the market. the analysis of manipulation around takeovers contained in Bagnoli and Lipman [3] and Vila [11]). dierent forms of manipulation can be sorted into the three categories action-based (e. and trade-based. Market manipulation is a topic that has attracted significant attention during the last two decades. this would generate a drop in the market rate. manipulation is a potential issue in such money markets. by gu- rus as suggested by Benabou and Laroque [5]). Under certain conditions.. We will discuss under which conditions this is a profitable strategy. so that it would look as an attractive possibility if market rates were temporarily lower to ease refinancing. in the US). a com- mercial bank. obliged to hold minimum reserves on average over a statement period. the bank may take up a credit from the central bank.. We will also discuss some of the means at the disposal of the central bank to eliminate this kind of behavior.g. ECB 8 Working Paper Series No. Specifically. the study of stock price manipulation due to Allen and Gorton [2]). the study of manipulation around seasoned equity oerings by Gerard and Nanda [8]) or uninformed (e. and which incentive eects are created by this possibility.g. which can either be informed (e. might have build up a significant red position over the period for some reason.g. To create lower rates. 399 October 2004 .g. According to a useful classification by Allen and Gale ([1])... information-based (e.

In Section 2. Section 4 concludes. in a potentially relevant way. Their model falls into the category of uninformed trade-based manipulation. The appendix contains technical derivations. At time w = 0. 399 October 2004 9 . which means that a non-marginal spread must be paid for a manipulation of the market rate. Figure 1). when compared to Kumar and Seppi’s prediction. The rest of the paper is structured as follows. As we will see. The dierence between our model and Kumar and Seppi’s is the cost structure underlying manipulative strategies. this aects the optimal strategy of the manipulator. there is a swap market where banks and larger companies trade interest rate swaps that cover the last day of the statement period. 2. that is. ECB Working Paper Series No. In w = 2. The net recourse to central bank facilities is published in the morning of the last day of the period. At time w = 1. the manipulator can aect the market only by having recourse to standing facilities. We discuss the consequences of endogenizing the price eect on the manipulator’s strategy in Section 3. while ours could be interpreted as one of action-based manipulation. we analyze the problem of the manipulator under the assumption of an exogenous price eect in the swap market. that is. during the last day of the statement period. Exogenous price eect in the swap market The time structure of our model is as follows (cf. In our model. there is the option available to the manipulator to have recourse to a credit or deposit facility. spot trading occurs.Our model is a variant of a model used by Kumar and Seppi [9] to study the profitability of manipulation in futures markets with cash settlement. on the evening before the last day of the statement period.

We assume that the market at time w = 2 does not suer from informational ECB 10 Working Paper Series No.. and declining rates undesirable for a manipulator with a long position. The manipulator approaches the swap market in w = 0. would use a non-linear pricing rule. We will use the convention that a long position (e. At time w = 0. submitting an additional order volume of \  Q(0> \2 ). and is assumed to be private information to the manipulator. In addition to the market maker. [0 A 0) means that the manipulator receives the variable leg. for some exogenous  A 0. when assumed to follow the usual no-profit condition. and that a short position means that the manipulator pays the variable leg. It will become clear that the market maker. This convention has the consequence that a long position in the swap makes increasing market rates desirable. An extension of the model incorporating this possibility will be discussed in Section 3.g. there are noise traders in the swap market. the manipulator submits a market order of [1 . 399 October 2004 . Total order volume is then given by ] = [1 + \ . We will assume initially that a market maker is willing to clear the swap market at a rate uW (]) = u0 + ]. This initial position may be the result of trading with non-bank customers. having an initial endowment [0  Q(0> 02 ) in the swap.

ECB Working Paper Series No.. The first order condition in w = 1 equalizes the marginal benefit from manipulation with the marginal cost of manipula- tion ([0 + [1 + V) = u(V)  uO@G (V).e. We assume that the corridor is symmetric around the central bank’s target rate u0 . where  A 0 is the liquidity eect on the last day.frictions. The model is solved backwards. Ignoring autonomous factor shocks (they would cancel out in expectation). where we write . we may assume that the market rate depends only on the net recourse to standing facilities V. 399 October 2004 11 . so that the market rate depends only on the liquidity in the market. i.. 2 Controlling the market rate. (V) = [0 (u(V)  u0 ) + [1 (u(V)  uW ) + V(u(V)  uO@G (V)).e. uG + uO u0 = . O ? u VA0 uO@G (V) = u0 V = 0 = G u V?0 for the interest rate that the manipulator either pays for having recourse to the marginal lending facility or that she receives for depositing money with the central bank. so that the spot rate amounts to u(V) = u0  V. Expected profit for the manipulator is given by the sum of the net returns on the individual positions in the swap and spot markets. Standing facility rates are given by uO for the marginal lending facility and uG ? uO for the deposit facility. i.

Proposition 1. Plugging the optimal usage 5 In practice. and profit from the tightening of the market. 2 2  Proof. while a manipulator with a su!ciently large black position ([ À 0) will have recourse to the deposit facility (V ? 0). a manipulator who has build up a su!ciently large red position in the swap market ([ ¿ 0) will have recourse to the marginal lending facility (V A 0) to cause prices to fall. Rearranging and taking care of the discontinuity at zero yields our first in- termediary result. Specifically.5 In contrast to Kumar and Seppi’s [9] model. See the appendix. 399 October 2004 . Proceding backwards. Building up a position. this position taking could also be accomplished by satisfying reserve re- quirements unevenly over time. we now pose the question of how the manipulator chooses the swap order. See Figure 2 for illustration. This is due to the non-marginal cost of having recourse to standing facilities. as mentioned earlier. ECB 12 Working Paper Series No. we find that manipulation is not always profitable. the main dierence between our model and the one used by Kumar and Seppi. but we ignore this possibility for reasons of simplicity. the optimal strategic use of standing facilities at date t = 1 is . For given swap position [ = [0 + [1 . A A [ uO  u0 uO  u0 A A   if [   A A 2 2  A A A A ? W uO  u0 u0  uG V ([) = 0 if  ?[? A A   A A A A A A A A [ u0  uG u0  uG =  + if [  . there is an intermediate range for the swap position [ where manipulation of the spot rate does not pay o. which is.¶ Thus.

of the standing facilities into the objective function of the manipulator and carefully considering the resulting problem for the manipulator at date w = 0. Proposition 2 illustrates another dierence to Kumar and Seppi’s model. we obtain our next main result: Proposition 2. When the initial posi- tion is su!ciently red ([0 ¿ 0). there is (endogenously) no price eect in the futures market. Then. the optimal swap order size is finite and given by . A A  u0  uG u0  uG A A  ([ 0  ) if [0  A A 4     A A A A ? W uO  u0 u0  uG [1 = 0 if  ? [0 ? . when the initial position is su!ciently black ([0 À 0). 399 October 2004 13 . Assume that the liquidity eect in the spot market is not too large when compared to the price impact in the swap market. Subsequently.. have an incentive to leverage her position in the swap market. In their model. A A   A A A A A A A A  uO  u0 uO  u0 = ([0 + ) if [0   4     Proof. and the manipulator will subsequently draw reserves from the market.e. the manipulator will increase her exposure by going further short in the swap market ([1 ? 0). she will inflate reserves in the market by having recourse to the marginal lending facility (V A 0). for a given initial swap position [0 .  ? 4. in an- ticipation of profitable opportunities to control the market rate. Conversely. ECB Working Paper Series No. then the long position will be further enlarged ([1 A 0). See the appendix.¶ The above result stresses the eect that a market participant may. i.

(1) 0 0 It is not di!cult to see that the expression on the right-hand side decreases in . As a consequence. depending on the relative size of price eect in the swap market and liquidity eect. Note that this link is not present in our model. which is not the case in Kumar and Seppi’s analysis. as we will see. The dierence to Kumar and Seppi’s model that drives this eect seems to be that in their model. so that the manipulator would always want to build up an infinite position unless hindered by a margin requirement. So the finiteness of the position is not an artifact of the exogenity of the price eect.6 In the case considered in the Proposition. a large order in the futures market implies that the price in the spot market will increase not only due to manipulative trading. the larger the liquidity eect . then the probability of manipulation increases 6 In fact. the more likely will it be that the manipulator will leverage the initial position. The probability that the manipulator does not leverage her position in equi- librium is given by uO  u0 u0  uG pr{[1 = 0} = pr{ ? [0 ? }   u0  uG uO  u0 = x( )  x( ). the futures (swap) rate in our model exhibits a reaction to the order flow. Thus. but also due to the changing expectations of the market specialist in the spot market. In the present model. Similarly. ECB 14 Working Paper Series No. if the interest rate corridor is tightened by either decreasing the lending rate uO or by increasing the deposit rate uG or both. we find an optimal finite position. there are parameter values for which the endogenously deter- mined price eect in the swap market generates finite positions. 399 October 2004 . the optimal position in the swap market may be either finite or infinite.

399 October 2004 15 . we would expect any commercial bank to stand ready for such activities. In fact. This provokes the question as to why there should be only one potential manipulator. we would expect that even in a large currency area. and the coincidence of two or more banks making simultaneously strategic usage of central bank facilities may be neglected without much loss. and under suitable conditions. If su!ciently profitable. only few banks may ECB Working Paper Series No. Several manipulators The main prediction of the present paper is that in a corridor system of monetary policy implementation. This latter comparative statics result suggests that tightening the interest rate corridor “too much” may be detrimental to the objectives of monetary policy implementation. the theoretical analysis suggests that a strategic recourse to central bank facilities would be profitable only under the very restrictive condition that the potential manipulator possesses a secretly acquired and su!ciently large position in short-term interest rate instruments. then it should be expected that the market maker would request a mark-up on futures prices. For these reasons. How- ever. including the involved daringness vis-à-vis the cen- tral bank and potentially other regulatory institutions. In well. Thus. making manipulation un- profitable. (ii) its general readiness to take strategic measures in the search of profit opportunities. the decision to manipulate will depend not only on the initial endowment but also on (i) the overall trading and collateral capacities of the bank. an individual bank may find it worthwhile to make strategic use of central bank standing facilities. manipulation would be very unlikely. if the initial position were public information.

3. be prepared for manipulative actions such as those described in this paper. Proposition 1 ECB 16 Working Paper Series No. Indeed. We will allow for a general pricing rule uW (]) = u0 + (]). and finally. first the optimal order size for the manipulator. it appears that in practice other reasons may amplify the sporadic nature of manipulation. from (=). Thus. the market maker’s posterior beliefs about [1 given ]. In this section. it may also be di!cult for an individual bank to repeat an unwanted manipulative strategy. we will discuss the question of endogenizing the pricing rule in this set-up. the non- linear strategy used by the manipulator suggests that the pricing rule should take this behavior into account. Note that the more general form of the pricing rule in the swap market does not aect the manipulator’s problem in the spot market. so that the restriction to just one manipulator does not seem as a serious qualification for the validity of the predictions. The plan is now to calculate. Note that we are back in the previously studied case when (])  ]. Endogenous price eect We have noted before that the linear price rule of the market maker in the swap market may not correspond to a zero-profit condition. then the resulting distribution of orders [1 . 399 October 2004 . for some twice dierentiable function (=). When these posterior beliefs correspond to (=). Depending on the central bank’s stance on this issue. we have identified an equilibrium. In sum.

On the one hand.. as before. (2)   Proof. for either uO  u0 u0  uG [0   or [0  .   the optimal swap order is given implicity by K([1 ) = [0 . the extent of leverage declines for larger initial positions. ). the reader may refer to Figure 3. i. the manipulator refrains from leveraging small initial positions. The illustration suggests two features of the equilibrium.¶ For illustration. Proposition 3.remains valid without change. For an initial swap position uO  u0 u0  uG [0 5 ( . The reason is that in the model with endogenous pricing.. 399 October 2004 17 . the market maker responds to sizable orders by adjusting the price. See the appendix.e. which makes leveraging more expensive for the manipulator. where 2 b b 0 u0  uO@G ([1 ) K([1 ) = {([1 ) + [1  ([1 )}  [1 + . ECB Working Paper Series No. and in contrast to the model with exogenous pricing. Our starting point is therefore the manipula- tor’s problem of choosing [1 in the swap market so as to maximize expected profit. Outside of this interval. [1 = 0.   the manipulator will not leverage the initial position. i. On the other hand. which shows the size of the swap order [1 as a function of the initial position [0 in a simulated example.e.

. See the appendix. we have derived a formula for pr{[1 = 0}.e. The strategy of the manipulator will generate a distribution of market orders [1 with an atom at [0 = 0.e. The equilibrium condition is that uW (]) = u0 + (]) = u0  H[V|[1 + \ = ]]. The market maker in the swap market will form expectations about the extent of manipulation in the swap market. about V. Proof. 399 October 2004 . for the probability mass of the atom. By Proposition 1..¶ We proceed by calculating the price eect from the optimal strategy. the density of the distribution for values [1 6= 0 can be calculated as a transformation of the distribution of the initial position. Denote by i (=) the density of [1 . i. satisfying Z pr{[1 = 0} + i([1 )g[1 = 1. {([ (4) ECB 18 Working Paper Series No. the density function is given by K 0 ([1 ) K([1 ) i([1 ) = | |!( ). For [1 6= 0. i. With the help of the previous proposition. Z (]) =  b 1 ) + [1 0 ([1 )}g([1 |]). [10 6=0 In equation (1). Proposition 4. (3) 0 0 where 1 w2 !(w) := s exp( ) 2 2 is the density of the standard normal distribution.

ECB Working Paper Series No. The functional equation (4). We think that the intuitions gained are interesting. We have then used methods of numerical integration to calculate sampling points of the smoothed function ([ b0 ([1 ) and  b 1 ) on a somewhat smaller interval. (3) and (5). we have used the standard method of approximating fixed points of a functional operator by iterating the operator. By Bayes’ rule. but this formula need not be spelled out because the integrand in (4) vanishes at zero. so that we will briefly describe the computations and the results. ]  [1 i ([1 )!( ) Z \ g([1 |]) = (5) ] ]  [10 pr{[1 = 0}!( ) + i ([10 )!( )g[10 \ 0 [1 6=0 \ for [1 6= 0. The functional equation that determines the price eect in the swap market is highly non-linear so that we doubt that an explicit solution is feasible. The derivatives  b00 ([1 ) 7 There exists an analogous formula for the case [1 = 0. given by its values on a number of sampling points in a pre-specified interval.7 Numerical computation. specifies the endogenous price eect in the swap market.where g([1 |]) is the conditional distribution of [1 given ]. complemented by equations (2). We have therefore used numerical methods to discuss the properties of the equilibrium. 399 October 2004 19 . The functional operator has been programmed as follows. Starting from an approximation 0 (]) of the pricing rule. To find the non-linear equilibrium.

we obtain a new approximation 1 (]) for the price eect in the swap market. the density function i ([1 ) could be calculated on sampling points using the expression given in Proposition 4. Varying now ] over the same set of sampling points. From the thereby derived approximations. 399 October 2004 . Fig- ure 4). for a given ]. This property of the pricing rule is due to the fact that for small ECB 20 Working Paper Series No. However. 2\3 \2 2\2 which can be found using integration by parts. 2\3 2\2 and Z b00 1 0 \2  ([1 ) = s  ([1 + \ )\ exp( )g\ 2\3 2\2 Z 1 \2 \2 = s ([ 1 + \ )(1  ) exp( )g\ . The resulting pricing eect in the swap market is predicted to be very low for small values of ]. based on the explicit formulas Z b 0 1 \2  ([1 ) = s 0 ([1 + \ ) exp( 2 )g\ 2\ 2\ Z 1 \2 =s ([ 1 + \ )\ exp( )g\ . This makes it feasible to numerically ap- proximate (]) as given by (4). we have no formal argument that the ap- parent point-wise limit of the established sequence is an equilibrium of our model with endogenous price eect. This procedure was iterated. where each q (=) was defined on the same set of sampling points. again on a number of sampling points. so that a sequence of approximations (q (=))qD0 was generated. have been calculated similarly. and somewhat larger when ] becomes big (cf. the results are intuitive. The obtained approximation was then extended linearly to the larger set of sampling points (corresponding to the larger in- terval). This in turn allowed to determine the conditional density g([1 |]) for any given value of ]. Unfortulately.

The density again determines the specific form of the posterior. we mentioned the example of a bank that builds up a large short position in the market for short-term interest-rate instruments. This is because the posterior probability of the atom [1 = 0 decreases exponentially when ] grows lin- early. the density i ([1 ) is bimodal (cf. Specifically. the non-linear price eect in the swap market induces the manipulator to lever- age her position somewhat stronger for smaller (in absolute terms) initial positions when compared to the linear set-up studied before. ECB Working Paper Series No. The range of values for [1 in which the manipulator leverages her position remains the same as before. Figure 6). 399 October 2004 21 . for larger values of ]. 4. composed of central bank lending and deposit facili- ties. the market maker’s posterior assigns a relatively large probability to the atom [1 = 0. This behavior yields a very particular shape of the ex-post distribution of the market orders [1 . However.absolute values of ]. and that subsequently oers interbank credit at very low rates. we have pointed out that in money markets that are embedded in a corridor system. the posterior probability assigned by the market maker to a manipulative strategy increases overproportionally with ]. Specifically. and the results of Section 2 appear to be robust with respect to endogenizing the price eect in the swap market. which suggests that the numerical computations have in fact approximated an equilibrium. so that the likelihood of a leverage strategy is perceived to be small in the swap market. However. as Figure 5 illustrates. Conclusion In this paper. there is the potential for manipulative action that abuses these facilities in a strategic way.

one could argue that the availability of fine-tuning is a necessary condition for avoiding such kind of manipulative recourses.e. Assume first that [  0. financed from the central bank’s lending facility. We have shown that this type of manipulation can be profitable for a bank with suitable ex-ante char- acteristics. V W  0 for [  0. In addition. because V = 0 avoids the costs for having recourse to the marginal lending facility. In fact. This suggest a new theoretical rationale for having the rates not “too close” to the target or policy rate. Thus. Appendix Proof of Proposition 1. it cannot be optimal to choose V A 0. ECB 22 Working Paper Series No. we have seen that manipulation remains a feature of the equilibrium even if the market responds to the possibility of manipulation with a rational-expectations adaptation of the pricing rule. This supports the common understanding that with suitably chosen fine-tuning operations. the analysis provides a intuitive foundation for an optimal size of the interest rate corridor. to manipulate the price downwards. and does not lower the value of the overall position. The comparative statics analysis showed that the likelihood of manipulation increases with the liquidity eect. In fact. The second insight from the comparative statics analysis is that the likelihood of manipulation decreases with the width of the interest rate corridor. 399 October 2004 . the central bank has the means to ensure that attempts to control the market rate will in general not be successful.. when these costs of a tighter corridor are balanced with the benefit of cutting o the spikes of non-strategic interest rate volatility. In this case. i.

e.  while the boundary solution V W = 0 is optimal whenever V + A 0.¶ Proof of Proposition 2.  Consider first the problem where the manipulator is restrained to make an order [1  [ 1 . i. i. by Proposition 1. Step A.. the profit function is continuous and twice dierentiable for V  0.. Let uO  u0 [ 1 :=   [0  u0  uG [ 1 :=  [0 . when u0  uG [ . 399 October 2004 23 . which yields the assertion. when u0  uG 0[? . First and second order derivatives in this domain are given by C = [ + u0  2V  uG CV C2 = 2 ? 0.However.e. CV 2 From the concavity of the objective function it follows that the first-order condition 1 V+ = {[ + u0  uG } 2 characterizes the solution whenever V +  0. Then. 1 V W ([1 ) = ([ 1  [1 )  0. The proof consists of three steps.  A completely analogous argument can be made for the case [ ? 0. (6) 2 ECB Working Paper Series No.

ECB 24 Working Paper Series No. (8) Plugging (6) into (8) and dierentiating twice with respect to [1 gives C 1  = [0   (V + [1 ) + (  )[1 C[1 2 2  1 0 1 O + V  (u  V) + u 2 2 2 2 C      2 = +   C[1 2 2 4 4  =  2. When the solution is interior. From Proposition 1. for a su!ciently large initial long position. the optimal solution of the unconstrained problem satisfies [1  [ 1 . V = 0. (9) 4   1 However. Step B. Thus. Consider now the manipulator’s problem under the constraint [1 5 [[ 1 . 2 The constrained problem has a solution if and only if the second-order condi- tion  ? 4 is satisfied. This implies ([1 ) = [1 (u0  H[uW (])]) = ([1 )2 . i. so that the manipulator does not use the marginal lending facility. the interior solution cannot be optimal for [ 1 ? 0. [ 1 ].. we know that in this case. 399 October 2004 . since [1  [ 1 by assumption. the first-order condition yields 1 [13 = {[0 + uO  u0 } 4    = [ . and the profit function is given by ([1 ) = [0 (u(V)  u0 ) + [1 (u(V)  H[uW (])]) (7) + Vu(V)  VuO = [0 V  [1 (V + [1 ) + V(u0  V)  VuO .e. for [ 1 ? 0.

Now assume that [ 1  0.  ECB Working Paper Series No. we know that then the optimum must lie in the interval [[ 1 . if [ 1 ? 0 and [ 1 A 0 are satisfied simul- taneously. From Step B. Summarizing. the optimal choice for [1 is ½ 0 if [ 1  0 [1W = . + ? [1 if [ 1 ? [ 1  0 W [1 = 0 if [ 1 ? 0 ? [ 1 . [ 1 ]. But in this interval. then the optimal solution lies in the interval [1 5 [[ 1 . the optimal solution of the un- restrained problem satisfies [1  [ 1 . The manipulator chooses [1 in the swap market so as to maximize expected profits b([0 > [1 > ]> V) = [0 (u(V)  u0 ) + [1 (u(V)  uW (])) + V(u(V)  uO@G (V)). 4   Hence. Assume now that [ 1 ? [ 1  0. = 3 [1 if 0  [ 1 ? [ 1 This completes the proof of Proposition 2. under the restriction [1 5 [[ 1 . By considerations analogous to those performed in the previous two steps. for [ 1 ? [ 1  0. we obtain that in this case [1W := [13 ? 0. we obtain [1W = 0. 4). (10) [ 1 if [ 1 ? 0 We have seen in Step A that for [ 1 ? 0. 399 October 2004 25 . and the first-order condition (derived as in Step A) is satisfied for  [1+ =  [ 1  [ 1. Thus.¶ Proof of Proposition 3. Step C. we have that . one can show that for [ 1 A 0. we get [1W = [1+  0. and from (7). Then clearly [ 1 A 0. By completely analogous arguments. [ 1 ]. the problem is concave.Thus. the optimal solution of the unconstrained problem satisfies [1  [ 1 .

The corresponding equation for the case is given by [0 = K + ([1 ). 2\ 2\ Assuming first that either uO  u0 [0   . To determine i(=). we obtain H[b b 1 )) + V(u0  V)  VuO@G (V). denote by I (=) the cumulative distribution function of [1 . For [1 ? 0. 2 2  or. Taking expectations. K ([1 ) = + {([1 ) + [1    whose implicit solution will be denoted by [1+ .  ([1 > V)] = [0 V  [1 (V + ([ where b 1 ) = H[([1 + \ )] ([ Z 1 \2 =s ([1 + \ ) exp( 2 )g\ . K 3 ([1 ) =  + {([1 ) + [1  (11)   We start from the hypothesis that this equation gives an implicit expression for the optimal order [13 in the swap market for a non-linear pricing rule in the considered. where + u0  uG 2 b b0 ([1 )}  [1 .¶ Proof of Proposition 4. assuming strict monotonicity of [13 ECB 26 Working Paper Series No.  we get the first-order condition O@G b0 ([1 )   [1 =  ([0 + u b 1 ) + [1   u0 ([ ). where uO  u0 2 b b0 ([1 )}  [1 . more concisely [0 = K 3 ([1 ). 399 October 2004 .

0 A similar argument can be made for [1 A 0. we have I ([1 ) = pr{[13  [1 } = pr{[0  K 3 ([1 )} K 3 ([1 ) = x( ).¶ ECB Working Paper Series No. This proves the assertion.with respect to [0 . 399 October 2004 27 .

124-147. C. and D. Lipman. Gurus and Credibility. 2001. International Finance 6 (3). 2003. Quarterly Journal of Economics 107 (August). References [1] Allen. and G. Using Privileged Information to Manip- ulate Markets: Insiders. Stock Price Manipulation. London. European Economic Review 36 (April). [7] Furfine. Standing Facilities and Interbank Borrowing: Evi- dence from the Federal Reserve’s New Discount Window. [8] Gerard. [3] Bagnoli.. and G.. and V. F. [4] Bank of England. Nanda. [5] Benabou. 213-245.. [6] Furfine. 503-529. 1996. 921-958. Reform of the Bank of England’s Operations in the Sterling Money Markets: A Consultative Paper by the Bank of England. 2004. Stock Price Manipulation through Takeover Bids. Gorton. 1993.. Stock Price Manipulation. Laroque.. and Asymmetric Information. Trading and Manipulation around Seasoned Equity Oerings. The Reluctance to Borrow from the Fed. 1992. Rand Journal of Economics 27 (1). and B. 624-630. ECB 28 Working Paper Series No. Market Mi- crostructure. Review of Fi- nancial Studies 5 (3). L. 1992. B. C. Journal of Finance 48 (1). [2] Allen. Gale... 399 October 2004 . F. 329-347. Economics Letters 72. 209-213. M. R.

2003. and H. Princeton University Press. 399 October 2004 29 . ECB Working Paper Series No. Banco de España and Universitat Autònoma de Barcelona. mimeo.P. 1485-1502. 1992. [11] Vila. [12] Woodford. G. [9] Kumar. The Daily Market for Funds in Europe: What Has Changed with the EMU?. Futures Manipulation with “Cash Settlement.. Money and Prices: Foundations of a Theory of Monetary Policy. 2003. Seppi. [10] Quirós. M. R. 21-26.. J. Mendizábal.. Princeton. Simple Games of Market Manipulation. P. 1989.” Journal of Finance 47 (4). and D. J.-L. Economics Letters 29.

Swap order flow X1 1 -20 -15 -10 -5 5 10 15 20 Initial position X0 -1 Figure 3. The curvature of the graph shows that small initial positions are leveraged at lower marginal costs. Equilibrium swap trading as a function of the manipulator‘s initial position. Time structure of the model. t = 0: t = 1: t = 2: Swap Standing Spot trading facilities trading Figure 1. Net usage of central bank Recourse to credit facility facilities S lowers overnight rate and adds value to red positions Total swap position X Recourse to deposit facility raises overnight rate and adds value to black positions Figure 2. Net usage of standing facilities as a function of the manipulator‘s total swap position. ECB 30 Working Paper Series No. 399 October 2004 .

8 1.2 0.8 0.6 -0. ECB Working Paper Series No.8 -1. Manipulation occurs with probability smaller than one. 399 October 2004 31 .4 Initial 0. The price effect of demand in the swap market can be seen to be comparably low unless manipulation is apparent.2 Total order -0.4 -0.0 0.6 0.0 -1. Equilibrium swap spread as a function of the total order volume.8 -1.8 -0.4 -0.6 -0.2 -0.4 volume Z -0.4 0.8 0.2 0.0 0. Net usage of standing facilities as a function of the initial position. (Z) 1.4 0.0 -0.6 0.2 position X0 -10 -8 -6 -4 -2 2 4 6 8 10 -0.0 Figure 4.2 0.0 -0. Net usage of standing facilities S 1.0 Figure 5.6 -0.6 0.0 0.

60 0.60 -0.40 0.40 -0.0 -1. f(X1) 0.3 0.5 0. ECB 32 Working Paper Series No.00 -0. Non-normal ex-post density of the manipulator‘s swap order flow.4 0.80 -0.1 0.20 0.80 1. 399 October 2004 .00 X1 Figure 6. Note: the distribution possesses an atom at X1 = 0.20 0.00 0.2 0.

July 2004. 385 “Euro area sovereign yield dynamics: the role of order imbalance” by A. M. Peersman and R. P. Annicchiarico and N. 388 “Euro area inflation differentials” by I. Levin. Ehrmann. H. Baudry. M. 373 “Technology shocks and robust sign restrictions in a euro area SVAR” by G. 383 “Explicit inflation objectives and macroeconomic outcomes” by A. Giammarioli. B. Piger. Diaz del Hoyo. E.European Central Bank working paper series For a complete list of Working Papers published by the ECB. J. Billi. F. Michel. N. information. Skudelny. Haug and W. V. 380 “Optimal monetary policy under discretion with a zero bound on nominal interest rates” by K. Ejerskov and N. August 2004. Adam and R. ECB Working Paper Series No. 375 “Guess what: it’s the settlements!” by T. Adam and R. J. July 2004. 379 “Do financial market variables show (symmetric) indicator properties relative to exchange rate returns?” by O. S. Evidence from the French CPI micro-data” by L. Tarrieu. Y. 377 “Optimal monetary policy under commitment with a zero bound on nominal interest rates” by K. July 2004. 1880-2001” by A. 387 “Horizontal and vertical integration in securities trading and settlement” by J. Roma and F. T. Yang. August 2004. July 2004. Holthausen and J. Ewerhart. Natalucci and J. please visit the ECB’s website (http://www. M. Tapking. July 2004. L. Monnet. 378 “Liquidity. 376 “Raising rival’s costs in the securities settlement industry” by C. M. Castrén. Thibault and J. major industrial countries. July 2004. Straub. Valla. Cassola. M. de Jong. G. Benalal. A. 399 October 2004 33 . 384 “Price rigidity. August 2004. Tapking and J. Angeloni and M. 382 “Longer-term effects of monetary growth on real and nominal variables. Vidal. 386 “Intergenerational altruism and neoclassical growth models” by P.-P. Koeppl and C. Billi. 374 “To aggregate or not to aggregate? Euro area inflation forecasting” by N. August 2004. August 2004. Dewald. July 2004. Menkveld. Landau. Sevestre and S. and the overnight rate” by C. August 2004. Cheung and F. 381 “Fiscal rules and sustainability of public finances in an endogenous growth model” by B. September 2004. August 2004. August 2004. Le Bihan.ecb.

Manzanares and B. Wouters. S. October 2004. Weller. September 2004. 399 “Sporadic manipulation in money markets with central bank standing facilities” by C. Fernández-Huertas Moraga and J. Hernández de Cos and S. Moschitz. Ardagna. Cavalcanti. Smets and R. September 2004. Wouters. money creation and destruction. Cassola. Temzelides. October 2004. 390 “Financial markets’ behavior around episodes of large changes in the fiscal stance” by S. Henry. 393 ”The determinants of the overnight interest rate in the euro area” by J. October 2004. 396 “The short-term impact of government budgets on prices: evidence from macroeconomic models” by J. 398 “Mergers and acquisitions and bank performance in Europe: the role of strategic similarities” by Y. Altunbas and D. N. P. ECB 34 Working Paper Series No. and the returns to banking” by Ricardo de O. 397 “Determinants of euro term structure of credit spreads” by A. Momigliano. September 2004. Ewerhart. 391 “Comparing shocks and frictions in US and euro area business cycles: a Bayesian DSGE approach” by F. A. 395 “Fiscal sustainability and public debt in an endogenous growth model” by J.-P. Marqués Ibáñez. Bindseil. Erosa and T. September 2004. 399 October 2004 . A. Smets and R. Valla. October 2004. September 2004. Vidal. 392 “The role of central bank capital revisited” by U. Ejerskov and N. 394 ”Liquidity. 389 “Forecasting with a Bayesian DSGE model: an application to the euro area” by F. Van Landschoot. October 2004. September 2004.