The Cboe Volatility Index (VIX) is often called the "fear gauge," because market watchers use it to measure expected volatility over the coming 30 days. It lived up to its name on Feb. 6, when—following months of relative placidity—the index spiked 199% from the previous day's low to a high of 50.3. Volatility shorts, whose bets were facilitated by niche exchange-traded products, were wiped out: the VelocityShares Daily Inverse VIX Short-Term ETN (XIV) fell 92.6% in a single session.

Allegations have long circulated that some traders have their fingers on the VIX's scale. On Feb. 12, following the market turmoil, Jason Zuckerman and Matt Stock of Zuckerman Law, a K Street firm, wrote to the enforcement divisions of two financial regulators, the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC). The letter laid out allegations of "rampant manipulation of the VIX index" on behalf of "an anonymous whistleblower who has held senior positions at some of the largest investment firms in the world."

The manipulation, according to the letter, is ongoing and "costs investors hundreds of millions of dollars each month," or $2 billion per year. The scheme allegedly exploits a flaw in the VIX, which allows traders to influence the index without risking any capital, simply by posting S&P options quotes. The profits from this activity amount to "multiple billions," according to the letter. (See also: The SEC Whistleblower Program's Quiet Success.)

It further alleges that the manipulation was in part responsible for extensive losses in VIX-linked exchange-traded products earlier in the month.

Zuckerman Law calls disclosures of the risk of VIX manipulation "woefully inadequate," given the length of the documentation—several hundred pages—and the fact that there is no need to directly risk money to influence the options quotes that determine the VIX, making the index "quite vulnerable." The law firm therefore alleges "a breach of fiduciary responsibility" on the part of Cboe Global Markets Inc. (CBOE), which the letter says earns 20% to 25% of its revenues from the VIX. The document attributes the "inadequate" disclosures to the CME Group Inc. (CME), however, which is distinct from Cboe and not involved in the VIX.

Cboe told Bloomberg that the letter "is replete with inaccurate statements, misconceptions and factual errors" – the Cboe-CME confusion being one example – and therefore "lacks credibility"; a Cboe spokesman confirmed that statement to Investopedia. Bill Speth, head of research at Cboe, cast doubt on the allegations, saying, "If you talk to any trader who's actively involved in the VIX, you know that nobody pays attention to the spot value," but rather to the prices of derivatives based on the VIX.

CFTC spokeswoman Erica Richardson said in an emailed statement that the regulator does not publicly comment on whistleblower complaints, which are "an integral part of the CFTC's enforcement program." A message left at the SEC's enforcement division was not returned.

Citing an unnamed source, the Wall Street Journal reported on Feb. 13 that the Financial Industry Regulatory Authority (Finra) is probing alleged VIX manipulation, calling the probe separate from the whistleblower's request that regulators investigate. The private, self-regulatory body has provided Cboe with "market surveillance, financial surveillance, examinations, investigations, and disciplinary services" since 2015. Spokesman Ray Pellechia told Investopedia that Finra does not comment on whether they're conducting specific investigations. (See also, Finra: How It Protects Investors.)

Not the First Time

This is not the first time the fear gauge has come under fire. A paper published in May 2017 by John Griffin and Amin Shams of the University of Texas at Austin, detailed "interesting" patterns in trading related to the VIX.

The index works by tracking the implied volatility of a range of S&P 500 index options. Since traders buy and sell these options in order to hedge against or profit from future moves in the market, the options' implied volatility indicates the turbulence that traders expect—if not necessarily the turbulence they get. (See also: Strategies to Trade Volatility Effectively With VIX.)

Griffin and Shams hypothesized that the VIX's mechanics leave it open to manipulation. Say you have a long position in VIX futures. If you're willing to get your hands dirty to ensure a profit, you can submit "aggressive" buy orders for S&P 500 options during the pre-open auction period—7:30 to 8:15 a.m. CST—driving up the index options' clearing prices and with them the VIX.

According to the authors, this scenario is not just hypothetical. On settlement days for VIX derivatives contracts—at least in months when the VIX gains significantly— the price of S&P options has tended to rise until 8:15, suggesting they are being bid up in attempt to inflate the VIX. The price then tends to list back downward for the final 15 minutes before settlement, when trading is only allowed in options unrelated to open VIX positions. This movement indicates that "other traders put in orders to sell the overpriced options and adjust the prices downward. However, the prices are not fully reversed, and we observe more downward adjustment from settlement to open."

Images sourced from Griffin and Shams.

For example, most options see increases in trading volume as expiration approaches. Not so with S&P 500 options, for which trading volume spikes exactly 30 days prior to expiration. "This is not due to any kind of obvious S&P 500 market-related event," the authors write, "but it is the date that the VIX settles." The authors also find that the spike in trading occurs only in out-of-the-money options, which factor into the VIX's calculation. In-the-money options, which don't affect the VIX, barely budge. (See also: What Is Option Moneyness?)

The authors explored two alternative explanations, hedging and pent-up demand for liquidity, but conclude that these do not explain the patterns they see in the trading data.

Cboe emailed a statement to Investopedia in June 2017 saying that Griffin and Shams' work was based on "fundamental misunderstandings" of the index's mechanics. Patterns suggestive of manipulation are "entirely consistent with normal and legitimate trading behavior," the statement said, and the paper's authors were not privy to all relevant data. "CBOE takes seriously any market abuse, including manipulation of the VIX settlement process," the statement added, "and maintains a regulatory program that surveils for violative activity, and takes appropriate disciplinary action when warranted." A Cboe spokeswoman told Investopedia that the exchange has never taken disciplinary action against a party for manipulating the VIX.

In an email to Investopedia, Griffin and Shams wrote, "Contrary to CBOE's assertions, we have studied the VIX settlement thoroughly, presented our paper widely, and have talked to various trading professionals who corroborate our understanding of the settlement process and findings." They called on the CBOE to release any data "they think would be useful to better understand and design the settlement" to academics, "as is commonly done with other exchanges." They expressed surprise at the Cboe's "apparent defensive posture" and said it was "disappointing that CBOE doesn't seem concerned that settlement deviations are extremely costly to the investors using their products."

In a Bloomberg column, Matt Levine put forward another, more "innocent" explanation for the apparent manipulation: traders taking cash delivery when their VIX derivatives expire (since physical delivery of volatility is impossible) and using it to purchase the underlying S&P 500 options so as to maintain similar volatility exposure. "We do test that possibility as one our hedging hypotheses in the paper," Griffin told Investopedia. "We discuss it and rule it out as a complete explanation."

Writing to Investopedia, Griffin and Shams likened potential manipulation of the VIX to past scandals surrounding LIBOR​, gold, silver and the foreign exchange market, "all of which were obviously gamed." (See also: The LIBOR Scandal.)