Re: Money Laundering through Options market.

[Istvan Steve Oszaraz von Keszi <vkisosza@acs.ucalgary.ca>]

On Mon, 18 Apr 1994, Alexander Chislenko wrote:

>   Of course, transactions in related areas, shifted contract positions, 
> etc. will be harder to track than directly balanced transactions, but
> somehow I doubt that existing schemes, if any, are that obscure.

Of course the keys are the use of European exercise options rather than 
American.  Recall that the payoff pattern for an option can be written 
succinctly as

                   Max (S-X,0) 

where the market price of the underlying asset is (S) and the exercise 
price is (X).  This expression of intrinsic value says that an option is 
worth whichever is greater, the asset price minus the exercise price or zero.

The most important pricing relationship derived from arbitrage is known 
as "put-call parity."  If S is the price of the underlying asset, C is 
the price of a euro-call with an exercise of X and P is the price of a 
Euro -put with the same strike price X and expiration date as the call then:
       
             Put-Call Parity: C - P = S - PV(X)

The call price minus the put price must equal the current price of the 
underlying asset minus the present value of the strike price, discounted 
back from the expiration date.

At option expiration, while we won't have any knowledge of what prices 
will be at that time, we do know that if it is above X the call will be 
in the money and the put will be out of the money.  The reverse will be 
true if the price is below X.  Since the two portfolios will have the 
same values at expiration, if they didn't cost the same amount at the 
beginning there would be an arbitrage.  Investors buy the cheaper 
portfolio and sell the more costly one, and keep the balance as a 
riskless profit.  At expiration portfolio proceeds from the bought 
portfolio would offset the one they were short.  This trade would 
continue in unlimited volume, so the situation cannot be an equilibrium.  
The only stable possibility is that the two portfolios must cost the same 
which proves that C - P = S - PV(X).

Options as such provide a strategy for producing "synthetic" securities 
out of such combinations.  The put-call parity relation shows how buying 
a call and writing a put produces the same pattern as buying the 
underlying asset and financing the part of the purchase with borrowing.  
These synthetics can then be the basis of derivatives.

However, normal caveats apply.  Cost elements must be taken into 
account.  One is commissions and "market impact" costs.  In an actual 
trading strategy, it is necessary to deduct the transaction costs getting 
into the position at the beginning and unwinding it at the end.  These 
involve commissions on all the securities traded plus impact costs due to 
the fact that securities have to be purchased at the market's ask price 
and sold at the bid price, and a large transaction may also cause those 
prices to move unfavourably.  These costs are inversely related.  Large 
transactions carry lower commissions while they tend to have greater 
market impact cost.  Other factors are taxation, and tax treatment which 
will depend on numerous factors.  Tax treatment is very complex.  In order
to minimize to minimize bandwidth, I will ignore that  enormous detail.

>  
>   Also, there are not that many commodities/currencies/... with markets
> large enough to execute $1M+ contracts like that at a time.

Actually, there is no cap on the size of contracts which can be 
executed.  Minimum transaction size on the interbank market is $1m USD

>   I'd expect people to use major markets in several transactions not large
> enough to attract attention of market analysts.

Perhaps, this is the general misconception.  It is the small 
transactions, relatively speaking, which attract analytical attention.  
The larger transactions are generally ignored since there is no 
overseeing authority.  The recent 'problems'/successes reported widely by 
the popular media are red herrings.  The market breadth is over $200 
billion hourly, 24 hours a day, seven days per week.  (Recall that, that 
is close to the entire annual US deficit.)

>    With access to the transactions database, one could more or less
> easily compile a list of traders engaged in such activities and amounts
> of money transferred.

I guess, that depends on the definition of 'easily'.  There is no 
centralized transactions database, as there is no centralized clearing.  
Some clearing is done on BIS in Basel, but only on a net basis.  So if 
someone maintains a balanced book they clear 0.

>  
>    I believe that this way of money laundering is well within understanding
> of at least some people.  The ways of catching them are, probably, too hard
> for the corresponding agencies, at least organizationally.

True, it requires transnational jurisdictional support.  And since 
regulations are usually sovereign, . . . well, it's a nightmare.  Take 
for example the SEC requesting documents from a market participant.  The 
risk is that the participant complies and dumps ten moving vans full of 
hardcopy documentation on the desk of the regulator, all unindexed. 

>   P.S.   I read Hillary Clinton turned $1K into $100K in cattle futures
>          market.   Isn't that amazing?

My maze ment is unbounded.

>  
>   P.P.S.  I'll bet $10K against $1 that you can't donate *me* $50K like this.
>           Any takers?
>  

That's a bet ;-)


> --------------------------------------------------------------------------
> Disclaimer:  The above text is pure speculation. 
>              I would never do anything mentioned there.
> 

I take it the check is in the mail??