The equity options traders are understood to have offered rival traders inducements to act as counter-parties in deals designed to drive down the FTSE 100 late on Friday afternoon. The Stock Exchange is thought to have been warned about these attempts at stock market manipulation, but failed to act until after the deals had been executed.
In the closing moments of trading on Friday, the FTSE fell by more than 30 points after substantial falls in the shares of pharmaceutical giants Glaxo Wellcome and SmithKline Beecham.
JP Morgan yesterday confirmed that it had suspended two employees and added that it did not expect to make further suspensions. It declined to name the two employees involved. The rival investment bank implicated in the deal has not yet been identified.
The two JP Morgan employees are understood to have approached traders from a number of investment banks and offered them financial inducements to enter "rogue" prices for a number of FTSE 100 stocks in the Stock Exchange's new electronic order book.
It is thought that the rogue prices were substantially lower than the prevailing prices for the stock. The traders are then believed to have sold stocks at these "rogue" prices in the closing moments of trade.
This prompted sharp falls in the prices of a number of FTSE 100 stocks, which in turn caused the FTSE 100 index to drop. The two traders are thought to have been trying to drive the index down to hedge a derivatives trade.
The Exchange is thought to have been contacted by one of the organisations approached by the dealers before the trades took place. But the Exchange, which is currently conducting an investigation into the allegations, did not act until after the trades had been executed.
Sets, the new electronic trading system launched by the Stock Exchange in October, facilitated the manipulation of the FTSE 100 index. Late in the afternoon and early in the morning, very few orders are placed on the Exchange's new order book and very few trades are conducted. This so-called lack of liquidity in the new order book at the beginning and the end of the trading day makes it easier for a small number of trades to distort the FTSE 100 index, as happened last week.
The Stock Exchange admitted last week that it was concerned about the lack of liquidity in the order book, which is only used to trade FTSE 100 stocks. It added that it was especially concerned about the unusual closing prices that it had observed for some blue-chip stocks during the weeks since the launch of Sets.
On 20 October, Sets replaced the Exchange's old quote-based system, where market-makers quoted buy and sell prices over the telephone to one another. Under Sets, market-makers type into an electronic order book the number and the price of shares they wish to sell (or buy). The orders then remain on the book until they are matched with an equivalent buy (or sell) order, at which point the trade is executed. Alternatively, market-makers can delete their own buy or sell orders before they are matched with the orders of a counter-party.
The lack of liquidity in the order book at certain times of the trading day is largely due to the reluctance of dealers to leave orders on the book overnight. In the last few minutes of trading, most unexecuted orders are deleted from the book, partly because traders wish to reassess their positions in the morning in the light of overnight news from trade in the Far East.
This widespread deletion of orders means that the few orders left on book early in the morning and late in the afternoon can differ widely from the majority of orders on the book throughout most of the trading day.
Traders dealing early in the morning or late in the evening therefore run the risk of executing trades at grossly unfavourable terms, a risk which last week prompted the Exchange to warn traders to use "limit orders" or price caps.
Over the past few weeks, there has been a number of so-called "rogue" closing prices, caused by dealers executing trades at the unrepresentative buy and sell prices that can prevail on the order book at the beginning and the end of the working day.
Aside from "educating member firms", the Exchange last week ruled out taking concrete steps to resolve the pricing problems before the new year. Changes that have been suggested to deal with early morning illiquidity include moving the trading day back one hour.
It has also been proposed that the Exchange deal with late afternoon illiquidity by calculating "closing" prices before the Exchange's official closing time of 4.30pm or by forcing traders to leave orders on the book overnight.