CFTC Scrutinizes Wash Trades

In its wide-ranging look at high-frequency trading, direct market access (DMA) and the technology of trading, during a recent four-hour hearing, the Technology Advisory Committee (TAC) of the US Commodity Futures Trading Commission (CFTC) identified that the practice of "wash trades" will likely require further scrutiny.

A "wash trade" can occur when a trader, an algorithm or algorithms acting on behalf of an institution buys and sells the same amount of the same security at the same price at about the same time, or at least in the same day. This can occur unintentionally if the trader or firm has multiple algorithms operating or is pursuing multiple strategies for multiple accounts all at the same time, and some of the specific trades are on the buy and sell side of the same order or transaction at the same time. The CFTC's issue with wash trades could be that they are more likely to occur the more high-frequency trading is conducted.

In real time, wash trades may be difficult to detect, according to Paul Zubulake, senior analyst at industry consultancy Aite Group. "But at the end of the day, [a regulator] should be able to say, ‘We had 10 wash trades, these are the participants and they have been warned,’" he says. "If it becomes a habitual occurrence, they should be able to shut them down."

Zubulake cautions against jumping the gun in labeling a transaction a wash trade, however. "It's very difficult on a technology basis to disallow the trade because technically if that account is the only buyer and seller at that price point, it's a locked market, meaning the bid and offer are the same, which is something the markets don't want to do," he says.

The TAC heard testimony from one of its members about the danger of such false positives, from John Bates, senior vice president, CTO and head of corporate development at Progress Software. "If it happens once, it may be innocent, and there's no intention, and suddenly you launch an investigation," he says. "You want to launch an investigation when you see patterns over time and where you see individuals or groups who are in breach."

An exchange could conceivably prevent wash trades, according to Zubulake. "From a technology perspective, the exchange should be able to put that logic into its matching engine so that if the account is a buyer then it can't sell to that."

The Chicago Mercantile Exchange (CME), for one, includes wash trades in its surveillance efforts, according to Bryan Durkin, COO and managing director of products and services at CME Group, who is also a member of the TAC. "We have found situations where users are totally unaware that those transactions occurred opposite themselves," he says. "We take that under consideration and work with the firm to make sure those situations don't occur in the future. We track those situations, and if there's a repetition, we take appropriate action."

Nonetheless, exchanges should re-examine their rules considering the current trading environment and establish acceptable reasons for wash trades, also known as inadvertent cross trades, as Mary Ann Burns, executive vice president, industry relations, at the Futures Industry Association (FIA), told the TAC at the hearing, while presenting FIA's views on execution risk tools in high-frequency trading and direct market access.

The CFTC and TAC will have to walk a line around over-regulating in reaction to wash trades, according to Zubulake. "The regulators should be concentrating on market abuse and manipulation, not micro-market structure issues in the futures market," he says. "The futures market still is the most efficient market out there. The CFTC is trying to find something in that market that they feel is not fair. That's fine—that's their job."