The CFTC Looks at HFT and Wash Trades, But Can They Prove It?

U.S. regulators are probing whether high frequency trading firms are engaging in wash sales, acting as both buyer and seller for the same transaction, which could drive up volumes and distort prices.

According to today’s Wall Street Journal, the Commodity Futures Trading Commission is investigating the practice which is illegal under U.S. law because it can “minimize financial risk for the trading firm while potentially creating a false impression of higher volume in the market.”

From Wall Street Journal:

The Commodity Futures Trading Commission is focused on suspected wash trades by high-speed firms in futures contracts tied to the value of crude oil, precious metals, agricultural commodities and the Standard & Poor's 500-stock index, among other underlying instruments, the people said.

The agency is looking at potential wash trades by multiple high-speed firms, although it isn't known which ones investigators are scrutinizing. Firms found guilty of intentionally distorting the market through wash trades could face hefty fines.

CFTC Commissioner Bart Chiltonappeared on CNBC this morning to discuss the regulator’s pursuit of wash sales by high frequency traders whom he previously called “Cheetahs.”

A wash sale is when somebody trades with themselves as both buyer and seller and according to Chilton, this is going on at a large voluminous level and it’s impacting what people see as volume. “This stuff just shouldn’t be allowed,” Chilton said on CNBC in the video interview CFTC Commissioner Wringing Out ‘Wash Sales’.

Specifically, he mentioned the strategy of ignition generation. “It looks like people are starting to trade, but they may not be taking any risk,” This is where regulators need to look at what’s right and what’s wrong.” He specifically pointed the finger at “these market-marker programs where they pay traders to be in the market. What Chilton didn’t say is that wash trades can help a trading firm meet certain volume thresholds they need to qualify for rebates or sharing in tape fees.

Chilton is calling for a rule that “standardizes these complex market maker programs to make sure there is no perverse incentive to be washing in these markets,” he said.

But, “wringing out” the wash sales is going to require the exchanges to go after the computerized trading firms that may be conducting this practice.

Regulators are looking for self-regulatory organizations (SROs) that operate electronic exchanges to find the activity and to impose steep fines. “I can’t believe at the quantity we are seeing that they don’t know this is occurring,” said the CFTC Commissioner.

In the wake of technical glitches that marred the Facebook IPO, and the Knight Capital losses from a technical glitch, regulators are leaning on exchanges to enforce the rules in a complex, high-speed market. They are also investigating whether exchanges are giving advantages (i.e., special order types) to sophisticated traders that allow them to profit at the expense of ordinary investors.

Regulators are said to be looking at two primary exchange operators, CME Group and the Intercontinental Exchange (ICE), which is acquiring NYSE Euronext for $8.2 billion. Most of the wash trades in futures are taking place on CME, according to the WSJ. In the article, a spokeswoman for CME said the futures exchange prohibits wash trading and is developing new technology to prevent wash trades at the “engine level” to be rolled out toward the middle of this year.

It has been challenging for regulators to crack down on wash sales because under commodities and securities laws they must prove that the suspicious activity is intentional, said the WSJ article. Also, it’s been hard for examiners to figure out whether the two sides of a trade are coming from different parts of the same firm, or if they are part of the same trading strategy, the WSJ reported. However, an examination of U.S. futures transaction data for 2012 by the CFTC, showed that several hundred thousand potential wash trades occur a day on futures exchanges, the WSJ noted.

If firms are caught engaging in wash trading they will be fined. However, Chilton said on CNBC that regulators are limited to $140,000 a day for individual traders. He would like to see the penalties raised to $1 million per day per trader and $10 million for an entity, so they are meaningful.