What is wash trading and how does it work?
High-profile cases have illuminated the practice of wash trading in recent years, sending a clear message that regulators are cracking down on it. But what is wash trading, and how can firms avoid it?
Written by a human
In brief:
- Wash trading is an illegal trading practice because it creates a false sense of liquidity and market interest
- A wash trade is an indicator of manipulative behavior and contravenes regulations designed to protect investors and the integrity of the securities markets
- Firms are required to report incidences of abusive market practices or strategies, including wash trading, or risk regulatory enforcement
What is wash trading?
To define wash trading, sometimes called circular trading, we need to jump straight into the realms of market manipulation.
Wash trading definition
Wash trading is the practice of buying and selling a security at the same time with the intent of manipulating the market. Specifically, it gives the impression that trading volumes are higher than they actually are for a particular security, giving the perception of increased liquidity and market interest.
This is done in an attempt to encourage other market participants to deal in that particular security, believing they could benefit financially.
Wash trading can involve collaboration between dealers-brokers and between investors and dealers-brokers, but not all cases of reported wash trading reveal this.
An example of wash trading
Let’s look at a real case of wash trading to illustrate in practical terms how this unethical behavior can be carried out.
Mr Adrian Geoffrey Horn was prosecuted for wash trading by the Financial Conduct Authority (FCA) in 2021 and slapped with a financial penalty of £75,000.
In this particular case, Mr Horn was a senior market-making trader at Stifel Nicolaus Europe. An experienced trader, Mr Horn believed that a minimum volume of 13,000 shares needed to be traded each day in order for real-estate firm McKay Securities Plc to remain in the FTSE All Share Index.
With this goal in mind, Mr Horn monitored the number of legitimate trades in McKay Securities Plc shares. If these fell below 13,000 on any day, he executed buy and sell orders simultaneously to fabricate trades, inflating liquidity of the investment.
Mr Horn reportedly placed orders into the market through a third-party broker via a Smart Order Router, which Investment firms typically have access to. This is an underhand tactic employed by broker-dealers to avoid their illegal trading behavior being detected. But Mr Horn’s strategy to manipulate the market was discovered and besides a substantial fine, he was also banned from working in the securities industry.
Wash trading regulations
Wash trading is prohibited by various regulations in the U.K., Europe, and U.S. Here’s a breakdown of wash trading rules by country.
In the U.K. and Europe, wash trading contravenes the Market Abuse Regulation which specifically targets insider dealing, unlawful disclosure of inside information, and market manipulation.
Section 397 misleading statements and practices of the Financial Services and Markets Act 2000 also covers market manipulation, including engaging in artificial trades to create the impression that there is more interest in the investment than really exists.
The FCA prosecutes individuals and firms who carry out wash trading, while in the US, this serious offense is charged by the Securities and Exchange Commission (SEC).
In the U.S. wash trading contravenes Section 17(a) of the Securities Act of 1933, and Section 10(b), and Rule 10b-5 of the Securities Exchange Act of 1934.
Wash trading enforcement in the cryptocurrency market
In a highly publicized case, the SEC filed 13 charges against cryptocurrency firm Binance Entities and its founder Changpeng Zhao in 2023 for various misdemeanors including wash trading.
The Binance wash trading case raised questions about the integrity of the broader cryptocurrency market and intensified regulatory scrutiny of cryptocurrency exchanges.
Wash trading crypto is widespread according to a 2022 study by Forbes, which found that 51% of the daily bitcoin trading volume being reported is likely to be fake.
How are regulators cracking down on wash trading?
As regulators become more sophisticated in their detection and enforcement efforts, we can expect to see a continued focus on prosecuting individuals and firms carrying out wash trading and other forms of market manipulation. This trend can be attributed to the following factors:
Increased scrutiny of financial markets
Regulators worldwide have become more vigilant in monitoring financial markets to identify and address potential misconduct. This is most notably as a result of the 2008 financial crisis and the increasing complexity of financial instruments. Crypto wash trading in particular has been a hot topic among regulators in recent years.
Technological advancements
Advances in technology have enabled regulators to develop more sophisticated tools for detecting and investigating market manipulation, including algorithms and data analytics.
Investor protection
A growing emphasis on protecting investors from fraudulent activities and ensuring fair market practices has fueled regulatory action.
Global cooperation
Increased international cooperation among regulators has facilitated a more coordinated approach to addressing global financial challenges such as market manipulation.
Public pressure
Public scrutiny and media attention surrounding financial scandals have put further pressure on regulators to take action against wrongdoing.
How can firms avoid wash trading?
Wash trading can have severe consequences for financial institutions and individuals involved or implicated. To prevent such practices and ensure compliance with market regulations, firms should implement the following strategies:
- Enhanced surveillance: Sophisticated analytics, real-time monitoring, and alert systems can help detect unusual trading patterns and suspicious activity as it occurs.
- Robust record-keeping: Maintain meticulous records of all trades, including order details, timestamps, and account information. Implement robust data security measures to protect sensitive information and prevent unauthorized access.
- Employee training: Conduct regular training programs to educate employees about the risks and consequences of wash trading. Establish a clear code of conduct that prohibits wash trading and other forms of market manipulation. It’s also important to create whistleblowing policies so employees can report any suspected instances of wash trading without fear of retaliation.
- Independent reviews: Conduct regular internal audits to assess compliance with market abuse regulations and identify potential vulnerabilities. Firms may also wish to engage independent third-party auditors to provide an objective assessment of compliance practices.
- Regulatory compliance: Stay updated with regulatory developments and maintain open communication with regulators to address questions and seek guidance.
By implementing these measures, firms can significantly reduce the risk of engaging in wash trading and demonstrate their commitment to fair and transparent market practices.
Summary
With heightened regulatory scrutiny and technological advancements, firms must enhance their vigilance in detecting market manipulation practices like wash trading. Robust record-keeping measures and strongly upheld policies should form the bedrock of a firm’s defense against this illegal practice. To strengthen the effectiveness of these strategies, communications surveillance represents an invaluable asset for firms wishing to remain compliant, protect investors, and uphold the integrity of the market.
