The Simplest Form of Market Manipulation
Wash trading is likely the simplest of market manipulation schemes. However, it lays the fundamentals for many other schemes, and even its most basic form has proven incredibly effective in unregulated markets like crypto. In this analysis, we’ll cover different ways wash trading is used and why it has remained a regulatory focus for so many years, including a recent study that shows what happens when that regulatory focus doesn’t exist.
Though introduced in the United States Commodities Exchange Act in 1936, the United Kingdom’s Financial Conduct Authority (FCA) MAR 1.6.2 probably offers the most concise definition of wash trading, which is “a sale or purchase of a qualifying investment where there is no change in beneficial interest or market risk, or where the transfer of beneficial interest or market risk is only between parties acting in concert or collusion, other than for legitimate reasons.” There are also more specific forms and variations of wash trading, such as pre-arranged trading, circular trading, or round-tripping. The behavior isn’t just used for market manipulation but also for tax or accounting fraud.
The Purpose of the Scheme
Price manipulation is a common purpose of the scheme; for example, the manipulator may perform wash trades to set unreasonable prices, especially for illiquid instruments. As they are taking both sides, the unreasonable position on one side is canceled out by the other, and the manipulator can also be quite precise in what price they want to achieve. We’ve explored in the past how profits are gained from price manipulation. However, an Autorité des marchés financiers France (AMF) case provides a uniquely wash trading-specific example. In 2021, the AMF fined a group of asset managers 37M EUR for performing wash trading to manipulate prices on the Euro Stoxx 50 Futures (FESX). The group had allocated the profitable side of the trade to their favored funds and the unprofitable side to unfavored accounts.
Illicit transfer of funds is another use; in this case, the trade is pre-agreed, and the unprofitable leg effectively transfers its losses to the person on the profitable side of the trade. An interesting example of this happened as part of the highly-publicized LIBOR scandal. In this case, the UK FCA determined that a broker had convinced a trader at UBS that he could influence the JPY LIBOR submission, which was bad already. So, considering these potential services, they arranged for a series of very large wash trades, which the UBS trader was willing to do every month. Overall, GBP 258,151 of unwarranted brokerage fees were generated—a fraud within a fraud.
Gaming Rebates
Similar to the generation of fees, many cases exist of people using wash trading to game rebate systems. A typical example with a modern twist is this case from the U.S. Securities and Exchange Commission (SEC), where two Florida residents were charged with wash trading because they put options in the hottest meme stocks of 2021, netting themselves over $700,000 in rebates. Their scheme focused on the “maker-taker” program. Under the maker-taker program, a trade order sent to an exchange and executed against a subsequently received order creates liquidity and generates a rebate from the exchange. In contrast, an order that immediately executes against a pre-existing order takes liquidity and is charged a fee. They were able to generate money by using broker-dealer accounts that passed rebates back to their customers to place initial orders on one side of the market, then used broker-dealer accounts that did not charge fees for taking liquidity for subsequent orders on the other side of the market. The pair said they chose out-of-the-money put options in meme stocks because they thought the meme craze made them much less likely to be traded against by others.
Returning to the simpler wash trading schemes, the other goal of the scheme is to generate fictitious volume. Often, the reason for generating fictitious volume is to build up a history of activity that leads to the performance of a pump-and-dump scheme. A less-used scenario is to generate volume to keep a company on an index, fund, or exchange. Being on an index, fund, or exchange can motivate many outside investors to acquire shares in a company, so a manipulator may generate fake volume to keep that company within the rules or push it across the line. A case in Mexico provides an interesting example where a steel company, Industrias CH, was fined the equivalent of $159,764 for effectively and intentionally trading with itself, as the regulator deemed.
Crypto Market Wash Trading
We’ve seen the most significant recent impact of wash trading in crypto markets. Bitwise, a crypto index fund manager, released their hotly debated report to the SEC in 2019, claiming that 71 of the 81 venues they reviewed engaged in wash trading, accounting for 95% of volume. They used very intuitive heuristics to show that trading patterns did not align with what happens in a normal market. For example, you would expect volume to rise and fall at certain times of the day, but some of the suspicious venues had consistent volume across the entire trading day. According to the report, at that time, a high ranking on sites such as coinmarketcap.com, which ranked by volume of activity, could bring in millions of dollars in listing fees for ICOs and alt-coins. Released at one of the crypto peaks and aiming to show that “actual volume” was smaller and better managed than thought, the report was controversial and did little to dampen enthusiasm at the time.
Taking a more academic approach, a group of researchers last year published a much more mathematically rigorous review of crypto activity in 2019. Though similar in concept to the Bitwise report, the researchers used mathematical models to estimate that, on average, over 70% of the reported volume of unregulated crypto exchanges consists of wash trades, with some newly established exchanges faking more than 90% of the reported volume. They also showed that in this environment, you almost needed to wash trade to survive; a 70% wash trading volume can move an exchange up by more than 25 spots on exchange ranking sites like CoinMarketCap compared to a similar venue that didn’t perform wash trading. Wash trading was both prolific and effective.
One big takeaway from both reports was that there was no significant wash trading in regulated crypto exchanges; both reports showed vastly divergent trading patterns between regulated and unregulated exchanges. The earlier days of crypto provide a useful lesson in the effectiveness of market manipulation if left unchecked and how regulated venues can provide a counter to some of the market’s excesses.
Regulatory Updates
19 March: The U.K. Financial Conduct Authority (FCA) released its business plan for 2024-25, with an operational focus on protecting consumers, protecting the integrity of the U.K. financial system, and promoting effective competition in the interests of consumers. To achieve these objectives, the FCA set out the 3-Year Strategy.
18 March: The Council of the European Union (EU) adopted a new regulation to strengthen market surveillance and ensure fair competition in the wholesale energy markets, increasing market transparency and integrity. The regulation includes stricter requirements for third-country market participants in the EU, empowers the European Union Agency for the Cooperation of Energy Regulators (ACER) to investigate cross-border cases, and introduces new investigatory tools for ACER, although the power to impose fines remains with the member states.
15 March: A senior regulator at the U.S. Commodities Futures Trading Commission (CFTC) pushed for the creation of an inter-agency task force to strengthen oversight of artificial intelligence (AI) technology. The task force would support the AI Safety Institute in developing guidelines, tools, benchmarks, and best practices for the use and regulation of AI in the financial services industry.
15 March: The Global Coalition to Fight Financial Crime’s Technology and Innovation Experts Working Group (GCFFC) published a paper on the use of AI as a tool to combat financial crime more effectively, specifically within financial institutions. The paper emphasizes the need for FIs to ensure they understand the technology and its underlying risks, and to have an adequate control framework in place.
14 March: The Swedish Financial Supervisory Authority (FSA) updated its Q&A on insider information, mainly targeting issuers who will handle and publish insider information to the market. Q&A in Swedish only.
13 March: The European Parliament approved the Artificial Intelligence Act, a regulation designed to ensure the safety and fundamental rights compliance of AI technology while also promoting innovation. The act bans certain AI applications that threaten citizens’ rights, places strict restrictions on law enforcement’s use of biometric identification and establishes clear obligations for the use of high-risk systems, among other measures.
11 March: Coinbase asked the Third Circuit to force the SEC to set rules for digital assets, arguing that the regulatory body failed to provide a reasoned explanation for why it denied an earlier request for crypto rulemaking.
7 March: The Belgian Financial Services and Markets Authority (FSMA) warns about the shadow investment game and the risks of prop trading firms. Prop trading firms allow consumers to trade in financial products without using their own money but often require consumers to take expensive courses before they can trade. The FSMA also raises concerns about the increase in advertising for these firms, the complexity and risk of the financial products they offer, and the potential for reckless behavior due to the gaming element of prop trading.
7 March: The CFTC’s Global Markets Advisory Committee (GMAC) advanced three recommendations, including the first-ever U.S. Taxonomy for digital assets. This taxonomy provides a comprehensive approach to classifying and understanding digital assets and aims to promote innovation and identify risk considerations while enabling an effective regulatory understanding of the digital asset ecosystem.
6 March: The SEC adopted new climate reporting regulations that require large companies to disclose their direct and indirect greenhouse gas emissions and reveal their climate-related risks. The rules, which will phase in starting in 2025 and be fully in effect by 2033, also demand standardization and enhancement of climate-related disclosures, including the disclosure of material climate risk, impacts on business strategy, and the company’s approach to managing these risks.
6 March: The SEC updated Rule 605 of Regulation NMS to enhance transparency and competition in the equity markets. The amendments expand the scope of entities required to produce monthly execution quality reports, change how orders are categorized, and require new statistical measures of execution quality.
1 March: The Hong Kong Securities and Futures Commission (SFC) announced that unlicensed virtual asset trading platforms operating in Hong Kong must close down their businesses by May 31, 2024. Previously, the SFC established a deadline for Virtual Asset Trading Platforms (VATP) to submit license applications by February 29, 2024, to continue operating in Hong Kong on or after June 1, 2024.
28 February: The Icelandic Central Bank published the 2024 issue of Financial Supervision. In publishing the Financial Supervision each year, the Central Bank aims to ensure an appropriate level of transparency on its activities and priorities in the field of financial supervision.
27 February: The FCA is shifting its approach to focus on cases that align with its strategic priorities and closing cases more quickly when an outcome is not achievable. The FCA is also planning to increase transparency by publishing updates on investigations and announcing when cases have been closed without enforcement, a significant change from its current process.
Enforcement Fines & Actions
The Financial Industry Regulatory Authority (FINRA) fined M1 Finance LLC $850,000 for allowing social media influencers to make misleading posts on the firm’s behalf. This case, which arises from FINRA’s targeted examination of customer acquisition through social media channels, marks FINRA’s first formal disciplinary action involving a firm’s supervision of social media influencers.
The FCA fined and banned the former chief executive of Indigo Global Partners Limited for his part in a sham trading scheme that falsely claimed €91.2 million from the Danish tax authority, SKAT. The former executive, who received more than £5.1 million from the scheme, was found to have acted dishonestly and without integrity, using false documents to support tax “reclaims.” This is the sixth case brought by the FCA in relation to cum-ex trading, with fines for the practice now totaling nearly £22.5 million.
The SEC charged a former Tallgrass Energy LP board member and four of his friends with insider trading for using nonpublic information to trade before Blackstone Infrastructure Partners’ offer to acquire Tallgrass. The parties involved have agreed to settlements totaling over $2.2 million for disgorgement, prejudgment interest, and civil penalties.
The SEC charged Genesis Global Capital, LLC for offering unregistered securities through the Gemini Earn crypto asset lending program. Genesis agreed to pay a $21 million penalty and accept a permanent injunction.
The SEC settled charges against two investment advisers, Delphia (USA) Inc. and Global Predictions Inc., who falsely claimed to use artificial intelligence (AI) in their operations. The firms agreed to pay a combined total of $400,000 in civil penalties for these misleading statements.
The CFTC charged U.S. Bank, N.A., and Oppenheimer & Co., Inc., for failing to maintain necessary records and for supervisory failures. As per the settlement, U.S. Bank will pay a civil penalty of $6 million, and Oppenheimer will pay $1 million.
The SEC charged the former Alfi, Inc. CEO with making misleading statements about the company’s financial and performance metrics on social media to inflate its stock price. According to the SEC, the former CEO made false claims about the company’s revenue and a non-existent contract with a successful restaurant chain.
The FBI Houston Field Office spearheaded the first criminal commodities insider trading case involving natural gas futures contracts. The former president of a Texas energy company pleaded guilty to an illegal kickback and commodities insider trading scheme, accepting over $5.5 million in illegal kickbacks.
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