Wash trading is defined by the Chicago Mercantile Exchange in rule 534 as trading where the trader knows that no change in beneficial ownership occurs. In wash trading there is no market risk, and no price discovery for the beneficial owner. The Intercontinental Exchange (ICE)
definition is very similar in their rule Exchange Rule 4.02(c).
Misleading signals is a simple way of stating that wash trades give the appearance that more trading activity is happening. It gives the false impression of additional liquidity — i.e., more activity attracts more people trading, more activity attracts algorithms trading, and more activity makes a lackluster market appear vibrant. See the case of Gordon Eberwein’s trading in trades in Ackroo Inc. on the Toronto Stock Exchange for an excellent example of misleading signals from wash trading (TSX-V:AKR).
Wash trading also can be used to artificially change a price in a market. If the market is trading at €12.50 and a wash trade is entered and reported at €13.00, then the market price has been inflated without any real price discovery.
Consider the following scenario:
- You own 100 Jelly Bean futures contracts. You bought them at €10 each.
- This investment was recommended by your investment advisor, who has trading discretion/privileges on your account.
- The Jelly bean market isn’t particularly liquid.
- The current last trade is €9.50 — you are losing money!
- Prior to your end of month statement from your investment, your advisor engages in a wash trade changing the last trade price back to €10.
In this case you now have an investment statement that says you haven’t lost any money. Have you been mislead? Of course you have.
Regulators worldwide are looking to prevent investors from being mistreated. This includes being mislead by market signals.
Wash Trading With Churning is Simple Thievery
There are several cases brought by FINRA for Churning, a practice where brokers use wash sales to generate commissions. In this case the client’s end of day position may not change from day to day. However, the broker and brokerage firm are taking commissions from the client’s account. In this case the broker is simply using wash sales to steal small amounts of money from the client.
Title Image Credit: Francisco Gonzalez Oct 1, 2012