Understanding Wash Trading: A Deep Dive into Market Manipulation

What is Wash Trading?

Wash trading is a form of market manipulation where an investor simultaneously buys and sells the same financial instruments to create misleading, artificial activity in the marketplace. This deceptive practice inflates trading volumes, potentially misleading other investors about the liquidity and true value of a security.

Wash trading refers to a deceptive and illegal trading practice in which a trader executes buy and sell orders simultaneously for the same financial instrument to manipulate markets. Essentially, wash traders are trading with themselves to create the artificial appearance of substantial market demand that can lure other participants into entering trades.

At its core, Wash trading generates volumes and volatility that are not real. By taking both sides of trades, wash traders give the illusion of liquidity and price movement when in fact one individual or colluding group is behind the activity. This market manipulation is extremely problematic because it:

• Distorts true supply and demand dynamics
• Obscures the real market volatility and volume
• Falsely signals to other traders that certain price levels are appropriate
• Allows wash traders to reap profits from their deception
• Compromises market transparency and integrity

The wash trader is hoping to influence other buyers and sellers by portraying market conditions that are detached from reality. These phantom trades in turn impact broader market activity as participants are misled into entering or exiting positions based on misperceptions. Thus, Wash trading jeopardizes efficient and equitable price discovery within financial markets.

Example of Wash Trading

Consider an investor, Alex, who owns a large quantity of a particular stock, XYZ Corp. Alex wants to create the illusion that XYZ Corp. is actively traded to attract other investors and drive up the stock's price. To do this, Alex sets up two brokerage accounts. From Account A, Alex sells 1,000 shares of XYZ Corp., and, almost simultaneously, from Account B, Alex buys those same 1,000 shares. This transaction does not change Alex's overall position in XYZ Corp., but it falsely increases the trading volume and potentially the stock's price.

Why Wash Trading is Manipulative

Wash trading is manipulative for several reasons:

1. False Market Activity: It creates the illusion of high demand or heavy trading activity, which can mislead other investors.
2. Price Manipulation: By creating a false perception of increased activity, it can artificially inflate or deflate the price of a security.
3. Market Integrity: It undermines the integrity of financial markets, leading to a loss of trust among investors.
4. Misleading Information: It provides false information about the liquidity and performance of a security, which can distort market analysis and decision-making.

Who Engages in Wash Trade and Why?

Wash trading is undertaken by traders seeking to manipulate markets for their benefit. Specific parties known to use wash trades include:

• Dishonest Individual Traders - Traders may create wash sales in hopes of triggering buying or selling pressure from other participants, allowing the wash trader to quickly close their position at a profit. They essentially aim to "fool" others into reacting to false signals.
• Market Makers - Occasionally, market makers might wash trade to portray stronger liquidity in their market that can attract other traders. More volume gives the appearance of a robust, active market.
• Fund Managers - Some fund managers have conducted wash trading to boost returns through fictional transactions, attempting to attract more investors and assets under management.
• Brokers - Less scrupulous brokers potentially engage in wash trading to seem more competitive. By inflating their volume and activity through wash trades, brokers can posture as a preferable option relative to alternatives.

The unifying motive is plain dishonesty - parties see an opportunity to use deception to their advantage to generate profits or credibility. Ultimately, wash trading betrays principles of transparent and ethical participation in financial markets. The behavior squanders public trust in capital markets.

(https://kriminiltrading.com/blogs/market-terms-summaries/wash-trading-what-is-it)

Regulations Against Wash Trading

To maintain market integrity, various regulatory bodies around the world have stringent rules against wash trading. In the United States, the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC) have clear prohibitions against this practice. The European Securities and Markets Authority (ESMA) enforces similar regulations in the European Union. Violations can result in severe penalties, including fines, suspension, and even imprisonment.

Procedure to Review Wash Trading Alerts

Financial institutions use sophisticated surveillance systems to detect potential wash trading. The procedure typically involves several steps:

1. Automated Detection: Surveillance systems flag suspicious transactions based on predefined criteria, such as simultaneous buy and sell orders for the same security by the same trader.
2. Initial Review: Compliance officers review the flagged transactions to assess whether they genuinely indicate wash trading or if there might be a legitimate explanation.
3. Investigation: A deeper investigation is conducted if the initial review raises concerns. This may involve reviewing trading patterns, communication records, and the trader’s history.
4. Reporting: If the investigation confirms wash trading, the incident is reported to regulatory authorities as required by law.

Actions to be Taken by the Company

When a company identifies potential wash trading, it must take decisive actions to address and prevent further occurrences:

1. Immediate Cease of Activity: Stop suspicious trading activity immediately to prevent further market manipulation.
2. Internal Investigation: Conduct a thorough internal investigation to understand the scope and details of the wash trading.
3. Employee Discipline: If employees are found to be involved, enforce appropriate disciplinary actions, which could range from warnings to termination.
4. Regulatory Reporting: Report the incident to relevant regulatory bodies, detailing the findings of the internal investigation and actions taken.
5. Policy Review and Enhancement: Review and strengthen internal policies and controls to prevent future occurrences. This might include enhanced surveillance, stricter compliance protocols, and employee training.
6. Ongoing Monitoring: Implement ongoing monitoring and periodic audits to ensure compliance with anti-manipulation regulations.

Conclusion

Wash trading is a serious offense that undermines the integrity of financial markets. Understanding its mechanics, recognizing its manipulative nature, and adhering to regulatory standards are crucial for maintaining a fair and transparent market environment. Companies must be vigilant in detecting and addressing such activities to protect investors and uphold market integrity.