Wash Trades is one of market manipulation scenarios according to new market abuse regulation (MAR) and related regulations by European Securities and Markets Authority (ESMA). This is however not the only scenario which is illegal according to MAR but also other scenarios like Improper Matched Trades, Pre-Arranged Trades and Painting the Tape. There are some differences between these similar scenarios and this is what we will explain in this article. All of these have one thing in common, namely, the reason why they are regarded illegal: In all these cases, trading volume for the day and product is manipulated without actual change of beneficial ownership and in the misleading way resulting in attraction of new traders/investors.

The Origin: Everything starts with trade matching and the way it works. As it is known, in order for trade to take place on the exchange, there should be someone willing to buy and someone willing to sell. As these two sides are provided, deal is set and trade is taking place.

Wash Trades: Sometimes, however, it happens that the buyer is the same as the seller. In other words, the buyer matches against own orders. These cases are also called “Crossed Trades”. There can be different motivation behind this unnatural type of matching. One of the most common is human error, a trader mistakenly buys a security which he didn’t intend to buy and he then has to close his position. Another reason can be hedging -buying from one account and selling from another, yet other reasons can be related to poor liquidity and technical order matching problems on the exchange. The last but not least cause can be market manipulation intent. In other words, the manipulator knows that by buying and at the same time selling the very same security, he most likely will not lose much money (but the commissions) but what he can achieve is to artificially increase the volume in the “sleeping” security. This might in turn trigger other traders or investors interest in this security, as they see increasing volume (a lot of investors have screening conditions for unusual volume for the day). The fact that the volume has been falsely manipulated which can in turn lead to false interpretations is illegal and thus the practice of wash trades is illegal too. The way compliance can detect these type of trades are fairly straight forward: Every time, same trading account or same client executes two or more different trades in the same security during a 5 minute (or less) time window where two or more trades have the following conditions: Different sides, same (or very similar e.g. 0,01%) price, same quantity (or very similar e.g. 0,01%), then you have it – the real wash trade.

Pre-Arranged Trades: This scenario is similar to Wash Trades scenario with one major extra feature. The wash trades are “pre-arranged” among two or more different traders/parties. For example, Party A agrees with Party B on coordinated buying and selling of the same security. At first, Party A sends market buy orders for 100 units the security ABC, whilst Party B at the same time sends market sell orders (either position closure or short selling) for the same security and same amounts. If they coordinate well (exactly at the same time) and if the security is not very liquid, the chances are good that they match with each other. They can then repeat this as many times as they can afford themselves in terms of lost commissions. What can be the rationale: They might have larger positions in these security and they might want to create some artificial activity. Or if not they themselves, someone else (friend, wife, business partner) might have a position in the security and thus might be interested in attracting additional inflow. The challenge for compliance users is to differentiate normal trades from “pre-arranged” trades as crossing of the trade is part of the business. For this matter, compliance officers should concentrate on the repetitive behaviour by the same parties. In other words, it is not enough to have one matched trade between two parties (even if it is same time, same price and same quantity). It is far stronger argumentation to show that the same parties have consistently(during the same day or over multiple days) matched between each other and achieved a significant trading volume share as compared to the average volume (e.g.25%). Thus, the alarm should be triggered only when two or more parties matched against each other at least 2 times during the day and at least 3 times during a week.

Improperly Matched Trades: This is a combination of two violations – wash trades with non-best execution. A trade is improperly matched when the matching price is “off-market” and it does not matter whether the trader has profited from the deviation or not. The fact that it is “off-market” and that the buyer is the same as seller is enough to set as illegal scenario for market participants. Behind off-market matching can be one person who matches against himself (for example in an illiquid security) or a group of traders who match between each other. It is worth to mention, that such deviations from market prices for the regulated markets are extremely rare. The motivation for perpetrators behind this scenario is twofold: 1. Invite additional Inflow by artificially increasing traded volume and create the impression of unusual activity 2. Profiting from “Off-Market” feature.

Painting the Tape: If Wash Trades or Pre-Arranged or Improperly Matched trades are taking place during the very sensitive periods of the trading such as Opening, Closing or Fixing, then this might easily lead to significant price jumps: Unusually Increasing Volume => False Interpretation => Additional Market Trades => Price Jumps. These cases are called Painting the Tape. It is called “painting the tape” as this price jump “paints the tape” in a way which is not a real replication of true demand/supply interaction. In other words, the price jump is not normally followed through by additional volume as smart money does not follow these tricks of perpetrators and thus the price jump fails soon after its origination (normally in the same trading session or right during the next one).

One last point that compliance officers should know is that there is and always will be a trade-off – Coverage and Investigation Workload. In other words, the less strict the detection thresholds are the more possible cases are covered but also the more cases need to be investigated and thus more time invested in the investigation. The Golden Medium should be found case by case, everyone for themselves. This is the inherent risk/benefit nature of the industry and compliance should learn to accept and live with it.

Kind Regards,

Gio Kevanishvili Consultancy