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Chicago Mercantile Exchange Trying to Clean Up Its Act on Wash Trades

July 21, 2013 6:44 pm
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By: Bryan Wiener

The Commodity Futures Trading Commission (CFTC) recently reached out to the trading community requesting feedback concerning a Chicago Mercantile Exchange (CME) proposal to update its own rule governing “wash trades” in its Globex electronic marketplace.

Specifically, the public has been invited to interject on CME Group Market Regulation Advisory Notice RA1308-5, submitted with regards to section 40.5 of the CFTC’s market regulations. Due to the heightened scrutiny surrounding market reform and HFT practices, it is quite auspicious of the CME to propose changes in rules governing its trading procedures.

A “wash trade” is essentially a situation where a trader, either human or machine, buys and sells the same contract at the same price with itself. This practice is generally not permitted because it misleads the market with respect to trading volumes.

Malicious wash trading is designed to stir activity in a product so as to trick other traders into buying or selling the contract. Then, the wash trader moves the market in an opposing direction. HFT traders engage in wash trading to prevent taking a position in a contract when it gets an opposing signal to its original order.

The HFT trader cannot cancel in time or is attempting to scratch the original position in a contract and doesn’t realize it is hitting its own bid or offer. Traders also decrease their transaction costs as they reach higher volume tiers.

Regardless of the reason, wash trading is not ethical and a true market maker should never behave in this manner.

The CME is attempting to make a distinction between intentional and unintentional self-trading. HFT firms claim that due to the high speed and volumes they trade, it is inevitable that they will trade with themselves. This argument, though, is essentially what is wrong with HFT.

According to a New York Law Journal article published February 25, 2013, HFT comprises approximately 60 percent of daily CME futures trading volume. That is astonishing and quite dangerous. HFT algorithms essentially operate like a reckless drunk driver not caring for anyone else on the road.

That is, until they approach a car full of hot chicks and swarm in. Kind of a brash analogy, but it is not far from the truth. The machines come in with large bids and/or offers that may or may not represent the true liquidity in the futures market. The firm’s bid or offer may get hit with an order a fraction of the original order size, pull the remaining order and sweep the same side of the market at the same price or subsequent deeper price levels.

These tactics are designed to mask the algorithm’s true directional intent and trick hand traders and/or other algorithms into joining their large bid or offer, providing the HFT with enough liquidity to execute its intended trade. They do not care who gets run over or how their order manipulation affects the global markets, just their own wallets.

So in this heightened state of unrest surrounding market reform across equity, option and futures exchanges, it is interesting that the CME is somewhat allowing for future wash trades. By “clarifying” what a wash trade is, it is essentially handing HFTs the blueprint for bypassing wash trading rules.

Traders saw how HFTs found a way to circumvent Reg NMS and take advantage of order types in the equities market to their advantage. Given that most HFTs inherently make their profits from borderline illegal trading activities, this rule change from the CME, originally intended to go into effect July 1, 2013, should only expect future abuses.

HFTs are smart. They will find a way to circumvent this new wash trade rule and will continue their abusive practices. It is inevitable, but we are at the mercy of the machines and the “Self-Regulatory Organization (SRO)” that allows this behavior to persist. Maybe we should revisit the concept of SROs and go back to good ole’ checks and balances with regard to industry standards that affect bank accounts and national security for that manner. But that’s just one man’s opinion. Maybe if I was a machine I’d get noticed by the powers that be.

If you’d like to post a comment to the CFTC, you can do so here.

Note: All submissions must be received by August 14, 2013.

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