High-frequency trading firms, who may be distorting financial market prices by conducting transactions with themselves, are drawing scrutiny from U.S. regulators. Investigations of so-called wash trades by the Securities Exchange Commission (“SEC”), Commodity Futures Trading Commission (“CFTC”), and Financial Industry Regulatory Authority (“FINRA”) represent another episode in the struggle to understand and properly regulate high-frequency trading activity.
Wash trades are a form of self-dealing that occurs when one party places bid and ask requests for the same security. This causes an appearance of increased activity in the security that can prompt other participants to enter the market. The lured-in traders drive activity that affects the price of the security. More importantly, the surge in volume creates profitable opportunities for high-frequency firms, who often act as market makers.
Wash trades can be seen as market manipulation because they artificially alter the price of a security by creating a false impression of higher market volatility. However, one problem in penalizing this behavior is that securities fraud traditionally requires proof of scienter, which is intent or knowledge of wrongdoing. Trading firms can escape liability by claiming they did not act with scienter. Firms often buy and sell the same security by mistake—especially as market speed has increased. Further, two separate parts of a trading firm may unintentionally cross bid and ask requests when executing different trade strategies.
In response, government agencies are looking to apply the new regulatory tools granted to them by the Dodd-Frank Act. For example, as Susan Court from Hogan Lovells reports, the lower standard of “recklessness” can be used to prosecute offenders under the CFTC’s new anti-manipulation rule. CFTC and FINRA officials are exploring whether these new powers can aid in cracking down on wash trades.
Renewed regulatory focus on high-frequency trading may be appropriate, especially as firms attempt to invent ways to deal with slumping trading volumes in post-recession markets. This slump in stock volumes has caused some of the largest high-frequency trading shops to post huge reductions in profits. However, commentators like Charles M. Jones, Professor of finance and economics at Columbia Business School, are not convinced of the evils of high-frequency trading. Jones argues that high-frequency trading has “not [destabilized] markets” and has “made markets better.” This assessment flies the face of high frequency trading critics and evidence that markets experience nearly a dozen mini flash crashes per day. Whatever the case, this most recent controversy of wash trading should spur on debate over how regulators can best handle high-frequency trading.