On July 15, 2013, the CFTC sought comments on a proposed CME Group Market Regulation Advisory (Advisory) providing guidance and answering frequently asked questions on wash trades. As the names implies a wash trade is (i) a transaction or series of transactions that produce a wash result, i.e., no bona fide market position, market risk or price competition and (ii) the parties intended that wash result. The Advisory states that “[i]ntent may be inferred from evidence of prearrangement or from evidence that the orders or trade(s) were structured, entered or executed in a manner that produces that the part(ies) knew, or reasonably should have known, would produce a wash result.” Advisory Answer to Q1.
Throughout the Advisory, this issue of intent flows through the answers to various questions. For example, in response to a question concerning wash trades when the buying and selling of accounts with common beneficial ownership — initiated by independent decision makers — coincidentally cross in the market, the Advisory cautions that such trades will be subject to scrutiny. The outcome of that scrutiny will be whether the trades were prearranged and whether either party “intended for their order to trade against the other’s order.” The Advisory states:
Buy and sell orders for accounts with common beneficial ownership that are independently initiated for legitimate and separate business purposes by independent decision makers and which coincidentally cross with each other in the competitive market are not considered wash trades provided that the trade was not prearranged and neither party had knowledge of the other’s order or otherwise intended for their order to trade against the other’s order. Market participants should be aware, however, that trades between accounts with common beneficial ownership may draw additional regulatory scrutiny and should be prepared to demonstrate that such trades are bona fide. Id. Answer to Q 10.
Similarly the issue of intent arises when different proprietary traders within the same firm match against each other, either through their own trading practices or the use of an algorithm. The Advisory states that “[p]rovided that the respective orders of each independent trader are entered in good faith for the purpose of executing bona fide transactions, are entered without prearrangement, and are entered without the knowledge of the other trader’s order, then such trades shall not be considered to violate the prohibition on wash trades.” Id. Answer to Q 12. Similarly, “orders generated by algorithms operated and controlled by fully independent traders in different trading groups that unintentionally and coincidentally match with each other will not be considered to be wash trades provided that the orders are initiated in good faith for the purpose of executing bona fide transactions, that the algorithms operate independently of one another, and that the respective trading groups do not have knowledge of one another’s orders. Id.
But in addition to showing this lack of intent, the Advisory stresses throughout that market participants must be proactive — by employing functionality — to prevent wash trades. For example, while the “unintentional and incidental matching of buy and sell orders entered by an individual trader on the electronic platform” generally will not be considered a wash trade, Id. Answer to Q 11, “if such self-matching occurs on more than an incidental basis in the context of the trader’s activity or in the context of the particular market’s activity, such trades may be deemed to violate the prohibition on wash trades. It is recommended that individual traders who frequently enter orders on opposing sides of the market that have a tendency to self-match on more than an incidental basis employ functionality that will minimize the potential for their buy and sell orders to match with each other.” Similarly, where multiple algorithms are operated or controlled by the same individual or team of individuals may generate self match events on more than an incidental basis, the Advisory recommends that individual or team “employ functionality to minimize or eliminate such occurrences.” Id. Answer to Q 13.
The CME Group introduced Self-Match Prevention (“SMP”) functionality on CME Globex in June 2013. While the SMP functionality is not mandatory, the Advisory reminded market participants that wash trades are illegal and “[f]irms and market participants should carefully review their operations and the guidance in this Advisory Notice, and, where appropriate, take steps necessary to minimize the potential for such trades either through the useof SMP functionality or by alternative means.” Id. Answer to Q 16.
Comments to the CFTC on the Advisory are due August 14, 2013.