Wash Your Back
Vol #89: July 15th, 2022
Financial professionals spend an enormous amount of time on continuing education and compliance training. Without these industry requirements it feels like we could have had the industry equivalent of the James Webb space photos last decade.
However it only takes one glance at the financial press, or the daily musings of the always entertaining Matt Levine to realize how pervasive financial crime is. All those hours are spent because I’d bet most professionals bump into some kind of suspicious activity on a weekly basis.
As a market maker in options, you often saw orderflow that set off alarm bells. A name that only traded a few hundred contracts a day would suddenly see a big buyer of upside calls. When the merger announcement came the next day, we dutifully filed Unusual Activity Reports that went into a regulator’s waste bin somewhere.
Some of those trades were certainly based on insider information, but some were also just a well timed bet. You don’t always remember the upside calls you sold that turned into nothing.
It’s important that not only regulators, but also participants, are always on the lookout for someone who is trying to cheat, or the system quickly starts to crumble for everyone. Markets are built on the fundamental principle of fair competition.
The invisible hand of Adam Smith works through individual agents pursuing their own interests, transacting and driving prices to a supply and demand equilibrium. Goods, services, and capital are most efficiently allocated when participants deal at an arm's length, according to mutually agreed upon rules.
The elegance of this 250 year old theory is indisputable. It provides a theoretical framework for how trillions of dollars moves around the globe every day. Much of the technological and industrial advances of the last 2 centuries have come because talent and capital were able to come together, forged by competition and commercial survival.
Fair competition is a subjective term. Most people would agree that inside information leading you to buy upside calls ahead of a merger deal is out of bounds - if both buyer and seller knew the same information, the price of those calls would be dramatically different.
It’s relatively cut and dry when the buyer is taking advantage of the seller, or vice versa. If I knowingly sell you a house that is riddled with asbestos, there’s a clear fault. But what if a realtor is posting listings and moving properties between different shell companies to create a false impression of an active neighborhood?
The financial equivalent of that is wash trading - where one party will trade with themselves to create the illusion of activity.
When I first heard about “painting the tape”, it took me a bit to understand why this might be illegal. At first blush, it seems like the exchanges are the big winners here - whether the transaction is “real” or “fake”, they take their fees.
Wash sales don’t necessarily have an immediate or direct harm on the market place. But creating the false impression of liquidity has a significant impact on a market’s ability to function as a capital allocator.
At the very least, it’s deceptive. Tracking volume has become a very popular way for retail traders to see where the action is. Dozens of Twitter accounts post big trades, and there are regular CNBC segments about where the flow is going.
Sometimes a big trade is a signal, but sometimes it’s a nothing burger - part of a bigger risk management strategy hedging other exposures. If you’re going to make a trade, you should have more reasons than just monkey see monkey do.
Fake liquidity also has a second order impact on how participants use capital markets. As traders we only see the prices flickering across the screens and the orderflow that pushes them up and down. But the reason markets are there in the first place, is to provide a pricing mechanism for investors and executives to make allocation decisions.
Digital asset markets are famously unregulated. Exchanges are able to set their own rules about how buyers and sellers match, and typically provide surveillance only to the extent that it furthers their business. Inside information is just called “alpha” and large whale accounts will frequently slam prices one way or another to shake out retail traders.
As I’ve said before, liquidity is the ability to get out of a trade when you need to. Misjudging liquidity is mispricing an investment. With no surveillance or rules around wash trading, the incentives to create fake liquidity can run rampant.
For capital to move into the digital asset space, it also needs a way to move out of the digital asset space. Most institutional investors pay their bills and their client distributions in fiat. When they invest in a project, they need a way to convert that equity token back into something that’s useful to them.
In reviewing a project this week, at first blush there was (relatively) robust volume. While the position in question was significant, it could be reasonably liquidated over an extended timeline without moving the price too much by keeping the percentage of volume low. The volume however, was a total canard.
Volume is more than a number - it must be an accessible volume. When I was analyzing equity options for managing my firm’s liquidity profile, we looked at where the volume was trading, and whether we could reasonably “touch” it. If it was taking place in large blocks through a crossing mechanism we couldn’t reasonably expect to interact with, you had to discount the numbers. This was complex, even in a well regulated market.
Enter crypto, where over 95% of the volume in this token I was looking at was inaccessible. It was easy to completely disrupt the painting of the tape with small orders that prevented the washing algorithm from creating volume. The true liquidity here required a different price and terms for capital allocation.
Buying and selling to yourself seems like a victimless crime. Deceptive liquidity however has a massive impact on capital flows, and how things are priced. If capital is unable to price its exit cost, it will go elsewhere.