What is 'Wash Trading'

Wash trading is a process whereby a trader buys and sells a security for the express purpose of feeding misleading information to the market. In some situations, wash trades are executed by a trader and a broker who are colluding with each other, and other times wash trades are executed by investors acting as both the buyer and the seller of the security. Wash trading is illegal under U.S. law, and the IRS bars taxpayers from deducting losses that result from wash trades from their taxable income.

BREAKING DOWN 'Wash Trading'

Wash trading was first barred by the federal government after passage of the of the Commodity Exchange Act in 1936, a law that amended the Grain Futures Act and also required all commodity trading to occur on regulated exchanges. Prior to their proscription in the 1930s, wash trading was a popular way for stock manipulators to falsely signal interest in a stock in an attempt to pump up the value, so that these manipulators could make money shorting the stock. 

Commodity Futures Trade Commission (CFTC) regulations also prohibit brokers from profiting from wash trades, even if they claim they weren’t aware of the traders intentions. Brokers therefore must perform due diligence on their customers to make sure that they are buying shares in a company for the purpose of common beneficial ownership.

The IRS also has strict regulations against wash trading, and requires that taxpayers refrain from deducting losses that result from wash sales. The IRS defines a wash sale as one that occurs within 30 days of the buying of the security, and results in a loss.

Wash Trading and High Frequency Trading

Wash trading returned to the headlines in 2013, right as the phenomenon of high frequency trading was becoming widespread. High frequency trading is the practice of using super fast computers and high-speed Internet connections to perform upwards of tens of thousands of trades per second. Starting in 2012, then-Commissioner of the Commodity Futures Trading Commission, Bart Chilton, announced his intention to investigate the high frequency trading industry for violations of wash trading laws, given how easy it would be for firms with this technology to enact wash trading under the radar.

In 2013, the Securities and Exchange Commission (SEC) charged Wedbush Securities for failing “to maintain direct and exclusive control over settings in trading platforms used by its customers,” a failure that enabled some its high-frequency traders to engage in wash trades and other prohibited and manipulative behavior.

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