UPDATE 1-US regulators examining 'wash trades,' CFTC's Chilton says

Mon Mar 18, 2013 6:47pm EDT

* "Voluminous" wash trades create "fantasy liquidity," Chilton says

* Chilton is frequent critic of high-frequency trading firms

* Wash trading barred by CFTC, exchange rules

By Ann Saphir

SAN FRANCISCO, March 17 (Reuters) - U.S. futures regulators, concerned about the frequency with which high-speed traders engage in banned self-dealing, are examining the practice with an eye toward crafting new rules to prevent it, a top regulator said on Monday.

The examination of so-called wash trades is "in a juvenile stage at this point," the Commodity Futures Trading Commission's Bart Chilton told Reuters on the sidelines of the National Grain and Feed Association meeting.

"We are trying to figure out whether it's going on and why it's going on," he said.

In a wash trade, a trading firm improperly sells a contract to itself without taking any risk in the market.

The practice is barred under CFTC and exchange rules because it can create the appearance of an active market where there is none.

The review was prompted by a recent report by CFTC surveillance staff showing a "shocking" level of wash trading across a range of markets, including financial, energy, agricultural and metals contracts, said Chilton, a CFTC commissioner.

He would not provide figures, saying that CFTC lawyers asked him not to, but he indicated the self-dealing was frequent enough that it was unlikely to be accidental.

"It's more than just bumping into each other," he said. The resulting volume, he said, is "fantasy liquidity."

He declined to say whether the CFTC's enforcement division was involved in the review of wash trades.

"If this were 0.4 percent (of trading) I wouldn't be giving speeches about it ... (these are) whole percentages," Chilton said. "We looked at it over a specific continuum, and we saw fairly constant wash sales being generated."

Chilton said that until recently he thought the practice was rare.

But the CFTC's surveillance data shows the practice is "voluminous" and widespread among high-frequency trading firms, said Chilton, who has frequently said rapid-fire computer-driven strategies distort markets and boost the cost of trading for individual investors.

Some 13.7 million contracts changed hands on an average day last month on CME Group Inc's futures markets; IntercontinentalExchange Inc's markets handled about 3.6 million contracts.

In a speech to the grain group, Chilton called for new restraints on high-frequency trading firms, including requiring them to register with regulators, test their computer programs before running them out in live markets, and have "wash-blocking" programs that prevent them from being on both sides of a trade.

MARKET MAKING?

He also said regulators should be able to levy greater fines on firms, and said he wanted the CFTC to crack down on market-making programs, in which exchanges typically reduce or waive fees for high-speed traders to boost liquidity in certain markets.

"We need to be sure there aren't any perverse incentives to be involved in things like wash trades," he said. "We should have a rule on the market maker programs, to standardize these things a little bit."

Exchanges including CME and IntercontinentalExchange run dozens of market-making programs that receive only cursory review from the CFTC, he said.

An IntercontinentalExchange spokeswoman said it has technology in place that prevents wash trades.

A CME spokeswoman said the exchange operator enforces its rules against wash trades and is "in the process of developing technology" to prevent them from happening at the exchange level.

Spokeswomen from both exchanges declined to comment on how common wash trades are.

On Monday CME fined a trader named Michael Cardwell $5,000 for wash sales made in 2009 and barred him from trading for nine months.