Wash Trading in Sub-$1 Stocks Hurting Market Makers, Knight Capital Says

A strategy that enables individuals to profit by trading low-priced stocks with themselves is damaging market makers, according to Jamil Nazarali, global head of electronic trading at Knight Capital Group Inc.

Knight and four other market-making firms met with the U.S. Securities and Exchange Commission’s division of trading and markets yesterday to discuss the practice, Nazarali said. They say the tactic enables traders to seek profits in low-priced stocks by collecting rebates for orders provided to markets for other investors to trade against.

The complaint comes amid a growing debate about how to oversee trading on 11 separate U.S. equity exchanges -- venues dominated by electronic market makers and firms providing bids and offers who are usually paid to supply liquidity. Knight has spoken with the New York-based Financial Industry Regulatory Authority, which oversees almost 4,700 brokers, and asked the Treasury Department to investigate.

“We see this all the time,” said Nazarali. “It’s damaging but it’s really hard to go after. There are days when our firm has spent tens of thousands of dollars on fees on a single stock because of these wash sales.”

Using the strategy Nazarali described, a trader can send a so-called limit-order bid to an exchange through one broker and a separate market order to sell shares through another firm, expecting to take both sides of the trade, known as a wash sale. The trader purchases 100,000 shares through a broker who passes along to its customers the exchange’s fees and rebates for trading on its market, earning about $250 because the venue pays fo liquidity. He pays the discount broker a commission to sell the stock, pocketing the difference.

Arbitrage Game

“There’s arbitrage gaming going on,” said William Karsh, chief operating officer at Direct Edge Holdings LLC in Jersey City, New Jersey. The company, which operates two stock exchanges, changed the trading fees it charges for securities trading below $1 to discourage the tactic, he said.

Some of the individuals or firms engaging in the practice are outside the U.S., making it harder for regulators to pursue them, Nazarali said. They also use multiple brokers and accounts to mask their activity he said.

CBOE Stock Exchange, or CBSX, which offers rebates for securities priced less than $1, is a market where the practice may be happening, Nazarali said. CBSX is operated by CBOE Holdings Inc. in Chicago.

“All other exchanges have realized this is a really big problem,” Nazarali said. The largest exchanges have altered the fees they charge for securities less than $1 to make the practice harder to employ, he said.

Gail Osten, a spokeswoman at CBOE, said the company “takes its regulatory responsibility very seriously and does investigate unusual trading activity. However, we do not comment on individual investigations.”

The practice “is something every exchange needs to be aware of from a surveillance standpoint,” said Jeromee Johnson, vice president at Bats Global Markets in Kansas City, Missouri. Bats monitors trading to ensure the practice doesn’t occur on Bats Exchange, he said. “It’s something we’ve seen take place on other exchanges in the past.”

To contact the reporter on this story: Nina Mehta in New York at nmehta24@bloomberg.net.

To contact the editor responsible for this story: Nick Baker at nbaker7@bloomberg.net.