By Mark S. Nelson, J.D.
The CFTC ordered TeraExchange LLC to abide by the Commission’s wash trading rules and the core principles for swap execution facilities after finding the exchange let two trading firms make wash trades and pre-arranged trades in the exchange’s new Bitcoin swap. TeraExchange had lauded the trades as the first ever Bitcoin swaps transactions on a regulated exchange, but that boast fell apart when CFTC officials and the National Futures Association began to investigate them as suspected wash trades (In the Matter of TeraExchange LLC, Release No. 15-33, September 24, 2015).
TeraExchange paid no penalty in the settled administrative matter, nor did it admit or deny the CFTC’s findings. But the lack of any penalty drew a terse dissent from Commissioner Sharon Bowen. “Tera Exchange facilitated wash trading and prearranged trading in violation of the Commodity Exchange Act,” she said. “That is why we brought this case. I fundamentally disagree with the notion that they deserve no penalty.”
Just testing system? At the crux of the CFTC’s order telling TeraExchange to stop breaking the rules for wash trades and pre-arranged trades is the concept of testing business systems to ensure they can logistically handle actual trading scenarios. TeraExchange is a provisionally registered swap execution facility, but its permanent SEF registration is still pending.
In an email to a trading firm, and in later separate correspondence with the CFTC’s Division of Market Oversight and the NFA, TeraExchange said the offsetting Bitcoin trades were intended to “test the pipes.” But other facts uncovered by the CFTC suggested the trades were pre-arranged to spur public interest in TeraExchange’s virtual currency prowess.
TeraExchange had arranged for two unnamed firms to execute the first ever Bitcoin swap transactions on a regulated exchange. Technically speaking, the trade involved a non-deliverable forward contract that followed the relative values of Bitcoin and the U.S. dollar. As part of a round-trip trade, one firm agreed to buy, and then sell, a Bitcoin swap with a notional value of $500,000, as fixed by reference to the Tera Bitcoin Index. The trades happened merely six minutes apart.
The CFTC said TeraExchange had Skype calls with the two trading firms as their offsetting trades were executed despite the exchange’s “onboarding” requirements for traders and its rulebook, which ban fictitious or wash trades. The day after the trade, TeraExchange issued a press release touting the first Bitcoin swap transaction, while its then-president boasted of the prior day’s trades while attending a meeting of the CFTC’s Global Markets Advisory Committee.
Core principles. The nascent SEF marketplace has had its share of ups and downs as firms try to launch their trading venues and swaps regulators, like the CFTC, try to fine tune their rules. Just today, Commissioner J. Christopher Giancarlo reiterated his wider concerns about the CFTC’s SEF rules in a speech unrelated to the TeraExchange order.
But despite SEFs’ bumpy road, the charges against TeraExchange involved an old transaction type that is not unique to SEFs, although it implicates the Commission’s core principles for these venues. The core principles, which are a pre-condition to SEF registration, mandate firms to adopt policies to prevent and detect abusive trading practices. Related CFTC guidance clarifies that banned practices include wash trading.
Elsewhere, the Commodity Exchange Act explicitly bans wash trades. The problem with wash trades is that the parties to them do not intend to take bona fide market positions that would otherwise produce legitimate changes in the parties’ financial positions. The CEA also bans pre-arranged trades that can appear on the open market, but without the attendant risk of price competition. The CFTC’s order emphasized that TeraExchange’s self-certification of the Bitcoin swap to the agency indicated its consent to follow the agency’s rules prohibiting wash trades and pre-arranged trading.
The release is No. 15-33.