John Lothian Commentary: Painting the Tape

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Painting the Tape, Washing Trades, or Building Markets

by John J. Lothian

Published November 25, 2002 in John Lothian Newsletter

Painting The Tape. I have heard that phrase used several times in the last week to describe various trading activities going on at different futures exchanges. What exactly is Painting the Tape and what does it mean in today's world?

Painting the Tape is described by equity-focused sources as "an illegal practice where manipulators buy and sell a security among themselves to create artificial trading activity. The succession of trades reported on the ticker tape lures in unwary investors because of the unusual volume."

How many times have you heard someone on CNBC say heavy volume on a stock moving up is a bullish sign? It can be. But it can also be used by the unscrupulous to trap unsuspecting traders into paying much too much for a stock because of the manipulative activity. There in lies a problem, especially for the momentum trader.

Painting the Tape is also confused sometimes with Wash Sales. According to the CFTC web site, Wash Sales are "transactions that give the appearance of purchases and sales but which are initiated without the intent to make a bona fide transaction and which generally do not result in any actual change in ownership. Such sales are prohibited by the Commodity Exchange Act."

One could use Wash Sales to Paint the Tape. Or, one could use Wash Sales to try to avoid taxes. Sometimes traders have been found guilty of Wash Trades to make it seem like there is a lot more trading going on in a particular market than there really is. It is hoped that the manipulated volume will give the market legitimacy and will attract other traders. We saw alleged instances of this with Enron and many of the other energy market participants who have filled the headlines in recent months with confessions of their (perhaps legal) malfeasance. In some circles this is called "Round Trips." A Round Trip is really a Wash Trade intended to Paint the Tape, but laws vary from market to market about its legality.

Some define Painting the Tape as trading from Market Maker to Market Maker. That is probably because in the equity world the parties found guilty of Painting the Tape were perhaps Market Makers looking to unload some stock they owned on non-Market Maker traders. I think the key to focus on here is the intent to unload inventory of something through manipulative means. I don't believe that means any Market Maker to Market Maker trading is Painting the Tape. Or if it does, then such a definition would have to be wide enough to describe illegal and legal instances of Painting the Tape.

In fact, the recent move (pending regulatory approval) by the International Securities Exchange to open their order execution facilities to all classes of traders will allow for greater Market Maker to Market Maker trading. There is no discriminating against Market Maker orders any more. But this increased Market Maker to Market Maker trading is not intended to manipulate the market, rather to even the playing field for all classes of traders. It is meant to increase the surety of trading for all traders.

In regards to fees at NASDAQ LIFFE Markets, there are two types of traders, market makers and market takers. A market maker is someone, professional or public trader, who provides a bid or an offer. A market taker, professional or public trader, is someone who hits the bid or offer and takes the trade. At NQLX, a market maker does not pay fees, a market taker does.

The heavy concentration of professional Market Maker to Market Maker trading so far in Securities Futures has some calling much of the trading Painting the Tape. However, while the Market Makers are trying to build these markets by demonstrating these contracts are liquid, there is no dumping of inventory or manipulative trading that I can see. I see competitive, transparent markets with a high concentration of professional Market Makers. Thus, I don't think the narrow definition of Painting the Tape is applicable.

Futures are an inherently different product than standard equity securities. For one, the potential volume of trade is not tied to owning or borrowing the shares if you want to sell, or having to wait for an up tick to sell short. Futures are more of a two-sided market. There are also no specialists to set prices. There are market makers, but the electronically traded Central Limit Order Book function of both OneChicago and NQLX means anyone can have the best bid or best offer and will get all or a portion of their order filled when an opposing order hits the market.

Securities Futures represent the most level playing field for securities trading that exists today, in my opinion. With no uptick rule to short, no borrowing costs to short or go long on margin, transparent prices including depth of market, quick electronic trading, and the latest and greatest online access, Securities Futures are a more open and level playing field.

This level playing field, transparency, openness and the fact that Security Futures volumes are dwarfed by cash equities volumes makes it unlikely that some unscrupulous parties would find value in illegally Painting the Tape in order to attract attention to a particular Securities Futures contract to unload their inventory on unwary investors.

The fact that the Security Futures contracts listed are among the most active and most well-capitalized companies also reduces the utility of trying to illegally Paint the Tape with Security Futures. It is much more likely to occur in a little known, thinly traded decentralized cash equity market with few Market Makers participating in the stock than in the electronically traded centralized Security Futures markets.

If there is real risk being taken on by a trader executing a trade, then this is not Painting the Tape. It does not matter if it is Market Maker to Market Maker trading. Real risk means it is not a wash trade. Real risk means real trading, not Painting the Tape.

Market building activity takes time, patience and real work and this is reflected in a wide distribution of growing open interest amongst a number of types of traders and different firms. That is the type of trading I see in Security Futures.

For the futures markets, the quick and easy way of Wash Trades and Painting the Tape means highly concentrated trading between few parties with little growth in open interest. Beware of such activity.

It is easy to see how in this post-Enron world many markets are being painted with similar broad strokes. The key difference in the marks made to the tape is in the way the brush is used productivity, not the way it is manipulated.