What Is Wash Trading?
Wash trading, also known as round-tripping, is a form of market manipulation done when an investor buys a financial instrument and sells it back to himself many times. This increases the instrument’s trade volume, creating the illusion that the asset is worth more than it actually is. Consequently, unsuspecting investors buy such assets only to realize they are not worth as much as they thought.
While wash trading is done by an individual, round-tripping can be done by one person buying and selling the same security within the same trading day or by two companies selling securities to themselves and agreeing to repurchase them at about the same price.
In this article, we’ll discuss wash trading, how it works, where it’s commonly used within crypto markets, and how to avoid falling prey to it.
Working Principle of Wash Trading
At a basic level, a wash trade is an investor buying and selling an asset at the same time. However, an actual wash trade goes further, taking into account the investor’s intent.
Therefore, two conditions are generally met to confirm a wash trade.
The first condition is intent. The wash trader must have had a specific strategy to buy and sell the same asset ahead of time. Again, wash trading is conducted in an effort to mislead. As a result, multiple accounts are needed to try to pull off the misrepresentation.
The trader, or firm, will make transactions on the same asset but will use the different accounts to result in changed prices or increased trading volume. The account with the asset will sell the asset to another account of the wash trader.
The second condition is the result. The result of the transaction must be a wash trade, where the investor has bought and sold the same asset at the same time, using accounts that have the same or common ownership.
One way to determine if wash trading is taking place is by inspecting the financial position of the investor. If the trade doesn’t change the investor’s overall position or expose them to any type of market risk, then it can be considered a wash.
A wash trade scenario
Let’s assume we have a stock trader named Joe, and a brokerage firm colluding to rapidly buy and sell stock in the company ABC. The idea is that other investors will notice the activity on ABC stock, and will decide to invest in ABC. As these investors buy ABC, the price rises, and Joe profits from the rally. Then, “Joe” short-sells ABC stock, driving the price lower and profiting from the downward price trend.
Wash trading has been suspected in cryptocurrencies, too, especially with regulators slow to regulate its existence. Back in 2017 and 2018, when blockchain projects would raise money via ICOs (initial coin offerings), the crowdfunding revenue could be recycled back to the exchanges to show a bolstered level of interest in the new project.
For example, large investors within a crypto project, XYZ, might buy some more XYZ crypto from that project using multiple addresses. Once they’ve acquired additional XYZ, then they would transfer the same amount of XYZ to the exchanges. At that point, they would convert XYZ to Ether and use that Ether to buy more XYZ. This behavior would continue for some time, using multiple addresses in an attempt to disguise their intent.
Outside investors would see the increased interest and volume in XYZ, then decide to buy into the project long-term. This additional interest from outside holders with long-term intent increases the price of XYZ. Then, the insider would sell some of their XYZ cryptos at a profit. In essence, the large investors of XYZ use wash trading to mislead others about the speculative interest in the project so they can eventually dump their holding at a profit.
According to Chainalysis’ 2022 Crypto Crime Report, a significant amount of criminal activity was associated with NFTs in 2021. The two illicit activities related to NFTs include wash trading artificially increasing the value of an NFT and money laundering through the purchase of NFTs.
How Does NFT Wash Trading Happen?
A wash trader would buy and sell their own NFT so that it will show inflated volume and interest and possibly a price increase. (The wash trader controls both the buy and sell prices so they can buy it at a higher price from themselves.) This behavior can be repeated over and over.
As a result, outsiders seeing this increased activity might consider buying the NFT at an inflated price. Once the NFT is sold to an outsider, the NFT creator pockets the difference.
Recently, Chainalysis completed research on this topic and found 110 wallet addresses that profited a combined $8.9 million from active wash trading.
A pictorial example of a wash trade
Is Wash Trading Legal?
NO. The Commodity Exchange Act prohibits wash trading. Prior to its passage, traders commonly used wash trading to manipulate markets and stock prices. The Commodity Futures Trading Commission (CFTC) also enforces regulations regarding wash trading, including guidelines that bar brokers from profiting as a result of wash trading activity.
The IRS also has rules regarding wash trades. These rules disallow investors from deducting capital losses on the taxes (from sales or trades of securities) that result from wash sales. For example, traders who are using wash trades in stocks to skip out on a tax bill will find themselves still owing the tax bill.
However, the regulations for crypto have not caught up yet. The Securities and Exchange Commission (SEC) has been taking an interest in cryptocurrencies. However, NFTs are not considered securities, because they’re non-fungible and are outside the purview of the SEC.
Likewise, the IRS considers crypto to be property, not securities. Until such time that the regulators figure out whose jurisdiction applies to overseeing crypto, there’s the risk of wash trading —and, therefore, of misleading price and volume data.
How to Avoid Wash Trading Scam
Wash trading is more prevalent in smaller and newer markets than in the larger, more established markets. This is because smaller markets are more easily manipulated.
A big whale can easily move the market in small- or micro-cap crypto, as the size of their balance sheet can be comparable to the value of the crypto itself. With small-cap crypto, just buying and selling a little bit will trigger some bots to “wake up” and generate more volume in the market.
Additionally, new coins that are added to the market won’t have any price or volume history attached. Therefore, developers or other insiders might engage in wash trading to mislead participants about the true value of the coin. That is why at bitget we introduced the Bitget Launchpad to mitigate this issue and ensure compliance with trading rules to prevent a wash trade.
Many NFTs have no volume or interest in their trading. Therefore, NFT owners can easily engage in wash trading to lure unsuspecting buyers into purchasing the NFT at an inflated price. The best defense against wash trading is to avoid new issues, small-cap cryptos, and NFTs.
To avoid being the victim of a wash trade incident, lean toward more established, larger volume cryptocurrencies. The larger the market is, the more funding is needed for nefarious players to manipulate the market. As you can imagine, this is extremely difficult to do in large markets like Bitcoin or Ethereum, which are worth hundreds of billions of dollars.
The larger the crypto market cap, the more exchanges will be dealing in it. This effectively allows for better price discovery. For example, if one exchange is allowing wash trades, then arbitrageurs will siphon away any difference in pricing with other exchanges. The bigger the cryptocurrency, the more likely there will be several exchanges dealing in that market which allows arbitrage opportunities between the different venues to bring pricing back in line.
Lastly, seek out those markets with an established track record of trading. That way, you can compare the volume of transactions now to that crypto’s history. This comparison will indicate whether extreme amounts of volume have entered the market, possibly misleading participants.
Any good trader or investor will have a plan and a strategy for their trades. Having a process and repeatable method to enter into trades and positions coupled with a process for an exit strategy on the trade is what brings consistency to trade. In your trading plan, also be sure to consider the age and size of the cryptocurrency.
NFT wash trading is sort of like a WhatsApp vendor sending you money to buy their products to make it seem like they’re making sales. In the case of NFTs, however, one person can easily finance multiple wallets they own to purchase their listed NFTs.
To check the transactions an NFT has gone through on a marketplace like OpenSea, go to the item activity tab below the NFT, and you’ll see the details of how the NFT has been bought and sold from several addresses. For more information on the NFT, click the diagonal arrow under the date column, and it takes you directly to the blockchain on which that NFT exists. You can go further by looking into the individual activity of each address associated with the NFT.
Disclaimer: All products and projects listed in this article are not endorsements, and are provided for informational purposes only.
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