Wash Trading is when a trader or investor buys and sells the same security over a short period of time in an attempt to mislead other market participants as to the price or liquidity of the asset. In the securities markets, “Wash Trading” is illegal, but the crypto industry has yet to set rules.
In this article, we will discuss what laundering is, how it works, where it is often used in the cryptocurrency markets – and how to avoid falling victim to it.
What is "Wash Trading"?
Wash Trading defines a sell where the trader sells an asset and then buys it back around the same time that he sold it.
Deals can be used as a form of market manipulation. An investor buys and sells the same asset in rapid succession in an attempt to influence the price or trading activity.
There are several reasons why a trader or company wants to participate in "Wash" trades. The goal may be to stimulate buyer activity to raise prices, or to stimulate sales to lower prices. Another motivation could be that the trader is trying to use "such" selling to lock in capital losses and then buy the asset at a lower cost, essentially seeking a tax credit.
Even though there may be several different traders, companies and accounts involved in Wash Trading, the motivation is the same. Its purpose is to mislead, increasing the perception of the price and volume of the traded financial asset.
How does Wash Trading work?
At a basic level, "Wash Trading" is the simultaneous purchase and sale of an asset by an investor. However, the real money laundering trade goes further, taking into account the intentions of the investor.
Therefore, two conditions are usually met to confirm a laundering trade.
- First condition is the intention. A trader must have a specific strategy for buying and selling the same asset in advance. Again, the "laundering" trade is conducted with the aim of misleading. As a result, it takes multiple accounts to try to mislead.
A trader or firm trades the same asset but uses different accounts to achieve price changes or increased trading volume. The account with the asset will sell the asset to another account of the laundering trader.
- Second condition is the result. The result of the trade should be a washout trade where an investor bought and sold the same asset at the same time using accounts that have the same or common ownership.
One way to determine if a "laundering trade" is taking place is to check the investor's financial position. If the transaction does not change the general position of the investor and does not expose him to any market risk, then it can be considered a “laundering” transaction.
An example of a Wash Trading trade
Let's say we have a stock trader named Joe and a brokerage firm conspiring to quickly buy and sell ABC stock. The idea is that other investors will notice the activity in ABC shares and decide to invest in ABC. When these investors buy ABC, the price rises and Joe profits from the rise. “Joe” then shorts ABC stock, lowering the price and profiting from the downtrend.
“Laundering trade” is also suspected in cryptocurrencies, especially in an environment where regulators are in no hurry to regulate its existence. In 2017 and 2018, when blockchain projects raised money through ICOs (Initial Coin Offerings), crowdfunding proceeds could return to exchanges to show an increased level of interest in a new project.
For example, large investors of the XYZ crypto project can buy some more XYZ cryptocurrency from this project using several addresses. After they purchase additional XYZ, they will transfer the same amount of XYZ to the exchanges. At that point, they convert XYZ to Ether and use that Ether to buy more XYZ. This behavior continued for some time, while they used several addresses in an attempt to hide their intentions.
Third party investors would see increased interest and XYZ volume and then decide to buy the project in the long run. This additional interest from long-term outside holders drives up the price of XYZ. The insider then sells a portion of their XYZ cryptocurrency for a profit. Essentially, large XYZ investors are using a "laundering trade" to mislead others about a speculative interest in a project - in order to end up dumping their stake at a profit.
Wash Trading and Market Creation: Differences
At first glance, it may seem that “washing” and market making are one and the same.
Marketmaking is the buying and selling of the same amount of an asset at the same time, but possibly in different places. For example, a Bitcoin market maker might offer a trader to buy it on one exchange for $49. Then, when the investor decides to buy 300 bitcoin that the market maker sold him, the market maker will turn around and quickly buy 0,01 bitcoin for $0,01 on another exchange. The market maker will remain in the red, but will profit from the spread and the difference in Bitcoin prices.
The key difference between market making and money laundering is intent. A market maker provides a service by making an asset freely available for purchase and sale by other investors. Therefore, other investors participate in market-making transactions. The market maker allows his cryptocurrency to be available for purchase by someone else (whom he doesn't know).
On the other hand, "laundering trade" is when the only "parties" in the transaction are accounts with common property. The money laundering trader uses beneficial and common ownership accounts as “parties” of the transaction. In this way, the "wash trader" is actually trading with himself - and with no one else. There is no immediate benefit as a result, other than misleading others about the price or volume of a financial asset.
How does Wash Trading work in NFTs?
NFTs, or non-playable tokens, have recently come under scrutiny in connection with laundering trade. First, let's look at how NFTs differ, and then we will describe how laundering trading with NFTs can take place.
What makes NFT different from Bitcoin or Ethereum?
To understand what an NFT is, we need to start with the concept of a “swapable token”. A swap token is an asset that can be exchanged like one for another. Fiat currency is fungible. You and I can exchange 10 dollar bills, and each of them will have the same value.
NFTs are different in that each one is unique. Real estate is unaffordable. You and I can have the same floor plan of two houses located on the same street in the same area. However, your home may have been upgraded and may be in better condition. Therefore, if we just exchanged houses, it would not be an equal exchange.
In cryptocurrency, an NFT is simply something unique whose owner and other data is stored on the blockchain. The number of NFTs that can be bought and collected is skyrocketing.
If you are an NFT creator, you need a way to allocate your NFT so that people can buy it from you and you can make a profit. For this reason, wash trading has entered the scope of the NFT.
The money trader buys and sells his own NFT in such a way that it shows inflated volume and interest, and possibly an increase in price. (The money trader controls the bid and ask prices - so he can buy it at a higher price from himself.) This behavior can be repeated over and over again.
As a result, outsiders seeing this increased activity may consider purchasing NFTs at an inflated price. Once the NFT is sold to a third party, the creator of the NFT gets the difference.
Chainalysis recently conducted a study on this topic and found 110 wallet addresses that generated $8,9 million in profits from active soap trading.
Is "Wash Trading" legal?
No. The Commodity Exchange Law prohibits "Wash Trading" trading. Prior to its adoption, traders often used “laundering trading” to manipulate markets and share prices. The Commodity Futures Trading Commission (CFTC) also enforces “washed trading” rules, including regulations that prohibit brokers from profiting from “washed trading”.
The IRS also has rules regarding "washed" transactions. These rules prohibit investors from deducting capital tax losses (from the sale or trading of securities) that result from "washed" sales. For example, traders who use “washed” stock trades to avoid paying taxes will still be in debt.
However, regulations regarding cryptocurrencies have not yet come down to us. The Securities and Exchange Commission (SEC) is showing interest in cryptocurrencies. However, NFTs are not considered securities because they are not easily marketable and are outside the SEC's purview.
Similarly, the IRS considers cryptocurrencies to be property, not securities. Until regulators figure out whose jurisdiction is to supervise cryptocurrencies, there is a risk of “laundering trading” and, therefore, misleading price and volume data.
How to Avoid Participating in Wash Trading
Wash Trading is more prevalent in smaller and newer markets than in larger, more established markets. This is because small markets are easier to manipulate.
A big whale can easily move the market for small or micro-cap cryptocurrencies, since the size of its balance sheet can be comparable to the value of the cryptocurrency itself. In the case of small cap cryptocurrencies, by simply buying and selling a little, some bots wake up and create more volume in the market.
In addition, new coins that appear on the market do not have a history of prices and volumes. Therefore, developers or other insiders may engage in “laundering” trading in order to mislead participants about the true value of the coin.
Finally, many NFTs have neither the volume nor the interest to trade them. Therefore, owners of NFTs can easily engage in a laundering trade to lure unsuspecting buyers into buying NFTs at an inflated price. The best defense against money laundering is to avoid new issuances, small cap cryptocurrencies and NFTs.
To avoid falling victim to a “laundering trade” incident, lean towards more established cryptocurrencies with high trading volume. The larger the market, the more funds are required by unscrupulous players to manipulate the market. As you can imagine, this is extremely difficult to do in such large markets as Bitcoin or Ethereum, which are worth hundreds of billions of dollars.
The more market capitalization cryptocurrencies, the more exchanges will trade it. This allows for better pricing. For example, if one exchange allows "laundering" transactions, then arbitrageurs will absorb any difference in prices on other exchanges. The larger the cryptocurrency, the more likely it is that there will be several exchanges operating in this market, which allows arbitrage between different platforms to bring prices in line.
Finally, look for markets that have been trading for a long time. In this way, you will be able to compare the current volume of transactions with the history of this cryptocurrency. This comparison will show if there are extreme volumes on the market that can mislead participants.
Any good trader or investor has a plan and strategy for their trades. Having a process and a repetitive method for entering trades and positions – coupled with a process for a trade exit strategy – is what brings consistency to trading. In your trading plan, also be sure to consider the age and size of the cryptocurrency.
Сonclusion
Wash Trading implies the intention to mislead and deceive market participants regarding the price of an asset and / or the volume of transactions made. In cryptocurrencies – and especially in less liquid NFTs – “laundering trading” is common as regulations have not yet caught on to this new asset class.
Until the rules are updated, you may not fall victim to “wash” traders by trading in crypto markets that are larger and have a longer price history.