Wash Trading is when a trader or investor buys and sells the same security within a short period of time in an attempt to mislead other market participants about the price or liquidity of the asset. In the securities markets, Wash Trading is illegal, but the crypto industry has yet to establish rules.
In this article, we'll discuss what wash trading is, how it works, where it's often used in cryptocurrency markets - and how to avoid becoming a victim.
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 motivations for a trader or company to engage in a Wash trade. The goal may be to stimulate buying activity to drive prices up, or to stimulate selling to drive prices down. Another motivation may be that the trader is trying to use the Wash to lock in a capital loss and then buy the asset at a lower cost, essentially seeking a tax rebate.
Although Wash Trading may involve several different traders, companies and accounts, the motivation is the same. The goal is to mislead by increasing the perception of the price and volume of the financial asset being traded.
How does Wash Trading work?
At its most basic level, Wash Trading is the simultaneous purchase and sale of an asset by an investor. However, true wash trading goes further, taking into account the investor's intentions.
Therefore, to confirm a money laundering trade, two conditions are usually met.
- First condition — is the intention. The trader must have a specific strategy for buying and selling the same asset in advance. Again, wash trading is done with the intention of misleading. As a result, multiple accounts are required to attempt 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 — This is the result. The result of the transaction should be a "wash" trade, where the investor bought and sold the same asset at the same time, using accounts that have the same or common ownership.
One way to determine whether a wash trade is taking place is to examine the investor's financial position. If the trade does not change the investor's overall position or expose them to any market risk, it can be considered a wash trade.
An example of a Wash Trading trade
Let's say we have a stock trader named Joe and a brokerage firm who conspire to quickly buy and sell shares of ABC. The idea is that other investors will notice the activity in ABC stock and decide to invest in ABC. When these investors buy ABC, the price goes up, and Joe profits from the rise. "Joe" then shorts ABC, driving the price down and profiting from the downward price trend.
Cryptocurrencies are also suspected of being subject to “wash trading,” especially in an environment where regulators are slow to regulate their existence. In 2017 and 2018, when blockchain projects raised money through ICOs (initial coin offerings), crowdfunding proceeds could be returned to exchanges to show increased interest in the 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.
Outside investors would see the increased interest and volume in XYZ and then decide to buy into the project for the long term. This additional interest from outside holders with long-term intentions drives up the price of XYZ. The insider then sells some of his XYZ cryptocurrency for a profit. Essentially, large XYZ investors are using “wash trading” to mislead others about the speculative interest in the project — so they can ultimately flip their stake for a profit.
Wash Trading and Market Creation: Differences
At first glance, it may seem that “washing” and market making are the same thing.
Market making is the act of buying and selling the same amount of an asset at the same time, but possibly in different locations. For example, a Bitcoin market maker might offer a trader the opportunity to buy it on one exchange for $49. Then, when the investor decides to buy the 300 Bitcoin that the market maker sold them, the market maker will turn around and quickly buy the 0,01 Bitcoin for $0,01 on another exchange. The market maker will end up in the red, but will make a profit from the spread and the difference in Bitcoin prices.
The key difference between market making and wash trading is the intent. A market maker provides a service by making an asset freely available for other investors to buy and sell. Therefore, market making transactions involve other investors. The market maker allows their cryptocurrency to be available for purchase by someone else (whom they do not know).
On the other hand, a wash trade is when the only "parties" to a transaction are the jointly owned accounts. The wash trader uses the beneficial and jointly owned accounts as the "parties" to the transaction. In this way, the wash trader is effectively trading with himself - and 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 “fungible token.” A fungible token is an asset that can be exchanged one for another. Fiat currency is fungible. You and I can exchange $10 bills, and each 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 purchased and collected is growing rapidly.
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.
A wash trader buys and sells their own NFT so that it shows inflated volume and interest, and possibly a price increase. (The wash trader controls the buy and sell prices, so they can buy it at a higher price from themselves.) 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 made $8,9 million in profits from active soap trading.
Is Wash Trading Legal?
No. The Commodity Exchange Act prohibits "wash trading." Before the act, traders often used "wash trading" to manipulate markets and stock prices. The Commodity Futures Trading Commission (CFTC) also enforces rules regarding "wash trading," including regulations that prohibit brokers from profiting from "wash trading."
The IRS also has rules regarding washed trades. These rules prohibit investors from deducting capital 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 owe money.
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.
Likewise, the IRS considers cryptocurrencies to be property, not securities. Until regulators figure out whose jurisdiction it is to oversee cryptocurrencies, there is a risk of “wash trading” and, therefore, unreliable 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 large whale can easily move the market of a small or micro cap cryptocurrency, as the size of its balance can be comparable to the value of the cryptocurrency itself. In the case of small cap cryptocurrencies, simply by buying and selling a little, some bots “wake up” and create more volume in the market.
Additionally, new coins that appear on the market have no price or volume history, so developers or other insiders may engage in wash trading to mislead participants about the true value of the coin.
Finally, many NFTs have neither volume nor interest in trading them. Therefore, NFT owners can easily engage in wash trading to lure unsuspecting buyers into purchasing NFTs at inflated prices. The best defense against wash trading is to avoid new issues, small-cap cryptocurrencies, and NFTs.
To avoid becoming a victim of a wash trading incident, stick to more established cryptocurrencies with higher trading volumes. The larger the market, the more funds it takes for bad actors 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 more market capitalization cryptocurrency, the more exchanges will trade it. This allows for better price discovery. For example, if one exchange allows laundering, arbitrageurs will absorb any price differences on other exchanges. The larger the cryptocurrency, the more likely it is that multiple exchanges will operate in that market, allowing for arbitrage between different venues to bring prices into 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 repeatable method for entering trades and positions – coupled with a process for a trade exit strategy – is what brings consistency to trading. Make sure to also factor in the age and size of the cryptocurrency in your trading plan.
Сonclusion
Wash trading involves the intent to mislead and deceive market participants about the price of an asset and/or the volume of trades being made. In cryptocurrencies — and especially in less liquid NFTs — wash trading is common because regulations have not yet reached this new asset class.
Until the regulations are updated, you can avoid becoming a victim of laundering traders by trading in crypto markets that are larger in size and have a longer price history.