What is Wash Trading?

Wash trading is a market manipulation technique where investors buy and sell securities (a fungible and negotiable financial instrument with value) in order to manipulate the market. The U.S. Securities and Exchange Commission(SEC) deems wash trading illegal. It is also known as round-trip trading.

Wash trading can be carried out by an individual or a firm to increase trading volume artificially. This way, the securities become more appealing to the market traders and can lead to undesirable results in favor of the manipulator.

However, brokers can carry out wash trading unknowingly. That is why they require a complete understanding of wash trading. Additionally, wash trading can let traders show losses, enabling them to benefit during tax returns. That is why the Internal Revenue Service(IRS) dictates that investors cannot deduct losses from wash trading from taxable income. Currently, IRS has put a 30-day window from the date of purchase, where investors cannot claim for loss due to buying and selling of a security.

Regulated markets benefit from these regulations, but what about cryptocurrency trading? We will discuss wash trading in cryptocurrency later on in the article.

Motivations Behind Wash Trading

To truly understand wash trading, we need to understand the motivations behind the investors carrying out wash trading. An investor can wash trade:

• To manipulate the market by feeding it with false information by artificially boosting the security position in the market.
• To make other investors believe that the security trades at a higher volume.
• To manipulate security prices to go higher or lower temporarily.
• To benefit from tax rebates by locking capital loss and buying a lower price.

Wash Trading Brief History

So, how did wash trading start? Before the 1930s, wash trading was very common among traders. However, the regulators identified the trend and learned how investors use wash trading to manipulate the market, gain an unfair advantage and make money.

In 1936, the federal government passed the Commodity Exchange Act to stop wash trading. It amended the Grain Futures Act, which meant wash trading got banned. It enforced regulated exchanges to do commodity trading based on new acts.

The Commodity Futures Trade Commissions(CFTC) stopped wash trading by brokers by putting the onus of responsibility on brokers even when they don’t know about the trader’s intentions.

In 2013, wash trading became popular again, where super-fast computers carried out high-frequency trades. These computers can carry out thousands of trades per second. Firms with good infrastructure are more likely to carry out high-frequency trading. To ban firms from high-frequency trading, Bart Chilton, the Commissioner of the Commodity Futures Trading Commission, investigated firms. In 2014, SEC charged Wedbush Securities for failing to secure their platform correctly, allowing users to do high-frequency trades.

How Does Wash Trading Work and How to Identify It?

Wash trading occurs when an investor acts as both the seller and buyer to execute a wash trade. This leads to an increased yet false trading volume which can have an undesirable impact on the market. Wash trading can also be termed as insider trading as it requires more knowledge about the asset, giving an advantage to the trader.

Let’s take an example. An investor owns 100 shares of a particular company. He sells all this inventory for that particular company and incurs a loss of $500. Next, he buys back the 100 shares and gains a $1000 profit. For now, wash trading has not occurred. However, IRS defines the practice as wash trading if the investor claims a tax deduction for his $500 loss when filing taxes.

To protect yourself from wash trading, you need to keep the wash sale window of 61 days in mind, i.e., 30 days before the sale, 30 days after the sale, and the day on which the sale is made.

Additionally, to identify a wash trade, you need to learn about two conditions. These two conditions need to be met for a wash trade to take place.

• Intent: For a wash trade to happen, one of the involved parties (broker or investor) needs to have the intent to do a wash trade.
• Result: If the trade takes place instantaneously (buying and selling) or within the suggested short span, then the trade is termed a wash trade.

Wash Trading In Cryptocurrency markets

Wash trading in cryptocurrency is very common. There are many reasons for it. The biggest reason is how crowded the cryptocurrency market is. You can find thousands of tokens with new tokens added almost every single day. As cryptocurrency is mostly unregulated, it gives investors an easy way to do wash trading, especially when it is a new or hyped token.

By doing wash trading, investors temporarily improve the crypto asset’s market position, luring new investors. Once it reaches a certain price, the investor sells his shares, making a huge profit. This profit-making process by temporarily increasing token value is also known as the pump-and-dump scheme. The pump-and-dump scheme combines insider information, inflated trading volumes, and general social sentiment toward the token. You can take Dogecoin crypto as a prime example when it was hyped and increased in price, only to get dumped later on.

Another significant reason for crypto wash trading is unregulated cryptocurrency platforms. This means investors can create multiple accounts and use bots for wash trading. Even the most famous crypto, Bitcoin, is not safe from wash trading.

In summary, cryptocurrency is susceptible to wash trading because:

• Not all cryptocurrency platforms are regulated;
• Lack of acceptable methods to calculate daily trading volumes;
• Extreme volatility incentivizes rapid buying and selling;
• Lack of proper local government laws related to crypto trading.

NFT Wash Trading

NFTs, also known as non-fungible tokens, are not safe from wash trading. Before we discuss how it is done, let’s learn what an NFT is.

NFTs are similar to crypto. They’re digital and reside on the blockchain. However, cryptos are fungible assets with exchange capability without the need to be unique. Similarly, fiat is fungible. NFTs, on the other hand, are non-fungible as they are unique. This means that only one copy of a said NFT and only one person can own and store it on blockchain at any time.

You can think of yourself as an NFT as you’re unique, and there is not a single person in the world like you (even if you have a twin, as each person has unique biometric data).

In short, NFTs are owned by a single person and stored on the blockchain. On the ownership side, you can either create an NFT or buy it from someone else.

NFT wash trading occurs when the owner or creator sells the NFTs to himself at an inflated price. This gives false and misleading information to the marketplace, giving others an illusion of more value. The owner/creator can repeat the process until an outsider buys it. Ultimately, he makes a profit by gaming the system with wash trading.

Cryptopunk 9998 example

One prominent example is the Cryptopunk 9998. The NFT was traded among two wallets with total purchase power of 124,47 ether (ETH). At that time, it meant a transaction of $532 million. The CryptoPunks bot always announced the transaction on Twitter, making matters worse.

However, how did the owner get access to so much ETH? He took a flash loan of 124,457 ETH and made the smart contract transaction, transferring the Cryptpunk 9998 to the seller’s wallet. Once the transaction was done, he repaid the loans.

The CryptoPunks team learned about the suspicious activity of wash trading and nulled the transaction to protect potential buyers.

Conclusion

Wash trading is an illegal act of manipulating the market to make profits. It is banned by IRS and other regulatory firms across the world. However, lack of knowledge also leads to unintentionally doing wash trading. We hope you learned a lot about wash trading and can use the information for trading responsibly. Happy trading!

Frequently Asked Questions (FAQ)

Q: What Is Wash Trading?

A: Wash trading is a market manipulation tactic where investors buy and sell securities by themselves or with the help of others. This leads to market manipulation and is hence deemed illegal by the SEC.

Q: Is Wash Trading Legal?

A: Wash trading is illegal. However, there are fine lines that make trading securities complex. For example, what if the securities are sold to others? As a trader or investor, it is important to study wash trading carefully so that you don’t fall victim to it incidentally. The best way to avoid a wash trade is to identify tax losses and think twice before buying or selling a particular security, especially within the 61-day wash trade period, 30-days before and 30-days after the sale, and the day when you made the trade.

Q: What are the motivations behind doing Wash Trading?

A: In most cases, it is to improve the position of the security in the market. It requires either an investor or broker to do the trade or requires collaboration from both seller and buyer. It inflates the trading volume and can send positive signals to other buyers in the market.