Wash trading is a situation where a trader or investor buys and sells the same asset in a short period of time. This is an attempt to mislead other market participants about the price or liquidity of the asset.
In this article, we will discuss what wash trading is, including how it works and how to avoid falling into it. Let’s take a closer look below.
What is Wash Trading?
Wash trading can be defined as a condition where a trader sells an asset and then buys it back at the same time as the selling process. Simply put, an investor will simultaneously buy and sell the same asset in an attempt to influence the price or trading activity. That is why this method is often used as a form of market manipulation.
Even though it involves several different traders, companies, and accounts, they all basically have the same motivation. One of them is to spur purchasing activity by raising prices while at the same time encouraging sales. Another motivation is to avoid capital losses.
So, it can be concluded that wash trading aims to mislead the market by increasing the perception of the price and volume of the financial asset being traded.
How Does Wash Trading Work?
In general, wash trading occurs when investors buy and sell assets at the same time or within a short time interval. There are two general conditions that must be met to confirm the occurrence of this practice.
The first condition is intention. Wash traders must have a specific strategy for buying and selling the same asset. Once again, wash trading is done as an attempt to mislead the market. It is not uncommon for multiple accounts to try to misrepresent the market in this way.
Traders or companies will make transactions on the same assets but using different accounts. The goal is to result in a change in price or an increase in trading volume. Later, some of these accounts will sell assets to other accounts belonging to wash traders.
The second condition is the result. In this case, it is the result of the transaction where investors have bought and sold assets at the same time using a jointly owned account.
One way to determine the occurrence of wash trading is to examine the financial position of the investor. If trading activity does not change the investor’s overall position, it can be considered a form of wash trading.
Example of Wash Trading
In 2017 and 2018, when blockchain projects raised money through ICOs (initial coin offerings). Crowdfunding revenue could be recycled back to exchanges to show the level of interest supported in new projects.
For example, there is a large investor involved in the XYZ crypto project. They then make multiple purchases of XYZ crypto from the project using several different addresses. After acquiring a large amount of XYZ crypto, they transfer that same amount of XYZ to the exchange.
Then, they convert XYZ to Ether and use it to buy more XYZ crypto. This behavior continues for some time using various addresses in an attempt to disguise their intent.
Later, other investors see increased interest and volume in XYZ, so they decide to buy the project long-term. It’s the additional interest from outside investors that can then drive up XYZ’s price.
In essence, big XYZ investors are using wash trading to mislead others about the speculative interest in the project.
Wash Trading vs Market Making: The Difference
Market making is the activity of buying and selling assets simultaneously in the same amount but in different locations. For example, the Bitcoin market maker allows a trader to buy on one exchange for $49,300. Then, there is an investor who wants to buy 0.01 Bitcoin that the market maker sells to them.
Later, the market maker will quickly buy 0.01 Bitcoin for $49,200 on another exchange and then sell it to the investor. So, the market maker will benefit from the difference in the price of Bitcoin.
At first glance, wash trading and market making may appear to be the same thing. However, they have some differences. The main difference is intent. Market makers provide assets to be bought and sold to other investors, so other investors are involved in this market-making transaction. In contrast, in wash trading, the parties involved in the transaction are accounts with joint ownership. Later, wash traders will use the shared ownership account as a party involved in the trading process.
Simply put, wash traders can be said to be trading with themselves without involving other people, unlike market makers who involve people they may not know.
Is Wash Trading Legal?
The answer is no. The Commodity Exchange Act strictly prohibits this activity. The reason is that traders usually use wash trading to manipulate the market and stock prices. The Commodity Futures Trading Commission (CFTC) also enforces regulations regarding this, including guidelines that prohibit brokers from taking advantage of wash trading activities.
Likewise, the IRS has made rules to prohibit investors from reducing capital losses on taxes resulting from the sale or trading of securities, which generally result from wash trading.
However, regulations for crypto have not been fully developed yet. The Securities and Exchange Commission (SEC) has been keeping an eye on cryptocurrencies, but NFTs are not considered securities as they are non-fungible and outside the scope of the SEC. Similarly, the IRS considers crypto as property, not securities.
How to Avoid the Wash Trading Trap
This activity generally occurs in small and new markets, rather than in large and established markets. This is because small markets tend to be easier to manipulate, coupled with the big whales that can move small or micro crypto markets with ease. As a result, even a small amount of buying and selling activity in a crypto market can trigger some bots to “wake up” and generate more volume on the market.
Also, newly added coins to the market will not have any price or volume history. Therefore, the people involved can mislead other participants about the true value of the coin. Finally, many NFTs do not list interest or volume in their trades. Therefore, NFT owners can easily engage in wash trades to lure unsuspecting buyers when the price of the NFT is increased.
So, it can be concluded that the best defense against wash trading is to avoid buying crypto and NFTs with small markets. It’s best to choose a more established cryptocurrency market with larger volume so as not to fall victim to it. The bigger the market, the more funds the rogue players need to manipulate the market. That’s why wash trading is so hard to do in big markets like Bitcoin and Ethereum which are worth hundreds of billions of dollars.
Also, look for markets with a fairly long trading track record. That way, you can compare current and past transaction volumes through the historical price movements of the crypto market. This comparison will show whether there has been an extreme volume change in the market, which often misleads the participants.