Wash trading, a form of fake trade strategy is a process whereby a trader buys and sells a security for the express purpose of feeding misleading information to the market. In some situations, wash trades are executed by a trader and a broker who are colluding with each other, and at other times, wash trades are executed by investors acting as both the buyer and the seller of the security.
By no means is wash trading a new phenomenon having made its appearance among stock traders, especially in high-frequency trading using super-fast computers and high-speed internet connections to perform upwards of tens of thousands of trades per second. Wash trading is often performed to artificially inflate the trading volume of a security.
Wash trading misleads investors into believing that trading volumes for security are higher than they actually are, potentially increasing legitimate trading activity on the security in the process. Wash trading is illegal under U.S. Law, and the Internal Revenue Service (IRS) bars taxpayers from deducting losses that result from wash trades from their taxable income.
Understanding Wash Trading
Wash trading was first barred by the federal government after the passage of the Commodity Exchange Act in 1936, a law that amended the Grain Futures Act and also required all commodity trading to occur on regulated exchanges. Prior to its proscription in the 1930s, wash trading was a popular way for stock manipulators to falsely signal interest in a stock in an attempt to pump up the value so that these manipulators could make money shorting the stock.
Commodity Futures Trade Commission (CFTC) regulations also prohibit brokers from profiting in wash trades, even if they claim they weren’t aware of the trader’s intentions. Brokers therefore must perform due diligence on their customers to make sure that they are buying shares in a company for the purpose of common beneficial ownership.
The IRS also has strict regulations against wash trading and requires that taxpayers refrain from deducting losses that result from wash sales. The IRS defines a wash sale as one that occurs within 30 days of buying the security and results in a loss.
Wash Trading and Cryptocurrencies
In recent years, wash trading has infiltrated the cryptocurrency space as well. The desire to give the impression of popularity and high trading volumes is clear: there are thousands of cryptocurrency tokens available throughout the world, and most have a difficult time distinguishing themselves. But even the most popular cryptocurrencies, including Bitcoin, experience wash trading.
A 2022 study of 157 cryptocurrency exchanges by Forbes found that over half of all reported Bitcoin trading volume is either fake or non-economic wash trading.6 Cryptocurrencies are particularly vulnerable to pump-and-dump schemes, in which a combination of inflated trading volumes and strong publicity or recommendations from insiders artificially boosts a token’s value, allowing certain holders to sell at a massive profit while interest is high.
There are multiple potential reasons for the prevalence of wash trading in the crypto space. Even major digital currencies like Bitcoin often lack universally accepted methods of calculating daily trading volume. This leads to cryptocurrency firms producing oftentimes wildly divergent figures for historical trading volumes. Cryptocurrency exchanges themselves often lack legitimacy, and there have been many high-profile public collapses of token exchanges in recent years. Extreme volatility in the cryptocurrency space may incentivize rapid buys and sells. Finally, crypto’s murky status with U.S. and other government regulators creates a further opportunity for misleading trade activity.
Why would someone do fake trading?
In some cases, wash trading bolsters the trading volume of a security, potentially inspiring more legitimate trade activity. Wash trading can also be used to help artificially boost the security price as part of a pump-and-dump scheme.
Wash trades are essentially trades that cancel each other out and have no commercial value, as such. But they are used in a variety of trading situations.
For example, wash trades were used in the LIBOR scandal to pay off brokers who manipulated the LIBOR submission panels for the Japanese yen. According to charges filed by the U.K. financial authorities, UBS traders conducted nine wash trades with a brokerage firm to generate 170,000 pounds in fees as a reward to the firm for its role in manipulating LIBOR rates.7
Wash trades can also be used to generate fake volumes for a stock and pump up its price. Suppose a trader XYZ and a brokerage firm collude to buy and sell stock ABC rapidly. Noticing activity on the stock, other traders may put money into ABC to profit from its price movements. XYZ, then shorts the stock, thereby profiting from its downward price movement.
Are fake trades really common on decentralized crypto exchanges?
Decentralized crypto exchanges are a hotbed for a certain type of fraud known as wash trading, according to a new report from Solidus Labs. blockchain research firm found that at least $2 billion worth of cryptocurrency on Ethereum-based decentralized exchanges have been washed traded since September 2020. The fraudulent practice has manipulated the price and volume of about 20,000 tokens on DeFi exchanges, the firm said.The
Wash trading is a form of market manipulation where fraudulent parties are essentially trading themselves to artificially boost the price of a crypto token and give the illusion of liquidity, which piques the interest of other crypto investors.
Fraudsters have an especially high incentive to wash trade on decentralized crypto exchanges, where crypto trades are made with no middleman, the report said. That’s because transaction fees are often lower on DeFi exchanges, and fraudsters are aiming to attract as many investors to the tokens they’re trading as possible.
“A token deploys ability to either get their token listed on a centralized exchange or rug-pull their investors for profit depends upon their skill in attracting speculators to the liquidity pool on which their token is traded. We find that many token deployers will resort to [decentralized exchange] wash trading to do so,” the report said.
The trends run contrary to the general perception of DeFi exchanges, which are seen by some investors as a safer alternative compared to centralized exchanges like FTX and Binance, which are sometimes viewed as less transparent. Decentralized platforms, it is argued, benefit from users trading directly with one another rather than handing tokens over to the exchange as a middleman. Inflows into DeFi exchanges surged in late 2022 through early 2023, following FTX’s collapse, according to data compiled by The Block.
A working paper from the National Bureau of Economic Research previously found that wash trades accounted for nearly all of the transactions made on non-compliant crypto exchanges, and crypto investors have sounded the alarms on wash trading as a major form of fraud in the industry. The practice could be responsible for the next “implosion” to hit the crypto space since the FTX saga, according to “Shark Tank” investor and longtime crypto bull Mark Cuban.
How common is wash trading?
Wash trading could be as simple as sending crypto from one wallet to another, but there are more elaborate schemes out there, says Kim Grauer, the director of research at Chainalysis. In her research, wash trades were identified when a trade met certain relationship criteria with other wallets and addresses – suggesting something fraudulent could be taking place.
The NBER paper studied 29 crypto exchanges that were classified as regulated or unregulated, with unregulated exchanges being sorted into two tiers based on size. The authors found wash trading was virtually absent on regulated crypto exchanges, but made up an average of 77.5% of trading volume on unregulated exchanges. Tier-1 unregulated exchanges had a slightly lower proportion of wash trades at 61.8% of transactions, compared to 86.2% of transactions Tier-2 unregulated exchanges.
For Binance, the largest crypto exchange in the world by trading volume and an unregulated Tier-1 exchange in the study, wash trading was estimated to comprise 46.4% of all transactions.
KuCoin, another top-five crypto exchange according to CoinMarketCap, estimated 52.9% of its transactions consist of wash trades. A spokesperson from the exchange says that it did not engage in wash trading.
The paper also found a higher incident of wash trading in the few weeks after the crypto market saw positive returns, or experienced a drop in volatility. “Price increases could draw retail investors’ attention and encourage speculation. Therefore, crypto exchanges are incentivized to pump up volumes to vie for better ranking and more clients.”
There’s no way to truly identify a wash trade unless you have access to account data, which is typically only available to the exchanges themselves, according to Martin Leinweber, digital assets product specialist at MarketVector Indexes. The paper’s findings, do, however, give an idea of how important regulation is in the industry, he said.
Have you also heard of a head-fake trade? Recognizing a head-fake allows traders to adjust strategies, potentially minimizing losses or profiting from such market scenarios. Fascinating, but the bottom line is, that there are many ways of making money, but the illegal way is not as grievous as when you’ve picked the short stick.