What is wash trading? Why is it illegal in 2023?
The crypto market is plagued with a plethora of trading mechanisms, that are both twisted and illegal. Investors are looking to make quick money, and as a consequence take up practices that are not only illegal but also weaken the crypto space in general.
As informed users who intend on making educated and fruitful financial decisions, it is essential that we must stay aware of what these trading practices are, how they work, and what are the legal provisions against them.
One such popular and the simultaneously disastrous scheme is the Wash Trdaing practice. This market manipulation technique is illegal and has resulted in users to bear severe losses. In this article, we will take you through everything that is to know about wash trading and how can you safeguard your funds against it.
What we are going to learn?
What is wash trading?
Let’s begin with obtaining a basic idea of what wash trading actually is before we delve deep into learning more about it.
Wash trading is rooted in the concept of market manipulation. In Market manipulation, perpetrators basically undertake the act of artificially inflating or deflating the price of an asset or otherwise influencing the market for the very investment in a way that is not based on the underlying performance of the company or asset.
Now let’s see how this market manipulation plays out in Wash Trading. When wash trading occurs, as a component of it, a trader simultaneously buys and sells the same financial instruments, usually with the intention of creating the illusion or perception of increased trading volume and liquidity. Basically, in simple words, the trader uses tactics that portray the asset as a viable investment without it actually having any true or substantial merit. Look at this simplified flowchart that explains wash trading
Also known popularly as round trip trading, This fraudulent activity is often used to manipulate the price of a security or deceive investors about the true demand for a particular asset. Wash trading can take various forms, such as placing offsetting trades through different accounts or coordinating with other traders to place fake buy and sell orders. Wash trading also becomes a valuable resource to facilitate asset brokers and give them their commission fee as a reimbursement against the securities they can’t compensate or settle immediately.
It is difficult to detect, as it can be disguised as legitimate trading activity, but regulators have developed tools and techniques to identify and prosecute wash traders. Engaging in wash trading can result in financial penalties, criminal charges, and a ban from participating in the financial markets.
How does wash trading work?
Now let’s shift focus to learning the mechanism on which wash trading works. By understanding the workings of this kind of trading you can gain better insight into the world and hence gain awareness that can aid you in spotting and being safe from such practices. Have a look at this image that gives a streamlined idea of the working of wash trading.
The establishment of the “intent” of the transaction is the foremost step for the beginning of a wash trade scheme. The trader or investor must develop and ideate a prominent strategy that serves the purpose of basically misleading users by buying and selling assets before hand.
The second condition after intent is the “result” of the transaction. This result must be a wash trade, which implies that the trader or investor has been able to both buy and sell the very asset concurrently in a way that gives the appearance of different accounts but is in reality have a sole genesis or a common proprietorship
Ways of executing a wash trade
Wash trades usually occur on the principle of insider trading. Insider trading is the act of buying or selling securities based on non-public, material information about a company. There are a few different ways that wash trading can be carried out.
One common method is for an individual or group of individuals to buy and sell a security among themselves, without any real change in ownership. For example, an individual might buy 100 shares of a particular stock, and then sell those same 100 shares back to the same party a short time later. This creates the appearance of trading activity, but in reality, the security has not changed hands.
Another way wash trading can be carried out is by using multiple accounts to buy and sell a security, again without any real change in ownership. For example, an individual might use one account to buy 100 shares of a particular stock, and then use a different account to sell those same 100 shares. This can create the appearance of multiple parties trading the security when in reality it is all being done by a single individual or group.
A third way to execute a wash trade is by using fake or fictitious orders to create the appearance of trading activity. For example, an individual might place a large number of fake buy orders in an attempt to drive up the price of a security. This can mislead other market participants and influence the price of the security.
Finally, wash trading can also be carried out by trading a security back and forth between two parties at a predetermined price, with the goal of manipulating the price of the security. This can be done repeatedly over time in order to maintain the desired price level.
Wash Trading in the Cryptocurrency market
Even though a while back wash trading was a prevalent phenomenon in the stock market, it has gradually infiltrated the crypto area in a massive way as well in the last few years.
Forbes, the mammoth global media company that deals with business, investing, technology, entrepreneurship, leadership, and lifestyle, conducted and published research in 2022 that went to highlight how in the 157 cryptocurrency exchanges that were studied, an alarming 51% of the daily bitcoin trading volume that is reported is actually either fake or a form of non-economic wash trade.
An example given on the learning platform by ByBit can be helpful in understanding wash trading and its mechanism in the crypto markets.
“For example, large investors within a crypto project, XYZ, might buy some more XYZ crypto from that project using multiple addresses. Once they’ve acquired additional XYZ, then they would transfer the same amount of XYZ to the exchanges. At that point, they would convert XYZ to Ether and use that Ether to buy more XYZ. This behaviour would continue for some time, using multiple addresses in an attempt to disguise their intent.
Outside investors would see the increased interest and volume in XYZ, and then decide to buy into the project long-term. This additional interest from outside holders with long-term intent increases the price of XYZ. Then, the insider would sell some of their XYZ cryptos at a profit. In essence, the large investors of XYZ use wash trading to mislead others about the speculative interest in the project — so they can eventually dump their holding at a profit.”
Many reasons can be acknowledged for creating the plurality of wash trades in the crypto space. There are a few reasons why wash trading has become more prevalent in the cryptocurrency market including yet not restricted to the following
- the absence of a universally acknowledged mechanism to calculate and configure daily trading volumes of even major digital assets
- the presence of crypto exchanges that are deficient in substantial legitimacy
- the extreme volatility associated with the crypto markets and the nature of being easily influenced by public perception
- the lack of clear regulations and the presence of blurred lines with respect to governing constraints in such financial markets
- the inadequate and scarce transparency associated with exchanges
- the relatively low barriers of entry for individuals or groups to the cryptocurrency market
- Legal provisions associated with Wash trading
In 1936 the federal government made sure wash trading was prohibited under the passage of the Commodity Exchange Act. The Commodity Futures Trading Commission (CFTC) is an independent agency of the United States government that regulates the futures and options markets and was created in 1974 in response to the collapse of the agricultural futures market in the early 1970s. The CFTC is responsible for enforcing federal regulations and laws that apply to the futures and options markets, including those related to market manipulation, fraud, and other forms of misconduct. These regulations bar brokers from making money through wash trading.
Under the law of the United States of America, wash trading is deemed illegal and there are many rules against it set in place by the Internal Revenue Service (IRS), which is the agency of the United States government responsible for administering the federal tax system. The IRS is a bureau of the Department of the Treasury and is responsible for collecting taxes, enforcing tax laws, and providing guidance on tax-related matters.
The Securities and Exchange Commission (SEC) is responsible for developing legal regulations when it comes to wash trading in crypto. The U.S. Securities and Exchange Commission (SEC) is a federal agency that is responsible for regulating the securities industry and protecting investors. The SEC has the authority to bring enforcement actions against individuals and firms that engage in wash trading or other forms of market manipulation. This can include civil or criminal penalties, such as fines and imprisonment. NFTs being non fungible in nature are not regarded as securities, and hence are outside the jurisdiction of the SEC.
Detection of Wash Trading
In the context of cryptocurrency, wash trading can be particularly difficult to detect and prevent because of the decentralized nature of many cryptocurrency exchanges and the lack of regulatory oversight in some jurisdictions. However, there are still steps that exchanges and regulators can take to deter and punish wash trading.
One approach is for exchanges to implement strict know-your-customer (KYC) and anti-money laundering (AML) policies, which can help to identify and prevent illicit activity on the platform. Exchanges can also use advanced surveillance tools to detect and investigate suspicious trading patterns and take appropriate action if wash trading is discovered.
In addition, some exchanges have adopted self-regulatory measures, such as the Virtual Commodity Association (VCA), which is a self-regulatory organization (SRO) for the virtual asset industry. The VCA has established best practices for exchanges to follow in order to promote fair and transparent markets and reduce the risk of market manipulation, including wash trading.
One of the best steps you can take to avoid being a victim to wash trading is to resort to only trusted and reputable exchanges. Beware of schemes that appear too good to be true. Remember that the bigger the market size is, the more capital is required in order to execute scams like wash trading, and hence inclining towards established and large-volume assets is a safer bet. Do impeccable research about every crypto you wish to invest in, the exchange on which you plan you trade your assets, the wallet you use to manage these assets and each and every remaining aspect of your crypto investment.
Also read related articles on
- What are Pump and Dump Schemes in Crypto?
- How To DYOR Crypto: How To Analyse Crypto Projects For Investment?
To conclude and summarise
Wash trading is a serious issue that can undermine the integrity of financial markets and harm investors. It is important for traders to be aware of the risks of wash trading and to take steps to avoid being involved in it. Exchanges and regulators also have a role to play in preventing wash trading, by implementing strict policies and using advanced tools to detect and investigate suspicious activity. Ultimately, cracking down on wash trading and other forms of market manipulation is essential for maintaining fair and transparent markets and protecting investors.