What is Wash Trading?

Market participants use multiple tactics to manipulate prices in their favor. 

Wash trading is one of the most frequently employed forms of trading. Some traders and crypto firms may engage in this fraudulent practice to inflate prices, deceive investors, and create the illusion of higher trading volume.

What is Wash Trading?

Wash trading, a primitive price manipulation strategy, involves a trade operation where the buyer and seller are the same entity, creating an illusion that the asset is more popular than it actually is. This attracts genuine investors who later trade the artificially hyped asset at a higher price. In the traditional markets, such practice is banned, but in the crypto market, it is still prevalent.

Wash traders execute the scheme by buying the same asset from themselves, switching money between two or more wallets owned by them, and repeating the process multiple times. This creates a strong activity that attracts other investors, boosting the asset's price. The traders then dump their loads of the asset for a colossal price and walk away, keeping their funds. The wallets used for wash trading can even belong to a single person, with the traders only spending money on transaction fees. However, this trade type is contentious and sucks wealth from fair investors.

Besides manipulating prices, wash trading is also used to exaggerate trading volume rates of crypto exchanges, attracting more traders and earning higher trading fees. Some exchanges offer privileges for high-volume traders, encouraging users to do wash trading to get these perks.

The Interplay Between Wash Trading and High-Frequency Trading

The emergence of high-frequency trading, which utilizes lightning-fast computers and internet connections to execute tens of thousands of trades per second, coincided with the resurgence of wash trading in 2013.

In 2012, Bart Chilton, then-Commissioner of the Commodity Futures Trading Commission, expressed concerns about potential violations of wash trading laws in the high-frequency trading industry. He noted that the advanced technology used by firms in this industry could make it easy to engage in wash trading without detection.

The Securities and Exchange Commission (SEC) took action in 2014 when it charged Wedbush Securities with failing to maintain direct and exclusive control over trading platform settings used by its customers. This failure enabled some of its high-frequency traders to engage in prohibited and manipulative behavior, including wash trading.

The case of Wedbush Securities highlights the need for effective oversight and regulation of both high-frequency trading and wash trading. While high-frequency trading can provide market liquidity and efficiency, it can also create an environment ripe for market manipulation. Likewise, wash trading can distort market indicators and harm investor confidence.

Regulators have taken steps to address these concerns. The SEC has proposed rules to improve oversight of high-frequency trading and reduce the risk of market manipulation. The Commodity Futures Trading Commission has also implemented measures to detect and prevent wash trading in the futures market.

The Threat of Wash Trading in Cryptocurrencies and NFT Markets

Cryptocurrencies have become a comfort zone for modern wash traders, opening a new season for price manipulation. Unlike traditional markets, cryptocurrencies offer ways to obscure one's identity, and the legal uncertainty over wash trading in the crypto market makes it challenging to prosecute bad actors.

The decentralized nature of the blockchain industry and the anonymity of some platforms make it harder to identify wash traders in the crypto market. The lack of clear regulations also complicates the prosecution of wash traders, as it is not always clear which authorities are responsible for controlling the crypto markets and related crimes.

NFT markets are particularly vulnerable to wash trading as many NFTs lack trading volume. Wash traders can conduct a series of back-and-forth trades of an NFT to create an illusion of trading activity, tricking rookie NFT hunters into thinking it is a worthy investment. However, once purchased, investors may find that no one wants to buy the NFT, as all previous buyers were actually the same person or a group of people.

The Bottom Line

Wash trading is an illegal activity where a trader buys and sells the same security, either within a short period or on separate exchanges, to inflate the trading volume or price of that security. Although it can occur across various industries and assets, wash trading has become a significant concern in the cryptocurrency and high-frequency trading spaces.

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