Wash trading, a deceptive trading strategy, involves buying and selling a security to mislead the market. It can be done by colluding traders and brokers or by investors acting as both buyers and sellers. This practice has been prevalent among stock traders, particularly in high-frequency trading using advanced technology. The aim of wash trading is to artificially increase the trading volume of a security.
Wash trading deceives investors by creating a false impression of high trading volumes, potentially increasing legitimate trading activity. It is illegal under U.S. law, and taxpayers are prohibited by the Internal Revenue Service (IRS) from deducting losses resulting from wash trades.
The concept of wash trading originated in the 1930s and was prohibited by the federal government with the passage of the Commodity Exchange Act. Before the ban, wash trading was a popular method for manipulating stock prices and profiting from short selling.
Regulations from the Commodity Futures Trade Commission (CFTC) also forbid brokers from profiting from wash trades, even if they claim ignorance of the trader’s intentions. Brokers are required to conduct due diligence to ensure that customers are buying shares for legitimate purposes.
The IRS also has strict regulations against wash trading and disallows taxpayers from deducting losses resulting from wash sales. A wash sale is defined as a sale that occurs within 30 days of purchasing a security and results in a loss.
Wash trading has also infiltrated the cryptocurrency space in recent years. The desire to create the illusion of popularity and high trading volumes is evident, as there are thousands of cryptocurrency tokens available, making it challenging for them to stand out. Even popular cryptocurrencies like Bitcoin are not immune to wash trading.
A study conducted in 2022 found that over half of reported Bitcoin trading volume is either fake or the result of non-economic wash trading. Cryptocurrencies are particularly vulnerable to pump-and-dump schemes, where inflated trading volumes and insider recommendations artificially increase a token’s value, allowing certain holders to sell at a significant profit.
There are several reasons why wash trading is prevalent in the crypto space. Cryptocurrencies often lack universally accepted methods of calculating trading volume, leading to divergent figures from different firms. Additionally, the legitimacy of cryptocurrency exchanges is often questionable, with several high-profile collapses in recent years. The extreme volatility of the crypto market and the ambiguous regulatory status also contribute to misleading trade activity.
Wash trading serves various purposes. It can boost the trading volume of a security, attract more legitimate trading activity, and artificially inflate the security’s price as part of a pump-and-dump scheme.
Wash trades, which cancel each other out and have no commercial value, are utilized in various trading scenarios. For example, wash trades were used in the LIBOR scandal to reward brokers who manipulated LIBOR rates. They can also generate fake volumes for a stock and allow traders to profit from price movements.
Decentralized crypto exchanges are particularly susceptible to wash trading. A report from Solidus Labs revealed that at least $2 billion worth of cryptocurrency on Ethereum-based decentralized exchanges has been involved in wash trading since September 2020. Fraudsters engage in wash trading to manipulate token prices and create the illusion of liquidity to attract investors.
Contrary to popular belief, wash trading is not limited to centralized exchanges, and decentralized platforms are not immune to this fraudulent practice. The influx of users into DeFi exchanges following the collapse of centralized exchanges like FTX has led to a surge in wash trading.
Research has shown that wash trading is more prevalent on unregulated crypto exchanges. While regulated exchanges have minimal instances of wash trading, it makes up a significant proportion of trading volume on unregulated exchanges. Binance, the largest crypto exchange, estimates that wash trading accounts for 46.4% of its transactions.
Identifying wash trades can be challenging without access to account data. However, the findings emphasize the importance of regulation in the industry.
In conclusion, wash trading is a deceptive strategy used to mislead the market and artificially inflate trading volumes. It is prevalent in both traditional stock trading and the cryptocurrency space. Regulatory measures are crucial in combating this fraudulent practice and protecting investors.