Introduction
It is an illegal type of trading where brokers and traders come together to profit from the market by providing misleading information. The Federal government first barred the term wash trading during the introduction of the Commodity Exchange Act 1936 that aimed at amending Grain Futures Act. Around the 1930s, stock manipulators falsely signal interest in a stock to pump up its value and make money shorting it.
What is Wash Trading?
Wash Trading is also termed as “Round Trip trading “which is an illegal practice where investors buy and sell the same financial securities to manipulate the market. The wash trading naturally increases the trading volume and makes security appear more desirable. The phenomenon includes feeding misleading information to the market and is executed by traders and brokers. In other cases wash traders are executed by investors who act as both buyers and sellers of the security. Alongside, wash trading misleads investors in believing that trading volume for the security is high potential. In many cases, it can also be done to provide brokers with commission fees to compensate for securities if they cannot be settled outright. Generally, the high–frequency trading firms and cryptocurrency exchanges use wash trading to manipulate prices.
How Wash Trading Works?
Basically, the wash trade happens when an investor buys and sells assets at the same time. However, the more expandable wash trade happens when the trader goes further and takes into account the investors’ intent. Wash trading is the outcome of two main factors that leads to misleading transactions and information. As a result, these factors lead to transactions being categorized as wash trade.
Intent: The parties indulged in wash results can be surmised by evidence of pre-arrangement where traders are structured or executed in the manner where the party reasonably knows the transaction produces wash results. As a result, it can be said that wash traders must have specific strategies to buy and sell the asset before the time. This makes it evident that multiple accounts are required to pull off the misrepresentation. By having multiple accounts the trader or firm conduct the transaction on the same asset but using different account which leads to a price rise and an increase in trading volume.
Result: A single transaction or series of transactions produce a wash result or a situation where the purchase and sale of the instrument takes place at the same price. On the other hand, the similar price for accounts with the same or common beneficiary ownership leads to washing trading. The one fundamental way to identify wash trade is to inspect the financial position of the investor. If the overall position of the trader is not changed or exposed to any form of market risk then it can be termed as being washed.
Wash Trading In Cryptocurrencies
The concept of wash trading has been widely seen in the cryptocurrency ecosystem as well. In recent times there are thousands of cryptocurrency tokens are available across the globe. As a result, the desire to give the impression of huge trading volume and popularity is indeed the trend today. The study conducted by Forbes in 2022 found that there were 157 cryptocurrency exchanges with over more than half of them being reported with fake trading volume or non–economic wash.
The pump and dump schemes which are the combinations of inflated trading volume and strong publicity /recommendations facilitate crypto holders to sell the securities at massive profit. As a result, this entire scheme allows cryptocurrency firms to produce divergent figures or trading volumes.
How To Detect Wash Trading For Cryptocurrencies?
Wash Trading is a phenomenon that shall be timely identified to develop the right trading strategies and identify the suspicious data an activity that triggers price movement of NFT and Digital Coins trading. Some characteristics of wash traded cryptocurrencies and NFTs are as follows which act as the identification mark.
- If the same NFT is traded at the same address with a high – frequency.
- When the collection of NFT foes into self–selling mode and no marketing or promotion is required to make a sale.
- When the average historical prices of the asset are transacted at prices X times different marketplaces.
- If it is found that the same wallet address funds all suspicious wallets and buys and sells the NFTs or cryptocurrencies.
- When there exists abnormally high trading volume on a constant basis.
These are the few general guidelines to identify wash traded securities but the above-mentioned assumptions can vary based on several other comprehensive scorecards prepared by experts.
Example of Wash Trading
Let us assume that the large investors within a crypto project named ABC buy more digital coins from the project using multiple addresses. After they acquire additional ABC coins then the same amount is transferred to the exchanges. After this these ABC coins are converted to Ether and Ether is further used to buy more ABC coins in the crypto project. This phenomenon goes on using multiple addresses with the intent to disguise the environment.
The external investors see it as the increased interest and volume for ABC coins. As a result, it appears the long–term investment project to outsiders. When this outsider buys ABC coin the additional interest with long–term intent increases the price of the coin. At this point, the insiders sell some of these ABC coins to earn profit. Thus, in the overall scenario, large investors of ABC use wash trading to mislead others and speculate their interest in the crypto project.
Final Words
Wash trading is an illegal activity that is often seen as a short–term trading strategy and inflates the trading volume. This occurs across a variety of industries and assets but is mostly observed in Non –Fungible Tokens that are rare and unique. As a result, attract several enthusiasts and high–frequency trading spaces.
