What is Wash Trading, How it Works and How do you Identify Wash Trades?

Key takeaways:

  • Wash trading refers to an illegal form of trading where a broker and trader collude and profit by providing the market with misleading information.

  • Cryptocurrency exchanges and high-frequency trading firms conduct it to manipulate prices.

Introduction

There are several ways market participants attempt to manipulate the price in their favor. One of the most used forms of trading is wash trading. Known as “round-trip trading,” it is a form of market manipulation that was first outlawed by the Commodity Exchange Act (CEA) and the Securities Exchange Act of 1934.

What is Wash Trading?

Wash trading is an illegal form of trading where an investor buys and sells the same security investment at the same time. This means that buying the same security cancels out the sale of that security. It is called round-trip trading because the investors end up with shares of the same security in their portfolios.

It is mostly used as a form of market manipulation in an attempt to influence pricing or trading activity. By buying and selling the same securities, investors attempt to spur buying activity to send prices up or encourage selling to drive prices down.

Investors and brokers may sometimes work together to influence trading volume for both parties’ benefit. For instance, the broker may benefit from collecting commissions from other investors who want to purchase a stock, security or crypto being targeted for wash trading. The investor may also take advantage by realizing gains from the sale of securities through price manipulation.

Many experts consider it to fall under insider trading. In the United States, it was first banned by the federal government after the passage of the Commodity Exchange Act in 1936. Prior to this, stock manipulators used wash trading to falsely signal interest in a stock to pump up its value. This allowed manipulators to make money by shorting the stock.

Wash trading in the cryptocurrency market

In recent years, wash trading has been seen in the cryptocurrency market as well. There is a clear attempt by many crypto projects to give the impression of popularity and high trading volumes. This isn’t restricted to low-cap coins and has affected even the most popular cryptocurrencies such as Bitcoin.

There are multiple reasons for wash trading to exist in the crypto space. Major currencies such as Bitcoin lack universally accepted methods for daily trading volume calculations. As a result, cryptocurrency firms often produce divergent figures for historical trading volumes.

Many cryptocurrency exchanges lack legitimacy, as evidenced by the number of high-profile public collapses of token exchanges in recent years. There is also extreme volatility in the cryptocurrency space that incentivizes rapid buys and sells. Further opportunities come as a result of crypto’s murky status with the U.S. and other government regulators.

How does Wash trading work?

For a wash trade to exist, there are generally two conditions that must be met.

The intent of either the broker or investor must be that at last one of them entered into the transactions specifically for that purpose.

The result must be a wash trade where the investors bought and sold the same asset within a short time span for accounts with the same or common beneficial ownership.

In this context, beneficial ownership refers to accounts which belong to the same individual or entity. Accountants with common beneficial ownership may attract the attention of financial regulators as they might suspect wash trading at work.

One of the tell-tale signs of wash trading is if a trade doesn’t change the overall market position in the security or expose them to market risk. They do not have to involve actual trades and can occur if investors and traders appear to make a trade on paper without any asset changing hands.

How do you identify it?

To identify wash trading, firms and regulatory authorities look for unusual or atypical trading patterns among traders. Any action such as buying and selling in a brief time period that has no impact on the profit and loss of the entity is flagged. Robust trade surveillance is the only solution for detecting it by a firm.

Once a firm discovers a case like this, it has to report to the regulator as soon as possible. It should also make the necessary legal steps to undo any harm that the activities have caused. It should review its compliance program to check whether any existing weaknesses enabled the wash trading to take place.

FAQs

How does wash trading apply to NFT trading?

Buyers and sellers of NFTs can use wash trading to drive up the price. The buyer and seller report the first sale publicly but continue to sell the piece back and forth to drive up the cost. The money and NFT are returned to the original seller at the same time in the next exchange.

Are wash trades illegal?

Wash trading is considered illegal in the United States under the Commodity Futures Trade Commission (CFTC).

Why would someone engage in wash trading?

Wash trading can bolster the trading volume of security which can inspire more legitimate trade activity. Wash trading can also be used to boost the price of securities artificially as part of a pump-and-dump scheme.