Wash trading, in general, is a type of market manipulation. It happens when someone (traders, brokers, or even an exchange) conducts buys and sells for the sole purpose of manipulating the market. For instance, you might see repeated buys and sells on a crypto exchange that looks automated, match in amount, and essentially wash each other out.
There are several key players who have historically engaged in wash trading:
- Traders and brokers working together to post fake trades.
- Investors of varying sizes (usually big) performing both the buys and sells of a particular security
- Exchanges who trade on their own platform, as we are seeing with crypto exchanges in the current market.
Are wash trades legal?
Not in the US, no. The first time it was officially banned in the US dates back to 1936. At that time, wash trading was used extensively to create false signals of interest in a security. They used this manipulation to pump the value so they could profit from shorting the stock.
Shorting refers to short selling, which happens when an investor borrows shares of a stock from a broker. They then sell the shares for a higher price thinking the value is going to fall. If it does, they can pay back the broker at the lower price. Here’s a great example of how this works by HerMoney.com:
“Say you think Company ABC is overpriced at $50 a share. You borrow 100 shares from your broker—pay interest on the loan—and sell them for $5,000. Time ticks on, and as you suspected, the stock price falls. At $40 a share, you buy 100 shares for $4,000 and return them to your broker. You walk away $1,000 richer, minus investing costs.”
Other traders use wash trading to help with their capital gains reporting. But the IRS now prohibits anyone from claiming losses that stem from wash trades that are initiated for the sole purpose of creating deductible losses. They define a wash sale as “one that occurs within 30 days of the buying of one security and results in a loss”.
High Frequency Trading and its Effect on Wash Trades
Starting in 2013, a new trading trend hit traditional markets – high-frequency trading. Basically, this means that asset managers and institutional investors began using computers and high-speed internet connections to place thousands of trades per second.
It became increasingly difficult to monitor and regulate the exponentially increasing number of trades and thus control wash trades. To this day, it is an issue that regulators continue to grapple with. In the crypto world, high-frequency trading has morphed into a tangle of trading bots, algorithmic trading programs, and now copy trading has started to pick up steam as well.
What does wash trading look like in crypto?
We’ve seen multiple reports from late 2018 and early 2019 that confirm what most seasoned crypto investors already know. Cryptocurrency exchanges are creating transactions to beef up their trading volume numbers. According to various sources, between 67% and 95% of bitcoin exchange volume is faked through wash trading.
What’s happening is that exchanges are fabricating transactions that cancel (or wash) each other out. They do this because the perceived value of these exchanges is highly dependent on the number of transactions happening on their exchange. The amount of these transactions ends up pumping the trading volume to sometimes ridiculous heights.
For example, one exchange, IDAX, showed a 24-hour BTC pair trading volume on CoinMarketCap as $79,860.070. Yet according to BlockchainTransparency.org, the accurate 24-hour volume was $3,161,821.
Why wash trades?
Two words: Listing fees.
Investors and regulators agree on this one. Exchanges are pumping up their numbers to appear more attractive to cryptocurrency projects who want to get their coin listed. We reported back in November about how crypto exchanges were charging exorbitant listing fees.
With regulation and self-regulation within the crypto community still developing, it seems that many exchanges are taking advantage of this gray area.
When investing in cryptocurrency, it’s important to look at many factors in regards to an exchange. At this time, many of these new exchanges are over reporting and it’s estimated that 95% of BTC trade volume overall is falsified through wash trading on some cryptocurrency exchanges.
Be safe, do your own due diligence and check out the crypto exchanges on this Exchange Advisory List. The exchanges that operate primarily by pumping up their numbers cannot last long term. Additionally, since the Bitwise report was submitted to the SEC containing news of this mass falsification, now regulators know what to look for. Soon, the hope is that as the cryptocurrency market evolves, so will the exchanges. Newly designed policies will no doubt reflect the stronger standards and self-regulation that the crypto community demands.