Wash trading, which involves repeatedly buying and selling the same cryptocurrency to create misleading activity, has been used in many financial markets for decades. However, in recent years it has become more popular in the cryptocurrency market and other markets like the foreign exchange market (forex) and securities markets.
This is because wash trading benefits traders who want to make their cryptocurrency holdings look more valuable than they are. Unfortunately, it's also used by bad actors who want to manipulate the value of a cryptocurrency or an entire market so that they can later sell at a higher price than they bought before creating their fake activity.
That being said, if you’re actively engaged in cryptocurrency trading, it’s important to understand what wash trading is and how to avoid being scammed by malicious traders who could have ulterior motives other than profit when engaging in this practice.
What is Wash Trading?
As previously said, wash trading is an act in which the same item is sold and acquired in a short time. Wash trading happens when a trader or investor buys and sells the same assets several times in a short period to mislead other market players about the price or liquidity of an asset.
Wash trading is a market manipulation strategy traders use to impact an asset's trading activity and price. Typically, one or more cooperating agents execute a series of deals without considering market risks, resulting in no change in the hostile actors' initial position.
Wash Trading is very common among NFT flippers, where wash traders attempt to make the asset appear far more valuable than it is. Typically, cryptocurrency trading (including NFTs) allow partial anonymity; hence, a single user can create several wallets and trade between those wallets to carry out wash trades, manually inflating the amount of the NFT assets. This is achieved by selling from one wallet and buying from another. When several such transactions are completed, the trading volume increases. As a result, the underlying asset appears to be in great demand. Some wash traders have gone so far as to conduct hundreds of transactions using their self-controlled wallets.
Why Do People Wash Trade?
For starters, they may be attempting to manipulate the price of a crypto asset (especially Non-fungible tokens) for personal advantage. For example, they may be attempting to artificially increase the price to benefit from the sale of their interests.
Second, they may be doing it to increase market liquidity. They make the asset look more liquid than it is by repeatedly purchasing and selling it. This may entice other traders to purchase this asset, which may be sold at a greater price. This is especially advantageous for a cryptocurrency asset class.
Lastly, wash trades can be used to conceal legitimate trading activity from regulators and exchanges. For example, traders that engage in wash transactions make it harder for regulators to trace their true trading activity and earnings.
In addition, because investors can decrease their taxes by claiming trading losses, some execute wash transactions seem to incur a loss. As a result, the IRS made it illegal to claim losses on deals in which the assets sold at a loss were repurchased within a month.
Is Wash Trading Illegal?
Wash trading is considered criminal in traditional finance. However, in the world of DeFi, its legality remains unclear. While it is definitely "unethical," no regulation anywhere in the world specifies what is and isn't legal in NFT trading since its asset class has not been established.
Although bitcoin wash trading may be banned in some jurisdictions, the decentralized structure of cryptocurrencies makes it difficult to identify culprits. In addition, unlike traditional financial instruments, such as equities and securities, which need verified KYC standards, blockchain-powered assets may be traded without exposing identities.
However, the difficulty with NFT wash trading is that countries have not explicitly characterized these assets as either financial security or a commodity, making regulation difficult. The sanctioning authority must also demonstrate intent to deceive and price gouge. Wash trading is very unethical and is regarded similarly to insider trading.
How to Avoid Wash Trades
To prevent being involved in a wash deal, it is important to investigate the trading history of assets. Additionally, keep an eye out for red signals such as requests to transfer a comparable quantity of cryptocurrency for the same price back and forth.
Things get a little more tricky when it comes to avoiding the implications of wash sales and purchases made by other market players. You may check to see whether the rise in volume aligns with a change in the number of unique addresses used to trade that currency. You may also search directly through the deals made in the last few hours or days. This is much easier to conduct in blockchains since they are transparent and have a clear transaction history.
How Can I Spot a Wash Trader?
Some red flags may suggest that a wash trader carried out the transaction. For example, if two transactions with the same price spread, trading volume, and execution time appear in succession, this might be a wash trade.