Wash trading, a deceptive trading strategy, involves buying and selling a security to provide false information to the market. It can be carried out by colluding traders and brokers or by investors acting as both buyers and sellers. This practice has been prevalent among stock traders, especially in high-frequency trading where super-fast computers and high-speed internet connections allow for tens of thousands of trades per second. The goal of wash trading is often to artificially inflate the trading volume of a security, misleading investors into believing that there is more activity than there actually is. Wash trading is illegal in the United States, and the Internal Revenue Service (IRS) prohibits taxpayers from deducting losses resulting from wash trades from their taxable income.
The concept of wash trading originated in the 1930s when the federal government introduced the Commodity Exchange Act, which prohibited wash trading and required all commodity trading to take place on regulated exchanges. Prior to this, wash trading was a popular method for stock manipulators to create false interest in a stock and profit from shorting it. The Commodity Futures Trading Commission (CFTC) also has regulations in place to prevent brokers from profiting from wash trades, even if they claim to be unaware of the trader’s intentions. Brokers are required to conduct due diligence on their customers to ensure that they are purchasing shares for legitimate purposes.
Wash trading has also made its way into the cryptocurrency space. With thousands of cryptocurrencies available worldwide, it can be challenging for tokens to stand out. Wash trading is used to create the illusion of popularity and high trading volumes, particularly in pump-and-dump schemes where trading volumes and publicity artificially boost a token’s value. A recent study found that over half of reported Bitcoin trading volume is fake or a result of wash trading. Cryptocurrencies are vulnerable to these schemes due to the lack of universally accepted methods for calculating trading volume, the legitimacy issues surrounding cryptocurrency exchanges, and the volatility of the market. The unclear regulatory status of cryptocurrencies also provides an opportunity for misleading trading activity.
Wash trading serves various purposes, such as increasing trading volume and artificially boosting security prices. It can be used in fraudulent activities like the LIBOR scandal, where wash trades were conducted to reward a brokerage firm for manipulating LIBOR rates. By generating fake volumes for a stock, wash trading can attract other traders who hope to profit from price movements. However, engaging in wash trading is illegal and can result in penalties.
Decentralized crypto exchanges are particularly susceptible to wash trading, as the absence of a middleman and lower transaction fees attract fraudsters who aim to attract investors to the tokens they are trading. Despite the perception that decentralized exchanges are safer than centralized ones, wash trading has been found to be prevalent in these platforms. Wash trading has been identified as a major form of fraud in the crypto industry and has the potential to cause significant disruptions.
The prevalence of wash trading varies among exchanges, with regulated exchanges having lower instances of wash trades compared to unregulated ones. Binance, the largest crypto exchange in the world, estimated that wash trading comprised 46.4% of its transactions. KuCoin, another top-five exchange, reported that 52.9% of its transactions were wash trades. The occurrence of wash trading tends to increase after positive market returns or a decrease in volatility, as exchanges strive to increase volumes to attract more clients.
Identifying wash trades can be difficult without access to account data, which is usually only available to exchanges. However, understanding the importance of regulation in the industry can help combat this fraudulent practice. While there are various ways to make money, engaging in illegal activities like wash trading can have severe consequences.
