What is crypto wash trading?

What is wash trading?

Wash trading is an old concept that occurs in multiple financial markets. The term originated in the stock market in the early 1900s as a process where a trader buys and sells a security to feed misleading information to the market.  

In other words, a trader buys and sells an asset which is in rapid succession to artificially boost its price and trick other traders and investors to do the same. Today wash trading is associated with the crypto industry but it kind of works the same as with stocks. 

Wash trading misleads investors into thinking that the trading volumes of an asset are higher than they are. Sometimes the broker and trader execute wash trading by colluding with others, and other times investors execute it by buying and selling the asset. 

It is important to mention that wash trading is illegal. For example, the United States first banned wash trading after the adoption of the 1936 Commodity Exchange Act. Prior to the law’s enactment, this activity was frequently used by stock manipulators to maliciously signal interest in a stock to boost its value.

What is wash trading in the crypto space?

Similar to its traditional counterpart, crypto wash trading happens when a trader sells and then immediately buys the same crypto asset. In other cases, a user can sell an asset such as a non-fungible token (NFT) to themselves by colluding with a third party to make a trade but not change the ownership itself. 

Crypto wash trading represents a type of market manipulation that has the potential to artificially pump prices and mislead investors into believing that the market liquidity of a crypto asset is bigger than it is in reality.  

For example, if a trader decides to place simultaneous buy and sell orders at divergent trading accounts, an exchange of value won’t take place, but the activity shall create a false impression that the trading volume is higher than it is. 

Additionally, wash traders are likely to use automated trading programs to mass-produce fake orders which essentially reduces the proportion of authentic trading volumes and results in less trade clustering.

How bad is it for the crypto market?

Wash trading is bad for several reasons. Primarily, it amounts to an unfair advantage on the market for the person who engages in this type of market manipulation. 

By artificially pumping the price of an asset, malicious actors mislead unsuspecting investors into buying assets at a higher price. This diminishes the trust in the market itself and presents a damaging activity for newcomers on the market who may not be aware of the wash trade concept and its consequences. 

Finally, wash trading at a larger scale can make the market even more volatile. When a crypto asset’s price is being falsely boosted, it can create a bubble on the market that is waiting to burst and cause broad price fluctuations. Rapid drops in the price of crypto assets can produce a ripple effect on the whole market and end in a market crash. 

Several economic concepts that stem from traditional financial markets can be applied within the crypto ecosystem. To learn more about the application of traditional economics in crypto, we suggest reading this article: 'How do popular theories in economics shape crypto?'.

The crypto market is highly speculative, and crypto traders look for financial market fluctuations they interpret as positive investment trends. Wash trading can be efficiently used to artificially create investment performance and influence the market sentiment.

Is it common?

Wash trading can happen in any market, either a traditional financial market or a crypto market. However, it became an attractive option to rogue investors in the crypto space.

The U.S. National Bureau of Economic Research found out that wash trading accounts amounted to 70% of trades on unregulated crypto exchanges. 

Back in 2019, Bitwise Asset Management presented evidence on wash trading on several crypto exchanges to the U.S. Securities and Exchange Commission (SEC), along with several other research studies that found proof of this activity within the crypto industry and that a major percentage of the trading volume reported by unregulated exchanges was fake. 

Wash trading is a common occurrence in any economy, and when it comes to crypto, it can be as simple as sending assets from one crypto wallet to another. However, a trade still needs to meet certain criteria to be recognised as a wash trade. 

Crypto wash trading is hard to identify if you don’t have access to account data which is available to exchanges themselves. A straightforward way to detect fake transactions and wash trades is to identify the buyer and the seller and prove that they are the same person or entity.

While several research studies found that wash trading wasn’t a frequent activity on regulated exchanges, the Solidus Trade Surveillance data demonstrated the world of decentralised finance (DeFi) was susceptible to this kind of market manipulation with Ethereum-based decentralised cryptocurrency exchanges (DEXs) wash trading approximately $2 billion worth of cryptocurrency since September 2020. 

How does crypto wash trading work?

To wash trade crypto or any other asset on financial markets, traders need to create an artificial activity that meets certain criteria. This type of market manipulation typically involves multiple participants or accounts to execute trades. Participants can be either individual users, groups, or automated bots. 

Secondly, cryptocurrency wash trading is based on simultaneous buying and selling; crypto wash traders must place orders for the same crypto asset simultaneously. Simply put, a wash trader places a buy order on one account, and a sell order on another for the same quantity of the asset in question. 

Intent is a key feature of wash trading; it needs to create an illusion of trading activity without changing ownership. The buy and sell orders cancel each other out and don’t affect the wash trader’s position in the market but create an illusion of activity. 

Wash trading is not a one-time thing- traders repeatedly conduct such trades to produce significant fake trading volumes and provide the illusion of high activity on the crypto market. Increased trading volumes send false signals to crypto traders and investors who rely on such indicators and other financial market indices to make decisions. 

This market manipulation technique misleads trading volumes but can also have an impact on price movements. Coordinated crypto wash trading at certain price points can result in artificial price fluctuations. 

A practical example of crypto wash trading

Let’s lay down a hypothetical example involving two individual traders, Peter and Heather who want to trade a particular cryptocurrency. 

For starters, Peter and Heather each have two trading accounts on a certain crypto exchange. Peter has accounts A1 and A2, and Heather has accounts B1 and B2. 

To conduct a successful wash trade, Peter and Heather need to coordinate their actions; Peter places a buy order for 150 units of the desired cryptocurrency on account A1 for $20 per unit; at the same time, Heather places the same order on account B1. These accounts get matched and a transaction happens, but the ownership didn’t change because Peter and Heather are working on coordinated trades. 

Now they repeat the whole process on accounts A2 and B2 to create fake market activity. They continue this process to create further appearance of trading activity of that particular crypto asset, and eventually the trading volumes of the asset increase on the crypto exchange.  

What is the difference between crypto wash trading and market making?

The main difference between market making and wash trading lies in the fact that market making is not a manipulation technique but a legal activity.

A market maker, either a company or an individual, buys and sells assets at publicly quoted prices on demand and therefore, provides liquidity and facilitates trades between buyers and sellers. If you are trading through an online broker, you’re using a market maker.  

Market makers profit from their intermediary activities, but their intent is not to create false trading volume and mislead users yet to keep the capital moving and to act as a middleman between the market and the investor.

What is NFT wash trading?

Wash trading isn’t associated only with cryptocurrency; it can also occur concerning non-fungible tokens (NFTs). To wash NFTs, a user typically sets out multiple accounts to buy and sell the same NFT and make it appear as a highly valuable asset. 

Transactions between crypto addresses are stored on a blockchain and anyone can see them. Therefore, any user can see when an NFT was traded and how much it cost.

However, wallet addresses look like a string of alphanumeric characters with no identifying information; it is hard to tell who is behind a transaction and whether two addresses are owned by the same person.

Similar to crypto wash trading, the practice of NFT wash trading is bad for the whole market. As it can artificially increase the value of a particular non-fungible token, it can lead to a bubble that may burst when the market realises that the demand is just an illusion.

Secondly, NFT wash trading can mislead users who may think that a particular token is valuable. Therefore, this activity has the potential to undermine the integrity of NFT markets.

If you want to know what's next for NFTs, why not read this article: 'NFTs: Fad or New Digital Frontier?'.

How to avoid crypto wash trading?

Wash traders operate in the dark and identifying wash trading can be a challenging task, but there are certain red flags to look out for as well as tools and strategies that can be used to detect it. 

If you are new to the crypto space, it is important to always do your own research and educate yourself about all the technical details, main features, and perils of crypto assets. You can always take a look at available courses at our Learn Crypto Academy and start learning. 

Let’s start with some basic red flags to help you avoid wash trading activities. When analysing crypto trading data, several indicators may signal that wash trading is going on. 

High trading volume and symmetrical trading patterns

If you spot significant upturns in the trading volume of an asset without any significant news or market trends, it could be a sign of a wash trading activity. It is not easy to detect it, but you should start with comparing the trading volume with historical data. 

The second red flag refers to symmetrical trading patterns as mirror-image patterns where buy and sell orders are conducted at the same quantity and price. Symmetrical patterns could represent a sign of coordinated trading activity.

Consistent trades and abnormal spreads

Wash traders conduct trades repeatedly with a high level of precision. This repetitive pattern of trades executed at regular intervals can serve as another indication of an artificial market activity.  

Crypto wash trading can happen with minimal or no spread at all between the bid and ask prices which also potentially signals that the traders involved are not really interested in the profit.

The bottom line

Wash trading is a major problem within the crypto industry. With the occurrence of market manipulation methods such as wash trading of cryptocurrencies and NFTs, the crypto market cannot fulfil its potential to provide accessible, transparent, and secure financial services. 

As mentioned above in the text, detecting wash trading activities is a challenging task, and aside from spotting potential red flags, it requires specialised technology and a high level of technical and financial expertise. 

However, the crypto space has made efforts to combat the wash trading problems over the past couple of years as many cryptocurrency exchanges include compliance teams, mainly larger than those in traditional finance.  

As an individual investor or crypto trader, you can protect yourself from falling prey to wash trading schemes by being aware of the risks associated with the crypto space and by carefully choosing a crypto exchange. 

This article is meant only for educational purposes. Keep in mind that doing your research and gaining knowledge related to crypto and finance is the best way to go.