Wash trading allegations are prevalent in the crypto industry, but it’s not a new phenomenon. Wash trading has been around as long as markets themselves. In the United States, it’s been illegal since the 1930s. People engaged in wash trading can go to prison and trading platforms must have controls in place to detect and prevent it. In the crypto world, the risk is greater since many trading platforms remain unregulated. In this post, I explain what wash trading is, how to detect it and why you should care if it’s occurring.
What is wash trading?
Simply put, wash trading is the same person/group trading with themselves to make it look like there is more interest in an asset than there actually is. It’s called wash trading because the transactions are “a wash” for the traders involved. They buy and sell the asset at the same price. Their goal is not to profit off the transactions. It’s to create the appearance that trading volume is higher than it actually is and/or to create the appearance that the asset is trading at higher price than it actually is. Wash traders hope the increased volume draws in other unsuspecting investors. These unsuspecting investors buy the assets, often at artificially inflated prices, because they believe demand is high.
Technology has made it possible for wash traders to operate on a much larger scale. Today, much of the trading volume (legitimate and illegitimate) in all assets and securities is done electronically using algorithms and automated trading systems. This technology has dramatically increased the speed and volume at which trades can be entered and executed. Wash traders exploit this technology to artificially inflate volume to levels that would have been unprecedented just a few years ago.
How do you detect wash trading?
To understand how to detect wash trading you have to understand how it looks different from legitimate trading activity. Most traders are trying to make money. To make money, the trader must risk losing money. While they may trade frequently like a wash trader, using similar algorithms and automated trading systems, the net result for a legitimate trader is a series of winners, losers and some trades where they break even.
Wash traders, on the other hand, aren’t trying to profit. They aren’t trying to take risk. In fact, they are trying to increase volume while taking as little risk as possible. So a wash trader’s account activity will look different from a legitimate trader. Wash traders will have very few winners or losers and a whole lot of break even trades.
Once you understand how wash trading looks different from legitimate trading, platform operators can develop automated monitor to detect wash trading. Once detected, the trading platform can decide whether to give the trader a warning or prevent them from trading on the platform all together and whether it has any obligation to report to activity to local authorities.
Why you should care if wash trading is occurring?
Wash trading is deception. It’s one user or group of users trying to take advantage of another group of unsuspecting users. In many cases, the victims are significantly less sophisticated than the wash traders.
For trading platforms, when this type of activity is exposed it hurts investor confidence. If investors don’t believe a market is fair, they won’t participate. This can impact not only the specific trading platform or exchange, but the entire industry as a whole. This is particularly true in the crypto world where cryptoassets, trading platforms and exchanges are already battling a perception that they are indifferent (or worse) to criminal activity. The failure to address blatant market manipulation, such as wash trading, could prevent the further mainstream adoption of cryptoassets and the growth of the industry.