Wash trading is the practice of artificially boosting the trading volume of assets in the financial markets with the intent of profiting from the misinformed market interest. This is typically done through short-selling.
Understanding the Dynamics of Wash Trading
Wash trading is commonly executed by exchanges, funds, or investors aiming to mislead the market into believing there is increasing interest in a particular asset.
By artificially boosting trading volumes through high-frequency trading (HFT) and other methods, these bad actors can sometimes deceive traders and investors into thinking a trend is forming. This gives the impression that there is significant market interest in a particular commodity, stock, cryptocurrency, or other financial asset.
This artificially inflated volume attracts legitimate interest, causing prices to rise. At this point, wash traders begin shorting the market and cease their fake trading, leading to a rapid drop in volume.
When legitimate traders notice this, they may interpret it as a bearish signal and start selling. This causes the price to drop as well, which results in profits for the short-selling wash traders.
The Intersection of Wash Trading and High-Frequency Trading
High-frequency trading (HFT) is a widely used trading method that involves algorithmic trading bots. It’s done by placing large quantities of trades over short periods.
Wash trading is often done in the form of HFT, as it:
- Obscures the origin of funds (especially in the crypto world)
- Can disguise wash trades as organic market activity (e.g., day trading)
Wash Trading’s Impact on the Cryptocurrency Market
Due to its lagging regulatory oversight, the crypto market has been a prime target for wash trading activity. It often reaches trading volumes in the hundreds of billions of USD per day.
Many major exchanges such as Binance U.S., Coinbase, and Bitfinex have been accused of participating in wash trading practices. They were artificially boosting trading volumes and undermining their users.
The problem of wash trading in decentralized finance (DeFi) is even bigger. The illegitimate trading volume allegedly reached $2B by the end of 2020.
NFT Wash trading
Wash trading, particularly that done through the purchase and sale of Non-Fungible Tokens (NFTs), may also be used for money laundering.
A recent U.S. Treasury Department assessment highlights the NFT sector’s vulnerability to fraud and illegal activities, including terrorism financing, money laundering, and sanctions evasion. Wash trading in the NFT market is a tactic that can be leveraged to achieve these illicit goals.
According to a 2022 report by Chainalysis, the volume of NFT trades originating from addresses linked to illicit activity spiked in 2021 to $1.4M — a small but significant number. The report also details the overall profits from wash trading NFTs was $8,458,331 in 2021.
Case Studies: Identifying Wash Trading Practices
Wash trading in cryptocurrencies is receiving increasing attention. Websites have published articles on a startup faking volume for exchanges and exchanges have promised to come clean on wash trading.
Victor, F., & Weintraud, A. M. (n.d.)
Some of the most notable cases of high-profile wash trading in recent years have been in the crypto space:
- Binance (2023): The SEC charged Binance and founder Changpeng Zhao with, among other violations, engaging in wash trading through their affiliate Sigma Chain. This was done by inflating trading volumes on the Binance.US platform. The SEC alleges this manipulative trading misled investors about the platform’s true market activity. The effectiveness of its trading controls.
- Coinbase (2021): The CFTC fined Coinbase $6.5 million for false reporting and wash trading by a former employee on its GDAX platform. Between 2015 and 2018, Coinbase’s automated trading programs generated trades that matched with each other, resulting in misleading transaction information.
- Wash Trading Crypto Exchanges (2021 Study): A study by Le Pennec, Fiedler, and Ante analyzed wash trading based on web traffic and wallet data across twelve crypto exchanges. They found suspicious trading volumes exceeding 90% at most exchanges, indicating that wash trading was used to artificially signal liquidity.
The best way to protect against it is to steer clear of unreputable exchanges and keep a lookout for suspicious market activity. That may include sudden, large spikes in trading volume, overly predictable price patterns, and cyclical price patterns.
Conclusion
Wash trading has been around for a long time. The advent of automated trading and the high-frequency trading that was made possible by advancements in computing power and high-speed internet have made the problem that much bigger.
Modern financial regulations are comprehensive and bad actors are usually caught quickly. However, in the more difficult-to-regulate crypto world and especially in the DeFi space, the practice is still very much ubiquitous.
Victor, F., & Weintraud, A. M. (n.d.). Detecting and quantifying wash trading on decentralized cryptocurrency exchanges. Technische Universität Berlin.
https://berkeley-defi.github.io/assets/material/Detecting%20and%20Quantifying%20Wash%20Trading.pdf
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