wash-trading

Wash Trading: An Easy Explanation Along With Effective Example

You have undoubtedly known about NFTS (non fungible tokens) and you may have many questions on that matter. In recent times, we have seen a strange tendency in the sector. Some creators are beginning to purchase, generating skepticism in the industry. What do we call this? Is it wash trading?  

In this respect, let us have a look at the idea of this type of trading and how it is performed. Wash trading is done when an investor or trader purchases and sells the same security within a short window in an attempt to mislead other market players about the value or liquidity of an asset. 

Many wonders if wash trading illegal? Within the security space, wash trading is considered illegal, but there are yet to create regulations within the crypto space. So now without any further delay, let us begin with this article. 

What Is Wash Trading?

Wash trading illustrates a sale in which a trader is selling an asset, then re-buying it at or about a similar time as the sale. Wash trades can be utilized as a form of industry manipulation. An investor purchases and sells the same asset, in quick succession, in a try to influence the value or trading activity.

There are various motivations for a trader or entity aiming to engage in this type of trading. The aim might be to spur purchasing activity in order to send values up or encourage selling to drive prices lower. Another motivation may include a trader trying to avail the wash sale to lock in case of a capital loss, and then to purchase the asset on a lower cost basis, primarily seeking a tax rebate.

Even though this trading may include several varied traders, entities, and accounts, the motivation is the constant. The desire of this type of trading is to mislead, boosting dimensions of the value and volume of a financial asset that is being traded.

How Does Wash Trading Work?

At a primary level, a wash trade is an investor purchasing and selling an asset at the same time. However, a real wash trade goes further, taking into consideration the intent of the investor. Hence, two scenarios are generally catered to confirm a wash trade.

The first scenario is intent. The wash trader must hold a specific strategy to purchase and sell the same asset before time. Again, this is conducted in an attempt to mislead. As an outcome, several accounts are required to try to pull off the misrepresentation.

The trader, or firm, will carry transactions on the same asset but will use the varied accounts to report in changed values or raised trading volume. The account that has the asset will sell the asset to another account of that wash trader.

The second scenario is the outcome. The outcome of the transaction must be a wash trade, where the investor has purchased and sold the same asset at the same period of time, using accounts that have the common or same ownership.

One way to evaluate if wash trading is occurring is by evaluating the financial position of the investor. If the trade does not alter the overall position of the investor or expose them to any form of market risk, then it can be accounted for as a wash.

Wash Trading Example

Let us think we have a stock trader whose name is Joe, and a brokerage firm conspiring to rapidly purchase and sell stock in the company ABC. The concept is that other investors will observe the activity on ABC stock, and will plan to invest in ABC. As these investors purchase ABC, the price increases, and Joe earns profits from the rally. Then, “Joe” short-sells the stock of ABC, driving the value lower and profiting from the downward value trend.

This form of trading has been suspected in digital currencies, too, especially when regulators are slow to regulate its prevalence. Back in 2017 and 2018, when blockchain projects would create money through initial coin offerings (ICO), the revenue of crowdfunding could be recycled back to the exchanges to portray a bolstered level of interest in the latest project.

For instance, large investors within a crypto space, XYZ, might purchase some more XYZ crypto from that project by utilizing multiple addresses. Once they have acquired added XYZ, then they would transfer a similar amount of XYZ to the exchanges. At that point, they would change XYZ to Ether and use that Ether to purchase more XYZ. This behavior would prevail for some time, using several addresses in an attempt to disguise their intent.

Outside investors would see the raised interest and volume in XYZ, then plan to purchase into the project long-term. This added interest from outside holders with long-term intent raises the value of XYZ. Then, the insider would sell some of their XYZ cryptos at a good profit margin. With respect to that, the large investors of XYZ use wash trading for misleading others about the speculative interest in the venture so they can ultimately dump their holding at a profit. With that, you may wonder how to detect wash trading? 

To detect a cross trade or wash trade, the surveyor searches for implementation in two local accounts (cross trade) or one local account (wash trade) with matching symbol, price, size, venue, and millisecond timestamp. 

How Does NFT Wash Trading Occur?

Non-fungible tokens or NFT, have come under scrutiny lately vis-à-vis wash trading. First, let us review what makes NFTs varied, then illustrate how this trading can happen with NFTs.

What Makes NFTs Varied From Bitcoin Or Ethereum?

To evaluate NFTs, we first require to begin with a fungible token. A fungible token is a digital asset that can be exchanged like-for-like. Fiat currency is fungible. Anyone can trade $10 dollar bills, and we will still each have the same value. And also the bitcoin price for one user will be the same as the other one. 

NFTs are varied as each one is unique. Real estate space is non-fungible. Anyone can have a similar floor plan for our two houses, on a similar street in the same neighborhood. However, your home may have upgrades in it, and may perhaps be in a better scenario. Therefore, it would not be the same value exchange if we simply traded houses.

Within crypto, a non fungible token is simply something unique, whose owner and other details are kept on a blockchain. There is a rapidly rising amount of NFTs to purchase and collect.

If you are an NFT creator, you will wish for a way for your NFT to stand out, so that people can purchase it from you and you can earn profit. For this purpose, this trading has entered the NFT area.

A wash trader would purchase and sell their own NFT in wash trading NFT so that it will show increased interest and volume and possibly a price raise. This scenario can be repeated over and over.

As an outcome, outsiders seeing this inflated activity might think of purchasing the NFT at an inflated value. Once the NFT is sold to an outsider, the NFT creator pockets the variation. 

Recently, Chainalysis finished the research on this topic and it found 110 wallet addresses that profited a mixture of $8.9 million from active wash trading crypto.

Conclusion

Unfortunately, like any latest technology, NFTs can improve illegal activity like wash trading. The industry is still educating itself on how this new asset class might change how we see ownership rights. In the meantime, the regulator must develop elements to make NFT investing as secure and safe as possible. There have been many scenarios of wash trading money laundering cases as well.

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