Today’s investors live in a world where a plethora of market data is available for every single security or asset on sale, on every market existing, at the touch of a button.
For crypto investors, this is even more true. The innate transparency of public ledgers and the rising tide of on-chain data analytical tools allows keen investors to examine transaction and market information from just about every mathematical perspective.
Despite this, a wide majority of the new crypto adopters who flocked to the market during the past couple of years are inexperienced and analytics-agnostic. This is compounded by the boom of meme coins and obscure NFT collections of dubious backing. While diamonds in the rough are always a possibility, the wide majority of these ‘unmissable investment opportunities’ represent projects with virtually no history or market trends to utilise in order to put their values in perspective.
This scenario is comparable to an even bleaker version of Plato’s Cave: these investors are blindly crawling through the crypto space, ready to interpret the faintest glimmer of light as the very sun. This usually comes in the form of a vaguely positive basic indicator, such as high volume or historical price trends (the gambler’s fallacy is still alive and thriving). It can then be amplified to the masses through sensationalistic YouTube speeches or aggressive Twitter shilling.
When the totally unregulated status of the crypto and NFT markets are taken into account, it’s plain to see how the above provides a very rife environment for wash trading.
What is Wash Trading?
Wash trading is a practice that was very common in the early days of the stock market and was outlawed right after the Great Depression in a bid to rectify some of the exploits most commonly used to achieve market and price manipulation. In the US, it is currently actively prohibited both by the Commodities Exchange Act (CEA) and the Securities Exchange Act (SEA).
By definition, it occurs when an investor or trader purchases and sells the same assets multiple times in a short period of time, with the trades undertaken essentially cancelling out each other and resulting in no commercial value. The goal is, indeed, not outright financial upside but the deception of other market participants about said asset’s price or liquidity – essentially, manipulation of the market trends.
An example of this might be the generation of fictitious volumes on selected stocks or cryptocurrencies, in a bid to pump their price and gain a bigger profit when offloading bags of said asset. Or, vice versa, the tanking of a token’s price to enter a desired position at an unrealistically low price.
Despite its illegal status, this type of activity has been brought back to the fore of regulators’ anxieties by the rise of high-frequency trading in the last decade. The incredibly high number of transactions processed and the superhuman speed at which they are carried out have facilitated obfuscating any proof left of such practices, and tempted many to engage in such nefarious tricks.
A Widespread Issue
It goes without saying that, with crypto markets still mostly unregulated and highly saturated by high-frequency traders, wash trades have blossomed there.
According to the Blockchain Transparency Institute, more than 80% of the top 25 trading pairs for BTC had been wash traded – as early as 2018! As a response, the institution launched its own self-regulatory tool in 2019 in a bid to reduce the issue.
More recently, research at Cornell University pointed out that, on average, up to 70% of transactions on unregulated exchanges are fake.
As for NFTs, the examples are endless, but prominently the major NFT marketplace LooksRare was outed in April 2022 when 95% of its overall trade volume was shown to be made up of wash trades – for a staggering total of $18 billion cumulatively.
Laundering and Taxes (Avoided)
Another major application of wash trading techniques is the avoidance or evasion (depending on the severity and complexity of the tricks at play) of taxation.
Trades which bear no immediate commercial value might still represent a substantial source of financial upside for those who perform them if they allow them to misleadingly claim losses in a tactical pattern to reduce liability.
In an even more outright violation of several ethical investment principles (it’s all we have until regulation beckons), the NFT market has turned into a major vehicle for money laundering through wash sales. Art purchases are often ‘self-financed’ – meaning that the coins used for the sale come directly from the selling address or another parent address funding both.
This allows users to both confound the origins of the coins circulated and simultaneously inflate the valuation and volume of their digital art.
How To Spot Crypto Wash Trading
The bad news is that, as an individual retail investor, you probably can’t avoid participation in ‘washed’ markets. Wash trading is too widespread and those who employ it are skilled at covering their tracks. Even governmental regulators and crypto analytics giants often struggle with it.
The good news is that in most markets, this won’t matter. If they are big enough, it’s likely that any wash trading is tied to obtaining individual, personal advantages (such as tax avoidance or fee manipulation) rather than price manipulation. Any such attempts would be patently obvious due to the required (huge) transaction size to shift weights.
Therefore, in order to not be significantly deceived in one’s investment strategies, avoiding small cap meme coins and rising projects with little adoption is a surefire solution. This is even more true in the NFT space, where feelings of manufactured FOMO and obsessions for early adopter status are easily elicited.
Given that many are currently forecasting the death of such hyper-speculative assets, it shouldn’t be too complicated. In the long term, it seems inevitable that such unethical and dangerous practices will need to be eradicated from the industry in order for its maturing and adoption to continue. After all, the employment of crypto and NFTs in illicit practices such as money laundering is one of the main sources of FUD inspiration for crypto sceptics of all kinds.