What is Wash Trading? Definition and How it Works

Wash trading is a form of market manipulation where an investor or trader buys and sells the same asset simultaneously to create the illusion of high trading volume. This illegal practice can inflate the market activity of a security, misleading unsuspecting investors about its true value. Wash trading involves no real change in the trader’s position, often resulting in no market risk and can artificially inflate trading volumes.

Traders may engage in such activities to manipulate the market, increase trading volumes, or even for tax advantages. In the U.S. and U.K., regulators like the SEC and CFTC prohibit wash trading to maintain market integrity and protect investors from false information and market abuse.

History of Wash Trading

Prior to 1930, wash trading was not controlled and was a common practice among traders. Investors made “wash sales” to signal the false desirability of an asset and thereby drive up its price. Fearing lost profits, the duped investors would buy the asset, driving up the price of the asset even more.

Wash traders would then profit from shorting the asset when the surface interest in it and the artificially high price drops. A short sell is when an investor makes a profit by buying back a borrowed asset at a lower price than he sold it for.

However, following the Great Depression – the worldwide economic downturn of 1929 to 1939 that began in the US – financial regulators were forced into action to prevent practices like wash trading. The government approved the Commodity Exchange Act (CEA) and the Securities Exchange Act (SEA) in 1934 to regulate practices like wash trading. These laws banned wash trading and required strict regulation on all commodity futures.

In addition, the US Commodity Futures Trading Commission (CFTC) warned that brokers would be involved in “wash” trading whether or not they knew of the intentions of the trader they hired.

How Wash Trading Works

What Is A Wash Sale In Day Trading?

According to Investopedia, wash trading is an illegal practice that can artificially inflate trading volumes. day trading refers to the purchase and sale of a financial instrument on the same day or several times during a day’s course. IRS guidelines further communicate that a taxable trade is a “wash” in day trading if a trader re-acquires identical or similar asset(s) 30 days before or after the sale, at the same price.

Additionally, the sale rule applies if an investor was acquiring stock or securities for their retirement arrangement (IRA), or Roth IRA since these have the benefit of being tax-free and must avoid practices like wash trading. Note that tax evasion is a critical point in a wash trade.

Moreover, the IRS considers a transaction a wash if the asset/security/option repurchase was performed by the trader’s company or spouse.

What Are the Rules for A Wash Sale?

Certain conditions must be present for a transaction to be categorized as a wash sale. For starters, there are two main factors considered:

1. The intent: a transaction is a wash sale if the parties involved knowingly partook in it, or pre-arranged it to achieve the result below.

2. The result: a transaction is also a wash sale if the parties involved wanted it to have the results of a wash sale. Results, in this case, are the purchase and sale of the same asset at the same time, and the same price. This can either happen on a single account, or different accounts with the same, or common beneficial ownership.

Note that accounts are deemed to have common beneficial ownership if:

• They bring a certain degree of gain to their owners

• They are owned by the same person or entity

• They are owned by different entities that are fully owned by one parent entity

However, there are various instances in which trades executed from accounts with common ownership don’t fall into the wash trade category. They include transactions that:

• Were initiated independently

• Were Initiated for separate and legitimate business purposes

• Crossed each other in a competitive market out of pure coincidence

• Had no pre-arranged structure

• The buyer and seller do not know each other – such a scenario could be deemed insider trading. The term refers to a transaction in which an investor has more knowledge about the trade than the general public. Insider trading is frowned upon just like wash trading, and it is also just as illegal and prosecutable by law.

Essentially, if one does not replace an instrument they sold with a substantially similar one within the 30-day frame and does not seek a tax cut for capital loss, then the transaction is not a wash sale.

Example of a Wash Trade

A notable wash trading example is the one involving the LIBOR (London Interbank Offered Rate) scandal. LIBOR is a rate that is used as a benchmark to determine the rates for loans and derivatives on a global scale. The rate is determined by reference interest rates put forward by certain banks in the U.K.

During the scheme, banks involved in determining its rate consciously submitted lower or higher rates to influence the LIBOR. With rates set to their liking, banks made profits from loans, derivatives, and various forms of trade in the financial markets. Wash trading came in when brokers received payment for their role in manipulating the LIBOR, which is a practice that can also be seen in the cryptocurrency market.

In 2012, the scandal was publicized, causing public outrage as many felt conned out of their pockets. Major banking institutions such as The Royal Bank of Scotland, Barclays, JPMorgan Chase, and Deutsche Bank were implicated. The LIBOR rate is now being phased out, to be replaced with the Secured Overnight Financing Rate (SOFR).

Suppose hypothetically Trader X has 100 shares that he sells on June 9 at a loss of $5,000. He then buys back all the shares on 15 June, resulting in a taxable gain of $10 000. If Trader X claims a tax deduction to offset his original loss of $5 000, then a ‘wash sale’ is deemed to have taken place.

Crypto Wash Trading

When it comes to the cryptocurrency market, wash trading is mostly done to falsely boost traders’ interest in a particular digital currency or asset, including non-fungible tokens (NFTs), and is considered an illegal practice. Other investors react by buying, say, the cryptocurrency xyz, due to the fear of missing out (FOMO) on the potential gains. Eventually the wash trader sells their digital assets when the price is favorable, much like shorting stocks.

In many cases, the digital asset in question is usually a cryptocurrency with a small market capitalization, with manipulators trying to boost its value for selfish gain.

The fact that computers are aiding high-frequency trading only makes cryptocurrency trading even more prevalent. Furthermore, many countries have not imposed clear rules on practices like wash trading in the crypto market. This is mainly due to the fact that the sector is still young and regulators are trying to figure it out in an effort to draft sensible regulatory frameworks. Where they are regulated, crypto and other blockchain assets are subject to property tax laws rather than laws governing securities, options or equities.

Overtime, various blockchain intelligence firms have disclosed evidence showing that the crypto industry is rife with washing trading. A research paper from the Blockchain Transparency Institute reveals that of the top 25 Bitcoin trading pairs, over 80 percent were wash traded in exchanges in 2018.

What is NFT Wash Trading?

NFT wash trading is where an unscrupulous NFT creator or holder engages in wash trading by using multiple addresses that all belong to him. The NFT holder essentially buys and sells the same NFT to himself multiple times, successfully feeding misleading information to other investors. The information here is that a certain NFT has high sales volumes, and is therefore in high demand, or is as many traders like to say, “hot.”

Last year, NFTs brought in roughly $44 billion in sales. However, blockchain analysis firm Chainalysis detected several instances of NFT wash trading in 2021. Certain NFTs were repeatedly (over 25 times) sold off to wallets belonging to the same NFT holder, illustrating artificial trading patterns. The firm goes on to say that 110 NFT holders were wash traders, and they made a collective profit of about $9 million. Such manipulative behavior continues to draw interest among regulators worldwide.

The Legal Aspect of Wash Trading

Wash sales are prohibited in many jurisdictions, and therefore illegal. However, there is still a lack of clarity regarding wash trading in some scenarios. For instance, is a transaction a wash if one broker sells stocks or securities to another broker? To be on the safe side, such a practice should be avoided since it may be classified as insider trading.

Additionally, the IRS is unclear of what stocks or securities are similar to each other. Investors have therefore been forced to seek guidelines on the same from other third parties. The agency has, however, pointed out that financial instruments of different corporations are not “substantially similar,” and therefore do not constitute a wash sale.

Difference Between Wash Trading and Market Making

Wash trading and market making are two very different terms. The latter creates a market where investors can buy and sell securities on demand and at publicly quoted prices. In essence, market makers provide liquidity and prevent markets from becoming sluggish. Market makers’ profit comes from the spread, or the difference in pricing, between instruments at the time of buying or selling. Market making is very much legal and is performed by many banks including Deutsche Bank and UBS.

On the other hand, wash trading is illegal since it creates opportunities for making gains unfairly.

How to Avoid a Wash Trade

Engaging in an illegal wash sale can irreparably tarnish a trader’s reputation, and it could carry both financial and legal consequences. There are a number of steps an investor can take to avoid being implicated in a wash trade, especially in the cryptocurrency market:

1. Paying close attention to the timing and conditions in which a trade is performed to make sure it does not qualify as a wash sale. It is best to wait 61 days before replacing assets sold with the same or similar ones.

2. Staying up to date with regulations regarding wash trading, including those being developed in the crypto and NFT industry. Many wash trades are executed out of ignorance.

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