Traders use several strategies to get an edge in stock and cryptocurrency trading. Some of these strategies, like pump and dump schemes, are illegal in most countries.
In this article, we will focus on a strategy that has become extremely popular in the loosely regulated cryptocurrency industry. We will explain what wash trading in crypto is and the rules that exist in the industry.
What Is Wash Trading on the Stock Market?
Wash trading is a trading strategy that has been around for decades. Also known as round trip trading, wash trading is an approach where a trader opens buy and sell orders of an asset at the same time. The goal is to manipulate the market and take advantage of the prevailing volatility that emerges.
While wash trades are illegal in several countries like the United States, they are incredibly popular. In most cases, these trades usually occur among penny stocks that can be influenced by a single trader. It is often difficult for people to move highly valued mega-cap companies like Apple and Microsoft.
Wash trading in penny stocks was blamed for the 2010 flash crash when the Dow Jones fell by over 10% and then bounced back within minutes.
Another way of wash trading in stocks is when a trader sells an asset at a loss and then buys the same stock. They will then claim a tax benefit based on the initial loss.
What Is Wash Trading in Crypto?
The concept of wash trading in the crypto industry is similar to what happens in the stock market. The only difference is that it is more entrenched in the sector because of its global nature and the fact that the industry is loosely regulated in most countries.
This is unlike the stock market, where a small number of large brokers like Robinhood, Schwab, and Interactive Brokers dominate the market. In crypto, trading is usually facilitated by global companies like Coinbase, OKX, and Huobi, which are regulated in different jurisdictions. It is also hard to regulate wash sales in crypto because of the prevalence of decentralized exchanges like dYdX and Uniswap.
Wash trading in crypto is when a trader opens two or more buy and sell trades in order to manipulate the asset's price. This happens because most professional traders understand the importance of volume in the financial market. Ideally, traders tend to value assets that are moving up in high volume. At times, it could mean that an influential person in the market is buying the asset.
In most cases, wash sales in crypto are used as intentional market manipulation. In other times, they can be an honest mistake, where a person opens a trade and closes it right away. For example, many traders tend to press the sell button when they intend to go long the asset.
A good example of a wash trade is when a trader opens a trade buying a cryptocurrency, say Bitcoin. Immediately after doing that, they sell the asset, possibly at a small loss. Finally, after attracting more traders to the asset, the trader will enter a new trade and ride the bull run for a short while and then exit.
How Cryptocurrency Wash Selling Works
To understand how crypto wash sales work, it is important to explain how trading itself happens. Crypto trading mostly happens using two main types of companies: centralized exchanges (CeFi) and decentralized (DeFi).
Centralized companies like Binance and Kraken are private companies that are controlled by their shareholders and their management teams. These managers are then mandated to set their trading fees and rules.
Decentralized exchanges, on the other hand, are platforms that are open source in nature. Holders of the tokens, such as UNI and CAKE, usually set the rules through a voting process. Dexes are so popular that their volume accounts for most of all crypto trading.
In most cases, for this strategy to work, participants usually create a wash trading scheme, where they coordinate with other like-minded individuals. This coordination is important because of the substantial amount of volume that is usually needed.
Recently, popular social media platforms like StockTwits, Twitter, and Reddit have been used well to coordinate crypto wash trading. Participants collude and then coordinate the time when they will execute the trades.
Wash sale in crypto tends to be popular among small coins that have a relatively low market cap. For one, influencing Bitcoin, which has a market cap of more than $400 billion, is quite difficult.
Wash Trading Example
Therefore, a good example of a wash trade is one that involves a relatively small cryptocurrency that is thinly traded. At the time of writing, ZoidPay was a relatively small cryptocurrency that was valued at $53 million. The coin had a 24-hour volume of just $55,160. The 30-day average volume was about $60,000.
So, in this case, a trader with $100,000 can open several wash trades within a few minutes. The implication of this is that many regular traders will see this soaring volume as a bullish sign and join in, which will then push the price much higher.
NFT Wash Trading Explained
Wash trading is also extremely popular in the NFT trading industry. For starters, NFTs are art products that cannot be replicated. A good example of this was Jack Dorsey's first tweet that sold as an NFT for $2 million.
Like cryptocurrencies, NFTs are also loosely regulated since most of the trading happens on decentralized platforms. Also, most companies in the industry are registered in offshore countries where it is hard to enforce the law.
In April 2022, Bloomberg reported that LooksRare, a leading NFT marketplace, thrived because of wash trading. This happens when people trade NFTs among themselves with the goal of earning lucrative rewards. Data showed that about 95% of the company's volume was through wash sales.
This process works in a relatively simple way. For example, you can list an NFT in LooksRare or any other company that offers them. After this, you buy the same NFT and receive the rewards.
Crypto Wash Sale Rules and Regulations
A common question is whether there are any wash trading rules and whether the practice is legal.
In the United States, wash trading in stocks and cryptocurrencies is illegal. However, it is extremely difficult to enforce these rules.
For example, as mentioned above, in stocks, when you sell a loss-making stock and buy it again, you have made a wash sale trade. But it is also possible to sell an asset and then buy one that is closely correlated to the first one. For example, if you made a loss in Chevron but are still long the company, you could buy ExxonMobil instead since these shares tend to move in sync.
Another challenge for regulators to enforce crypto wash sale rules is the fact that most trades happen in decentralized exchanges that are hard to track.
Most importantly, to enforce these rules, the regulator needs to prove the intent without a reasonable doubt, which can be a tough task. One way in which they can prove the case is when they intercept messages among participants of a scheme.
How Do You Spot a Wash Trade?
As mentioned, Bitcoin wash sale is illegal, and it can put you in trouble with regulators. Therefore, we don’t recommend that you do it. Instead, we recommend that you follow simple day-trading crypto rules and be ethical.
You can implement wash sales if you have a substantial amount of money. Next, find a thinly traded cryptocurrency and start implementing buy and sell orders. Doing this will tell other market participants that the coin is getting popular. Then buy the coin and exit when it hits your target.
Another way of implementing wash sales in crypto is to team up with a group of other traders and then coordinate the process. Finally, you can do wash trading NFTs by creating an account with platforms like OpenSea, Rarible, and LooksRare. Here, you will be creating and buying NFTs and then receiving the rewards.
