Author: Cyberscope, blockchain audit company Translator: Shan Ouba, Golden Finance

Among the hundreds of questions about centralized cryptocurrency exchanges, wash trading has emerged as a prominent issue. A wash trade is when someone sells something to themselves to increase demand or make the market appear to have more activity. This deceptive practice may be driven by a variety of motivations, such as attracting liquidity and customers, artificially creating demand for non-fungible tokens (NFTs), or participating in tax loss harvesting.

The main goal is to create the illusion of higher trading volume, thereby potentially attracting legitimate trading activity. This deceptive tactic misleads investors into believing that demand for the asset is greater than it actually is.

Under U.S. law, wash trading is considered illegal because it undermines the integrity of financial markets. Additionally, the Internal Revenue Service (IRS) prohibits taxpayers from deducting losses resulting from wash trades, thereby adding an economic disincentive to this illegal practice. In essence, wash trading undermines market transparency and creates legal and financial consequences for participants.

This is only a formal overview of this illegal activity. Now, let’s discuss what wash trading in cryptocurrencies is and how traders can identify such activity and avoid potential losses.

Understand wash trading

Whitewash trading is a deceptive practice that a company or entity takes advantage of Self-dealing creates artificial effects in the market. Timothy Cradle, director of regulatory affairs at Blockchain Intelligence Group, emphasized the purpose: Inflate prices, create the illusion of liquidity, and attract the interest of other investors.

Such manipulation may mislead investors into purchasing tokens at artificially inflated prices, constituting fraud and market manipulation.

Whitewash trading is not just for individual wrongdoers. Even cryptocurrency exchanges may employ this strategy. Exchanges may engage in wash trades to inflate their trading volumes, making them appear more active and liquid than they actually are.

Timothy Cradle emphasized the lack of rationality in this approach and emphasized that industry competition cannot be an excuse for wash transactions. Maintaining transparency, especially in the cryptocurrency space where trust is crucial, is critical to fostering a healthy and trustworthy market environment.

How do wash trades work in cryptocurrencies?

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Imagine you are in a crowded market where everyone is checking out the most popular items. In the crypto world, transaction volume is like the popularity of a digital currency. Wash traders focus on making a specific cryptocurrency appear more popular than it actually is. They do this by buying and selling the same currency quickly, creating false trading volume. This artificial popularity can attract other investors who believe the token is in high demand.

Imagine this: you have a bag of candies and you trade them back and forth with yourself quickly, making it look like there's a lot of trading activity. Since trading volume affects the price of a coin, your bag of candy will now look more valuable. But here's where it gets tricky. Others see the high cost and think the currency is hot, so they buy it. But when you decide to sell your tokens, the price collapses because it’s all fake activity. Now, other buyers cannot sell their tokens because there are no real buyers anymore.

Simply put, wash trading is like pretending that a toy is very popular, tricking others into buying it at a high price, and then suddenly showing no real interest, resulting in Decline in value.

How common are wash trades in cryptocurrencies?

Wash transactions can vary in complexity, from simple transactions between wallets to more complex schemes. Chainaanalysis Research Director Kim Grauer identifies wash transactions based on specific relationship criteria between wallets and addresses, indicating potential fraudulent activity.

Research by the National Bureau of Economic Research (NBER) delves into the prevalence of fake trading on 29 cryptocurrency exchanges, divided into regulated and unregulated Two categories. Research shows that regulated exchanges rarely experience wash trading, while unregulated exchanges, especially secondary exchanges, attribute an average of 77.5% of their trading volume to wash trading.

Binance, the world’s largest cryptocurrency exchange, was classified as an unregulated Tier 1 exchange in the study, with an estimated 46.4% of its trades Attributed to wash trades. Nonetheless, a Binance spokesperson strongly denied being involved in wash trading and emphasized the existence of a dedicated market monitoring team to monitor and prevent manipulation.

It was reported that 52.9% of transactions at KuCoin, another well-known exchange, were classified as wash trades, although the exchange denied participating in such behavior. The NBER paper also notes that wash trades occur more frequently after positive returns or a decrease in market volatility, suggesting exchanges have an incentive to inflate trading volumes during these periods to attract attention and customers.

However, identifying wash trades is challenging without access to account data that is often held exclusively by exchanges. Martin Leinweber, digital asset product expert at MarketVector Indexes, emphasized the importance of industry regulation to maintain the integrity and transparency of crypto markets, as evidenced by the findings of the study.

NFT Wash Trading

Now that we have covered the basics of wash trading in the cryptocurrency world knowledge, let’s explore how it applies to NFTs specifically. While the principles are similar, the unique nature of NFTs brings some differences in how wash trades are conducted.

Unlike fungible tokens, which have clear trading volumes, NFTs have lower trading volumes due to their uniqueness. However, it also makes it easier to track their movements. Still, those with malicious intentions can still try to hide wash trading activity, especially in the early stages.

Imagine encountering a new NFT project shortly after its release. You will notice that the price of a specific token is significantly higher than others, despite having Similar functionality. Further investigation revealed an increase in sales of the same NFT over the past 24 hours, with the token changing hands between seemingly different individuals.

Is this a wash trade? unnecessary. Celebrities may endorse the token, increasing interest and real transactions. However, it is crucial to handle such situations with caution. It's best to stay alert and avoid suspicious situations to protect yourself from potential losses.

Example of wash trade

Examples of wash trades in the cryptocurrency world are mentioned below.

Mentougou (2014)

Mt. Gox was once the world’s largest Bitcoin exchange , but collapsed in 2014, causing users to lose hundreds of millions of dollars worth of Bitcoin. Wash trading was found to be one of the unethical practices employed by Mt. Gox that resulted in artificially inflating the price of Bitcoin on its platform. The Mt. Gox case remains one of the most notorious incidents in the history of cryptocurrency exchanges.

Bitfinex and Tether (2018)

New York Attorney General’s Office accuses Bitfinex and Tether of involvement Massive wash trading scheme. The accusations involve Bitfinex using Tether’s USDT stablecoin to artificially inflate the price of Bitcoin and other cryptocurrencies, creating a false sense of demand. The ongoing case highlights the legal consequences exchanges can face for wash trading.

Why do people engage in this illegal activity

People engage in cryptocurrency wash trading mainly To make a quick profit without regard to ethical or legal implications. However, another tax-related aspect has prompted some to explore wash trading strategies.

During a wash trade, a trader may intentionally take a large initial loss with the expectation of subsequently selling the token for a substantial profit. The idea is to use these human losses as deductions when filing your taxes. While this may seem tempting, it is important to understand that this approach is wrong and that tax authorities have safeguards in place to prevent abuse.

For example, the IRS has specific measures to address wash trading attempts. The Internal Revenue Service (IRS) considers wash trade losses resulting from an asset sale event within 30 days of acquiring the asset. In addition, wash trade amounts can be discounted from tax deductions. Simply put, even if someone attempts to launder trade to artificially cause losses, the IRS will not allow those losses to be used as a tax deduction.

How to Detect Wash Trades

Avoiding Cryptocurrency Wash Trades to Protect Your Investment The combination is crucial. Here's a more detailed explanation of how to identify and avoid potential fake trading situations, focusing on traditional cryptocurrencies (rather than NFTs):

1. Analysis Trading Volume

View trading volume for a specific crypto project. While popular cryptocurrencies often have large trading volumes, critically evaluate whether trading activity is consistent with the project's popularity and relevance.

Consider factors such as the age of the project, recent releases, mainstream news coverage, and overall online presence. If volume appears to be disproportionately high without a clear reason, that raises a red flag.

2. Blockchain browser survey

If You are familiar with the blockchain explorer, please delve into the projects on the blockchain. Check how many wallets hold the majority of coins and identify any unusual trading patterns.

Look for wallets that make consistent, fast transactions but do not realize significant gains. This type of repetitive and unprofitable trading activity may indicate wash trading.

Also read: Blockchain Security Services: The Definitive Guide

3. New tokens and bull markets

Analyzing new coins Coins, especially in bullish markets, can be challenging. Speculative activity is high and distinguishing genuine interest from sham trading becomes even trickier.

Follow the transaction behavior of a specific wallet. If one or a few wallets continue to trade the coin with no apparent benefit, this indicates a potential wash trade.

Now that you know how to detect wash trades in crypto tokens, let’s move on to learn how to do the same with NFTs:

1. Take advantage of the NFT market

The largest NFT Platforms such as marketplace OpenSea provide insights into NFT trading history. Explore the landing pages of specific NFTs on such platforms to gain transparency into their trading processes.

2. Identify suspicious transaction patterns

Be wary of those who do it every day Wallets that trade the same NFT multiple times, sometimes hundreds of times, without making a profit or even suffering a loss. Sustained high-frequency trading without financial gain is a clear sign of potential wash trading in the NFT space.

Who is responsible for processing?

Tackling fraudulent activity such as cryptocurrency wash trading is complex due to unclear regulation of cryptocurrencies and NFTs. While stocks and bonds fall under the jurisdiction of the SEC, the Commodity Futures Trading Commission (CFTC) regulates commodities such as gold and oil. The lack of clear classification of crypto-assets hinders the ability of regulators to take legal action against them.

However, individual exchanges can take action. Binance, for example, has taken steps to combat fake transactions. Last month, the exchange launched a new opt-in feature, Self-Trading Prevention, to curb unintentional wash trading on its platform. This proactive approach by the exchange is seen as a step towards maintaining the integrity of the crypto industry given the current regulatory uncertainty.

Wash trades and cross trades

Wash trades and cross trades are usually used in financial markets illegal behavior. Participants who engage in these deceptive practices may face severe legal consequences, including substantial fines and penalties. As you know, a wash trade is the simultaneous purchase and sale of the same asset.

In contrast, cross trading involves buying and selling different assets simultaneously. The focus here is on manipulating the price of a specific asset group. Traders who execute cross trades strategically use trades involving different securities to influence the price of a target asset. Results may include artificially inflated prices and misleading perceptions of market demand or value.

Conclusion: Protect yourself from whipsaw trading in the cryptocurrency market

As a cryptocurrency It is crucial for investors or traders in the market to understand the mechanisms and consequences of wash trading and avoid participating in such deceptive practices. Key strategies to protect your investment include choosing a reputable exchange, conducting due diligence, reviewing trading volume and depth, diversifying data sources, and approaching unusually high returns with appropriate skepticism.

By staying informed and vigilant, you can protect your investment and contribute to fostering a more transparent and trustworthy market environment. Choosing ethical trading practices not only complies with regulatory standards but also plays a key role in maintaining the integrity of the broader crypto ecosystem.