What Is Wash Trading and How Does It Work?

Wash trading is a term that's become increasingly relevant in today's financial markets, especially with the rise of high-frequency trading and the adoption of cryptocurrencies. It's an illegal practice where a trader buys and sells the same security with the intention of creating false market activity, misleading other investors. In this article, we'll delve into what wash trading is, how it works, and provide examples to illustrate this deceptive practice.

What Is Wash Trading?

Wash trading is the deliberate act of trading a security with the sole purpose of creating misleading market data. This often involves executing simultaneous buy and sell orders on the same security, giving the appearance of genuine trading activity. The motivation behind wash trading can vary, but it's typically done to make a security seem more popular or to artificially inflate its trading volume.

In some instances, wash trades are orchestrated by traders and brokers who collude to generate profit by manipulating the market. Other times, it's individual investors acting as both the buyer and the seller in a trade.

The Legal Perspective

Wash trading is illegal in the United States, and the Internal Revenue Service (IRS) has specific regulations prohibiting taxpayers from deducting losses resulting from wash trades from their taxable income. It was banned by the federal government in 1936 through the Commodity Exchange Act to safeguard against market manipulation.

The Commodity Futures Trade Commission (CFTC) also imposes strict rules to prevent brokers from benefiting from wash trades, even if they claim ignorance of the trader's intentions. As a result, brokers must conduct due diligence on their customers to ensure they are buying shares for common beneficial ownership.

Wash Trading and High-Frequency Trading

Wash trading gained renewed attention in 2013, coinciding with the rise of high-frequency trading. High-frequency trading involves using advanced technology to execute thousands of trades per second. Bart Chilton, then-Commissioner of the Commodity Futures Trading Commission, aimed to investigate high-frequency trading firms for potential violations of wash trading laws. With their rapid trading capabilities, such firms could easily engage in wash trading without being detected.

The Securities and Exchange Commission (SEC) also took action against firms involved in wash trading. In 2014, Wedbush Securities was charged for failing to maintain control over settings in trading platforms used by customers, enabling high-frequency traders to engage in wash trades and other prohibited activities.

Wash Trading and Cryptocurrencies

In recent years, wash trading has extended into the cryptocurrency space. Cryptocurrencies face challenges in distinguishing themselves among thousands of tokens, leading to the use of wash trading to exaggerate trading volumes and generate artificial interest. A 2022 Forbes study revealed that over half of reported Bitcoin trading volume is fake or non-economic wash trading. This issue is exacerbated by the lack of universally accepted methods for calculating trading volume and the volatility of the cryptocurrency market.

Examples of Wash Trading

Wash trading may involve trades that cancel each other out and hold no commercial value. For instance, in the LIBOR scandal, UBS traders conducted wash trades to reward a brokerage firm for manipulating LIBOR rates. These wash trades generated fees and helped hide the manipulation.

In a stock context, wash trading can pump up a stock's price. For example, a trader and a brokerage firm might collude to buy and sell a stock rapidly. This can attract other traders, who then invest in the stock, thinking it's gaining popularity. Meanwhile, the colluding trader shorts the stock, profiting from its subsequent drop in price.

In summary, wash trading is a deceptive practice with significant legal consequences. It's used to create a false sense of market activity and artificially boost the trading volume or price of a security, often with the intention of manipulating the market. Recognizing and preventing wash trading is essential for maintaining the integrity and transparency of financial markets.

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