Wash Trading: What It Is and How It Works, With Examples

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Wash Trading: What It Is and How It Works, With Examples

What Is Wash Trading?

Wash trading is the practice of buying and selling securities with the intent of providing false information to the market. In certain cases, wash transactions are done by a trader and a broker working together, while in others, wash trades are executed by investors acting as both the buyer and seller of the securities.

Wash trading deceives investors into thinking that trade volumes for a securities are larger than they are, possibly boosting real trading activity on the asset. Wash trading is unlawful in the United States, and the Internal Revenue Service (IRS) prohibits taxpayers from deducting wash trade losses from their taxable income.

Key Takeaways

  • Wash trading is a sort of unlawful trading in which a broker and trader conspire to benefit by providing incorrect information to the market.
  • Wash trading may be used to influence prices by high-frequency trading businesses and cryptocurrency exchanges.
  • The IRS prohibits taxpayers from deducting wash trade losses from their taxable income.

Understanding Wash Trading

The federal government initially prohibited wash trading with the adoption of the Commodity Exchange Act in 1936, which revised the Grain Futures Act and forced all commodity trading to take place on regulated exchanges. Prior to its prohibition in the 1930s, wash trading was a common method for stock manipulators to falsely indicate interest in a company in order to artificially inflate its value so that the manipulators could profit by shorting the stock.

Brokers are likewise prohibited by CFTC laws from benefitting from wash deals, even if they claim they were unaware of the trader’s objectives. Brokers must thus do due diligence on their clients to ensure that they are purchasing shares in a firm for the purpose of shared beneficial ownership.

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The IRS also has severe laws against wash trading and compels taxpayers not to deduct losses from wash sales. A wash sale is one that happens within 30 days after the purchase of the security and resulting in a loss, according to the IRS.

Wash Trading and High-Frequency Trading

Wash trading made a comeback in 2013, just as the phenomena of high-frequency trading was becoming more popular. High-frequency trading is the process of doing tens of thousands of transactions per second utilizing superfast computers and high-speed internet connections.

Starting in 2012, then-Commodity Futures Trading Commission Commissioner Bart Chilton stated his intention to investigate the high-frequency trading sector for breaches of wash trading regulations, citing the ease with which businesses using this technology may engage in wash trading.

The Securities and Exchange Commission (SEC) charged Wedbush Securities in 2014 with failing “to maintain direct and exclusive control over settings in trading platforms used by its customers,” allowing some of its high-frequency traders to engage in wash trades and other illegal and manipulative behavior.

Wash Trading and Cryptocurrencies

Wash trade has invaded the bitcoin market in recent years. The urge to convey the idea of popularity and huge trading volumes is understandable: there are hundreds of cryptocurrency tokens accessible throughout the globe, and most struggle to differentiate themselves. However, even the most popular cryptocurrencies, such as Bitcoin, are subject to wash trading.

Forbes discovered that almost half of all stated Bitcoin trading activity is either fraudulent or non-economic wash trading in a 2022 analysis of 157 cryptocurrency exchanges. Cryptocurrencies are especially prone to pump-and-dump schemes, in which exaggerated trade volumes combined with significant publicity or recommendations from insiders artificially enhance a token’s value, enabling select holders to sell at a big profit while interest is high.

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There are many possible explanations for the frequency of wash trading in the crypto realm. Even big digital currencies, such as Bitcoin, sometimes lack widely recognized techniques for assessing daily transaction volume. As a result, cryptocurrency businesses often provide radically disparate estimates for past trade volumes. Cryptocurrency exchanges are often untrustworthy, and there have been several high-profile public failures of token exchanges in recent years. Extreme volatility in the bitcoin market may encourage quick buys and sells. Finally, crypto’s ambiguous standing with US and other government agencies opens the door to further deceptive economic behavior.

Examples of Wash Trading

Wash deals are trades that cancel one other out and hence have no economic value. They are, nevertheless, utilised in a number of trading circumstances.

In the LIBOR scam, for example, wash transactions were used to pay off brokers who rigged the LIBOR submission panels for the Japanese yen. According to allegations filed by the United Kingdom’s financial regulators, UBS traders engaged in nine wash transactions with a brokerage business in order to produce 170,000 pounds in fees as a compensation for the firm’s participation in manipulating LIBOR rates.

Wash trades may also be used to inflate a stock’s price by inflating its volume. Assume a trader XYZ and a brokerage business conspire to acquire and sell stock ABC quickly. Observing the stock’s activity, other traders may decide to invest in ABC in order to benefit from its price swings. XYZ then shorts the stock, benefitting from its decline in price.

What Is Wash Trading?

Wash trading is an unlawful practice in which a single trader buys and sells the same asset in order to produce false market data. Wash trading is sometimes used to artificially exaggerate a security’s trading volume.

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What Is an Example of Wash Trading?

A wash sale is one that occurs within 30 days after the purchase of the same security and results in a loss, according to the IRS.

Why Would Someone Do Wash Trading?

In certain circumstances, wash trading increases a security’s trading volume, perhaps encouraging additional legal transaction activity. As part of a pump-and-dump plan, wash trading may also be employed to artificially raise the price of an asset.

The Bottom Line

Wash trading is an unlawful practice in which a trader buys and sells the same asset in a short period of time or on several exchanges in order to inflate the trading volume or price of that security. Wash trading may occur across a wide range of businesses and assets, but it has lately emerged as a serious concern in the cryptocurrency and high-frequency trading markets.

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