Last Updated on 11 September, 2023 by Samuelsson
Trading has become so diverse that they need to be some form of regulation to control some activities. Investors have lost money due to some manipulative activities of other traders. And one of those manipulations is wash trading. But what does it mean?
Wash trading, also known as round trip trading, is a process where investors or traders buy and sell the same security at the same time, with the intent to manipulate the market. This is done to create a false sense of high activity in the market so as to lure in other traders or to generate profits for some brokers.
In this article, you’ll learn what a wash trade is and the position of the law about it. We’ll discuss it under the following headings:
- What is wash trading?
- How wash trading works/understanding wash trading
- Why does wash trading matter?
- Example of a wash trade
- Wash trade and high-frequency trading
- How do you identify wash trades?
- Is wash trading illegal?
- How to avoid a wash trade
What is wash trading?
Wash trading (also known as round trip trading) is a process whereby traders or investors tries to mislead the general market (a form of market manipulation) by buying and selling securities at a specific price point at the same time thereby creating the impression of a high volume of trading for that security.
Wash trading can happen between two investors of different accounts or by a single investor as well as between brokers and their clients.
This practice can increase the volume of security unexpectedly making it appear to ignorant investors that the security is high in demand than it really is. Also, brokers may benefit from it in form of commission or fees to cover for securities they can’t settle outright.
Sometimes, traders use wash trading to create fictitious losses in their trading account so as to claim tax benefits. However, tax officials have learned how to spot these illicit maneuvers.
How wash trading works
To understand how wash trading works, let’s look at a non-trading analogy: Say a business owner wants a loan, so they went to the bank for it, but the bank wants them to present an active account. What do they do? They simply inform a friend of theirs to deposit a huge sum into their account — thereby creating some fake account activity which then qualifies them for the loan.
When applied to the financial market, this is known as wash trading. When investors see liquidity in any market, they’re convinced it is an active one.
In the case of financial trading, a trader places a buy and sell order for the same security, creating a false sense of a highly active market. Basically, the trader sells the security to himself, which is a form of insider trading. Insider trading is the process of buying and selling security where the involved party has more knowledge of the security than the general public. Because the trader has the advantage of more information, they have the upper hand about the trade.
The two main factors that distinguish wash trade from a normal trade are these:
- Result: the execution or series of execution of trades resulting in a wash trade occurs if security is been bought and sold simultaneously at the same price point by accounts with the same or closely related owners.
- Intentions: when there is evidence/patterns or some form of perceived prearrangement before a trade was executed in a manner/fashion that the investors knew would produce a wash trade.
In addition, a trade may not be considered as a wash trade if the orders:
- Are not dependent on each other or are of different business purposes.
- Are executed by independent traders
- Happen coincidentally in a competitive market.
- Are not prearranged and the investors had no prior knowledge about each other’s order.
Some questions still surround the buying and selling of financial instruments amongst some brokers. As an example, is it legal for brokers to trade between themselves? Several people in the trading, finance, and tax services had advised that such practice should be shunned because it could fall under the category of insider trading.
A common assumption by traders is that a wash trade occurs only when buying and selling are executed immediately. This is where many brokers and investors get it wrong and get in trouble. A trade can be considered a wash trade if buying and selling are executed within a 30-day time frame.
Why does wash trading matter?
Since investors lose money about 80% of the time, it is, therefore, necessary to check the activities going on in the market.
An investor can lose the significant value of their capital if they enter into a market with misleading information such as fake volume. Wash trading is a concern in most markets and although with strict regulations, investors still find their way around it.
An example of a market prone to this is the broader cryptocurrency market which has seen a lot of false projects with big volumes. During the early stage of bitcoin (CNY market era), there have been a lot of false volume flat price movement in bitcoin until the CNY market lost its dominance in the crypto market.
The cryptocurrency market has been the playground of wash trading due to its not been regulated, this is now a major worry as investors are deceived into buying and holding coins that show a high trading activity which is later dumped on them with no one to sell to at a higher price.
Example of a wash trade
It goes this way: Trader XYZ arranges with a brokerage firm to buy a stock of Company ABC and at the same time, arranges with another broker to sell the same stock.
The simultaneous buying and selling of Company ABC’s stock would generate a high volume on the chart. Retail traders like you and I may see this high trading activity on stock ABC and decide to join the ride. Other traders see this too and then join the bull side to profit from the price movement that would come from the high trading activity, without knowing that it is all a trap.
Trader XYZ, knowing what’s going on, goes ahead and short the stock, having used the false trade to generate enough orders to fill his own. Since retail traders don’t have the capacity to move the market, the stock fall as Trader XYZ expected, making him some profits. This game is mostly played on securities with low liquidity.
Wash trade and high-frequency trading
Wash trading made a comeback in 2013 right at a time when high-frequency trading was becoming prevalent. High-frequency trading is a form of trading practice whereby traders use super-fast computers and high-speed Internet services to execute an excess of more than ten thousand trades per second.
From 2012, the then-Commissioner of the Commodities Futures Trading Commission (CFTC), Bart Chilton said he will start to scrutinize the traders employing the use of high-frequency trading for the breaking of the wash trade laws given how these firms hide under the guise of high-frequency trading to perform wash trades.
Also, the Securities and Exchange Commission (SEC), filed a charge against Wedbush Securities for being negligence about the way they maintain direct and exclusive control over the settings of their trading platform used by their clients – an action which high-frequency traders took advantage of to execute wash trades and other barred and manipulative trading practices.
In addition, Cryptocurrency exchanges are the recent playground for wash trades. Research by Blockchain Transparency Institute reported that over 80% of the most popular trading pairs for bitcoin on Cryptocurrency exchanges in 2018 were wash trades.
How do you identify wash trades?
Identifying wash trades could be a difficult process for retail investors. It goes beyond just staring at the charts and following all the price action! Why it doesn’t work that way, there are some techniques you could employ to help in your trading.
The first is knowing your broker. Honestly, to be on the safer side of the investor’s quadrant and save yourself from trading fraud, you should know the credibility score of your broker because a broker with a good score in most cases has strict rules regarding wash trading. While it may not be eliminated completely, you can be sure you’re trading in a fair market environment. Unregulated brokerage firms should be shunned at all costs no matter their offerings because they are going to take more than what you are being given.
Secondly, you have to pay attention to trading volume to price movement. When you start seeing spikes in volume but little to no activities in price movement (quiet market), you should be suspicious of foul play. This would help you avoid falling into a wrong trade. There’s no need in trading when you are suspicious of a security’s price performance.
The cryptocurrency market can however be a challenge in terms of finding credible trading information for assets. About 70% of the trading volumes of most coins are fake. Even the major exchanges here are not innocent as some of them have been known to trade against their clients with the use of bots to buy and sell rapidly – creating the impressions of high trading activities.
To help you know the actual daily trading volume of some assets on exchanges, you can go to the Blockchain Transparency Institute’s website. Using the data provided on the website will help you in knowing the dollar amount being traded. Also, coins that are listed only on unpopular exchange should be avoided because these are often used for pump and dump practices.
Is wash trading illegal?
Wash trading was banned as early as the late 1930s, after the creation of the Commodities and Exchange Act in 1936. The law resolved the Grain Futures Act and pressed on the need for commodities trading to be done on regulated exchanges. Before the amendment of the act of 1936, wash trading was a popular method by which investors manipulated the markets by creating fictitious high volume to pump up the price of a stock – thereby making more money when they short the stock.
The regulations by the Commodities Futures Trade Commission (CFTC) restricted brokers from gaining from wash trades even though they claim they had no knowledge of the investors’ intention. Brokers are therefore charged to scrutinize their client’s trades to be certain they are buying the stocks of companies for the sole intention of owning them and not as a wash trade.
The Internal Revenue Service (IRS) also adopted a similar measure and placed tighter regulations against wash trading which requires taxpayers to stop the deduction of losses that resulted from wash trading. Wash trade (as defined by the IRS) is one that happens within 30 days which resulted in a loss.
How to avoid a wash trade
It is possible for traders and brokers to commit was trades without knowing. The investor or broker must catch themselves before they execute a wash trade. It happens when tax losses are realized. It comes when a trader sells a security at loss and then buys the same or matched security within 30 days of selling it, either before or after.
Wash trading is an illegal practice. But investors unknowingly fall into the practice when the time comes to realize losses. Investors must therefore be careful enough and pay a closer look when they buy and sell financial instruments to avoid committing an illegal trade.
Wash trading is an illegal practice that you must avoid at all costs in other not to fall short with the regulatory authorities. There are real-life consequences when caught in the act such as jail term and a heavy fine. Some traders commit this crime inadvertently and others deliberately do so. However, you should pay attention to the way you buy and sell securities.
Also, some trading platforms should be avoided because most of them trade against their clients. The key things to watch are real volumes compared with what is being reported on the exchange and checking their credibility score. The Blockchain Transparency Institute’s website is also a great place to get first-hand authentic data concerning cryptocurrency trading volume.