There are different forms of trading in the financial industry, some of which are legal and some of which are not. This article specifically covers wash trading in both the traditional and newer cryptocurrency industry. So what is "wash trading"?
"Wash trading" is a practice where a transaction or multiple transactions are executed to give an authentic appearance. Wash trading is considered to take place when an investor or trader buys and then sells the same/similar financial instruments at the same time and at the same/similar price. The trade may be actual or it may be done on paper without there being an exchange of assets. Later we will see how much time is meant by "same time" when it comes to wash trading.
Typically, a "wash" transaction or "wash" sale involves an investor or investors acting alone or an investor(s) in collusion with a broker(s). The result is no significant change in the investor's portfolio or trading position, which is why wash trading is also referred to as round-trip trading. At the end of the trade, the investor returns to the same place from which they started without having experienced market risk and price competition.
It is important to note that traders who wash trade usually have one or all of three main intentions. The first is to significantly increase trading volumes, and thus the price of an asset, by making its desirability more inflated than it actually is. This is effectively tantamount to market manipulation. Second, a trader may attempt to execute a wash trade to claim a tax deduction for losses suffered. Third, the broker may want to take advantage of the commissions charged on the trade.
One can also engage in wash trading out of sheer ignorance, with the sole motive of financial gain. Whatever the reason for a wash sale, the act remains illegal in many jurisdictions, especially for traditional financial instruments.
History of Wash Trading
Prior to 1930, wash trading was not controlled and was a common practice among traders. Investors made "wash sales" to signal the false desirability of an asset and thereby drive up its price. Fearing lost profits, the duped investors would buy the asset, driving up the price of the asset even more.
Wash traders would then profit from shorting the asset when the surface interest in it and the artificially high price drops. A short sell is when an investor makes a profit by buying back a borrowed asset at a lower price than he sold it for.
However, following the Great Depression - the worldwide economic downturn of 1929 to 1939 that began in the US - financial regulators were forced into action. The government approved the Commodity Exchange Act (CEA) and the Securities Exchange Act (SEA) in 1934. These laws banned wash trading and required strict regulation on all commodity futures.
In addition, the US Commodity Futures Trading Commission (CFTC) warned that brokers would be involved in "wash" trading whether or not they knew of the intentions of the trader they hired.
Moreover, the Internal Revenue Service (IRS) issued the wash sale rule, barring taxpayers from claiming a capital loss, and therefore a tax deduction, following wash trading. The federal agency also outlined the time frame within which a trade is considered a wash sale, as covered in the section below.
In 2013, wash trading reappeared in the headlines due to the phenomenon of high-frequency trading (HFT). It involves the use of high-speed computers and lightning-fast internet connectivity to conduct tens of thousands of transactions per second, all from just one device.
In 2012, Bart Chilton, the then Commissioner of the CFTC, announced investigations into the use of such devices for fictitious trade. Consequently, HFT became illegal and unethical since it enabled market manipulation, which is one of the motives of wash trading.
A year later, the agency determined wash trading in the case of two individuals trading corn futures contracts. The CFTC imposed on the pair a fine of $400,000, in addition to a 140-day trading ban. Thereafter, the regulator and other similar regulators have taken legal action against such market manipulators.
How Wash Trading Works
What Is A Wash Sale In Day Trading?
According to Investopedia, day trading refers to the purchase and sale of a financial instrument on the same day or several times during a day’s course. IRS guidelines further communicate that a taxable trade is a “wash” in day trading if a trader re-acquires identical or similar asset(s) 30 days before or after the sale, at the same price.
Additionally, the sale rule applies if an investor was acquiring stock or securities for their retirement arrangement (IRA), or Roth IRA since these have the benefit of being tax-free. Note that tax evasion is a critical point in a wash trade.
Moreover, the IRS considers a transaction a wash if the asset/security/option repurchase was performed by the trader’s company or spouse.
What Are the Rules for A Wash Sale?
Certain conditions must be present for a transaction to be categorized as a wash sale. For starters, there are two main factors considered:
1. The intent: a transaction is a wash sale if the parties involved knowingly partook in it, or pre-arranged it to achieve the result below.
2. The result: a transaction is also a wash sale if the parties involved wanted it to have the results of a wash sale. Results, in this case, are the purchase and sale of the same asset at the same time, and the same price. This can either happen on a single account, or different accounts with the same, or common beneficial ownership.
Note that accounts are deemed to have common beneficial ownership if:
• They bring a certain degree of gain to their owners
• They are owned by the same person or entity
• They are owned by different entities that are fully owned by one parent entity
However, there are various instances in which trades executed from accounts with common ownership don’t fall into the wash trade category. They include transactions that:
• Were initiated independently
• Were Initiated for separate and legitimate business purposes
• Crossed each other in a competitive market out of pure coincidence
• Had no pre-arranged structure
• The buyer and seller do not know each other - such a scenario could be deemed insider trading. The term refers to a transaction in which an investor has more knowledge about the trade than the general public. Insider trading is frowned upon just like wash trading, and it is also just as illegal and prosecutable by law.
Essentially, if one does not replace an instrument they sold with a substantially similar one within the 30-day frame and does not seek a tax cut for capital loss, then the transaction is not a wash sale.
Example of a Wash Trade
A notable wash trading example is the one involving the LIBOR (London Interbank Offered Rate) scandal. LIBOR is a rate that is used as a benchmark to determine the rates for loans and derivatives on a global scale. The rate is determined by reference interest rates put forward by certain banks.
During the scheme, banks involved in determining its rate consciously submitted lower or higher rates to influence the LIBOR. With rates set to their liking, banks made profits from loans, derivatives, and various forms of trade. Wash trading came in when brokers received payment for their role in manipulating the LIBOR.
In 2012, the scandal was publicized, causing public outrage as many felt conned out of their pockets. Major banking institutions such as The Royal Bank of Scotland, Barclays, JPMorgan Chase, and Deutsche Bank were implicated. The LIBOR rate is now being phased out, to be replaced with the Secured Overnight Financing Rate (SOFR).
Suppose hypothetically Trader X has 100 shares that he sells on June 9 at a loss of $5,000. He then buys back all the shares on 15 June, resulting in a taxable gain of $10 000. If Trader X claims a tax deduction to offset his original loss of $5 000, then a 'wash sale' is deemed to have taken place.
Crypto Wash Trading
When it comes to the cryptocurrency industry, wash trading is mostly done to falsely boost traders' interest in a particular digital currency or asset, including non-fungible tokens (NFTs). Other investors react by buying, say, the cryptocurrency xyz, due to the fear of missing out (FOMO) on the potential gains. Eventually the wash trader sells their digital assets when the price is favorable, much like shorting stocks.
In many cases, the digital asset in question is usually a cryptocurrency with a small market capitalization, with manipulators trying to boost its value for selfish gain.
The fact that computers are aiding high-frequency trading only makes cryptocurrency trading even more prevalent. Furthermore, many countries have not imposed clear rules on the crypto market. This is mainly due to the fact that the sector is still young and regulators are trying to figure it out in an effort to draft sensible regulatory frameworks. Where they are regulated, crypto and other blockchain assets are subject to property tax laws rather than laws governing securities, options or equities.
Overtime, various blockchain intelligence firms have disclosed evidence showing that the crypto industry is rife with washing trading. A research paper from the Blockchain Transparency Institute reveals that of the top 25 Bitcoin trading pairs, over 80 percent were wash traded in exchanges in 2018.
Over time, various blockchain intelligence firms have found evidence that the crypto industry is rife with laundering trade. A research paper by the Blockchain Transparency Institute reveals that of the top 25 bitcoin trading pairs on exchanges in 2018, over 80% of their volumes were wash traded.
Additionally, a whitepaper published from the blockchain consultancy firm Integra FEC suggests that the EOS initial coin offering (ICO), was marred by wash trading. The yearlong ICO had raised $4.1 billion by 2018, making it the largest fundraise of its kind to date. However, greater scrutiny shows that Ether (ETH) and EOS tokens were recycled multiple times to draw investor attention. ETH tokens were involved since EOS, at the time, was built on Ethereum, with EOS being an ERC-20 token.
Round-trip trading has also become common practice among NFTs, as covered in the section below.
What is NFT Wash Trading?
NFT wash trading is where an unscrupulous NFT creator or holder trades an NFT using multiple addresses that all belong to him. The NFT holder essentially buys and sells the same NFT to himself multiple times, successfully feeding misleading information to other investors. The information here is that a certain NFT has high sales volumes, and is therefore in high demand, or is as many traders like to say, “hot.”
Last year, NFTs brought in roughly $44 billion in sales. However, blockchain analysis firm Chainalysis detected several instances of NFT wash trading in 2021. Certain NFTs were repeatedly (over 25 times) sold off to wallets belonging to the same NFT holder. The firm goes on to say that 110 NFT holders were wash traders, and they made a collective profit of about $9 million. Such manipulative behavior continues to draw interest among regulators worldwide.
The Legal Aspect of Wash Trading
Wash sales are prohibited in many jurisdictions, and therefore illegal. However, there is still a lack of clarity regarding wash trading in some scenarios. For instance, is a transaction a wash if one broker sells stocks or securities to another broker? To be on the safe side, such a practice should be avoided since it may be classified as insider trading.
Additionally, the IRS is unclear of what stocks or securities are similar to each other. Investors have therefore been forced to seek guidelines on the same from other third parties. The agency has, however, pointed out that financial instruments of different corporations are not “substantially similar,” and therefore do not constitute a wash sale.
Even more, regulators all over the world are still navigating the relatively nascent financial industry of cryptocurrencies, NFTs, and the like. Many countries have still not managed to come up with clear regulations regarding crypto. In the US, for instance, the CFTC and other regulators are still trying to form legal frameworks for digital assets.
Difference Between Wash Trading and Market Making
Wash trading and market making are two very different terms. The latter creates a market where investors can buy and sell securities on demand and at publicly quoted prices. In essence, market makers provide liquidity and prevent markets from becoming sluggish. Market makers’ profit comes from the spread, or the difference in pricing, between instruments at the time of buying or selling. Market making is very much legal and is performed by many banks including Deutsche Bank and UBS.
On the other hand, wash trading is illegal since it creates opportunities for making gains unfairly.
How to Avoid a Wash Trade
Engaging in an illegal wash sale can irreparably tarnish a trader’s reputation, and it could carry both financial and legal consequences. There are a number of steps an investor can take to avoid being implicated in a wash trade:
1. Paying close attention to the timing and conditions in which a trade is performed to make sure it does not qualify as a wash sale. It is best to wait 61 days before replacing assets sold with the same or similar ones.
2. Staying up to date with regulations regarding wash trading, including those being developed in the crypto and NFT industry. Many wash trades are executed out of ignorance.
What is a wash trade example?
Trader A sells off a security at a loss on June 9. He then repurchases the same security at the same amount and price on June 30, and thereafter makes a profit on it. Should the trader seek a tax deduction on his original loss, he is said to have committed a wash trade. Alternatively, if the trader does multiple such transactions to pump the price of an asset, then profiteer from shorting it, he will be said to have committed a wash sale.
How Do You Identify Wash Trades?
A wash trade is identified by the intent and the result. Intent is knowingly making a transaction(s) to get the results of a wash sale. The results here are tax deductions from original losses, market manipulation, and/or making extra trading fees for a brokerage firm.
What Is A Wash in Day Trading?
A wash in day trading is a transaction that defies the IRS’ financial instruments sale rule. It starts with reacquiring the same amount of a sold security at the same price one sold it for, and within 30 days before or after the sale. If a trader deliberately misreports this kind of trading activity to obtain a tax cut for his capital loss, then the transaction is called a wash.
Is Wash Trading Illegal in Crypto?
Yes and no. As per writing time, there were no clear regulations regarding wash trading crypto. However, it is possible for a body, such as a cryptocurrency exchange, to be questioned regarding facilitating such a practice. This not only tarnishes the exchange’s reputation; the firm could as well be banned from operating in certain jurisdictions. That said, since regulations in the industry remain scarce, wash trading is rampant and many perpetrators go free.
Can I Sell Crypto for A Loss and Buy It Back?
Yes. As of this writing, regulators are yet to provide clear frameworks regarding crypto trading.