What is Wash Trading and why is it a bad thing?

13 May, 2019

For some people, cryptocurrencies like Bitcoin are just monetary systems. They might buy bitcoins in order to shop online or play their favorite casino games, like Mega Moolah. But other people buy and sell cryptocurrencies as investments. Their crypto world is entirely different. As such, they get involved in things that the average crypto buyer has never even heard of.

A good example is something known as 'wash trading'. Wash trading is not exclusive to cryptocurrency and, in fact, it has been around for as long as the oldest stock markets. The problem with cryptocurrency in this regard is that wash trading is so easy to pull off. When people do it, wash trading puts unnecessary pressure on the market that can contribute to price volatility.

From this post you will learn exactly what wash trading is and why it is a bad practice. If you engage in wash trading, perhaps it's time to step back and ask yourself if it's okay to artificially manipulate markets for your own gain, knowing that what you're doing is harming other people.

Wash Trading explained

The practice of wash trading is pretty simple. You sell and buy the same asset for the sole purpose of increasing volume. Here is the official Investopedia definition:

"Wash trading is a process whereby a trader buys and sells a security for the express purpose of feeding misleading information to the market."

Investopedia goes on to explain that sometimes wash trades are conducted through a partnership between trader and broker in which both benefit from higher volumes. Other times a single investor is selling his or her own asset and then buying it back again.

You could execute wash trading using your own bitcoins. To do so, you would open an account with an exchange that allows the practice. Note that most exchanges say in their terms and conditions that wash trading is not allowed, yet still look the other way when it happens.

At any rate, with your account established you are ready to go. You choose a certain number of bitcoins to sell on the exchange and place your order. You then turn around and place a buy order for the same number of tokens at the same price you are selling. Within seconds you have both sold and purchased the same asset.

There are fees involved with every trade, but they are nominal compared to what it is you are trying to accomplish. So that begs the question, why engage in wash trading? What is there to be gained from selling coins and then turning around and purchasing them back again?

It's all about volume

As the Investopedia definition of wash trading states, the whole purpose behind the practice is to feed misleading information to the market. In other words, you are trying to create the illusion that more people are buying and selling bitcoins. You are trying to help increase the trading volume artificially. Why do this? Because volume and price are intrinsically linked.

Smart investors look at a number of different parameters when buying and selling. One of those parameters is volume. If you are not familiar with the whole investment scene, volume is a representation of how many people are buying and selling a given asset. Higher volume means more people are actively trading that asset on a given day.

Volume tends to tell investors that a particular asset is hot. As long as volume is high and price is either holding steady or increasing, there is an intrinsic invitation to buy an asset with high volume. The point of wash trading is to push the volume up commensurate with price gains. That causes more people to buy, thus further supporting price increases.

A smart wash trader is able to artificially pump volume, increase price, and then sell in earnest before the price starts falling. However, individual investors are not the only ones who benefit from wash trading. So do exchanges. That explains why so many exchanges look the other way.

How exchanges benefit

Exchanges make their money by charging fees on every transaction. Buy some bitcoins and you will pay a small fee. Sell those bitcoins and there is another fee involved. Moreover, the person buying the coins you're selling also pays a fee. Do you see how exchanges benefit from wash trading?

The exchange charges fees for every wash trade. But that is not the best part. Remember that the point of wash trading is to artificially manipulate the market by inflating volume. If a particular asset looks hot due to a large amount of wash trading, more investors will be encouraged to buy that asset. Every purchase results in more money in the exchange's pocket. Likewise, there comes a point when price levels off and that asset is no longer hot. Then people start to sell. There is more money for the exchange to earn.

Traders engage in wash trading because high volumes make it easier for them to manipulate the price of whatever coin they are dealing in. Exchanges either turn a blind eye to wash trading or actively participate in it in order to earn more money through trade fees. In either case, wash trading is about one thing: artificially increasing volume.

Wash Trading is illegal

We previously mentioned that wash trading is not exclusive to cryptocurrencies. You can wash trade essentially any asset made available on publicly accessible exchanges. You can wash trade stocks, shares, and other assets as easily as cryptocurrencies. As such, jurisdictions around the world have outlawed the practice.

To put this as simply and plainly as possible, wash trading is illegal in most places around the world. It is very difficult to do with standard securities without getting caught. That is because tight controls have been put in place to safeguard against it. But cryptocurrency is a different matter altogether.

Wash trading cryptocurrencies is a lot easier for one simple reason: most cryptocurrency exchanges fall outside the purview of regulatory authorities. That means they operate in an unregulated environment. They are free to do what they want it without fear of government interference.

Is this sufficient reason to start regulating exchanges? That is a discussion for a separate blog post. Regulation has its pros and cons, and you could make the case either way. The point is that exchanges currently operate in a largely unregulated arena with very few controls in place to prevent wash trading.

Wash Trading is bad for crypto

Wash trading may seem harmless on its face. After all, the fact that a single investor is selling and buying the same asset doesn't hurt anyone but him/her. He or she is the one who pays double fees for no apparent gain.

The truth is that wash traders would not take a hit on double fees if they did not gain something from the practice. What they gain is exactly why wash trading is bad for cryptocurrency. Wash trading is bad because it artificially influences the market. As such, it causes people to make decisions based on false information.

Imagine you are a brand-new investor getting involved in Bitcoin for the first time. You are not sure that you should put your money into that particular coin, so you're also thinking about Bitcoin Cash, XRP, and even Ox. Then one of your friends starts talking to you about volume and its relationship to price.

The two of you start comparing volumes and you realize that Bitcoin is outpacing all of your other choices. Not only that, Bitcoin's price is rising faster than the other coins. The combination of high volume and rising price makes Bitcoin look like the one you should buy. So off you go.

If the high volume and price increases from that day were actually legitimate, you would have nothing to worry about. Your choice would have been made based on real information that showed a lot of interest in Bitcoin on that day. But what if your information wasn't accurate? What if it was based on market manipulation by wash traders?

Those wash traders could be located on the other side of the world. They spent a few hours manipulating the market to increase volume and price. Then they went to bed and let the market work its magic. By the time they got up the next morning, you were fast asleep. They started selling their coins for a nice profit. By the time you wake up the price of Bitcoin had dropped dramatically, and you have lost money on the deal.

Every investment has risks

At the end of the day, wash trading is bad for crypto because it artificially manipulates the market. Until such time as regulations are put in place to identify and prevent wash trading, it is something you have to be extremely sensitive to. It is one of the risks of investing in cryptocurrency.

Having said that, every investment comes with risks of some sort. It is up to the investor to determine his or her own risk appetite before putting money into a particular asset. That includes cryptocurrency. So if you are looking to do more than purchase bitcoins so that you can play Mega Moolah online, do yourself a favor and do plenty of research before you spend anything. Know exactly what you're doing. Know the amount of risk you are taking.