Wash trading is a deceptive practice where a trader buys and sells a security simultaneously to create the illusion of activity in the market. This can be done either in collusion with a broker or by an investor acting as both buyer and seller.
Wash trading gives the false impression of increased trading volumes, misleading other investors into thinking there is genuine interest and activity in a particular security. This tactic can subsequently lead to a real increase in legitimate trades. However, wash trading is illegal under U.S. law. The Internal Revenue Service (IRS) prohibits taxpayers from deducting losses resulting from wash trades from their taxable income.
Key Takeaways
- Wash trading is an illegal practice whereby misleading information is fed to the market through a trader and broker’s collusion.
- High-frequency trading firms and cryptocurrency exchanges often resort to wash trading to manipulate prices.
- The IRS disallows deductions for losses incurred from wash trades.
The Historical Roots and Legal Ramifications
Wash trading was first outlawed by the Commodity Exchange Act of 1936, an amendment to the Grain Futures Act. Prior to the 1930s, stock manipulators often used wash trading to falsely inflate stock value and then profit by shorting it.
Commodity Futures Trade Commission (CFTC) rules prohibit brokers from earning profits from wash trades, even if they claim ignorance of a trader’s intentions. Hence, brokers must ensure their clients have genuine intentions when buying shares.
The IRS has rigorous regulations against wash trading, defining a wash sale as one occurring within 30 days of a security purchase and resulting in a loss.
Wash Trading and High-Frequency Trading
Wash trading reappeared in headlines in 2013 alongside the rise of high-frequency trading. This practice uses ultra-fast computers to execute tens of thousands of trades per second. In 2012, then-CFTC Commissioner Bart Chilton expressed intentions to investigate the high-frequency trading industry for wash trading violations.
In 2014, the Securities and Exchange Commission (SEC) charged Wedbush Securities for failing to maintain control over settings in their trading platforms, enabling high-frequency traders to perform wash trades and other illegal activities.
The Impact on Cryptocurrencies
In recent years, wash trading has also infiltrated the cryptocurrency market. With thousands of tokens available and the majority striving for recognition, wash trading falsely signals popularity and boosts trading volumes. Even popular cryptocurrencies like Bitcoin are not immune.
A 2022 study by Forbes indicated that over half of all reported trading volumes for Bitcoin are either fake or non-economic wash trades. Cryptocurrencies, being vulnerable to pump-and-dump schemes, achieve inflated value through wash trading, allowing certain holders to profit significantly.
Reasons for wash trading’s prevalence in the crypto space include lack of standardized methods for calculating daily trading volumes, questionably legitimate exchanges, extreme market volatility, and unclear regulatory frameworks.
Example Scenarios in Wash Trading
Wash trades cancel each other out and hold no commercial value, yet they still play a role in crafty trading strategies.
For instance, during the LIBOR scandal, traders manipulated the LIBOR submission panels for the Japanese yen, executing wash trades to reward brokers involved.
A trader XYZ and brokerage firm could collude to sell stock ABC simultaneously to create artificial activity. This, in turn, prompts other traders to invest, eventually leading XYZ to profit from shorting the stock as its value drops.
Final Thoughts
Wash trading stands as a significant illegal activity where a trader buys and sells the same security in quick succession to skew market perceptions. Whether within traditional markets or new-age cryptocurrencies, this deceptive tactic remains a potent concern for industry regulators aiming to uphold market integrity and protect legitimate trade activities.
Related Terms: Market Manipulation, High-Frequency Trading, Cryptocurrency, Pump-and-Dump, Trading Volumes, Broker Collusion, IRS Regulations.
References
- Internal Revenue Service. “Publication 550: Investment Income and Expenses”, Page 56.
- Commodity Futures Trading Commission. “CFTC Glossary”.
- Commodity Futures Trading Commission. “History of the CFTC: US Futures Trading and Regulation Before the Creation of the CFTC”.
- Commodity Futures Trading Commission. “Opening Statement of Commissioner Bart Chilton Before the CFTC Technology Advisory Committee Meeting”.
- Securities and Exchange Commission. “SEC Announces Charges Against Wedbush Securities and Two Officials for Market Access Violations”.
- Forbes. “More Than Half of All Bitcoin Trades Are Fake”.
- Financial Services Authority. “Final Notice”, Pages 1-4.
