Crypto wash trading occurs when an investor sells and then immediately buys the same crypto asset. Alternatively, the investor sells an asset like an NFT to themselves, often via a colluding third party. A trade is made, but ownership doesn’t change.

For example, an investor who owns crypto coins places simultaneous buy and sell orders from different trading accounts. There’s no exchange of value, but the trade creates an artificial impression of market activity. It seems as though trading volume is higher than in reality.

Wash trading is a type of market manipulation that can artificially inflate prices and lead investors to believe there is greater market liquidity than there actually is. Widespread crypto wash trading profoundly distorts markets, erodes investor trust, and skews financial market indices.

Wash trading can happen in any market and is illegal in most, but cryptocurrency exchanges are particularly attractive to rogue investors. The U.S. National Bureau of Economic Research estimates that wash trading accounts for 70% of trades on unregulated exchanges. Statistical analysis by the Centre for Economic Policy Research indicates that it is also common in centralized exchanges.

How Does Wash Trading Crypto Work?

Wash trading has emerged as a significant concern in cryptocurrency and NFT markets. Traders buy and sell assets to themselves or through coordinated groups, creating a deceptive picture of market activity. The anonymity, speed, and lack of regulatory oversight in the crypto space make crypto markets an enticing target for manipulation.

Let’s look at some of the techniques used by crypto wash traders.

• Multiple Accounts or Collusion: A single trader might use several wallets or cryptocurrency exchange accounts or collude with other traders to buy and sell the same cryptocurrency simultaneously, creating the illusion of high trading volume.
• Automated Trading Bots: Wash traders often employ sophisticated bots and automated trading programs to execute trades automatically. These bots can rapidly buy and sell a cryptocurrency between controlled accounts, significantly inflating trade volumes without any real change in ownership.
• Leveraging Anonymity: The pseudo-anonymous nature of many blockchain transactions facilitates wash trading. Since linking transactions to real-world identities is harder, traders can more easily manipulate market activity without detection.
• Small or Unregulated Exchanges: Some wash traders target smaller or less-regulated crypto exchanges where oversight is laxer. These platforms might lack the sophisticated monitoring tools of larger exchanges, making them more vulnerable to manipulation.

Wash trading is also used to artificially inflate prices for other crypto assets, including Non-Fungible Tokens (NFTs). In 2023, NFT markets tend to be small and illiquid, with low trading volumes. This makes it easier for wash traders to influence prices for profit.

Why Wash Trade Crypto?

Crypto wash trading is all about profit and market manipulation. But it’s helpful to consider the multiple roles it plays in rogue crypto traders’ strategies.

Inflating Trading Volumes

High trading volumes are often correlated with high liquidity and investor interest. Wash trading artificially inflates trading volumes, making a cryptocurrency seem more active and attractive. This can draw in genuine investors looking for popular, liquid assets.

Additionally, cryptocurrency exchanges often list tokens based on their trading volume. Wash trading can help a token meet volume thresholds, gaining it a spot on more prominent platforms and boosting its visibility and perceived legitimacy.

Manipulating Market Prices

Repeatedly buying and selling a cryptocurrency allows wash traders to create an illusion of increased demand and momentum. Simulated demand leads to a rise in the price, which might entice real investors to buy in, further driving up the price.

Wash trades can also be used to manipulate market trends. The crypto market is highly speculative. Traders look for financial market fluctuations they interpret as positive investment trends. Wash trading can be used to fabricate these trends, influencing market behavior.

Earning Exchange Rewards Rankings

Some crypto exchanges hold competitions with rewards for top traders based on trading volume. Dishonest traders use wash trading to inflate volumes, earning the trader a higher exchange ranking and greater rewards or recognition.

Exchange affiliate schemes can be exploited similarly. Wash trading can help traders meet affiliate program criteria and receive bonuses or reduced fees for high-volume trading.

Crypto Wash Trading and Money Laundering

Wash trading in cryptocurrencies and NFTs can disguise illegally obtained money as profits from legitimate trading. Frequent and rapid buys and sells, characteristic of wash trading, obscure the true nature of fund transfers. What might appear as independent trades may be a systematic effort to disguise the asset’s movement and origin.

The use of wash trading in NFT markets is particularly prevalent. Bad actors artificially inflate NFT values by repeatedly buying and selling the same NFT at escalating prices. Once the price of an NFT is artificially raised, it can be sold to unsuspecting buyers, turning the proceeds into seemingly legitimate income and cleaning the dirty money used for the initial purchase.

For additional information, view our blog Everything You Need to Know About NFT Money Laundering.

Is Crypto Wash Trading Illegal?

The legal status of crypto wash trading is something of a gray area. Wash trades are banned in many markets. The Commodity Exchange Act (1936) prohibits wash trading in commodity markets, and the Securities Exchange Act (1934) prohibits it in securities markets.

However, many crypto assets have not yet been legally categorized, making enforcement challenging. Are they securities and the responsibility of the Securities and Exchange Commission (SEC)? Or are they commodities and the responsibility of the Commodity Futures Trading Commission (CFTC)?

The SEC has enforced federal securities laws against several cryptocurrency exchanges in cases where it believes crypto assets should be categorized as securities. The CFTC is active in regulating cryptocurrencies classified as commodities, including Bitcoin and Ether, although its jurisdiction extends only as far as “fraudulent and manipulative activities in interstate commerce.”

There is ongoing debate in the regulatory space about which organization has jurisdiction, and the status of crypto wash trading is yet to be settled. Regardless of the current legal situation, there is no doubt that wash trading is illegal in many markets and that regulators are taking a keen interest in crypto wash trading. The current ambiguity is unlikely to persist.

Can Crypto Exchanges Prevent Crypto and NFT Wash Trading?

Crypto wash trading is legally risky. But aside from the legalities, it also distorts markets and erodes the investor trust on which cryptocurrency exchanges depend. Reputable exchanges are making a concerted effort to detect fake transactions and eliminate wash trading.

There are two fundamental approaches: data analytics and Know-Your-Customer processes. The simplest case is monitoring the transaction of a single account to distinguish suspicious buy and sell patterns from legitimate trading activity. More sophisticated network analysis can discover relationships between accounts and market participants, alerting operators to the likelihood of collusion.

Rigorous KYC, identity verification, and customer due diligence processes can help exchanges identify accounts with the same beneficial owner. Transaction and customer risk scoring can highlight entities for enhanced due diligence, which may be necessary to establish ultimate beneficial ownership.

Combating Money Laundering and Crypto Market Manipulation with Alessa

Alessa is a modular AML compliance and fraud management platform. We provide a comprehensive range of anti-money laundering and fraud detection tools to the cryptocurrency industry, including:

• Identify verification and Crypto KYC
• Transaction monitoring and screening
• Watchlist and sanctions screening
• Enhanced due diligence software

Contact our compliance experts today to learn how Alessa can help your business’s compliance and fraud prevention programs.