In a working paper, the American National Bureau of Economic Research has suggested crypto wash trading accounts for up to 70 per cent of trades on non-compliant exchanges.
- Wash trading is a form of illicit market manipulation where an entity buys and sells the same financial asset to create a false impression of market activity.
- Regulatory actions and global standards are suggested to eliminate crypto wash trading while fostering a healthy and sustainable crypto industry.
- Regulators may need to have a more comprehensive strategy to crack down on crypto wash trading.
As the global economy grappled with inflation in 2022, cryptocurrencies, once touted as inflation hedges, experienced their fair share of turmoil. The total market capitalization shrank from its $3 trillion peak in 2021 to below $1 trillion. Major currencies including Bitcoin and Ethereum lost more than 70 per cent of their peak value.
The unprecedented collapse of centralized institutions within the crypto industry, also known as CeFi characterized this dramatic downturn. The collapses of exchanges including Three Arrow Capitals, Voyager, Celsius, and FTX sent waves in the crypto sector. These happenings in the crypto market have proven that no entity is too big to collapse. All entities including venture funds, credit providers, crypto exchanges, and mining companies confront the same challenges.
The recent failures dealt devastating blows to millions of crypto investors and customers globally. Moreover, an implosion of scams and frauds meant that the crypto industry in 2022 closed in a low. Hackers and scammers made off with billions dealing a blow to the trust among crypto investors and enthusiasts. And even as the crypto industry looked to recover from the 2022 turmoil, crypto wash trading poses another worry for investors and enthusiasts.
What is crypto wash trading
Wash trading is a form of illicit market manipulation where an entity buys and sells the same financial asset to create a false impression of market activity. This practice gained traction with the rise of electronic trading in the early 2010s, as algorithmic trading programs began churning trades at unprecedented speeds. This old illegal financial market trick has unfortunately found its way into the crypto industry.
The US first banned wash trading in 1936 through the Commodity Exchange Act. Currently, the Commodity Futures Trade Commission (CFTC) prohibits brokers from profiting from wash trading, considered a form of market abuse. The US Securities and Exchange Commission (SEC) prosecutes wash trading through the Securities Act 1933 and the Securities Exchange Act 1934. The UK and other EU nations the practice is banned under the Market Abuse Regulation.
In the crypto industry, many carry out wash trading to falsely boost traders’ interest in a particular asset or digital currency, including NFTs. Investors react by purchasing a particular cryptocurrency due to the fear of missing out on the possible gains. Ultimately wash trader sell their crypto or digital assets when price become favorable, similar to shorting stocks.
A 2022 Forbes report that analyzed 157 crypto exchanges found that 51 per cent of trading was fake. In a working paper, the American National Bureau of Economic Research has suggested crypto wash trading accounts for up to 70 per cent of trades on non-compliant exchanges. While some crypto wash trading may be unintentional, it could also point to investors pumping prices or exchanges trying to entice investors.
These fabricated volumes, effectively the result of firms and crypto exchanges illegally trading with themselves, can amount to trillions of dollars annually. The fraudulent practice can offer a false impression of liquidity. The impression could result in an improved, but inaccurate, exchange ranking, as well as temporarily distorting crypto prices. Regulatory actions and global standards are suggested to eliminate crypto wash trading while fostering a healthy and sustainable crypto industry.
READ MORE: Kraken crypto exchange fined US$30 million for violating crypto regulations
How wash trading happens in crypto exchanges
Crypto wash trading could be as simple as transfering digital assets from one wallet to another. However, there are more elaborate schemes out there, says Kim Grauer, the director of research at Chainalysis. Recent events and industry rumors suggest that exchanges engage in crypro wash trading in several ways.
The most basic approach is to create false trading records in the trading history database. However, this is easily detectable by customers and observers who monitor live trade books on crypto exchange websites.
A more advanced technique is to deploy trading programmes that place fake orders into the real order book. These orders can be filled only by approved (exchange-owned) accounts or made available to the market. However, this approach requires greater technical expertise because it carries the risk of loss if positions are not closed in time or filled by other traders.
Some centralized crypto exchanges also incentivize users to engage in crypto wash trading through fee rebates or transaction-mining programmes. Additionally, exchanges can deploy wash-trading-only robots or include wash trades in other activities such as market-making or outsource it to professional market makers. They can activate or deactivate these methods as needed.
Combining these actions can also prove effective. Despite the complexity of the problem, crypto wash trading had remained under the radar until several researchers rigorously established the practice as a rampant, industry-wide phenomenon.
The most straightforward way to detect wash trades in the trading record is to identify the buyer and seller and prove that they are the same entity. However, every operating exchange conceals traders’ identities in public trading records as a commercial secret. Therefore, it is unrealistic to directly mark which transaction represents crypto wash trading at a meaningful scale.
The fact that computers facilitate high-frequency trading makes crypto wash trading even more prevalent. Furthermore, many countries globally have yet to impose clear regulation for the crypto market. This is mainly because the sector is still in the nascent stages. Thus, regulators are trying to understand it to draft sensible regulatory frameworks. Where regulations exist, crypto and other digital assets remains subject to property tax laws rather than laws governing securities, options or equities.
The need for comprehensive regulation of the crypto industry
Researchers have found that found crypto wash trading is virtually absent on regulated exchanges. However, the illegal practice makes up an average 77.5 per cent of trading volume on crypto unregulated exchanges.
There is no way to truly identify crypto wash trading unless one access account data, which is typically only available to the exchanges themselves, according to Martin Leinweber, digital assets product specialist at MarketVector Indexes. However, he observes that a comprehensive regulation with the crypto industry can go a long way.
However, challenges remain since the legal framework for crypto regulation remains ambiguous. For instance, many in the industry have classified cryptocurrencies as commodities and not securities. But that definition creates a loophole in the regulation of crypto industry.
Therefore, regulators may need to have a more comprehensive strategy to crack down on crypto wash trading. To govern these exchanges, regulators must have a global strategy. Otherwise, regulatory arbitrage would always exist. The expectation is that there will be increased regulation. However, the crypto industry requires intelligent and comprehensive regulation.
READ MORE: AI tools heighten safety and transparency in the NFT market
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- Source: https://web3africa.news/2023/06/10/industry-talk/crypto-wash-trading-needs-comprehensive-regulation/
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