Crypto wash trading and the need for comprehensive regulation.

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 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 capitalisation 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 centralised institutions within the crypto industry, also known as CeFi, characterised 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 devastated millions of crypto investors and customers globally. Moreover, an implosion of scams and frauds meant that the crypto industry in 2022 closed at 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. Unfortunately, this old illegal financial market trick has 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, which is 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 practice is banned under the Market Abuse Regulation in the UK and other EU nations.

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 specific cryptocurrency for fear of missing out on possible gains. Ultimately, wash traders sell their crypto or digital assets when prices become favourable, similar to shorting stocks.

A 2022 Forbes report analysing 157 crypto exchanges found that 51% 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 resulting from 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 and temporarily distort crypto prices. Regulatory actions and global standards are suggested to eliminate crypto wash trading while fostering a healthy and sustainable crypto industry.

How to wash trading happens in crypto exchanges.

Crypto wash trading could be as simple as transferring digital assets from one wallet to another. However, there are more elaborate schemes, says Kim Grauer, the director of research at Chainalysis. Recent events and industry rumours suggest that exchanges use crypto 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 natural order book. These orders can be filled only by approved (exchange-owned) accounts or made available to the market. However, this approach requires more technical expertise because it risks loss if other traders do not close in time or fill positions.

Some centralised crypto exchanges also incentivise users to engage in crypto wash trading through fee rebates or transaction-mining programmes. Additionally, exchanges can deploy wash-trading-only robots, 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 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 precise crypto market regulations. 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 remain 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 crypto wash trading is virtually absent on regulated exchanges. However, the illegal practice makes up an average of 77.5 per cent of trading volume on unregulated crypto 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, the digital assets product specialist at MarketVector Indexes. However, he observes that comprehensive regulation of 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, not securities. But that definition creates a loophole in the regulation of the crypto industry.

Therefore, regulators may need a more comprehensive strategy to crack down on crypto wash trading. To govern these exchanges, regulators must have a global approach. Otherwise, regulatory arbitrage would always exist. The expectation is that there will be increased regulation. However, the crypto industry requires intelligent and comprehensive regulation.