What is wash trading and its impact on the crypto market?

  • Wash trades account for 70% of transactions on some cryptocurrency exchanges.
  • The practice of trading with firms to artificially inflate prices can attract inexperienced investors.
  • Three experts weigh in on the experience and what it means for the cryptocurrency market.

Illegal cryptocurrency transactions have skyrocketed in 2022 as fraudsters and hackers made billions, but there is another type of fraud lurking in the industry – wash trading, a fraudulent practice that some traders and crypto firms can use to inflate prices, deceive investors and show trades more liquid.

A recent National Bureau of Economic Research working paper found that laundering accounts for up to 70% of all transactions on non-compliant cryptocurrency exchanges, indicating that the majority of trades on these platforms are fraudulent. Avid cryptocurrency investor Mark Cuban has warned his followers that regulatory action on discovery and wash trading could potentially cause another explosion in the industry.

What is wash trading and why is it bad?

According to Timothy Cradle, director of regulatory affairs at Blockchain Intelligence Group, wash trading is essentially when a firm or party trades with itself to artificially inflate prices, give the illusion of liquidity and generate interest from other investors. This may cause other investors to buy the token at an artificially high price. It is a form of fraud and market manipulation, he said.

But the experience is not limited to individual bad actors. Cryptocurrency exchanges may also perform wash trades to artificially increase trading volume, making the exchange appear more productive or more liquid than it actually is. This could potentially attract investors looking for a place to keep their money, especially if they compare exchanges.

“There’s competition in every industry. That’s no excuse to go out and do wash trades and try to make your exchange look more liquid than it is, especially when you’re dealing in cryptocurrency,” Cradle said.

How common is it?

Kim Grauer, director of research at Chainalysis, says that laundering trades can be as simple as sending crypto from one wallet to another, but there are more complex schemes out there. In his research, a wash trade was identified when the trade met certain criteria of communication with other wallets and addresses – indicating that something fraudulent might be going on.

The NBER paper studied 29 cryptocurrencies classified as regulated or unregulated, with unregulated exchanges divided into two tiers based on their size. The authors found that wash trading was virtually non-existent on regulated cryptocurrency exchanges, but accounted for an average of 77.5% of trading volume on unregulated exchanges. Tier-1 unregulated exchanges had a slightly lower percentage of wash transactions at 61.8% of transactions, compared to 86.2% of Tier-2 unregulated exchanges.

For Binance, the world’s largest cryptocurrency by trading volume and an unregulated Tier-1 exchange in the study, wash trades were estimated to account for 46.4% of all transactions.

“Binance does not, does not, and never has tolerated wash trades that violate our terms of use,” an exchange spokesperson told Insider. “Binance has a dedicated Market Control team responsible for reviewing controls for potentially abusive and/or manipulative behavior, including wash trading and manipulation of trading prices.”

KuCoin, another top-five cryptocurrency exchange according to CoinMarketCap, is estimated to have 52.9% of its transactions as laundering transactions. A spokesperson for the exchange told Insider that KuCoin does not engage in wash trading.

The paper also found a higher incidence of wash trading in weeks after the cryptocurrency market posted positive returns or reduced volatility. “Price increases can attract the attention of retail investors and encourage speculation. Therefore, crypto exchanges are encouraged to increase volumes to compete for better rankings and more customers.”

According to Martin Leinweber, product specialist for digital assets at MarketVector Indexes, there’s no way to truly identify a wash trade unless you have access to account information, which is usually only available to the exchanges themselves. The paper’s findings, however, provide insight into how important regulation is in the industry, he said.

How bad is this for the crypto industry?

Experts are hesitant to say whether this could lead to the crash Mark Cuban envisions, though another major cryptocurrency exchange risk due to fraudulent behavior is certainly possible, Cradle said.

“I have a hard time agreeing or disagreeing with that,” Cradle said. “It would be hard for me to see a complex industry collapse completely because of some kind of fraud or manipulation.”

“I don’t see the risk of a sudden collapse as investors are already moving to better exchanges,” Leinweber added, pointing to cryptocurrency traders moving to Tier 1 exchanges, which typically have better external ratings and are more compliant with regulations.

Why aren’t regulators paying more attention?

One problem may be that the legal framework for cryptocurrency regulation is currently unclear. For example, many in the industry argue that cryptocurrencies are commodities, not securities. But this definition puts crypto in a regulatory vacuum, as there is no federal oversight of the commodity spot market as there is for the futures market.

“We’re in this weird situation where both the CFTC and the SEC haven’t decided what cryptocurrency is, and the question is really who’s going to investigate it and why,” Cradle said.

Others criticized the CFTC and the SEC’s approach to regulation. SEC chief Gary Gensler previously said the U.S. has a regulatory framework for crypto companies, but many are not compliant, and urged exchanges to “come and talk.”

Leinweber speculated that regulators may need to have a more comprehensive strategy to actually stop wash trading.

“You have to have a global strategy to manage these exchanges. Otherwise, there would always be regulatory arbitrage,” he said. “I predict that regulation will be strengthened. But what we really need is smart regulation.”

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