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What is wash trading, the fraudulent practice that some experts say accounts for 70% of transactions on crypto exchanges?

Crypto coins

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  • Wash trading accounts for 70% of trades on some crypto exchanges, a study found. 
  • The practice of firms trading with themselves to boost prices artificially may lure inexperienced investors. 
  • Three experts dive into the practice and what it means for the crypto market. 

Illicit crypto transactions skyrocketed in 2022 as scammers and hackers made off with billions, but there’s another type of fraud lurking in the industry—wash trading, the fraudulent practice some traders and crypto firms can use to pump prices, dupe investors, and make trading appear more liquid. 

A recent working paper from the National Bureau of Economic Research found that wash trades accounted for up to 70% of all transaction on non-compliant crypto exchanges, suggesting most trades on these platforms are fraudulent. Mark Cuban, an avid cryptocurrency investor, warned his followers that the discovery and regulatory crackdown on wash trades could potentially set up another implosion in the industry.

What is wash trading and why is it bad?

Wash trading is essentially when a firm or party trades with itself to artificially boost prices, give the illusion of liquidity, and generate interest from other investors, according to Timothy Cradle, the director of regulatory affairs at Blockchain Intelligence. That can lead other investors to buy the token at an artificially high price. It’s fraud and a form of market manipulation, he said.

But the practice isn’t only limited to individual bad actors. Crypto exchanges can also do wash trading to artificially jack up trading volumes, making the exchange appear more productive or more liquid than it actually is. That could potentially lure investors who are looking for a place to park their money, especially if they’re comparing exchanges. 

“There’s competition in every industry. That’s not an excuse to go out and do wash trading and try to make your exchange look more liquid than it actually is, especially when you’re dealing with cryptocurrency,” Cradle said.

How common is it?

Wash trading could be as simple as sending crypto from one wallet to another, but there are more elaborate schemes out there, says Kim Grauer, the director of research as Chainalysis. In her research, wash trades were identified when a trade met certain relationship criteria with other wallets and addresses – suggesting something fraudulent could be taking place.

The NBER paper studied 29 crypto exchanges that were classified as regulated or unregulated, with unregulated exchanges being sorted into two tiers based on size. The authors found wash trading was virtually absent on regulated crypto exchanges, but made up an average 77.5% of trading volume on unregulated exchanges. Tier-1 unregulated exchanges had a slightly lower proportion of wash trades at 61.8% of transactions, compared to 86.2% of transactions Tier-2 unregulated exchanges. 

For Binance, the largest crypto exchange in the world by trading volume and an unregulated Tier-1 exchange in the study, wash trading was estimated to comprise 46.4% of all transactions. 

“Binance does not engage in or tolerate wash trading, which is a violation of our terms of use, nor has it ever done so,” a spokesperson from the exchange told Insider. “Binance has a dedicated Market Surveillance team that is responsible for reviewing surveillance related to potential abusive and/or manipulative behavior including wash trades and trade price manipulation.”

KuCoin, another top-five crypto exchange according CoinMarketCap, was estimated 52.9% of its transactions consist of wash trades. A spokesperson from the exchange told Insider KuCoin did not engage in wash trading.

The paper also found a higher incident of wash trading in the few weeks after the crypto market saw positive returns, or experienced a drop in volatility. “Price increases could draw retail investors’ attention and encourage speculation. Therefore, crypto exchanges are incentivized to pump up volumes to vie for better ranking and more clients.”

There’s no way to truly identify a wash trade unless you have access to account data, which is typically only available to the exchanges themselves, according to Martin Leinweber, digital assets product specialist at MarketVector Indexes. The paper’s findings, do, however, give an idea of how important regulation is in the industry, he said.

How bad is this for the crypto industry?

Experts are hesitant to say it could lead to the crash Mark Cuban envisioned, although the risk of another major crypto exchange going down because of fraudulent behavior is certainly possible, Cradle said.

“I struggle to agree or disagree with it,” Cradle said. “I would find it hard to see a complex industry completely go under because of one type of fraud or manipulation.”

“I don’t see a risk of a sudden crash as investors are already migrating to better exchanges,” Leinweber added, pointing the exodus of crypto traders towards Tier 1 exchanges, which typically have better external ratings and are more compliant with regulation. 

Why aren’t regulators paying more attention?

One problem could be that the legal framework for crypto regulation is currently ambiguous. For instance, many in the industry have claimed that cryptocurrencies are commodities, not securities. But that definition places crypto in a regulatory loophole, since there is no federal oversight over the commodities spot market the way there is for the futures market.

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

Others have criticized the CFTC and the SEC’s hands-off approach to regulation. SEC chief Gary Gensler has previously said the US has regulatory framework for crypto firms, but many are not compliant, he said, urging exchanges to “come in and talk.” 

Leinweber speculated that regulators may need to have a more comprehensive strategy if they are truly to crack down on wash trading. 

“To govern these exchanges, you must have a global strategy. Otherwise, regulatory arbitrage would always exist,” he said. “I predict there will be increased regulation. But what we really require is intelligent regulation.” 

Read the original article on Business Insider
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