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The term wash trading is not only new to the crypto world but for the most experienced NFT traders as well. Traders usually wonder what this term actually means. If you’re one of the people asking this question, join us as we explore the definition of wash trading and how it is leaving a bad impact on the crypto community in general and on NFTs in particular.
Cryptocurrency has gotten lots of traction in recent years, the total number of crypto coins has increased manifolds, and the market has grown exponentially worldwide. Alongside cryptocurrency, NFTs are also becoming a hot topic amongst investors and researchers alike as more and more people get to know their potential.
Sadly, just like every other financial market, the crypto market has also attracted lots of scammers and fraudsters. Fake influencers on social media platforms promote fishy projects and attract investment for rug pull schemes and wash trading.
The amount of money people lost to scammers in 2021 alone was approximated to be well above $10 billion. At the same time, the NFT market has grown from a mere $350 million to over $40 billion. The NFT market also has lots of loopholes and potential opportunities for scammers.
Wash Trading is the act of artificially soaring up the price of an NFT. This method is also used by money launderers and terrorists to send and receive money across borders without any inspection or taxation. A large chunk of crypto-related scams in the last year included wash trading of NFTs.
As the method continues to help the scammers loot lots of money, more fraudsters are joining the party to feast on novice and clueless investors’ money. If you’re looking to invest any amount of money in crypto, you must understand the true meaning of wash trading and how this method can be prevented to make crypto trading safer and easier.
What is Wash Trading?
The exact definition of wash trading varies depending on the market you’re looking at. Wash trading is usually about manipulating financial transactions and artificially showing the price of an asset higher than it actually is.
In the crypto market, wash trading is used to spread fake news in the market. Any type of asset a trader buys or sells appreciates in price. The person manipulating uses wash trading for his financial benefit.
Let’s take an example of an investor who wants to buy a $100 NFT for $1 million; he can easily do that. Digital items can be bought for far more than they’re actually worth because of their intrinsic value. The buyer pays for the piece and gets the same money back in one way or the other. By doing this, the investor can easily manipulate the price of an NFT in the market.
Now, whenever another investor buys that NFT, he’ll be paying much more than the actual value of that piece. This results in huge financial loss as the second investor wouldn’t be able to sell that piece for a reasonable price.
So, wash trading can primarily be used to push the value of anything related to cryptocurrency. This creates a false illusion that the price of an asset is much more than its current market value, pushing more people to buy into the fraud. These types of activities can easily change the market trends and impact the market in the long run.
A famous example of this fraud is the case related to CryptoPunks. The NFT project was sold for an astounding $532 million worth of ETH. Soon after all the money was transferred to the seller, it was returned back to the buyer in smaller bits. This is a clear example of wash trading.
Usually, people confuse wash trading and round-tripping. However, there’s a clear difference between the two despite the open five being the same. In wash trading, one person buys and sells the asset in one go.
Round tripping includes the collaboration between two or more identities or companies to mutually benefit from the set of transactions. In round-tripping, the entities taking part in the transaction look for the extra cash inflow from novice investors, thinking that the particular stock is appreciating in value.
Difference Between Wash Trading and Market Making
Many people are confused between wash trading and market making. Market making is basically buying and selling the same amount of assets at a time but at two different places. Market makers buy cryptocurrency and NFTs low and sell them high. They repeat the same process to make a profit from every transaction.
On the surface, wash trading and market making might look the same. However, the main difference between these two is the intent of the seller. In market making, selling your asset means that you are making it available for every investor looking to invest in the market. So, a market maker makes an asset available to every investor in the market.
On the other hand, inverse trading, both the buyer and seller are the same. Wash traders use multiple accounts to buy and sell NFTs and crypto. In this method, the divorce trader is trading with himself, and there is no other trader involved in the transaction. This way, the incoming investors are misled about the market and perceive its value as way higher than it actually is.
Is Wash Trading Legal in the Crypto World?
By the very nature of wash trading, it is designed to deceive the investors and sell a stock on an NFT for far higher than its actual worth. Due to the ill intentions of the people or companies involved, wash trading is considered illegal across the globe.
In normal circumstances, lots of investors would have to buy and sell a particular stock in order to raise its value. On the other hand, inverse trading, you create a false sense of value by taking money from an investor and buying an asset for far more than its actual worth.
The money is then returned to the actual investor, and the asset stays in the market with a much higher price tag. That false price tag now misleads the next investor who wishes to invest in the NFT or stock and hold it. By the time the investor realizes that he has made a mistake, he is deprived of a lot of money.
Despite declaring illegal intent, wash rating is still not illegal in some parts of the world either due to the lack of legislation or different core principles behind different laws. Some jurisdictions have yet to consider NFTs and cryptocurrency as an asset class. Therefore, the normal laws cannot be applied to NFT wash trading in some jurisdictions. This creates a huge legal loophole for scammers and thugs to exploit.
However, a number of countries and jurisdictions consider trading an illegal activity and have formed certain punishments for the people looking to get rich quickly through this manipulative practice.
In the past, exchanges like Bithub have faced severe backlash by internet communities for allegedly facilitating wash trading activity. The aforementioned exchange alone is estimated to be involved in a fraud worth over $250 million. However, it is still unclear what type of consequences they had to face since the Korean government launched an investigation into the issue.
Difference Between NFTs and Cryptocurrencies
NFT is a shortened form of nonfungible tokens. In order to understand the concept of NFT, you will have to learn about fungible tokens first. Fungible tokens are the ones that can be exchanged with each other while retaining the actual value. For example, if you give your friend a $10 bill and receive the same amount back in fiat currency, the original value will remain the same.
Every NFT is unique in itself and cannot be traded for another NFT. It is just like the real estate market. Every exit is unique in itself, and you cannot exchange one house for another.
In the crypto marketplace, NFTs and unique assets with the name of their owner are saved on the blockchain. The NFT marketplace is becoming increasingly popular, and there are now lots of NFTs to buy from across different platforms.
For the creators of NFTs, it is usually very difficult to associate a value with their token. Therefore, in order to make their NFT unique and valuable, the creators usually indulge in illegal activities like wash trading to artificially lift up the value of their NFT.
Since the person in possession of the transaction can easily determine the selling and buying price, wash traders can increase the selling price with every transaction and create a fake illusion that the price of their token is increasing with every sale. By repeating the same procedure over and over, the wash trader can significantly increase the value of their NFT.
Once a real trader buys a wash-traded NFT, the creator/ wash trader makes a profit.
How to Spot Wash Trading in NFTs?
Although the method is a bit complex, you can definitely learn a few preemptive measures to spot wash trades and avoid them. However, you will have to learn how to do proper blockchain analysis in order to spot wash trades. By learning how the blockchain system works, you can easily spot this type of illegal activity.
As you might already know, the blockchain system always keeps a record of every transaction happening on it in real-time. This means that you can always check and trace each and every transaction and can easily spot wash trading if the money used to buy an NFT is going in a circle.
Moreover, the blockchain system and The marketplace you use to trade NFTs both keep a record of every single NFT sold on them. This system is designed to help wash trades easily.
So, whenever you have to invest in an NFT, you can easily see its trade history and determine if it has been sold and bought by the same person. However, this process can only be applied if the money is going from and to the same wallet address. It won’t work if a group of people is involved in illegal activity.
So, one of the most reliable methods of avoiding watch trading is by trading with trustable people and through trustable platforms.
Negative Effects of NFT Wash Trading
NFT wash reading activity is already destroying the emerging NFT market in particular and the whole crypto market in general. Above all, traders and investors might be overestimating the whole market because of the wash trades going on.
Many independent reports suggest that most of the NFT trading activity still involves wash trades. Most of the users buy and sell NFTs to one another in order to earn more rewards in the form of cryptocurrency. This activity sits around roughly $18 billion, which is over 90% of all the NFT trading activity done in the last year.
It is very concerning for real investors and traders to know that over 90% of a marketplace is occupied by fake trades which involve money going from one account to another. However, due to the word supply popularity of the crypto marketplace, wash trading is far from making a tangible negative impact on the NFT marketplace.
A rapidly increasing trade volume and upward trend in the popularity of the NFT market is a living example of this fact. This is also because of the fact that a majority of wash trades did not generate as much benefit for the fraudsters as they expected. So, those trades won’t be worth the hassle.
In order to successfully execute a wash trade, a seller would have to make the transaction around 25 times from the same account. To make things even worse, this method never promises success in the end. This is the main reason why only a fraction of investors is patient enough to go through the whole process. If done wrong, these wash trades can also cause heavy losses. Most of the wash trades are made on the ETH network.
NFTs and Money Laundering
Money laundering has been one of the biggest problems for the art market since the beginning of time. The same is the case with NFTs as well. Self-financed accounts can easily buy and sell NFTs to themselves in order to white wash money and launder it easily.
Due to the anonymity of the crypto marketplace, money laundering has become a bigger problem in the world of NFTs than in the world of physical art.
Cybercriminals can easily launder money by using NFT trading. Moreover, since everything is publically listed on the blockchain, we can easily track money laundering activities and estimate their overall volume in the NFT marketplace.
Wash trading can easily be detected in NFT trades by carefully looking for self-financed accounts which buy and sell NFTs to themselves to artificially increase the value of their NFT with every transaction. This simple strategy can help us find lots of wash trades.
Whenever a cryptocurrency or NFT is launched, it has no value. Therefore, Investors indulge themselves in wash trading to artificially increase the value of their assets. This tricks naive investors into investing and losing their money.
How Can Exchanges Tackle Wash Trading?
Many exchanges push their investors to trade a particular token by introducing rewards and specific trading games for them. This is when wash traders make illegal trades in large volumes to attempt and win the competition and take the prize money. While this might increase the market volume of a specific token temporarily, it is usually seen to have a bad impact on the whole market in the long run.
Let’s take a look at a few steps exchanges can take to discourage wash trading activities.
- Every exchange should introduce a single fee schedule instead of making a tiered reschedule. NFTs with low trade volume is traded heavily by wash traders to access better fee schedules as per their exchange’s policy. If the exchanges are to reduce wash trading activities, they should start by introducing a single fee schedule for every user on the exchange.
- Exchanges can also try and restrict one person to only one account. A person shouldn’t be allowed to make wash trades and receive the same money back in their account. When a person is limited to one account, he’ll find it hard to add a person to their game and trust in them to return the money. So, by making hurdles, you can reduce the number of wash trades.
- The best way is possible would be to try and prevent wash-related trading orders from a user. By introducing measures to eliminate the orders that match, the exchanges can easily reduce the number of wash trades happening on their platform.
The final takeaway from the study of wash trading teaches us that we should always do due diligence when buying an NFT in particular and any crypto-related asset in general. That’ll help us eliminate or at least reduce our chances of contacting wash trades.