What is wash trading and why does it hurt crypto economy?

In 2022, Coinbase faced allegations that some of its employees were involved in wash trading. Wash trading involves buying and selling the same asset to create misleading market activity. The New York Attorney General’s office accused a former Coinbase employee of participating in a scheme that generated over $1 million in illicit profits. The company denied that wash trading was widespread within its platform and took steps to address the issue, emphasizing its commitment to maintaining a fair and transparent market.

The wash trading scheme on Coinbase primarily involved the trading of a specific cryptocurrency, Ethereum. According to the New York Attorney General’s findings, the former Coinbase employee and their associates engaged in wash trading activities involving Ethereum to manipulate its trading volume and price. The intention was to create an illusion of increased market activity for Ethereum, misleading other traders about its actual market conditions.

Here’s a detailed explanation of how the scheme allegedly worked:

How does Wash Trading exactly work?

Wash trading is a fraudulent practice where the same party is both the buyer and the seller of a security, in this case, cryptocurrency. This creates the illusion of increased market activity without any actual change in ownership, often to manipulate prices or trading volume.

Just like a16z wash trades the books from their associates, crypto trading firms also wash trades crypto shitcoins, with this, they can make the price go wherever they want, with no original or organic demand.

Number go up and suckers pile in, while they slowly dump on them. pic.twitter.com/KT1hFoEW1F
— Bitfinex'ed 🔥🐧 Κασσάνδρα 🏺 (@Bitfinexed) February 9, 2024

Steps of the Scheme

Account Creation: The involved parties created multiple accounts on Coinbase. These accounts could belong to the same individual or their associates.
Placement of Orders: The individuals placed buy and sell orders for the same cryptocurrency at the same or similar prices. This was done using different accounts to disguise that the transactions were self-executed.
Order Matching: Because the orders were placed at similar prices, they matched each other. This gave the appearance of legitimate trades occurring on the platform.
Volume and Price Manipulation: By repeatedly buying and selling the same cryptocurrency between their accounts, the individuals artificially inflated the trading volume and, potentially, the price of the cryptocurrency. This could mislead other traders into believing there was high demand or significant trading activity.
Profits Generation: The manipulated market activity could influence the prices, leading other traders to make decisions based on the false data. The perpetrators could then profit by eventually selling the cryptocurrency at manipulated higher prices to unsuspecting buyers or by creating the appearance of liquidity and demand for certain coins.

Detection of Wash Trading

Detecting wash trading can be challenging, but there are several signs and techniques that can help identify this fraudulent activity.

Unusual Trading Patterns

One key indicator is unusual trading patterns. If you notice the same cryptocurrency or asset being bought and sold repeatedly at similar prices, this could be a red flag. Trades that occur within very short time intervals or involve the same accounts frequently trading with each other might also indicate wash trading.

Volume Analysis

Volume analysis is another useful method. Sudden, unexplained spikes in trading volume can be suspicious, especially if there is little change in the price or market interest. Similarly, if one exchange has much higher volumes than others for the same asset, it might be due to wash trading.

🚨 NFT Wallet Wash Trading

Check the latest data on wash trading volume. This analysis reveals significant wash trading activity, with the most wallets trading over $1k USD.

How many wallets are involved in $5B+ wash trading?

Select your answer in the poll ⬇️ 🧵 pic.twitter.com/lTLhiPQ2yF
— bitsCrunch (@bitsCrunch) July 19, 2024

Order Book Examination

Examining the order book can provide clues. Look for large orders that are quickly matched by another order of the same size, or frequent matching of buy and sell orders at the same prices between the same accounts.

Account Activity Monitoring

Account activity is another area to monitor. Accounts that frequently trade with each other or show identical trading patterns could be involved in wash trading. High-frequency trading without significant market news or events can also be a red flag.

Reality check: Overwhelming majority of Tether trading is all wash trading on fraudulent, non-KYC/AML exchanges.

And a single trader wash trades trillions of dollars of fake trades. pic.twitter.com/wQ7ePvqn4v
— Bitfinex'ed 🔥🐧 Κασσάνδρα 🏺 (@Bitfinexed) January 12, 2023

Trade Size and Frequency Analysis

Analyzing trade size and frequency is important too. Trades that are always of the same size or occur at very high frequency without any external reasons might indicate wash trading.

Amazing how Solana went from $75-100 BILLION DAILY stablecoin volume to $7 BILLION daily in 1 day!!

Might it be because the data was totally fake??? Like how I've been talking about all these months??

And by the way even at $7 Billion 90% of the volume is still fake https://t.co/CnKWGAbjsM pic.twitter.com/ScfCgv5UhS
— Wazz (@WazzCrypto) June 25, 2024

Market Impact Analysis

Market impact analysis can reveal inconsistencies. If there is high trading volume without corresponding price changes, it suggests artificial trading activity. Comparing the trading volume of the asset on different exchanges can also highlight potential wash trading if one exchange shows disproportionately higher volumes.

Statistical Methods

Statistical methods, like examining how closely trades cluster around the Volume-Weighted Average Price (VWAP) or the Time-Weighted Average Price (TWAP), can help identify manipulation.

Blockchain Analysis Tools

Using blockchain analysis tools for cryptocurrencies can trace transactions and identify suspicious patterns. Financial institutions often use surveillance software to monitor and detect unusual trading activities.

Regulatory Reports and Alerts

Regulatory reports and alerts are valuable resources. Exchanges typically have mechanisms for reporting suspicious activities, and regulatory bodies like the SEC or CFTC may highlight suspicious trading in their reports.

Practical Example

For example, if you see a specific cryptocurrency with a daily trading volume of 10,000 units, but notice multiple instances where 1,000 units are traded back and forth between the same two accounts every few minutes without significant price movement, this pattern suggests possible wash trading. The high volume doesn’t correlate with normal market behavior.

The below video offers extra info on how to detect wash trading.

Impact of Wash Trading

Market Integrity: Wash trading undermines the integrity of the market by creating a false sense of activity and liquidity, leading to potential losses for unsuspecting investors.
Regulatory Scrutiny: The incident increased regulatory scrutiny on Coinbase and other cryptocurrency exchanges, prompting stricter regulations and oversight in the industry.
Trust and Reputation: While Coinbase took measures to address the issue, such incidents can harm the trust and reputation of the platform among its users and the broader financial community.

In short you can notice three common patterns in wash trading cases

Creation of False Volume: The primary goal is to create the illusion of higher trading volume.
Price Manipulation: By creating false activity, traders can manipulate the price of the asset.
Attraction of Investors: Higher trading volumes and manipulated prices can attract more investors, benefiting the wash traders.

Wash trading in recent history

Wash trading has been a recurring issue in various markets, including both traditional finance and cryptocurrency exchanges. Here are some notable cases:

1. Traditional Finance

1980s U.S. Stock Market:

In the 1980s, wash trading was relatively common in the U.S. stock market, leading to significant regulatory changes. For instance, stock brokers would often engage in wash trading to create the appearance of higher trading volumes to attract more clients.

2. Cryptocurrency Exchanges

Bitfinex and Tether (2017-2018):

Allegations surfaced that Bitfinex and Tether were involved in manipulating the price of Bitcoin through wash trading and issuing unbacked Tether tokens. This was part of a broader investigation into market manipulation in the cryptocurrency market.

Tether issued Tethers to Bitfinex for IOUs in 2017, proving my allegations that Tethers were being printed without dollar deposits, contrary to Bitfinex statements.

Tether gave billions of Tethers to the “anonymous trader” which ran wash trading and market manipulation bots.

🍿 pic.twitter.com/Wng2hslRPK
— Bitfinex'ed 🔥🐧 Κασσάνδρα 🏺 (@Bitfinexed) July 15, 2024

Bitforex and FCoin (2019):

Bitforex and FCoin were accused of wash trading to artificially inflate their trading volumes. This was part of a broader trend where smaller exchanges engaged in such practices to appear more popular and liquid than they actually were.

OKEx (2018):

OKEx, another major cryptocurrency exchange, faced allegations of wash trading. Studies indicated that a significant portion of its reported trading volume could be attributed to wash trading activities, leading to questions about the accuracy of its reported metrics.

3. Regulatory Actions

U.S. Commodity Futures Trading Commission (CFTC):

The CFTC has taken action against several firms and individuals for engaging in wash trading in futures markets. These actions include significant fines and bans from trading.

4. Recent Developments

South Korean Exchanges (2020):

Several South Korean cryptocurrency exchanges were investigated for wash trading and other fraudulent activities. These investigations led to increased regulatory scrutiny and the closure of some exchanges.

Impact of Wash Trading

Wash trading can significantly impact financial markets, affecting market integrity, regulatory scrutiny, and investor confidence.

Market Integrity

Wash trading undermines trust in market data by creating false trading volumes and misleading investors about the true activity and value of a security. This artificial inflation of trading volumes can make a security appear more popular and liquid than it is, distorting the perception of its demand and price stability. For example, a study revealed that over half of reported Bitcoin trading volume could be attributed to wash trading, which skews the real market activity and misleads traders.

Regulatory Scrutiny

Repeated incidents of wash trading lead to increased regulatory oversight and the implementation of stricter rules. Regulatory bodies like the SEC and the CFTC in the United States actively monitor and penalize wash trading to maintain market fairness. These agencies impose fines and enforce compliance measures to deter such activities. The Commodity Exchange Act of 1936 and subsequent regulations explicitly prohibit wash trading, reflecting the ongoing efforts to safeguard market integrity.

Investor Harm

Investors are misled by false trading data generated through wash trading, which can lead to poor investment decisions and potential financial losses. Artificially inflated trading volumes can create a false sense of security, leading investors to buy into a security based on deceptive information. This practice not only damages individual investor portfolios but also erodes overall market confidence. In the cryptocurrency market, for instance, wash trading can inflate the perceived value and demand for certain tokens, leading to significant losses when the true market conditions are revealed.

Overall, wash trading’s deceptive nature has far-reaching implications for market integrity, regulatory environments, and investor trust.