What Is Wash Trading?
Let me explain wash trading directly to you: it's a deceptive practice that fools market participants by artificially boosting trading volumes for securities. As a trader, if you buy and sell the same security yourself or through collusion with a broker, you're creating false signals of market activity. This can mislead you and other investors about a security's true popularity and price trends.
You should know that wash trading tricks people into believing a security has high trading volumes, which might encourage real trades. It's outright illegal under U.S. law, and the IRS won't let you deduct losses from these trades on your taxes.
Key Takeaways
- Wash trading is an illegal practice where traders buy and sell the same security to create false market signals.
- Regulations from bodies like the IRS and CFTC prohibit wash trading to prevent market manipulation and misleading information.
- High-frequency trading firms can exploit wash trading due to their technology, making regulatory enforcement challenging.
- Wash trading in cryptocurrencies inflates trading volumes and may be used in pump-and-dump schemes.
- The use of wash trading extends to various financial assets and has been involved in scandals like the LIBOR manipulation.
How Wash Trading Operates and Its Implications
The federal government banned wash trading back in 1936 with the Commodity Exchange Act, mandating that all commodity trading occurs on regulated exchanges. Before that ban, stock manipulators used it to inflate prices for their own profit.
CFTC regulations also stop brokers from profiting off wash trades, even if they say they didn't know the trader's intent. As a broker, you have to do due diligence on customers to ensure they're buying for legitimate ownership reasons.
On the tax side, the IRS disallows losses from wash sales, which occur if you buy and sell a security within 30 days and take a loss.
The Intersection of Wash Trading and High-Frequency Trading
Wash trading grabbed attention in 2013 as high-frequency trading took off. This involves using super-fast computers and connections to execute thousands of trades per second.
In 2012, CFTC Commissioner Bart Chilton pushed to investigate high-frequency trading for wash trading violations.
By 2014, the SEC charged Wedbush Securities for not controlling trading platform settings, allowing high-frequency traders to engage in wash trades and other manipulative acts.
The Role of Wash Trading in the Cryptocurrency Market
Lately, wash trading has infiltrated cryptocurrencies. Many tokens fake volumes to appear popular, and even Bitcoin sees this.
A 2022 Forbes study of 157 exchanges revealed over half of reported Bitcoin volume is fake or wash trading. Crypto is ripe for pump-and-dump, where fake volumes and hype inflate prices for insiders to sell high.
Several factors fuel this in crypto: no standard way to calculate volumes leads to inconsistent figures, exchanges often lack credibility with notable collapses, extreme volatility encourages quick trades, and unclear regulations open doors for deception.
Illustrative Cases of Wash Trading in Financial Markets
Wash trades essentially cancel out and lack real value, but they're used in various schemes.
For instance, in the LIBOR scandal, UBS traders did nine wash trades with a brokerage to generate 170,000 pounds in fees as a reward for manipulating yen LIBOR rates, per U.K. charges.
Another example: a trader and broker collude to rapidly trade a stock, drawing in other investors who buy in, then the colluders short it for profit as the price falls.
Frequently Asked Questions
What is wash trading? It's when a trader buys and sells the same security to mislead the market and inflate volumes.
What's an example? The IRS calls it a wash sale if you trade the same security within 30 days and claim a loss.
Why do it? To boost volumes for more real trades or to pump prices in schemes like pump-and-dump.
The Bottom Line
Wash trading is when you illegally trade the same security to mislead, inflate volumes, or manipulate prices. It's a big issue in high-frequency and crypto markets, hiding true activity and stability.
Regulations from the IRS and CFTC ban it with penalties to protect markets. As an investor, knowing about this helps you avoid deception and make better choices.
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