Wash trading is when a trader or investor buys and sells the same securities over a short period of time in an attempt to mislead other market participants about the price or liquidity of an asset. So what is a wash trade in crypto and why is wash trading illegal? If you do not know yet, let's read the article below.
What is a Wash Trade in crypto?
A wash trade is the process by which traders buy and sell securities with the express purpose of providing misleading information to the market. In some cases, wash trades are executed by colluding traders and brokers, while other times, wash trades are executed by investors who are both buyers and sellers of securities.
Wash trading misleads investors into believing that securities are being traded in higher-than-actual volumes, potentially increasing legitimate trading activity in securities in the process. Wash trading is illegal under US law, and the IRS prohibits taxpayers from deducting wash trading losses from their taxable income.
How Does Wash Trading Work?
At a basic level, wash trading is when investors buy and sell assets at the same time. However, given the intentions of investors, true wash trading goes further.
Therefore, two conditions usually need to be met to confirm a wash trade. The first condition is intent. Wash traders must have a specific strategy to buy and sell the same asset ahead of time. Again, wash trading is meant to be misleading. Therefore, multiple accounts are needed to try and eliminate misrepresentation.
A trader or company will trade the same asset but will use a different account resulting in a price change or an increase in trading volume. The account holding the asset will sell the asset to another account of the dishwasher.
The second condition is the result. The result of the transaction must be a wash trade, where investors use accounts with the same or common ownership to buy and sell the same asset at the same time. One way to determine whether to conduct wash trading is to examine an investor's financial situation. If a trade doesn't change an investor's overall position, or expose them to any type of market risk, then it can be seen as a wash.
Why is wash trading illegal?
The Commodity Exchange Act prohibits shuffle trading. Before it passed, traders often used wash trading to manipulate the market and stock prices. The Commodity Futures Trading Commission (CFTC) also enforces rules on wash trading, including guidelines that prohibit brokers from profiting from wash trading activities.
The IRS also has rules on wash trading. These rules do not allow investors to deduct capital losses for taxes arising from ghost sales (from securities sales or transactions). For example, traders who use stock wash trades to skip tax bills will find themselves still owed on their tax bills.
However, cryptocurrency regulations have not kept up. The U.S. Securities and Exchange Commission (SEC) has always been interested in cryptocurrencies. However, NFTs are not considered securities because they are non-fungible and outside the SEC's purview. Likewise, the IRS considers crypto to be property, not securities. Until regulators determine whose jurisdiction applies to regulating cryptocurrencies, there is a risk of shuffled trading, and therefore misleading price and volume data.
I hope you will now learn what is a wash trade in crypto and why is wash trading illegal. In some cases, wash trading increases the volume of securities traded, potentially spurring more legitimate trading activity. Wash trading can also be used to help artificially increase the price of securities as part of a pump-and-dump scheme.
