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Behind the Smoke and Mirrors: The Impact and Implications of Wash Trading

Updated: Feb 29


Wash trading is a deceptive practice where a trader buys and sells a security for the express purpose of feeding misleading information to the market. This can create the illusion of higher trading volumes for a security than are actually present, potentially spurring increased legitimate trading activity on the security. Wash trading is considered illegal under U.S. law and is strictly regulated by the Internal Revenue Service (IRS), the Securities and Exchange Commission (SEC), and the Commodity Futures Trade Commission (CFTC)​.



History and Regulations


The federal government first barred wash trading after the passage of the Commodity Exchange Act in 1936. This law required all commodity trading to occur on regulated exchanges and was a response to the prevalent use of wash trading to falsely signal interest in a stock in an attempt to manipulate its value. Brokers are also forbidden from profiting from wash trades, even if they claim they were unaware of the trader's intentions. Brokers are thus expected to perform due diligence on their customers to ensure that their trades are not for the purpose of wash trading​​.


Wash Trading and High-Frequency Trading


With the advent of high-frequency trading, a practice that uses super-fast computers and high-speed internet connections to perform a vast number of trades per second, the concern around wash trading resurfaced. Given the speed and volume of trades, it became easier for firms to enact wash trading under the radar. In fact, in 2014, the SEC charged Wedbush Securities for failing to maintain control over settings in trading platforms used by its customers, enabling some of its high-frequency traders to engage in wash trades​​.


Wash Trading in Cryptocurrencies


In recent years, wash trading has also infiltrated the cryptocurrency space. A 2022 study of 157 cryptocurrency exchanges found that over half of all reported Bitcoin trading volume was either fake or non-economic wash trading. The lack of universally accepted methods of calculating daily trading volume and the overall murky status of cryptocurrencies with U.S. and other government regulators create opportunities for misleading trade activity​​.


Examples of Wash Trading


Wash trades can be used in a variety of situations. They were used in the Libor scandal to pay off brokers who manipulated the Libor submission panels for the Japanese yen. Wash trades can also be used to generate fake volumes for a stock and pump up its price. For instance, a trader and a brokerage firm might collude to buy and sell a stock rapidly. Noticing activity on the stock, other traders may invest in the stock to profit from its price movements. The original trader then shorts the stock, thereby profiting from its downward price movement​.


Binance Charged with Wash Trading by the SEC


Recently, Binance, a major global cryptocurrency exchange, was charged by the Securities and Exchange Commission (SEC) with wash trading. From September 2019 to June 2022, Sigma Chain, a trading firm owned by Binance founder Changpeng Zhao, allegedly engaged in wash trading, making it seem like more tokens were changing hands on Binance.US than actually were​​. The SEC also filed an emergency action application seeking a temporary restraining order freezing assets and directing defendants to repatriate assets held for the benefit of customers of the Binance.US crypto trading platform. The aim is to ensure that Binance.US customers’ assets are protected and remain in the United States through the resolution of the SEC’s pending litigation​.


Wash trading, a manipulative strategy that artificially inflates trading volume, has been a concern in financial markets for nearly a century. Despite regulations and vigilant oversight by entities like the SEC, CFTC, and IRS, it persists as a tactic used to mislead investors and manipulate market dynamics. The advent of high-frequency trading and the emergence of cryptocurrencies have both brought new dimensions to this age-old problem.


The recent charges against Binance underscore the ongoing relevance of wash trading in today's complex and rapidly evolving financial landscape. As technologies and markets continue to evolve, so too do the tactics of those looking to manipulate them. Regulators, investors, and market participants must remain vigilant in identifying and combating such deceptive practices. The Binance case also highlights the global nature of these challenges. With digital assets able to move across borders with ease, the need for international cooperation in financial regulation is more important than ever. It's clear that wash trading, and other forms of market manipulation, will continue to be areas of focus for regulators worldwide.


In a world where financial markets are becoming increasingly digitized and globalized, the importance of understanding and combating practices like wash trading cannot be overstated. This not only requires strong and adaptable regulatory frameworks, but also a commitment from all market participants to uphold the integrity of the financial markets.


 

Interesting fact: Despite its illegality, wash trading was once a common practice. Before the passage of the Commodity Exchange Act in 1936, which explicitly outlawed wash trading, it was frequently used by stock manipulators to falsely signal interest in a stock in order to inflate its value. These manipulators would then profit by shorting the stock. The historical prevalence of this practice provides a fascinating glimpse into the evolution of financial regulation and the ongoing battle against market manipulation​.

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