Wash Trading: What It Is and How It Works, With Examples
SB
Summary:
Wash trading is an illegal trading practice that involves buying and selling the same security to manipulate market information. This article explores what wash trading is, its history, impact on various markets, and provides real-world examples. Discover why wash trading is illegal and how it affects investors.
Get Offers In Seconds
Compare rates from multiple vetted lenders. Discover your lowest eligible rate.
It's quick, free and won’t hurt your credit score
Understanding wash trading
Wash trading is a deceptive tactic where a trader engages in simultaneous buying and selling of a security. The primary aim is to create a false impression of market activity, often making it seem more active than it actually is. In some instances, this practice involves collusion between traders and brokers, while in others, individual investors play both buyer and seller roles.
Wash trading is not a new concept; it was outlawed in the 1930s with the passage of the Commodity Exchange Act. Prior to this, manipulative traders used it to inflate stock values for personal gain.
The regulatory landscape
Both federal and regulatory bodies like the Commodity Futures Trade Commission (CFTC) strictly prohibit wash trading. Brokers are also held accountable, even if they claim ignorance of the trader’s intentions. This emphasizes the importance of brokers conducting due diligence on customers to prevent such activities.
Furthermore, the Internal Revenue Service (IRS) has stringent rules against wash trading. Taxpayers cannot deduct losses resulting from wash sales. A wash sale, in IRS terms, is a transaction within 30 days of buying a security that leads to a loss.
Wash trading and high-frequency trading
Wash trading regained attention with the rise of high-frequency trading (HFT) in the early 2010s. HFT involves lightning-fast computers and internet connections, enabling thousands of trades per second. This technology made wash trading easier to execute covertly.
For instance, the Commodity Futures Trading Commission started investigating HFT firms for wash trading violations in 2012. The Securities and Exchange Commission also charged firms like Wedbush Securities for failing to maintain control over trading platforms, enabling high-frequency traders to engage in wash trades.
Wash trading and cryptocurrencies
Wash trading has also infiltrated the cryptocurrency space, where the desire to show high trading volumes is strong. Even popular cryptocurrencies like Bitcoin are not immune. A 2022 study found that over half of reported Bitcoin trading volume is fake or non-economic wash trading.
The reasons behind this prevalence in the crypto space include a lack of universally accepted methods to calculate trading volumes, the questionable legitimacy of cryptocurrency exchanges, extreme market volatility, and regulatory ambiguity.
Examples of wash trading
Wash trading can take various forms. In one example, it was used in the LIBOR scandal to compensate brokers manipulating LIBOR submission panels. UBS traders conducted wash trades with a brokerage firm, generating fees as a reward for their role in rate manipulation.
Another scenario involves traders colluding with brokerage firms to rapidly buy and sell a stock, creating activity that attracts other traders. Subsequently, the colluding trader shorts the stock, profiting from its price decline.
Frequently asked questions
What is wash trading?
Wash trading involves illegal trading practices where a trader buys and sells the same security to create misleading market information, often inflating trading volume.
Why is wash trading considered illegal?
Wash trading is illegal because it deceives the market by creating a false impression of trading activity, potentially harming legitimate investors. It undermines market integrity and fairness.
What are the consequences of engaging in wash trading?
Engaging in wash trading can lead to severe legal repercussions, including fines and penalties. Traders may also face loss of credibility in the financial industry.
How can investors protect themselves from wash trading?
Investors can protect themselves by conducting thorough due diligence on the securities they trade and the platforms they use. Staying informed about regulatory changes and market practices is crucial.
What is the role of regulators in combating wash trading?
Regulators like the Commodity Futures Trade Commission (CFTC) and the Securities and Exchange Commission (SEC) play a vital role in detecting and preventing wash trading. They enforce strict rules and investigate suspicious activities.
Is wash trading prevalent in the cryptocurrency market?
Yes, wash trading has infiltrated the cryptocurrency market due to its decentralized and often unregulated nature. Cryptocurrency exchanges must implement measures to combat this practice.
Can wash trading affect traditional stock markets?
While traditional stock markets have stringent regulations, wash trading can still occur, although it is relatively rare. Regulators actively monitor and enforce rules to maintain market integrity.
Key takeaways
- Wash trading involves deceptive practices to manipulate market information.
- It’s illegal and strictly regulated by authorities.
- High-frequency trading and cryptocurrencies have faced wash trading challenges.
- Real-world examples illustrate its impact on markets.
Share this post: