Despite the increased intervention of the government in the cryptocurrency industry in an attempt to regulate it, there are still numerous illegal activities that take place on a large scale. This is mostly because a majority of governments are still dealing with the crypto dilemma and have yet to devise a defining law for the industry. This creates many loopholes for ill actors and businesses on the lookout for easy ways to grow their company and platform.
We have heard about the news channels talking about the relation between cryptocurrencies and criminal activities on the dark web, money laundering, and terror financing hundreds of times. However, that is too far from where it all actually starts.
A cryptocurrency market tracking company, CoinMarketCap, watches over the cryptocurrency trading data from more than 250 cryptocurrency trading platforms. According to their data, the approximately $260 billion cryptocurrency industry sees an astonishing 24-hour crypto trading volume of anywhere between $50 billion to $60 billion. These numbers suggest an extraordinary rate of cryptocurrency adoption and show the increasing use of cryptocurrencies as a trading asset.
The high trading volumes raised the eyebrows of several survey organizations as they witnessed several suspicious price fluctuations of some crypto coins listed on a wide range of trading platforms. Thus, they set out to analyze the trading volumes of some of the most widely used cryptocurrency trading platforms.
Bitwise, a cryptocurrency company, surveyed the cryptocurrency trading platforms with some of the highest trading volumes. Their report concluded that as much as 95% of the total trading volumes on those platforms were fake.
Blockchain Transparency Institute also showed its interest in the matter and surveyed the top 25 cryptocurrency exchanges. According to its findings, 80% of the trading volume of those exchanges were fake. Besides that, it also brought to the attention that 100% of the trading volume of some cryptocurrency trading pairs was false.
Another reputed organization in the blockchain and cryptocurrency sphere, The Block, conducted its own survey to find that 86% of the trading volumes on the cryptocurrency exchange platforms were fake.
These researches were mostly conducted during the first quarter of 2019 when the prices of a few cryptocurrencies blew up by a noteworthy amount without any fundamental or technical reasons aiding the situation. Along with the prices, the trading volumes too increased to hit multi-million numbers from almost nowhere. These were definite signs of wash trading. Wash trading had once been a significant part of the stock trading industry until it was heavily regulated, and substantial fines and legal proceedings were listed in the law books for indulging in such activities.
While strict laws against wash trading in the stock market had a considerable impact on wash trading volumes, they have not been able to bust it completely. Hence, it would be unrealistic to expect there to be zero fake trading volumes in the cryptocurrency markets, but efforts must be made to reduce them to the lowest possible value.
Now that we have established a general idea of what we are discussing in this article let us go through the concept of wash trading in more detail.
What is Wash Trading?
If one were to buy and sell a cryptocurrency at the same price through two or more different accounts, the trader would neither register a profit nor a loss. However, the buy or sell orders on the exchange platform would add to the volume of that particular asset, and to the total 24-hour trading volume of the exchange.
Wash trading cryptocurrencies is easy because many crypto exchange platforms still do not require KYC compliance of their users. This allows anyone to create multiple accounts on the same platform. By using these accounts, traders can place one order from one account and then put the corresponding order through the other one at the same price. Hence, suppose, if a person places a sell order for 50 ETH at $150 each from their first account and then a buy order for 50 ETH at $150 each from their second account, the order would be executed without giving any profit or loss to the trader. In this case, one trade is washed out by the other one, thus giving it the name wash trading.
Such trading tactics only create a fake volume in the market to attract more users to trade a particular cryptocurrency or trust one exchange platform over the others for their high trading volume.
Small scale investors and traders can hardly have any effect on the market direction by wash trading as their volumes would be too small. This signifies that either the large scale investors, such as institutional investors or the cryptocurrency exchange platforms themselves, are responsible for wash trading.
As per the above-mentioned reports of cryptocurrency exchanges, it is the cryptocurrency exchange platforms that are responsible for causing the majority of the wash trades.
High-Frequency Trades for Wash Trading
Even if the lowest suggested value of wash trades, i.e., 80% of the total trading volume, was to be accurate, there are approximately $40 billion worth of fake trades each day. And even if all the 250 cryptocurrency exchanges were to be involved in wash trading, each exchange must have to process an average of 100s of million dollars worth of fake trades each day. This is impossible for a small team of people to do without getting detected.
This is where high-frequency trading comes in.
The concept of high-frequency trading dates back to around 2012, when many major institutional investors developed systems that could place high volume trades instantly. These systems use computers with high computational powers and send orders in the range of tens of thousands at once.
This form of trading has been used previously used in the stock and forex market to wash trade and put up fake volumes against specific assets. This method is not illegal as they help the legit traders trade with more comfort, but federal authorities remain highly skeptical about it and are vigilant towards tracking any wash trading using it.
Although there are several other strategies to create the illusion of cryptocurrency trading volumes in the market, it is highly likely that high-frequency trading is a highly reliable and effective method.
Types of Wash Trading
According to Crypto Integrity, a crypto fraud detection project, there are three ways in which cryptocurrency wash trading is executed:
- in-spread trades without limit orders: In this method, exchanges simply show off fake trading volumes in their reports, although it is in the order books. This is possible unless there are no limit orders in the order book, which prevents anyone from hitting the order.
- in-spread trades with short limit orders: This belongs to the above mentioned high-frequency trades where orders are present for a very short time in the order book.
- Trades near bid-ask caused by short limit orders: This is another commonly used way to wash trade cryptos where the sell orders are placed at a value close to the best bid, and the buy orders are situated close to the best ask. These trades are also executed within a fraction of a second.
Why Large Scale Investors Wash Trade?
High volumes automatically attract more traders to trade a particular asset. And there are hardly any chances of traders choosing assets that show low trading volumes. This is because low trading volume is synonymous with a lack of popularity and trust. Also, most traders keep out of low volume assets as they fear that the lack of liquidity would cause a delay in order execution, which might result in a loss for them.
New companies with their tokens listed on cryptocurrency trading platforms but lacking trading volumes may thus assign large scale traders to wash trade their crypto tokens. This would automatically bring in trading volumes for their token and may attract other traders to trade that token — thus adding to the popularity of the token and bringing liquidity to the token market.
Why Cryptocurrency Exchanges Wash Trade?
Crypto and blockchain space is growing rapidly. There is an ever-increasing competition to develop the best products for the users. Since the sudden cryptocurrency boom in 2017, the competition has become all the tighter. More businesses are starting now than they ever did. The number of cryptocurrency exchanges has seen a substantial increase. And every cryptocurrency exchange wants to attract as many investors to their platform as possible. However, the odds of that happening without a noteworthy daily trading volume on the exchange is pretty low.
So, in case the cryptocurrency exchanges do not get high enough trading volumes on their platform, they indulge in wash trading. By doing so, they benefit in two different manners:
- More top ranking on CoinMarketCap and other listing sites: CoinMarketCap is one of the most trustworthy information websites for crypto and blockchain businesses. Apart from listing all crypto tokens and token offerings, it also ranks cryptocurrency exchanges in order of their daily crypto trading volume. Hence, a higher trading volume on a platform makes an exchange rank higher on that platform. This increases the exposure of the platform while also helping them build credibility. And more the credibility of a trading platform, the more fees they can charge to list new crypto tokens on their platform.
- Lures traders to trade on that platform: High trading volumes, irrespective of whether it is of a specific cryptocurrency or the exchange as a whole, it signifies trust. And when cryptocurrency exchanges wash trade to add to their daily trading volumes, they show traders that they can get high liquidity while trading on their platform.
How to Stop Cryptocurrency Wash Trading?
That is a hard question to answer as most exchanges themselves indulge in wash trading to show fake volumes. With that in mind, the only way to stop, or at least bring down the fake trading volume, is by implementing more strict cryptocurrency regulations. This does not mean that governments need to ban cryptos. Instead, they must create laws targeted towards stopping wash trading.
On the other hand, we have institutional investors and other large scale investors who wash trade to increase the trading volume of certain cryptocurrencies. While the proper regulatory framework will bring down the volume of such trades, cryptocurrency exchanges, too, would need to take stringent measures to add to the cause.
Some viable options for cryptocurrency exchanges to reduce wash trading are:
- Single Accounts: If cryptocurrency exchanges can force all their users to use a single account with each account requiring to comply with strict KYC processes, exchanges can cut down on a huge volume of wash trades.
- Self-Trade Prevention: Though not very common, self trades may be planned and executed on cryptocurrency exchanges. Cryptocurrency exchanges can easily prevent wash trades that happen due to self-trades by ensuring that their platform’s algorithm does not match two trades from the same account.
Wash trading exists at such a wide scale because many jurisdictions haven’t defined it as an illegal activity. And even if there was a law to prevent wash trading on a worldwide level, it would not have prevented all of it. So, it would be a smart choice for cryptocurrency trading platforms not to try eliminating such practices as much as possible on their own by taking required actions against bad actors.
Companies must take wash trading seriously because it may be benefitting a few businesses in the short term, but it only creates a negative impression of the industry, which will affect all businesses in the future.