Wash trading is seen all over the NFT industry but is actually illegal in the traditional finance world, learn how it’s impacting the NFT markets and valuations.
- Wash trading in the NFT market is a transaction where a trader buys an NFT and then sells it to another account they oversee for a high valuation to give the appearance that the asset is trading within that price range. Coordinated wash trades can be effective in artificially pumping price floors.
- Wash trades may also be a tactic used by money launders to wash money into a more verifiable asset. These types of trades are typically characterized by NFTs selling at a price that is much higher than their market price.
- Wash trades in the traditional finance world have been illegal since 1936, but since the crypto and NFT markets are less regulated, little has be done to stop this type of activity. It’s important to be aware of activity that looks like wash trading when evaluating the markets.
- As of now we don’t really know what regulators have in store for crypto and NFT markets, but the current laissez-faire state of the market is unlikely to last forever.
Wash Trading Definition
Wash trades are trades where the same market participant is on both sides of the trade so it is not a true transaction and is often conducted to inflate the pricing and activity of a security.
Wash trades can also happen between different buyers and sellers who are colluding together to produce misleading market information so they can extract profits.
Wash trades are illegal in the traditional financial markets but the crypto and NFT markets are less regulated and they happen with much greater frequency.
Wash trades are also used as a money laundering tactic to wash the money into a more verifiable asset.
Why Wash Trades Were Outlawed
Back in 1936 the US passed the Commodity Exchange Act that provided regulatory oversight into commodities markets like grain, cattle, corn, and soybean. Before this law passed Congress, the markets were rife with manipulators who used wash trades to trigger pumps in prices allowing them to reap profits off shorting the market on the other side.
Wash Trading as defined by the Commodity and Futures Trading Commission (CFTC):
Entering into, or purporting to enter into, transactions to give the appearance that purchases and sales have been made, without incurring market risk or changing the trader's market position. The Commodity Exchange Act prohibits wash trading. Also called Round Trip Trading, Wash Sales.
You can see the definition in the CFTC's glossary of terms here
Part of good KYC (Know Your Customer) in centralized finance is knowing your customers' overall intentions in the market, their risk tolerance, and what other assets they might be holding in other accounts. None of this exists in crypto yet so it’s up to individual market participants to keep themselves safe from the fallout of a market inflated by wash trades.
The IRS also has strict regulations regarding wash trades and you cannot deduct losses from that result from wash trades otherwise everyone would use that strategy to offset tax burdens.
Wash trades are misleading because they are reported just like a true trade and without doing a lot of due diligence it’s hard to know the difference.
However, a lot of bad actors are also lazy actors and they don’t work too hard to conceal their wash trading activities, especially in NFTs.
How To Spot A Potential Wash Trade
Money Laundering Wash Trades
It takes some market education to spot an obvious wash trade or suspicious activity, but once you know what to look for they stick out like a sore thumb.
I mentioned above that wash trades are a tactic used by money laundering operations. In these circumstances an asset will trade at an insanely high price something like 500% - 20000% the normal trading range. If you don’t know what an asset's normal trading range is or how the market is valued this information might slip by you but to an astute observer it would be an instant red flag.
In the early days of NBA Top Shot the market was absolutely being taken advantage of by less savory actors hoping to wash their money through the platform. This is one of the reasons it took some time for the platform to shutdown these activities and stabilize their marketplace. I would see trades for common series 2 cards of average players going for 5-figure sums.
Oftentimes these strange transactions would come in sets of two or three as if that was enough to make them seem more normal. In the Top Shot marketplace these transactions set off the anti-fraud sensors and were investigated. Given that Top Shot was a closed marketplace at the time I think a lot of these people had trouble moving their funds out of their Dapper balances.
These same types of uber above-market transactions happen in other NFT marketplaces like OpenSea. They happen among blue chip projects and non-blue chips alike. But the trading activity on the lesser known projects usually receives less media attention.
Wash Trades To Inflate Activity
Other wash trading activity is done to inflate the activity and value of a specific asset in hopes it will attract new buyers to support that false pricing level. In these cases the sellers will plan the pricing and different wallets involved and make the market look “hot” when in reality the action is being entirely orchestrated behind the scenes.
Does this actually work?
The NFT markets are so young and these actors can be highly sophisticated and willing to invest money upfront to yield 100x profits or more if their wash trading scam gets off the ground.
A recent analysis by Chainalysis, a crypto compliance and security software group, recently reported that some sellers are making a killing in the six and seven-figures routinely conducting wash trades between accounts they manage.
The Case Of CryptoPunk 9998
One infamous case of wash trading that became widely publicized in the industry took place in October of 2021 when CryptoPunk 9998 appeared to “sell” for $532MM (124,467 in ETH at the time). In reality, this transaction was a not so cleverly hidden wash trade between three accounts likely all owned by the same person.
The flow of transactions was as follows:
Wallet 1 transferred the Punk to Wallet 2 and then an hour later Wallet 2 sold the NFT out to Wallet 3 for the 532MM in Ethereum. Following this transaction Wallet 3 transferred the Punk back to Wallet 1, the original custodial wallet.
This gives the appearance on the blockchain that the market is willing to pay that much money for this particular CryptoPunk. If you review the sales on the Punk alone you’d see the ETH transaction, but if you look at the entire transaction history it’d reveal the circular nature of the trading.
According to Larva Labs, the creators of CryptoPunks and owners of the CryptoPunk IP, the money for the wash trade came from a loan and the seller then repaid themselves back in the same transaction.
Apparently some Punk holders were also using this strategy to place large bids on their NFTs and then retract them. This is not quite a wash trade but it is a false bid done for the same purpose of inflating the market.
Did anything happen to the holder of Punk #9998?
No not really, but they were publicly called out by the community. Perhaps they will be subject to a deeper investigation, but enforcement agencies likely have bigger fish to fry.
Wash Trading on LooksRare
LooksRare is a new NFT marketplace designed to be a community-owned alternative to OpenSea.
In order to gain market share quickly, LooksRare aggressively incorporated incentives to encourage the adoption and use of their platform, including monetary incentives (in the form of the $LOOKS token rewards).
Rewards to trade NFTs on LooksRare has led to, what appears to be, a massive amount of wash trades on the platform.
It is unclear how long this situation will last given changing incentive structures as well as changes in the price of $LOOKS, but wash trading on LooksRare is something to watch out for when analyzing NFT trading data.
Can You Get Caught Using Wash Trades?
Even though we’re able to spot them, anyone can get away with wash trades, right?
I would be cautious about adding any wash trades transaction to wallet addresses you’re planning to be attached to for a longtime. While the markets are largely unregulated, the IRS cyber crimes division still investigates crypto transactions, especially the large and egregious.
In time it’ll likely get harder to trick regulators and enforcement agencies since the blockchain is an immutable record. Tools to analyze the movement of currency on blockchains are getting more sophisticated so the wild west days may be coming to an end before long.
We definitely can’t force anyone reading this to act ethically, but we also won’t enable bad behavior either, so no tips on “how to get away with wash trades” here.
Will NFTs become regulated?
With NFTs growing at such a fast rate it seems like regulations will never catch up with the market. However, the more money entering the space means the more attention and potential for harm from bad actors and likelihood that regulations in some form will be imposed.
What worries me is that NFTs will be lumped into regulations around cryptocurrency and they’ll be detrimental to the space’s growth trajectory.
The way NFTs operate are different enough from currencies like Bitcoin or Ethereum that they deserve their own considerations. Unfortunately the two will always be linked together and it’s going to take the government a long time to figure out their Meebits from their Voxies.
It’s important to be on the lookout for wash trades when you’re analyzing the NFT market. If any particular NFT has a lot of suspicious looking activity I’d be cautious about getting involved with the project.
If you launch a project or decide to purchase a NFTs don’t engage in wash trading. Some traders use them to avoid paying gas fees but in the end I don’t think it’s worth it. One of the arguments against Web3 is the proliferation of scams and money laundering activities and they are not wrong.
This is going to continue to be a main topic of conversation around adoption of these technologies and I think the fight is just beginning. Exposing scams, in my opinion, helps the community learn and grow, but it also creates a lot of negative press and perception that makes onboarding new people harder.
I think in time, the positives will outweigh the negatives and onboarding into crypto and Web3 will hit a point of no return which will trigger an entirely new era of the internet.