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Wash Trading: What It Means and How It Works in the NFT Market

Cryptocurrency Apr 24, 2022 12:30PM ET
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Wash Trading: What It Means and How It Works in the NFT Market
 
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Even for avid crypto supporters, it’s possible to come across some alien terminology in the crypto space and wonder what it means. Without a doubt, “wash trading” is a common example of this, and you would certainly not be alone in asking “What could this possibly mean?”

Before we dive into the core of the topic at hand, it’s widely agreed that 2021 was a landmark year for the crypto ecosystem. Most notably, the number of cryptocurrencies in circulation doubled, surpassing 10,000 in total, while NFTs gained more prominence than ever before.

Sadly, amidst the growing interest in the crypto space, there was just as much bad press levelled at the emerging ecosystem. Among other issues, a rising wave of investment style fraud has caught up with the crypto ecosystem.

For instance, Chainalysis, a research firm that provides data-driven insight on the crypto market, revealed in a recent report that crypto scammers stole approximately a cumulative $14 billion worth of cryptocurrency in 2021.

NFTs were the big surprise of 2021, as their market size exceeded $40 billion, up from the barely $350 million in the preceding year. However, in the same vein, NFTs also faced their fair share of backlash as scammers similarly took advantage of the growing interest in the field.

Circling back to Chainalysis’ ‘2022 Crypto Crime Report’, a significant portion of criminal activity was associated with NFTs in 2021. Interestingly, wash trading — the art of artificially increasing the value of an NFT — and money laundering through the purchase of NFTs, happened to be the two most common activities related to NFTs scams.

From Chainalysis’ report, it can be seen that wash trading is becoming more prominent with each passing day. And the sad part of this is that hardly anyone is even aware of the practice, let alone of what it means, its implications, and how it affects the everyday crypto enthusiast. With that in mind, let’s get to the root of the problem by explaining what wash trading means.

What Is Wash Trading?

Wash trading, which is also known as “round-tripping”, is described differently across various trading markets. Regardless, it is commonly explained as being a manipulative approach to trading financial instruments.

In the crypto market, wash trading is a manipulation technique in which a trader buys and sells financial instruments/crypto assets, such as options and NFTs, with the sole purpose of pushing misleading information on the market. This ultimately influences an asset’s trading activities and price, but orchestrated in a way that makes it favorable to the manipulator.

To use NFTs as an example, an investor can decide to spend $1 million on a digital item that is clearly worth less than $200. Of course, acquiring a digital piece for such an outrageous price is not a problem in itself, considering that such an item carries intrinsic value. The foul play here occurs when the buyer assumes the role of the seller, implying that the payment indirectly goes back to the buyer.

Sadly, the implication of this is that the cybercriminal behind the account successfully misrepresents the true value of the item to the market. Moreover, other potential investors would end up acquiring the item themselves for a “false” value, and in some cases, will then not be able to resell it for tangible values.

So in other words, the major aim of wash trading is to increase a crypto asset’s trade volume by creating the illusion that the asset is worth more than its “actual” value. Without a doubt, this is bad for investors and has the capacity to change the dynamics of the market for the worse, especially in the long run.

A prominent instance of a wash trade in the crypto space took place in October 2021, when a piece of the ‘CryptoPunks’ collection – a Larva Labs NFT project – was sold at a faux price.

The project, titled “CryptoPunk 9998”, sold for 124,457 Ether (ETH), or the equivalent of $532 million USD at the time. What was surprising about this was that the ETH used to purchase the NFT was transferred to the seller, but was subsequently returned to the buyer to repay the initial loan that was used to buy the digital art.

While the scenario effectively depicts a case of a flash loan it further qualifies for what can be described as NFT money laundering.

Wash Trading VS. Round-Tripping

You may be asking, “Is there any difference between wash trading and round-tripping?” Well, both technically mean the same thing, except that, while WT is carried out by an individual in a one-off event, round-tripping is carried out by an individual or two multiple times in a short trading duration.

Usually, in round-tripping, two corporate entities agree to sell options or security to themselves, and to repurchase it at about the same price in an attempt to bait inflow from external entities.

Is Wash Trade Illegal or Not?

Although wash trading may appear to be a “strategy” at first glance, the motive of the individuals involved, as well as the outcome of such transactions, reveals a manipulative undertone to the entire process.

For instance, a similar trade could occur in an ordinary scenario, where an investor buys and sells tokens of the same asset simultaneously and continuously. However, the definition of wash trades goes a step farther by considering the investor’s motive ⁠— to create a false sense of value, thereby misleading potential investors.

As a result, where the intent itself is determined to be unethical, it could be considered an illegal act. Regardless, different jurisdictions are guided by different rules, not to mention the lack of legislation and classification for certain asset classes like NFTs and other crypto assets. Hence, it cannot be said with any concrete conviction that the practice is illegal.

Despite the fact that the crypto asset class is largely unclassified, most governments around the world frown at any practice that denotes wash trading.

For instance, Bithub, a South Korean crypto exchange, faced intense backlash in 2018 after it reportedly facilitated a series of wash trades estimated to be worth more than $250 million in faux volume. While it wasn’t revealed how the Korean government addressed the situation, the negative press alone suggests that dire consequences must have happened behind the scenes.

How to Spot Wash Trading in NFTs

There are a number of ways to recognize a potential wash trade and thereby avoid it. However, considering that blockchain analysis is required to do so, having a deep understanding of how the blockchain works is highly recommended.

Each blockchain network keeps a record of trade activities, which implies that you can see which wallet address funds come from and go to. In the case of NFTs, each marketplace keeps track of the activity around each item.

By checking the trade history of an NFT, one can easily tell if it was sold to the same wallet address or not. Sadly, this isn’t always a perfect way of spotting wash trading, especially when it is carried out by a group of people.

Ultimately, the best way to avoid falling victim to a wash trade is by transacting on and with reputable marketplaces and traders.

The Effects of Wash Trade on the Emerging NFT Economy

The effect of wash trading on the emerging crypto economy is not a good one, and has an undesirable ripple effect. Among the most important, wash trading can lead to the false representation of how valuable a trade market is as a whole.

For instance, Bloomberg (quoting CryptoSlam, an NFT industry data aggregator ), recently revealed that the majority of trade activities in the NFT market is dominated by faux trades.

The report specifically revealed that most of the activities on ‘LooksRare’, an NFT marketplace, involve their users selling tokens between themselves in an attempt to earn more rewards in the form of coins. The report further equated what such users are doing on LooksRare to wash trading, alleging that the practice accounts for $18 billion, or 95% of the marketplace’s entire trade volume in 2021.

For a market that is worth nearly $20 billion, it is disconcerting to find out that approximately 95% of that trade volume consists of funds circulating from one user’s account to another, and is far from an organic trade volume.

While the aforementioned statistic is specific to the LooksRare marketplace, owing to its operational model, Chainalysis claimed in its report that wash trading does not appear to have had a negative impact on the NFT market thus far. And this is reflected in the consistently increasing trade volume in the NFT market.

Notably, OpenSea, the largest NFT marketplace in the world, exceeded $3.5 billion in monthly trade volume in January 2022, indicating a bullish market trend.

To back up its claim, Chainalysis revealed that most of the attempts at wash trading didn’t generate nearly as much as expected from the effort put in.

For instance, Chainalysis claims that executing a wash trade requires a collector to sell to and from a self-finance account approximately 25 times. Based on this criteria, only a small percentage of people would have the patience to go through the process, especially as it does not guarantee success in the end.

The research firm arrived at the forgoing conclusion after analysing the transactions of 262 sellers that were potentially involved in wash trading. Based on its findings, only 110 of the 262 sellers made more than $8 million from their wash trades, while others incurred losses of over $400,000 from the deceptive trade.

It is, however, important to note that only NFTs traded on the Ethereum network were analysed by Chainalysis, suggesting that the approach may differ across other networks.

In the end, increased awareness of wash trading has the potential to negatively influence investor perceptions of a particular market. More so, it has the capacity to limit the participation of genuine investors which ultimately has a detrimental effect on an emerging market.

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Wash Trading: What It Means and How It Works in the NFT Market
 

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