What is Wash Trading?
Wash trading is when a trader on an exchange buys and sells a particular asset with themselves. This gives the impression to the rest of the network that there is lots of activity, or volume. This tactic can be used to trick new investors into thinking that a particular asset is more popular than it actually is. Normally, a trader on the exchange is disincentivized to do this by the fees on the exchange. However, it is common practice in the cryptocurrency world for the exchange itself to wash trade assets. The exchange has the ability to completely bypass the fees on its own platform. But why would an exchange want to trade on its own platform?
Cryptocurrency volume is an indication of the popularity of a particular coin or token. In order for a project to gain traction they need to achieve two things.
- Get listed on as many reputable exchanges as possible
- Garner large amounts of trading volume
Some exchanges will offer projects a certain amount of volume if they become listed on the exchange. Instead of the volume being “real”, the exchange wash trades, and makes it look like a project has more volume than it actually does. Wash trading is illegal on the regular stock market as it feeds misleading information to the market.
When you own cryptocurrency, you own it directly. That’s only the case when you use a non-custodial wallet. When your cryptocurrency is being stored on an exchange, you are essentially giving ownership over your funds to the exchange. The exchange then keeps a database of accounts, and account balances. This is how an exchange keeps track of who owns what on their platform.
If you are the owner of the exchange (or someone who admin access), then you have the ability to edit the underlying database, and credit your own account with cryptocurrency. Normally, in order to credit your account, users need to deposit cryptocurrency onto the exchange. The reality is, that your balance is just a number in a database. Those numbers can be edited by the owners of the exchange.
This particular manipulation is very nefarious, because the exchange owner is literally creating money out of thin air. Then they are free to either withdraw, or trade with the newly created assets.
It’s common to know that a ponzi scheme is something that we want to stay away from. Not everyone knows exactly what it is though, and how to recognize one. A ponzi scheme is where there is more money going out of a business through the withdrawals of the owner, than is coming into the business, through the deposits of customers. Essentially, the owner is taking the customers money, and doing other things with it, like buying a boat, or a house. The customer is still allowed to use or trade with the money on the exchange or platform. Then, when the customer wants to withdraw their money, there may or may not be enough money left in the business to cover the amount.
A ponzi scheme collapses when one or many customers request more money from the business, than the business has on hand. A large ponzi scheme took place in Canada in 2018 where users lost about $190 million dollars. The company behind the scheme was QuadrigaCX. The owner had been running the cryptocurrency exchange as a ponzi scheme after significantly mismanaging customer deposits.
What to do About Market Manipulation
Combatting market manipulation is very difficult. On the one hand, having more businesses engaged in the world of cryptocurrency is a good thing. This is the way that the whole industry grows and gains legitimacy. On the other hand, it is very difficult to know whether or not a new exchange can be trusted. It is useful to be able to detect warning signs, and red flags that are indicative of a malicious exchange. Here are a few examples of red flags.
- Guaranteed Profits
- Customer Support asking you to deposit more money
- Blocked Withdrawals
If any one of the three above examples occur while using the exchange, it is highly likely that the exchange is fraudulent. These aspects help detect malicious exchanges, but what about exchanges that are engaging in market manipulation. Can market manipulation be detected?
Depending on the asset that you are planning on acquiring, or trading, there is a litmus test that you can apply. This test can help you determine whether or not the exchange is wash trading or manipulating the asset volume. Every asset on coinmarketcap comes with a “Markets” tab. This tab tells you where the asset is being traded. If the asset has a ton of volume on one exchange, and not others, it is highly likely that the higher volume exchange is wash trading.
No Manipulation for the Good of the Industry
It is in the best interest of the cryptocurrency industry to get rid of fraudulent, or manipulative exchanges. These exchanges perpetuate the narrative that cryptocurrencies are used by criminals, thieves, and hackers. The best thing you can do, as an individual in the cryptocurrency industry, is not use bad exchanges. At the end of the day, bad exchanges still need users’ deposits in order to stay alive. If bad exchanges are identified ahead of time, and their nefariousness publicized, then we can prevent hacks, attacks, and scams.
Have a look at highly rated, and reputable exchanges. Exchanges that are well established, and have a good track record of customer service are excellent places to start trading. To name a few, Kraken, Binance, and Coinbase are all considered to be legitimate exchanges. When it comes down to it, unless you’re a manipulator, you want a fair market. Fair markets are the foundation of capitalism. If you’re buying assets in a rigged system, then you’re just being cheated.