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Wash Trading in Traditional Markets

Wash trading is an illegal practice in most well-regulated markets, also sometimes referred to as “round trip” trading, which involves artificial trading activity in order to make an asset appear to have higher trading volume, a more liquid market and potentially to manipulate the price. The simultaneous (or swift) buying and selling, or vice versa, of the same asset leaves the trader(s) at a net position (as denominated in the traded asset) that washes out (nets to 0). At root, the increased trading volume, even if it has no impact otherwise, has the effect of making the asset appear more desirable than organic market activity might suggest. 

Key Market Participants and Order Types 

There are two categories of market participants in a healthy market: market makers and market takers.

Market makers are compensated with the “spread” between a buy-sell order for providing continual market liquidity. The spread is the difference between the bid and offer price. Market makers will typically attempt to purchase near the best offer and sell near the best bid, creating a market. Since market makers are compensated for providing liquidity, they are always willing to trade (buy or sell) and are often always positioned in the market. It is also the responsibility of the market maker to protect themselves during periods of increased volatility by withdrawing their liquidity. 

Market takers require market liquidity and immediacy to earn an acceptable execution price when entering or exiting a position. The majority of people fall within the market taker category. If a market taker desires immediate execution of a trade, they are ready to incur the transaction fee (spread) charged by market makers for the liquidity service offered. By definition, market takers have a lower rate of position change compared to market makers. Hence, they are significantly less concerned with submitting the absolute best bid/offer (since they need immediate liquidity). 

Additionally, in a market, there are two sorts of orders: limit orders and market orders. The remaining order kinds are variations of these two. Limit orders add liquidity to the market by advertising an offer/bid, whereas market orders remove liquidity from the market by executing at the current available price.

Institutions and professional traders are more prone to employ limit orders since they require substantial liquidity to be filled. These are comparable to the "boundaries" discussed above. Occasionally, sophisticated players will attempt to construct optimal liquidity conditions in order to get their wagers filled.

Back To Wash Trading!

It’s often the case that there are various commissions or brokerage payments intended to ensure appropriate liquidity in markets that can be exploited by those practicing wash trading. Take this example where two individuals are charged by the SEC for simultaneously placing buy and sell orders and pocketing hundreds of thousands of dollars in brokerage fees for GameStop shares. The generalized version of this sort of scam for securities with mature brokerage markets relies on market makers being incentivized to place limit orders, particularly those sufficiently outside of the current trading price that they are considered “non-marketable,” i.e., the brokerage is ensuring that there’s always a maker for an order a customer might want to place. If the corresponding  take fee is less than the make fee, then the wash trader can turn a profit by taking both simultaneously. 

The component of this practice that influences the asset’s price, in regulated securities markets at least, is known as “painting the tape.” Market participants practicing “painting the tape” are essentially buying and selling some asset among themselves in order to place an artificial upwards price pressure on the asset.   

In the crypto markets, where there is considerably less regulatory oversight and enforced structural norm (in some senses at least), wash trading can be pervasive and designed to achieve similar but distinct aims as the brazenly illegal case laid out above. In crypto markets, wash trading often aims to make an asset appear as though anyone is interested in trading it and often serve the exchanges themselves (somewhat counter to the above example) by suggesting that there will be less price slippage should one wish to trade the asset than one actually ends up experiencing.

Crypto Wash Trading

Over the years, there have been numerous instances of wash trading of crypto assets on centralized exchanges (CEXs). In 2019, Bitwise claimed in their own report that about 95% of the ~$6 billion in BTC spot trading activity reported by CoinMarketCap was fraudulent. Additionally, a July 2022 piece by Kaiko highlighted a huge increase in Binance's volume after trading fees were eliminated, which is a telltale sign of wash trading.