What are wash trading and money laundering in NFTs?

What is wash trading crypto?

Wash trading occurs when a trader or investor buys and sells the same securities multiple times in a short period to deceive other market participants about an asset's price or liquidity.

As mentioned, wash trading involves an act in which the same asset is sold and purchased within a short time. To influence an asset’s trading activity and price, traders use wash trading as a market manipulation technique. Typically, one or more colluding agents undertake a series of trades without considering market risks, resulting in no change in the antagonistic agents' original position.

In October 2021, Cryptopunks, a Larva Labs NFT project, witnessed something like a "wash sale" on the Ethereum blockchain. The cryptocurrency “CryptoPunk 9998” was sold for 124,457 Ether (ETH). The ETH used to purchase the NFT was transferred to the seller, then returned to the buyer to repay the loan used to buy the digital blockchain art from Larva Labs – effectively making it not only a flash loan but an example of significant NFT money laundering.

A trader or firm may be motivated to engage in wash trading for various reasons. For example, the purpose could be to stimulate purchasing to raise prices or encourage selling to drop prices. A trader may conduct a wash sale to lock in a capital loss before repurchasing the asset at a reduced cost basis, basically seeking a tax refund.

How does a wash trade work?

The intent of the parties involved in the wash trade and the result of such a transaction lets wash trading fulfill its purpose.

A wash trade happens when an investor buys and sells tokens of the same asset simultaneously. The definition of wash trades, on the other hand, goes a step farther and considers the investor's objective or intent and the result of the transaction.

The intent of traders or investors should be related to wash trading, and they should have bought and sold assets with common beneficial ownership within a short time. Beneficial ownership refers to accounts held by the same person or company. 

Financial regulators may be interested in trades made between accounts with common beneficial ownership since they could indicate wash trading activity. Nonetheless, wash trades don't always have to involve real deals; they can also occur when investors and dealers appear to conduct the transaction on paper, but no assets are exchanged.

Why is wash trading illegal?

Wash trading is prohibited in traditional finance. The legality of wash trading, on the other hand, has yet to be determined in the decentralized realm of nonfungible tokens (NFTs).

Despite the lack of legislation and classification for NFT, certain governments have stood against the practice. For example, Bithumb, a South Korean crypto exchange, was accused in 2018 of facilitating wash trading worth more than $250 million in phony volume.

On April 5, 2022, Bloomberg reported that NFT tracker CryptoSlam data showed that wash trading accounts for $18 billion, or 95% of overall trade volume on the NFT marketplace called LooksRare.

Even though crypto wash trading is prohibited in some jurisdictions, the decentralized structure of cryptocurrencies makes it difficult to track down the culprits. Unlike traditional financial instruments such as stocks, which have verified Know Your Customer standards, blockchain-powered assets can be traded anonymously, leading to a risk of wash trading. The risk arises due to misleading price and volume statistics, which cannot be eliminated unless authorities decide which jurisdiction is responsible for supervising crypto.

How are NFTs being used to launder money?

NFT crimes such as money laundering and wash trading scams happen when NFT sales are targeted at “self-financed” addresses.

Money laundering has long been a problem in the world of art, and it's easy to see why. Many people ask if NFTs are subject to similar abuses because of their history and the pseudonymity of crypto assets. So, can you launder money through NFTs?

Yes, scammers, malware operators, and Chatex conduct money laundering using NFTs. Chatex is a cryptocurrency bank that aims to make cryptocurrency transactions secure, simple and accessible to many customers while maintaining a functional edge over traditional banking.

While money laundering in physical art is challenging to quantify, the intrinsic openness of the blockchain allows us to create more realistic estimates of NFT money laundering. Therefore, money laundering occurs in NFT markets.

Wash trading scams were tracked by Chainalysis by looking at NFT sales to addresses that were "self-financed," i.e., sales that were funded either by the address that initially funded the selling address or by the selling address, itself. 

Hundreds of wash trades were discovered using this strategy. For example, one user, whom Chainalysis identified as the most active wash dealer, was found to have made 830 sales to addresses that they had self-financed.

Why is wash trading a problem for the NFT space?

NFT wash trading is a problem for investors, the global community, collectors and traders because these participants use less liquid nonfungible tokens to manipulate the price of an asset.

Due diligence has become more difficult as investors have been forced to rely on measurable statistics, making wrong investment decisions. To encourage NFT investments and prevent NFT scams, discrepancies in the data must be investigated by specialists. Additionally, NFT crimes hit the NFT community the hardest. Regulators and proponents of mainstream financial services can now use wash trading to combat decentralization.

Collectors and traders, likewise, are unable to make an informed judgment. When deceptive facts and history mislead people regarding a piece of art or collectible, it is simple for them to make rash decisions. So, with the NFT markets being impacted by wash trading, is there any way to spot it in the first place?

There is no price or volume history associated with new coins when they are introduced to the market. As a result, developers or other insiders may participate in wash trading to deceive participants about the coin's true worth. Therefore, avoid investing in those kinds of projects.

Moreover, many NFTs have no trading volume or investor interest. As a result, NFT owners can readily participate in wash trading to entice naïve purchasers to buy the NFT at an exorbitant price. Therefore, avoiding newly-issued small-cap cryptos and NFTs is the most significant way to prevent wash trading.

A trader must choose more established cryptocurrencies with a higher volume to avoid becoming a victim of wash trading. The broader the market, the more money scammers will need to manipulate it. For instance, already established cryptos like Bitcoin (BTC) or Ethereum, which are worth hundreds of billions of dollars, make crimes like wash trading incredibly challenging.

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