Stocks

Wash Trading What It Is and How It Works With Examples

Wash Trading What It Is and How It Works With Examples

Wash Trading: What It Is and How It Works, Examples

Wash trading is a process whereby a trader buys and sells a security to feed misleading information to the market. This can involve collusion between a trader and a broker, or investors acting as both the buyer and seller. The purpose is to create the illusion of higher trading volumes, potentially increasing legitimate trading activity. However, wash trading is illegal in the US, and taxpayers cannot deduct losses resulting from it.

Key Takeaways:

– Wash trading is an illegal type of trading where a broker and trader collude to mislead the market.

– High-frequency trading firms and cryptocurrency exchanges may use wash trading to manipulate prices.

– Taxpayers cannot deduct losses resulting from wash trades.

Understanding Wash Trading:

Wash trading was prohibited by the federal government in 1936 to prevent stock manipulators from falsely signaling interest in stocks for personal gain. Brokers are also prohibited from profiting from wash trades, even if unaware of the trader’s intentions. Due diligence is necessary to ensure common beneficial ownership of shares.

Wash Trading and High-Frequency Trading:

Wash trading came into focus in 2013 with the rise of high-frequency trading. This practice involves rapid, computer-driven trades. Investigations of potential wash trading violations were initiated due to the ease with which technology could enable such behavior. In 2014, the SEC charged Wedbush Securities with allowing high-frequency traders to engage in wash trades and other illicit activities.

Wash Trading and Cryptocurrencies:

Cryptocurrencies have also experienced wash trading. This is driven by the desire to create the appearance of popularity and high trading volumes. A Forbes study found that over half of reported Bitcoin trading volume is either fake or non-economic wash trading. Pump-and-dump schemes, combined with inflated volumes and insider recommendations, contribute to wash trading’s prevalence in the crypto space.

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Examples of Wash Trading:

Wash trades cancel each other out and have no commercial value. They are used in various trading situations. In the LIBOR scandal, wash trades were employed to pay off brokers manipulating LIBOR rates. Stock pump-and-dump schemes can also use wash trades to generate fake volumes and manipulate prices.

In conclusion, wash trading involves the buying and selling of the same security to create misleading market information. It is illegal and can be seen across different industries, particularly in the cryptocurrency and high-frequency trading sectors.

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