Wash Trading in the Financial Markets

Dec 27, 2021 04:26 PM ET
Wash Trading in the Financial Markets

Wash trading is a practice where traders make security transactions to make it seem like the trade has been executed, yet their portfolio has not changed. It is also referred to as round-trip trading since the trader ends up in the same position they had taken before the wash trade began. 

Wash trading can be a result of an intentional desire to manipulate the markets or a trader acting without proper knowledge of the phenomenon. It is most commonly seen in stocks, but it could also occur in other markets. 

Definition of wash trading

Wash trading occurs when a trader sells a security at a loss, then buys back the same amount of the security. After a short while, they sell the security at a profit, then claim tax exemption for the loss they made selling the security the first-time round. 

Traders can perform wash trades to manipulate the market. They may buy and sell the same securities in order to increase buying pressure and drive their prices up or to increase selling pressure and drive the security’s price down. They may also collaborate with brokers for each party’s personal gain. The broker, in this case, would benefit from the commissions obtained from defrauded investors. The trader would, in turn, benefit by profiting from the wash trade and evading tax obligations. 

The SEC defines insider trading as using information about security that the general public doesn’t have. Since the wash trader usually knows they are manipulating prices and other investors do not, it constitutes insider trading which is punishable by law. 

How it works

By definition, wash trading means the investor is buying and selling the same shares at the same time. However, a wash trade must satisfy two conditions for it to be valid:

  • Intent – Either the broker, trader, or both must have entered into the wash trade with full knowledge of and desire to commit the wash trade.

  • Result – The wash trade must be completed, i.e., the trader sold and bought the same security over a relatively short period of time through accounts with the same or beneficial ownership.

Beneficial ownership refers to accounts that are affiliated to the same individual or entity, such as a spouse’s account. 

Example

Let’s say an investor sells Tesla shares and suffers a $2000 loss on December 1. On 10th December, they purchased the same amount of Tesla shares, and a few days later, they sold them for a $6000 profit. When reporting their capital gains to the IRS, they claim tax deductions for the initial $2000 loss. It would constitute a wash trade if the trader intended to manipulate the markets or unfairly request a tax exemption. 

Legal ramifications

The Commodity Exchange Act deems wash trading illegal. This act is enforced by the Commodity Futures Trade Commission (CFTC). The IRS also prohibits traders from claiming tax deductions for their losses emanating from wash sales. The IRS defines a wash sale as when you sell stocks at a loss and within 30 days prior or after the sale:

  • You purchase the same stocks.

  • You purchase identical stocks through a fully taxable trade.

  • You get a contract or option to purchase the same stocks.

  • You purchase the same stocks for your individual retirement arrangement (IRA).

The wash sales rule applies even when you use a spouse’s account or that of a corporation you control. In 2013, two individuals were found by the CFTC to be in violation of this rule and were fined $400,000 each and banned from trading for 140 days.

Wash trading vs. market making

Market makers buy and sell securities at publicly quoted prices, with the intent to trade them to individual traders for a fee. This is not illegal. In fact, they provide liquidity and reduce transaction times in the financial markets. The spread they charge is just their compensation for keeping shares and other instruments moving. 

Wash trading, on the other hand, is illegally making round-trip trades to manipulate the market or unfairly benefit from tax deductions.

Wash trading in crypto

Recently, the EOS coin made headlines when several accounts engaged in wash trading to drive up the coin’s price during its initial coin offering (ICO). These accounts created artificial demand, thus making it seem like the coin was worth way more than it really was. This caused an overvaluation of the coin.

However, cryptocurrencies are not regulated security. For that reason, wash traders in the crypto space may get away with their actions, as the SEC would not be within their rights to prosecute such individuals. The IRS, too, does not have any rules against wash trading in crypto markets. 

Be that as it may, several governments are looking to exert more regulation and guidance to the crypto space as it grows to rival traditional finance systems. Very soon, cryptocurrencies may be subject to federal regulation. Therefore, if you’re a crypto trader, you should take time to familiarize yourself with how wash trading works and how you can avoid falling prey to it.

How to avoid wash trading

Investors should make sure they grasp what situations would constitute a wash trade, lest they execute one without their knowledge. You should always keep track of the number of securities you buy and sell and when you make the actual trades, be they stocks or cryptocurrencies. The 30-day wash trading rule applies to the 30 days prior to the sale, the day of the sale, and 30 days after the sale. So essentially, you should wait 61 days before replacing assets you sold from your portfolio.    

Conclusion

Wash trading refers to the practice of selling securities, only to repurchase themWash trading On in their entirety a short time later. This may be done to manipulate market prices or to claim tax deductions unfairly. Both the IRS and CFTC enforce laws against this practice. You should wait 61 days before replacing any assets you sell from your portfolio to avoid legal ramifications.


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