What is wash trading?
We refer to wash trading as the practice where the same actor sells and then purchase back a specific asset, usually within a short period of time, to influence its market activity and price. Is a technique of market manipulation that, particularly in the NFT space, is facilitated by the lack of personal identification needed when connecting wallets to buy or sell tokens.
How does wash trading work?
Although wash trading techniques may vary, the following basic example can help us grasp the concept. Let’s consider a scenario with one investor owning two wallets, a seller wallet and a buyer wallet, with $ 1 million stored in the last one.
- Through the seller wallet, our actor decides to mint an NFT and sell it for $ 1 million on a marketplace.
- With the buyer wallet, the same actor buys the NFT for this same amount.
- Finally, the actor transfers the NFT back to the seller wallet. He then decides to sell it again, for a higher price, on a marketplace.
In this scenario, no real transaction between two different parties happened. However, at the end of the loop the value of the token is now influenced by the fake trading activity. Whenever the trader decides to sell again this token on the market, its price will now be aligned with — or higher than — its past transaction value. In this example, even if the token is sold with a high discount — e.g. 90% — our actor would still profit $ 100K as its value has been influenced by the past trading activity.
How big is NFT wash trading?
In a report published from Chainanalysis in 2021, the company detected 262 users who have sold an NFT to a self-financed address (funded either by the selling address or by the address that initially funded the selling address) more than 25 times. The analysis was based only on trades made in Ethereum and Wrapped Ethereum, therefore leaving out potentially other wash trading transactions. Of the total users detected, 110 of them resulted in a total $8.9 million profit performing wash trading activity.
One of the most notable examples of this practice in recent years is a wash sale case performed in October 2021 on Cryptopunk 9998. The token was sold for 124,456 ETH and, once the ETH used for the purchase have been transferred to the seller, these were immediately returned to the buyer to repay the loan used for the transaction. The seller then put the token on sale in the market for 250,000 ETH, basically doubling its value. This was a significant increase considering that, prior to this activity, Cryptopunk 9998 was traded at a range between $300,000 and $400,000.
Is NFT wash trading illegal?
The answer to the question is: not yet.
While wash trading on conventional financial assets is illegal under many regulations, in the new realm of non-fungible tokens this practice is still not properly regulated. Given the early stage of the market, it is still hard for lawmakers and regulators to enforce instances where wash trading occurred involving non-fungible tokens.
How to spot wash trading?
The good news for investors is that, through a bit of analysis, there are specific clues that can help identify wash trades. The first one occurs whenever the same wallet has purchased a specific NFT more than once. This is a first good sign that we are in front of a wash trading, and it is something that can be easily verified through the activity history of the token within the marketplace itself.
Another clue of wash trading happens when there are transfers of crypto from the seller wallet to the buyer wallet, a clear sign that the sale is self-funded. Although a bit more complex to check than the previous case, tools like Etherscan comes handy as they enable users to look for wallets’ transaction history through public blockchain data.
NFT wash trading is an activity that all investors should carefully monitor when making their investment decisions. Considering the early stage of the market as well as the lack of solid historical data on most projects, activities like this one can easily manipulate trading analysis. At Rarespot, we also believe that marketplaces have a pivotal role in helping reduce this practice, as they could highlight more efficiently clues of wash trading — like the ones mentioned — within the transaction history they already expose.