Of all the major developments in the crypto community in the past year, many consider the mainstream adoption of the non-fungible token (NFT) as one of the most significant. While NFT sales had been growing steadily since their creation in 2014, trading volume surged in the second half of 2021, with analytics platform DappRadar reporting total sales in the third quarter of $10.67 billion – a 704% increase from the previous quarter.
Overall, 2021 sales reached $44.2 billion, an astonishing number considering that NFT marketplaces registered just $106 million in trading volume for 2020.
Although this market expansion attracted millions of new fans and propelled NFTs into the limelight, the rapid growth made possible several deceptive practices that NFT owners could implement to boost the price of their holdings.
As the NFT community moved farther ahead of any oversight or regulations, a practice known as wash trading took hold that inflated the prices of certain collections and exposed loopholes within the trading model.
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Understanding Wash Trading
Although wash trading has become a significant problem in the NFT community, it’s important to understand that the practice affects all types of financial securities and has been fought by regulators and law enforcement in the U.S. for nearly a century.
Wash trading occurs when the owner of an asset sells the asset to himself. This is done with the express purpose of deceiving the market about the true price of the asset since the seller gets to artificially choose the price. Through the trade, a wash trader uses market manipulation to give other investors false and misleading information about their asset’s liquidity and value.
Wash trading can be thought of as a form of insider trading since the buyer of an asset has inside information about the asset they are purchasing.
While wash trades are usually executed by a single individual on both sides of the deal, they can also take place in collusion with a brokerage firm or other entities.
Is Wash Trading Legal?
Like other types of insider trading, wash trading has been outlawed by the U.S. government since 1936 and is strictly enforced by the Securities and Exchange Commission (SEC).
The Commodity Futures Trade Commission (CFTC), an independent agency of the US government that regulates the U.S. derivatives markets, also has jurisdiction over many financial institutions and actively prohibits wash trading.
Brokerages are subject to intense scrutiny under all three agencies and are responsible for any wash trades that occur under their watch, even if they claim they weren’t aware of the trader’s intentions. Because of this, brokers and third parties are tasked with vetting customers closely to prevent illegal profits.
NFT Legal Status
Despite the strict measures that government agencies take to prosecute wash trades, NFT wash trading is not illegal. Although the practice might be described as unethical, the NFT asset class has not been clearly defined by most jurisdictions as financial security and is consequently not subject to these agencies’ laws.
However, in recent months certain regulators outside of the U.S. have been taking steps to curtail NFT wash trading. So far, the EU’s Markets in Cryptoassets (MiCA) agency, as well as the South Korean FSC, have passed laws against the practice.
In the U.S., the CFTC has prosecuted wash trading in the case of a Coinbase employee, but the illegal trade in question covered cryptocurrency, not NFTs.
Why Do Investors Wash Trade?
Investors engage in wash trading activity for two main reasons: to artificially inflate the value of the asset they hold and to receive tax benefits from selling the asset at a “loss.”
Inflated Value
NFTs are a form of digital art, and like all other art forms, it’s not always clear why prices for certain collections are so high or so low. NFT wash traders take advantage of this to buy their own NFTs at astronomical prices with a different account.
This makes their NFT stand out and gives outside observers the impression that the NFT is worth far more than it is. The wash trader can repeat this process over and over until their token has generated enough interest to be bought by an outsider – who ends up paying far more than they actually should.
Tax Benefits
NFT wash trading can also involve selling an NFT at a loss to receive a tax deduction. As the IRS allows taxpayers to offset their capital gains (the money they earned on investments) with capital losses (the money they lost on investments), selling an NFT to yourself at a lower price would allow a trader to lock in a capital loss and pay fewer taxes.
In normal trading, the Internal Revenue Service (IRS) works to prevent wash trades and has strict regulations that require taxpayers to refrain from deducting losses that result from wash sales. However, in the case of NFTs, the rules are not as defined and IRS has less jurisdiction.
Is NFT Wash Trading Profitable?
Contrary to popular belief, a study conducted by Chainalysis, a blockchain data platform, found that the majority of wash traders selling NFTs are unprofitable. Using blockchain analysis, the group was able to identify the 262 most frequent wash traders in the NFT space.
Of that number, 152 traders did not make a profit. This was mostly due to the gas fees incurred after each transaction, which buyers and sellers are required to pay after each resale on nearly every NFT platform. Overall, these “investors” lost over $416,000 during trading.
However, the story changes when looking at the 110 wallets that were profitable. Amazingly, these traders made a combined $8.9 million in earnings. Most of these sales went to unsuspecting buyers who believed the NFT they had purchased was in high demand.
Wash Trading Examples
CryptoPunks
One notorious example of a verified wash trade occurred in the CryptoPunks NFT collection, a famous project that was one of the first-ever NFT series released in 2017.
On October 28, 2021, CryptoPunk 9998 was sold for 124,457 ETH (worth around USD 532 million at the time). Before the sale, which was later identified as a wash trade, CryptoPunk 9998 had been trading between $300,000 and $400,000.
After a closer examination, it was revealed that the ETH that was used to buy the NFT was transferred from the seller to the buyer to repay the loan that was used to buy the digital blockchain art from Larva Labs.
The buyer then put the piece on the market for 250K (currently valued at $1.01B).
LooksRare
Although LooksRare is a new NFT marketplace that has instituted a “community-centric” model, the exchange has been hounded by allegations of NFT wash trading.
Recently, the NFT data aggregator CryptoSlam found that over $8.3 billion worth of wash trades had taken place on LooksRare since its founding in January of 2022, making up the vast majority of its volume on its site.
In this case, users wash traded on the company’s platform due to the site’s unique trading model, which rewards buyers and sellers for every transaction in the form of the platform’s native LOOKS token.
How are NFT Exchanges Fighting Wash Trading?
Despite the risks that come with every wash sale, analysts believe that the practice will only grow more common in the days ahead. This is not only because the same person can create multiple cryptocurrency wallets easily, but because more and more sites are offering tokens as a reward for transacting – meaning that there is another incentive for the same user to rack up trades with himself.
Certain NFT exchanges have taken measures to discourage wash trading. Recently, Rarible voted to discontinue rewarding RARI tokens to traders.
Additionally, OpenSea released a blog in January 2022 announcing the launch of a new NFT Security Group that will focus on eliminating vulnerability security issues, one of which is wash trading.
