TL;DR:
Exchanges and other avenues for market making in crypto are not always immune to some of the traditional problems seen in financial markets. Practices such as wash trading and front running have found their way into these markets as well.
It’s important to keep an eye out for these forms of manipulation as we participate in the markets. Let’s take a look at what they are, how they work, and how to avoid them — beginning with wash trading.
Wash trading is a deceptive and illegal practice in financial markets, including cryptocurrency markets, where a trader or entity artificially creates the appearance of trading activity.
Here, bad actors simultaneously buy and sell the same asset to themselves, giving the impression of genuine market activity. Think of it as creating a fake market for a specific asset, undermining the integrity of the overall market.
The typical pattern found in wash trading consists of a series of events that lead to the creation of a fake market:
A person or entity places both buy and sell orders for the same asset at similar prices. These orders are not intended to be executed and do not represent genuine trading interest.
As these fake orders are matched, they create the illusion of high trading volume and activity in the market. This inflated volume can mislead other traders, investors, and market participants into thinking that there is significant interest in the asset.
Once a significant amount of market participants pay attention to the false volume, market sentiment and perceptions are altered. This might attract another set of traders who might fall prey to what’s known as the “Lollapalooza effect.”
While wash trading doesn’t directly impact prices, it can indirectly influence them. If others see increased trading volume, they might believe that the asset is in demand and start buying it. This increased demand can then lead to price changes.
Wash trading was outlawed in the Commodity Exchange Act of 1936. In traditional finance, the activity is kept at bay by relevant authorities such as the Securities Exchange Commission (SEC) and the Internal Revenue Service (IRS). However, these authorities have a harder time preventing it in cryptocurrency markets.
Traditional order book models, such as those found in CEXes, can be especially prone to wash trading. While it can also occur in AMM systems like those used in decentralized exchanges (DEXes), 95% of wash trading happens on these centralized trading platforms. When it does happen in DEXes, it is usually due to their permissionless and programmatic nature, which can be exploited by Sybil attacks, algorithmic trading, or mercenary capital.
Unlike traditional exchanges with central oversight, crypto exchanges have limited control over user behavior. This makes it very hard to police in these markets precisely because of their innovations.
However, there are a number of ways in which crypto market makers can protect themselves. Some include:
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