What is Wash Trading?
Wash trading is a type of market manipulation where an investor tries to create series of fictitious transactions in the market by buying and selling the securities, where they input the sell order and ends up buying those securities with the intention to never take an actual position in the market instead it just tries to mislead other investors by unauthenticated transactions.
- The way it works is considered illegal by the Internal Revenue System (IRS) in the USA and bars any investor by indulging in any such type of trading.
- One of the prime reasons for this type of tax deductions was that before the IRS regulations in 1984 investment losses were tax-deductible and therefore, investors found a way to benefit from this where they used to sell the securities at a loss and then buying the same securities immediately which allows them to get tax evasion without changing their open position in the market.
- The new regulation allows investors to claim investment losses but only if the security is not repurchased within the thirty-day time frame, which is known as a thirty-day wash rule.
- The regulation is not only limited to equity investment but also commodities, options, warrants, preferred stock or short sales. The rule is applicable to the investor’s spouse as well, where if the investor uses his/her spouse account for wash trading will be considered illegal.
- It means trades in the account having beneficial ownership are prohibited under the laws implemented by the IRS, the result and intent of the wash trade are clearly defined in these regulations.
How Does it Work?
- The series of trades done to manipulate the market claim false tax deductions come under the definition of wash trading.
- Initially, the investor has a position in the market with one of the companies and is trying to make a sell which will eventually result in loss.
- Then the investor immediately within a period of 30 days tries to take a similar position in the market which has identical exposure.
- With the second transaction, the investor makes a huge profit, considerably more than the loss he suffered from the previous sell.
- The investor claims tax deduction on the loss, he made which will eventually try to offset the tax he has to pay from the profit he made from the second transaction.
- In this manner, It is being conducted and authorities keep a very close eye on investors and their beneficial ownership accounts as well, eventually prohibiting them from buying and selling securities with similar positions within the thirty-day timeframe.
Example of Wash Trading
- Let us consider that Mr. Smith owns 500 shares at the price of $10 each in the Alphabet company as of 20th September 2019 which is the parent company of search engine Google.
- The market reacts negatively on 21st September 2019 and subsequently, the price of Alphabet share comes down to $8 so Mr. Smith thinks of an idea and sells of his 500 shares at $8 making a loss of $1000.
- Then on 23rd September 2019, Mr. Smith executes his second phase of the plan by again buying 500 shares of Alphabet at market price on that day.
- So, the situation currently is that Mr. Smith still owns 500 shares of Alphabet with the same exposure and he has suffered a loss of $1000. Wash trading is still not in motion, it will be active when Mr. Smith claims investment loss tax deduction for his loss of $1000.
- Eventually, what Mr. Smith is trying to implement here is that he wants to pay less tax on his gain and also wants a tax deduction on the loss he made by selling the initial 500 shares, however, the exposure of his risk in the Alphabet company is still the same.
- This type of trading activity is prohibited under the IRS regulation for most of the asset classes and an investor must adhere to these laws to prevent any offensive action against their trading accounts.
How to Track Wash Trading?
- The most viable solution for exchanges to track wash trading is to implement technical solutions that will enable self-trade prevention, if the sell order of any individual perfectly matches his buy order then the system will not allow the trader to move ahead with the second transaction.
- Authorities can regularly keep a check on the investment losses being claimed at the party versus the tax on gains they are paying, a model can be implemented to track such numbers which will allow them to raise a red flag on any suspicious transaction.
- Exchanges and institutions can restrict trading in for an investor in a single account and adhere to a very strict and vigorous KYC process. This will help traders trade from a single account and not from multiple accounts.
Differences between Wash Trading and Market Making
- A market maker tries to enable liquidity in the market by making the market and enabling the traders with sufficient funds at the time of transacting, they are the ones who help potential traders with their assets at a considerable pace and also reducing the risk of liquidity at the same time.
- On the other hand, wash trading is to duplicate a transaction with the same exposure in order to have a tax benefit.
- Mostly large banks or financial institutions are market makers which give a platform to the investor to buy and sell securities infusing them with enough liquidity, whereas any individual can be a wash trader aiming to get false tax deductions.
Wash trading is a very common trading practice in a healthy market, but it exploits the intention of trading by the authorities. There are regulations and laws in place for the traders to avoid taking advantage of this loophole resulting in a fair-trading environment.
This has been a guide to what is Wash Trading and its definition. Here we discuss how does wash trading works with an example and differences. You may learn more about Financing from the following articles –