Wash Trading

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.

Explanation

Wash Trading

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Source: Wash Trading (wallstreetmojo.com)

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

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

Conclusion

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.

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