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Wash Trading

Updated on June 4, 2024
Article byWallstreetmojo Team
Edited byAaron Crowe
Reviewed byDheeraj Vaidya, CFA, FRM

What is Wash Trading?

Wash trading is a type of market manipulation where an investor tries to create a series of fictitious transactions in the market by buying and selling securities. They input the sell order and purchase those securities, never taking an actual position in the market. Instead, it tries to mislead other investors through unauthenticated transactions.

Wash Trading

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Wash trading is a very common practice in a healthy market, but it exploits the intention of trading by the authorities. There are regulations and laws for the traders to avoid taking advantage of this loophole resulting in a fair-trading environment. It is also referred to as round-trip trading which according to the Internal Revenue System (IRS) and wash trading rules, it is illegal.

Key Takeaways

  • Wash trading involves an investor engaging in fictitious transactions by buying and selling securities without taking an actual market position.
  • The investor places sell orders and purchase the same securities to create false activity and mislead other investors.
  • While wash trading is common in some markets, it is considered market manipulation. It is regulated by laws and regulations to ensure a fair trading environment and prevent traders from exploiting loopholes.
  • Wash trading can create a false appearance of liquidity and market interest, potentially influencing other investors’ decisions and distorting market information.

Wash Trading Explained

Wash trading is the act of buying and selling the same securities in the market to manipulate the numbers and mislead other players in the market. The way it works is considered illegal by the Internal Revenue System (IRS) in the USA and bars any investor from indulging in any trading.

One of the prime reasons for this type of tax deduction was that investment losses were tax-deductible before the IRS regulations in 1984. Therefore, investors found a way to benefit from this. They used to sell the securities at a loss and then buy the same securities immediately, which allowed them to get tax evasion without changing their open position in the market.

The new regulation allows investors to claim investment losses if the security does not repurchase within the thirty-day time frame, known as a thirty-day wash rule.

The regulation limits equity investment, commodities, options, warrants, preferred stock, or short sales. The rule also applies to the investor’s spouse, where wash trading may consider illegal if the investor uses their spouse’s account.

It means trades in the account are having beneficial ownership prohibited under the laws implemented by the IRS. The result and intent of the wash trade are defined clearly in these regulations.

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How Does it Work?

Let us understand how these transactions are carried out in the market and thereby understand the wash trade tax through the discussion below.

  • A series of trades that manipulate the market to 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 sell, eventually resulting in a loss.
  • Then, within 30 days, the investor immediately 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 last sale.
  • The investor claims a tax deduction on the loss he made, which will eventually offset the tax he must pay from the second transaction’s profit.
  • In this manner, authorities keep a close eye on investors and their beneficial ownership accounts, eventually prohibiting them from buying and selling securities with similar positions within the thirty-day timeframe.

Examples

Let us understand the wash trading rules in detail with the help of a couple of examples.

Example #1

Mr. Smith owns 500 shares at the price of $10 each in Alphabet Co. as of 20th September 2019, the parent company of the search engine Google.

The market reacted negatively on 21st September 2019. Subsequently, the price of Alphabet Co. shares comes down to $8. So, Mr. Smith thinks of an idea and sells his 500 shares at $8, making a loss of $1,000.

Then, on 23rd September 2019, Mr. Smith executed his second phase of the plan by again buying 500 shares of Alphabet Co. at market price.

So, currently, Mr. Smith still owns 500 shares of Alphabet Co. with the same exposure, and he has suffered a $1,000. Wash trading is still not in motion; it will be active when Mr. Smith claims an investment loss tax deduction for his loss of $1,000.

Eventually, Mr. Smith is trying to pay less tax on his gain and wants a tax deduction on the loss he made by selling the initial 500 shares. However, his risk exposure in Alphabet Co. is still the same.

This type of trading activity is prohibited under the IRS regulation for most asset classes. Investors must adhere to these laws to prevent offensive action against their trading accounts.

Example #2

Peter Coker Jr., a former resident of North Carolina, was arrested in Phuket, Thailand in connection with securities fraud.  Both Coker Sr. and Jr. were involved in wash trades of two publicly listed companies- Hometown International Inc. and E-Waste Corp. from 2014 till 2022.

Peter Coker Jr. was charged in a 12-count indictment including securities fraud and conspiracy to commit fraud. However, the decision from the magistrate was not declared.

It is important to note that the maximum years in prison is 20 years for securities fraud and a $5 million fine. Moreover, a conspiracy to commit securities fraud holds a maximum of 5 years in prison and a $250,000 fine or twice the profit or loss, whichever is greater.

How to Detect?

As responsible citizens who employ their hard-earned money into systematic investments. It is also important to know about the wash trading rules and how to spot them. Let us do so through the explanation below.

  • The most viable solution for exchanges to track wash trading is implementing technical solutions that enable self-trade prevention. For example, if the sell order of any individual perfectly matches their buy order, then the system will not allow the trader to move ahead with the second transaction.
  • Authorities can regularly check the investment losses claimed at the party versus the tax on gains they are paying. In addition, one can implement a model to track such numbers, allowing them to raise a red flag on any suspicious transaction.
  • Exchanges and institutions can restrict trading for an investor in a single account and adhere to a very strict and vigorous KYC process. Therefore, it will help traders trade from a single account, not multiple accounts.

Wash Trading Vs Market Making

Both wash trading and market making are terminologies that an investor always hears, but not necessarily understands. Let us understand the differences and thereby, understand their individual and collective implications on the market through the explanation below.

  • market maker tries to enable liquidity by making the market and allowing traders sufficient funds when transacting. They are the ones who help potential traders with their assets at a considerable pace and also reduce the risk of liquidity at the same time.
  • On the other hand, wash trading duplicates a transaction with exposure to a tax benefit.
  • Large banks or financial institutions are market makers that give investors a platform to buy and sell securities, infusing them with enough liquidity. In contrast, any individual can be a wash trader aiming to get false tax deductions.

Frequently Asked Questions (FAQs)

1. What is the difference between circular trading and wash trading?

Circular trading involves a group of entities artificially creating trading activity by repeatedly buying and selling among themselves, aiming to inflate trading volumes. On the other hand, wash trading involves an individual or entity simultaneously executing buy and sell orders to deceive others about market interest and artificially increase trading activity. While both practices manipulate markets, circular trading focuses on trading among multiple entities, whereas a single entity primarily conducts wash trading.

2. What are the advantages of wash trading?

Wash trading can create a false appearance of liquidity and activity in a market, potentially attracting other traders. It may also manipulate prices temporarily, allowing certain participants to benefit from the price movement.

3. What are the disadvantages of wash trading?

Wash trading is illegal and unethical, leading to distorted market information, increased market volatility, and potential harm to other traders and investors. In addition, it undermines market integrity, hinders fair price discovery, and can result in financial losses for unsuspecting participants.

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