For the scoundrels of the crypto space, random cartoon JPEGs on blockchain and wash trading are a match made in heaven. Generous airdrops and 0% marketplace fees have only added fuel to the fire, with fake trading volume breaking records in the NFT market.
Fortunately, the blockchain is transparent and NFT wash trading is easy to spot. This is bad news for guilty culprits, as regulators start labeling our simple JPEGs as financial instruments.
What is NFT wash trading and why do market participants bother with it? Is there a blurry line between savvy trading activity and market manipulation?
What Is NFT Wash Trading?
A wash trade is any exchange where a single trader is both the buyer and the seller in a transaction. This is generally done to create misleading market data and inflate trading volumes.
Wash trading isn’t exclusive to NFTs and digital currencies like Bitcoin and Ethereum. Stocks and other traditional assets can also be wash traded for various reasons. But what exactly does a wash-sale look like?
Imagine you own a cryptopunk and you list it for sale on an NFT marketplace like Opensea or Blur. With another cryptocurrency wallet you control, you buy the collectible from yourself. From an outsider’s perspective, a trade has occurred. However, you still own the cryptopunk and the crypto used to pay for it.
It seems like a pointless exercise. However, according to Chainalysis, some wallets have made over 800 sales to self-financed wallets. How do traders stand to benefit from this, and is it worth attracting the scrutiny of the IRS?
Why Does Crypto and NFT Wash Trading Happen?
Despite being a moral and an ethical gray area, NFT wash trading does have its benefits. Trading platforms and brokerages often find ways to incentive and reward users. Wash trading helps users artificially inflate their figures and receive greater rewards.
Even on reputable cryptocurrency exchanges, traders are suspected of wash trading. Forbes analysis suggests that over 50% of all Bitcoin trade volume is fake.
What’s the point in faking this volume, and how do crypto and NFT traders benefit?
Token airdrops are perhaps one of the most common ways blockchain protocols incentivize and attract users. Some NFT traders and smart contract deployers earned over $1 million in the $BLUR airdrops of February 2023.
Although Blur claims that they excluded wash trading volume from the airdrop, that doesn’t mean that NFT traders wouldn’t have tried anyway in the hope of outsmarting the system.
The Blur airdrop opened renewed speculation about a potential OpenSea airdrop. Blur has been steadily siphoning market volume away from the NFT marketplace kingpin. In anticipation of a future airdrop, wash traders have been furiously inflating their volume on Opensea by trading scam NFTs on Polygon.
This significantly boosted trade volume (over 900%) on Polygon over 24 hours. Airdrop farmers have most likely chosen the Polygon network due to its minimal gas fees. Some shade-throwing Twitter users even speculated that the Polygon team was behind the wash trading themselves, leading us to our next point.
Some traders use NFT wash trading to create false hype and inflate the value of their NFTs. This tactic isn’t only used for singular NFTs; we’ve seen entire collections boost their trade volume in this way.
For example, imagine I want to try and prove my ‘rare’ NFT is more valuable than the floor price of the collection. I list my NFT at twice the value of the floor price and immediately purchase it using another cryptocurrency wallet I control. Thanks to my clever trick, another trader might think that the NFT has a higher valuation than it should.
NFT traders follow volume. This means that if a certain collection has a sudden spike in buys and sells, that could indicate a bullish announcement or partnership has been announced. Overcome by FOMO, traders might immediately buy NFTs based purely on the trading activity of others.
Scam collections often take advantage of this FOMO. They will wash trade between their wallets to generate hype, hoping unaware traders will rush into a trending collection without researching market risk. This boosts the floor price of the collection and brings exit liquidity to existing holders placing sell orders.
Tax Loss Harvesting
Less malicious than falsifying trading volume to lure unfortunate traders, many NFT traders use wash trading to offset their tax losses. Crypto taxes are a complicated topic, but tax loss harvesting is a clever way to reduce your tax liability. NFT wash trading helps traders realize a tax loss without losing beneficial ownership of the NFT itself.
If I buy an NFT for 1 ETH and sell it for 0.5 ETH, I can claim 0.5 ETH as capital gains losses. However, if I sell that NFT to another cryptocurrency wallet I control, I get to offset my tax liability while still holding and owning the NFT. I can still use it as a PFP and get all the holder benefits while saving on my tax bill.
If you think it’s all too good to be true, that’s because it is.
Is NFT Wash Trading Illegal?
The Commodity Exchange Act (CEA) and the Commodity Futures Trading Commission (CFTC) say wash trading is illegal. It’s considered market manipulation. Profiting from wash trading is strictly prohibited, with severe repercussions for those caught in the act.
The Internal Revenue Service (IRS) has its own regulations to discourage people from wash trading and enforces a wash sale rule. According to Investopedia, the wash sale rule prevents any tax deduction from being claimed on a security sold at a loss and rebought within 30 days. This extends to similar stocks and securities owned by a spouse or company of the original seller.
Long story short, NFT wash trading is illegal and cannot be used for tax deduction purposes. Of course, that doesn’t stop people in the crypto space from trying anyway.
Fortunately, there are other ways to discourage NFT wash trading that hit traders where it hurts the most, their wallets.
How Do You Stop NFT Wash Trading?
Aside from the obvious threats of regulation and law enforcement, there are other ways of limiting NFT wash trading. Marketplace fees and creator royalties are the obvious methods to stop wash traders by taking a percentage of all their transactions.
However, marketplace wars are tense in the NFT space. Competition for users has forced NFT marketplaces to lower, and in some cases remove, marketplace fees in their entirety.
The move has had mixed responses from the wider NFT community. On the one hand, traders are happy because they no longer need to pay fees to intermediaries like OpenSea. At the same time, 0% fee marketplaces have opened the door to unrestrained market manipulation from wash traders. Moreover, removing creator royalties has been detrimental to many NFT collections, which rely on secondary volume as a source of income.
0% fee marketplaces were pioneered on Solana a few months before the Ethereum ecosystem caught up. Since then, royalty payments have become optional on the Solana network.
On the Flipside
- While NFT wash trading provides some benefits to traders, it is illegal. It is expected that any wash trading activity will be discovered by regulators when users declare their tax returns.
Why You Should Care
NFT wash trading, while illegal, is a common occurrence in both the NFT market and the wider crypto space. Understanding why and how wash trading happens will help you to recognize it in the future and protect you from unknowingly being a victim of market manipulation.
What is wash trading in crypto?
In crypto and NFTs, wash trading is when an individual is both a trade’s buyer and seller. Traders wash trade their digital assets by buying them with another crypto wallet they control.
Is wash trading NFTs legal?
No, profiting from NFT wash trading is illegal and cannot be used for tax deductions.
Is wash trading money laundering?
While wash trading itself isn’t money laundering, it is still a technique that can be used to hide funds. However, traders should expect that they will be caught by regulators when they try to withdraw these funds to fiat currency.
How do NFTs detect wash trading?
The most common way to detect NFT wash trading is to track how the wallet that buys the NFT is funded. If there is any prior link or transfer of funds between the wallet that buys the NFT and the wallet that sells the NFT, the wallets are likely owned by the same person or company.
Is income from NFT taxable?
Any income generated from cryptocurrency or NFT trading is taxable, depending on your local governing body. Crypto tax software is a great way to manage your taxes in the blockchain industry.