Much Crypto Trading On Unregulated Platforms Could Be Phony, New Research Shows

If the scandal surrounding the FTX crypto-exchange wasn’t bad enough to scare all-but the crypto diehards to flee, now there’s even more bad news for cryptocurrency investors.

Up to four fifths of crypto trading on unregulated crypto exchanges may be phony, new research shows.

“[…] most major unregulated crypto exchanges feature excessive wash trading,” states the report titled Crypto Wash Trading, which was recently distributed buy the National Bureau of Economic Research. It was authored by , Ke Tang and Yang Tang, both of Tsinghua University, and Lin William Cong of Cornell and Xi Li who lives in Newcastle Upon Tyne.

“We estimate the average wash trading to be 53.4% of trading on unregulated Tier-1 exchanges and 81.8% on Tier-2 exchanges.” Tier-2 exchanges were mostly founded during 2017 and 2018, while, those in Tier-1 were older, the report states.

Regulated exchanges — Bitstamp, Coinbase, and Gemni — must comply with government regulations. And activity on those platforms isn’t in question.

But it seems that the unregulated ones — those cited by the NBER paper — are where wash trades may be running rampant. And for investors that’s a big big problem.

Investopedia defines wash trading in the following way:

• “Wash trading is a process whereby a trader buys and sells a security for the express purpose of feeding misleading information to the market. In some situations, wash trades are executed by a trader and a broker who are colluding with each other, and other times wash trades are executed by investors acting as both the buyer and the seller of the security.”

It matters for a few reasons. The first is that wash trades create an illusion that the market for the security or asset has larger trading volumes than truly exist.

The phrase volume-creates-volume comes to mind here. When an asset’s trading volume takes off institutional investors tend to get more interested in betting their money on that asset. However, those investors are likely making the decision to invest based on the belief that the stated volume is overwhelmingly legit.

The NBER paper cites data showing 19% of institutional investors invest in crypto.

Fake volume creates a falsehood that may attract investors in the same way that fake profits shown on an income statement trick investors into parting with their money.

That’s at least part of the reason that wash trades are prohibited under U.S. law. In addition, Wash trading was used by investors in the past to avoid income tax and is also illegal.

Does this mean those unregulated crypto trading platforms are doing something bad?

Maybe. Maybe not, according to the NBER paper. It states: ““We are not claiming that all wash trading is done by the exchanges. Individuals could wash trade as well.”

In other words, exactly who should get fingered for the possible market manipulation outlined by the authors in the NBER paper, remains to be seen.