Cryptocurrency has entered that stage, common to newly traded assets, where volume matters.  When that happens, traders in a new frontier seem unable to resist the temptation to engage in wash trades to build their book and create an illusion of liquidity and value. Having gone through this before, regulatory agencies are now ready. Whether or not the Commodities Futures Trading Commission (“CFTC”) and Securities Exchange Commission (“SEC”) have jurisdiction will play itself out in courts.  In the meantime, it is time for digital asset trading companies and their exchanges to assess their positions, understand potential regulatory exposure to wash trades, and develop a strategy for mitigating reputational risk and potential penalties.

IT’S A WASH: Understand Your Trade Book

Wash trades are a series of transactions that give the appearance of authentic purchases and sales, but effectively cancel each other out so that there is no actual change in market position. These trades give an impression of liquidity and may serve to artificially inflate market prices for the asset as buyers who would not otherwise enter into an illiquid market choose to do so based on the falsified trades.

The SEC traditionally has focused on wash sales of securities (i.e., stocks and bonds). Authorized by the wash sale rule (26 U.S. Code Section 1091), the SEC aims to prevent trading for the purpose of accruing tax benefits by selling shares at a loss and then rebuying the same security back within 30 days. Correspondingly, the Internal Revenue Service (“IRS”) has a number of tax forms that can be filed to ensure the timing of sales and purchases of securities are not in violation of the wash sales rules.

The CFTC also oversees wash trades, but with respect to commodities. In 2000, the CFTC stated that “such violations are grave” (CFTC Docket Number 97-9 Opinion and Order) with respect to wheat. In the early aughts, after Enron implemented roundtrip trades as part of its fraudulent accounting practices, regulatory scrutiny focused on energy. Both the CFTC and Federal Energy Regulatory Commission (“FERC”) subsequently brought a number of actions against energy trading companies that were methodically using round trip trades to bolster volumes, trade rankings, growth rates, and valuations. Since then, the CFTC has brought claims against traders transacting corn, foreign currency, oil, gold, and other commodities.

RINSE IT OUT: Clear the Trades

In burgeoning industries, the nature of and incentives behind wash trades tend to spread through market participants. The cryptocurrency industry is no different. The Blockchain Transparency Institute (“BTI”) issued a finding in 2018 that 23 out of 25 exchanges had wash trades. By 2019, the BTI report indicated that wash trades had decreased by 37.5 percent among the top 40 cryptocurrency exchanges, but it was still prevalent. A Forbes analysis of 157 exchanges in 2022 indicated that half of the daily bitcoin trading volume is suspect. A recent paper by the National Bureau of Economic Research estimated that wash trading represented an average of over 70 percent of trading activity on unregulated crypto exchanges. Traders transacting digital assets are motivated to do back-to-back trades, and there appears to be a pervasive lack of governance and controls to stop them.

In 2021, the CFTC settled with Coinbase Global Inc. after alleging that the company intentionally conducted back-to-back trades between 2015 and 2018 to increase the appearance of trade volumes. On March 22, 2023, the SEC swooped in with a double allegation against Tronix (TRX) and BitTorrent tokens (BTT) claiming that they are unregistered securities (hence asserting jurisdiction) and alleging an “extensive wash trading” program. Since then, the SEC and CFTC have announced new investigations and charges tied to failure to register, placing companies with wash trades in the crosshairs of regulatory scrutiny. Targeted companies are now bringing lawsuits countering those cases and claiming that cryptocurrency is not subject to either regulatory jurisdiction. For an industry still reeling from the apparent lack of governance at FTX, another shoe has dropped.

SPIN CYCLE:  Control the Narrative

In the face of growing regulatory oversight, risk mitigation can be the best strategy and changing business practices in anticipation of regulation a worthwhile tactic. When energy trading began, and wash trades and falsified trade volume reporting rampant, the Federal Energy Regulatory Commission required energy companies to review their trading practices and positions. Following a few initial enforcement actions, companies with trade floors were offered an opportunity to come forward to acknowledge wrongdoing in exchange for lower penalties. Expect similar calls to self-reporting in cryptocurrencies and other digital assets. If handled properly, most cryptocurrency companies will have an opportunity to remedy their activities and manage the message.

DRY CLEAN: Get It Done

If risk management practices, oversight, and good governance are not in place, firms trading digital assets should take time to implement those protections now. Showing a proactive approach to compliance will be well-received by regulators. Understanding and mitigating exposure to regulatory risk will be well-received by shareholders. For blockchain-based asset trades, the data is publicly available and accessible to others, including regulators. It is better to take control of the narrative now than to wait for the other shoe to drop.

Read additional insights in StoneTurn’s Full Disclosure series:

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About the Authors

Tanya Bodell StoneTurn

Tanya Bodell

Tanya Bodell, Partner, leads StoneTurn’s energy and sustainability offerings in business advisory services, regulatory support and expert testimony in large-stakes litigation, levering more than 25 years of experience in energy […]

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Kyla Curley

Kyla Curley, a Partner with StoneTurn, has over 20 years of experience investigating and making sense of complex and sensitive issues involving financial fraud, misuse, and misappropriation, as well as […]

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