What is “wash trading” and why is it negative for non-fungible tokens?

Mass adoption of NFT is a pipe dream if users cannot trust the statistics and numbers that projects are advertising. Learn exactly what is defined as wash trading, how to spot it, and what projects and leaders should be doing to avoid it.

dafky20002020-08-18

Introduction

In recent weeks we’ve noticed an increased volume of “wash trading” of NFTs. While not a new concept to “crypto” or the world in general, wash trading has been mostly limited to isolated cases in the non-fungible token space. We wrote about this briefly in a previous article, Behaviors in the NFT ecosystem that we hope will decrease in 2020.

Some examples include:

On the blockchain, whether wash trading is at the hand of a platform/company, content creator (artist, minter, etc), investor, ill-intentioned user, or sabotage by competitors is anyone’s guess in many cases. 

We believe that wash trading and ill-intentioned behaviours are the leading problems deterring new users from entering the ecosystem. From our research, NFT-curious and even experienced users are worried about making the wrong decisions and being out-smarted by insiders.

What is wash trading?

Ignoring the definition’s use of the term “security”, from Investopedia: “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.”

At the core, in regards to non-fungible tokens, wash trading includes any purchases or sales made not for the sole purpose of buying/selling a product. Some more concrete examples include:

  • Purchases to create the illusion of artificial demand for a specific project
  • Purchases to create hype or false demand for a specific asset, publisher/artist, or platform
  • Purchasing assets with the purpose of artificially inflating public metrics
  • Purchasing assets to collect rewards where the reward value exceeds the cost-of-attack

This has short and long term consequences on users, sentiment, reputation, and growth of the global ecosystem.

Why is wash trading a problem?

Illegitimate/wash trading has negative impacts for all involved. For projects themselves, investors, collectors, traders, and the global community of enthusiasts. 

Projects no longer have reliable statistics about their own platform’s growth and reach. They need to spend their time cleaning their own records to determine actual use vs. fabricated use instead of focusing on their product. Project workers will also need to spend their time managing unreal expectations and correcting misinformed users.

Investors are forced to rely on measurable statistics less and less, making the due-diligence process much more difficult. They require specialists to analyze the data for discrepancies.

Collectors and Traders are unable to make informed decisions. If a user likes a piece of art or collectible, they may pay too much, sell for too little, or otherwise make an uninformed decision due to misleading statistics and history.

The Community is affected the hardest. Wash trading gives regulators and proponents of mainstream financial services additional ammunition against decentralization. The more we can conform to acceptable social norms (property rights, financial practice, marketing tactics), the more adopted and accepted the technology will become.

How to fix it?

Project leaders must design systems carefully with bad actors at the front of their mind. Due to the anonymous, free, and open nature of blockchain, there are many implications that project leaders need to be aware and respectful of, constantly.

Although not an absolute fix, market fees play a big role in preventing wash trading. Attackers are less likely to perform an attack if they are losing a percentage with every attack.

Rewards or incentive must be less than the cost-of-attack. Anonymity and 0-accountability make people do crazy things, take an active role in not fostering negative behaviour.

Similar to outsourcing software (smart contract) audits, projects should consider economic model audits. Manipulation and the probability of risk-free and anonymous illegitimate activities needs to be considered with every new feature and update, these attacks will quickly dominate a system.

Statistics platforms (such as NonFungible.com) need to develop methods to detect wash trading and flag “wash-volume” and “wash-sales” accordingly. It is extremely important that every potential customer checking these profiles is aware of the issues so they are making fully informed decisions based on accurate data.

Aggregator and statistics platforms also need to play a role in education, users need to be aware of these techniques as well as past, present, and potential future cases. Ultimately, we need to prevent users from making decisions based on false/manufactured statistics.

Recently, CoinTelegraph suggested that regulation is likely the long term answer. We prefer to believe otherwise, people are better than that, no? The community must be willing and capable of self-policing in a decentralized and democratic way to make this work, profit is a short-sighted use case.

Conclusions

At this stage of infancy, everyone needs to play an active role. Project leaders need to be respectful of their community and the general crypto community by building systems that discourage or eliminate these damaging behaviours. Aggregators need to enhance their methods of identifying this behaviour and presenting it in a non-destructive but clear manner. And, the NFT community needs to hold each other, project leaders, and influencers accountable from magnifying the problem.

At NonFungible.com, we are building a suite of detection techniques designed to identify and make apparent wash trading statistics per project, asset, publisher, or wallet automatically. Our goal has always and continues to be: “to provide the community with the most accurate and reliable information about NFT markets”, wash traded “sales” are not supported by this statement. If you see wash trading, report it! Contact us using our contact form, tag us on Twitter (@nonfungibles), or let us know on Discord.

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