In October 2021, CryptoPunk #9998 sold for 124,457 ETH ($532 million at the time) — or so it seemed. Like any standard NFT transaction, the buyer sent Ether to the CryptoPunk’s smart contract, which transferred it to the seller.
Oddly though, the seller then sent the Ether back to the buyer an hour and a half later, along with the CryptoPunk NFT, which was sent back to the original wallet address. The NFT was subsequently offered up for sale again to the market for 250,000 ETH (more than $1 billion).
CryptoPunks creator, Larva Labs took to Twitter to explain that “someone bought this punk from themself with borrowed money and repaid the loan in the same transaction” — or in other words, a modern-day wash trade.
What is wash trading?
Traditionally, wash trading occurs when a buyer and seller collude to mislead the market and artificially inflate the value of a security without incurring any actual risk or changing the traders’ positions. In other words, the buyer and seller send the same asset back and forth, while only publicly reporting the initial sale. In the second exchange, the security and money are returned to their original owners at the same time.
With NFTs, the same pattern occurs, only this time, the asset is “sold” to a new wallet that the original owner also controls.
How big of an issue is wash trading?
Wash trading is a significant issue that’s distorting the price of NFTs and creating false demand.
Chainalysis reports that 110 wash traders alone generated $8.9 million in profit in 2021. In all likelihood, that number is actually much higher, as the report only looked at transactions made in Ethereum and Wrapped Ethereum. As of April 2022, wash trading accounted for $18 billion, or 95 percent of overall trading volume on NFT marketplace LooksRare, according to Bloomberg.
Not all wash traders are profitable, though.
Kim Grauer, head of research at Chainalysis, explains, “Many wash traders came out negative due to the amount spent on gas versus the amount generated from their sales.” Out of the 262 wash traders the report looked at, 152 were unprofitable, and lost $416,984, collectively.
Is wash trading illegal?
So other than potential financial loss, what consequences are these NFT wash traders facing — if any?
The answer: nothing yet.
Thanks to both the Securities Exchange Act (SEA) of 1934 and the Commodity Exchange Act (CEA) of 1936, wash trading is illegal under federal law. The Internal Revenue Service (IRS) even has its own rules governing wash trades. However, given that NFTs are still relatively new, it’s difficult for lawmakers and regulators to enforce instances where a clear “wash” has occurred, begging the need for case law that directly speaks to wash trading with an NFT.
You’ve been victimized…now what?
Before investing, it is crucial to understand how the NFT is being marketed and promoted. Similar to the due diligence taken in evaluating a rug pull, identifying a wash trade requires you to:
(1) actually look at the blockchain and where money is being sent, as well as:
(2) inquire with the community on whether they are familiar with the project and their experience with their investment.
You may just save yourself tens of thousands of dollars.
But, in the event you have been the victim of a wash trade, the unfortunate reality is that you have an uphill battle in ever seeing your money again. The lack of sophistication in industry available tools/mechanisms that could accurately identify and/or predict potential risks, as well as proving intent by the “known” parties to the transaction, make it a near-impossible feat — at least right now.
As NFTs are still nascent with respect to their regulation and oversight, applying traditional wash trading rules falls under a “gray area” for lawmakers, but doesn’t eliminate the unethical and illegitimate character traits that still involve the intent to mislead the market and investors.
Ultimately, it will require our legal landscape to continue diving into the NFT space to better understand their mechanics, tokenomics, application, and utilization to have a better understanding of how to apply the CEA and SEA to modern assets.
Andrew Rossow is an attorney and journalist who focuses on Web3, fintech, and intellectual property law.
The information provided on this website does not, and is not intended to, constitute legal advice; instead, all information, content, and materials available on this site are for general informational purposes only.