Get ready for the feds to start indicting NFT wash traders

Securities and Exchange Commission regulators should move to protect investors from traders who distort the NFT market with manipulative trades — and they probably will soon.

Studies show that most people who attempt to wash trade nonfungible tokens (NFTs) are unprofitable. But that doesn’t stop them from trying, which makes it a glaring regulatory and enforcement issue for the industry.

In wash trading, manipulators buy and sell an asset between themselves to create the appearance that the asset is in higher demand and, therefore, worth more than it would be otherwise. With NFTs, wash trading is fairly straightforward: Imagine an investor holds $1 million in Ether (ETH). The investor mints an NFT and proceeds to sell it to themself for all the ETH they own. The transaction is then on the blockchain for $1 million in ETH. The price of the NFT has been set through a wash trade to the benefit of the individual who minted the NFT.

It might be tempting to think that this is a “victimless” crime since it’s unlikely any money actually changed hands if it was a wash trade, but that’s false. By rewarding allegedly fake high-volume traders with real money, NFT investors stand to lose millions to scammers, and legitimate traders may be fooled into overpaying for their investments.

These fraudulent transactions also drive Gresham’s Law (bad money drives out good money) in crypto, driving out legitimate investors and traders as the exchange’s reputation is destroyed.

When it comes to NFTs, however, the rules are not so clear. Such tokens may not be securities, so the same laws and regulations governing securities trading may not apply to them.

The background on wash trading laws

Wash trading has been barred in the United States since the passing of the Commodity Exchange Act in 1936 in response to its popularity as a manipulation tool. Since then, however, the Securities and Exchange Commission and Commodities Futures Trading Commission have carefully scrutinized markets and brought numerous enforcement actions for “wash traders,” thereby adding a degree of safety to the securities and futures markets.

According to the SEC, “Wash trading is an abusive practice that misleads the market about the genuine supply and demand for a stock.” Meanwhile, the U.S. Internal Revenue Service prohibits taxpayers from deducting losses that result from wash sales, so it is entirely possible that wash trading NFTs could result in an enforcement action. It hinges on how NFTs are classified by regulators.

Traders should examine sales history closely before buying NFTs

Accepting the idea that cryptocurrencies tend to be volatile, along with the slow pace of enforcement actions against new assets like NFTs, it seems natural that many sellers will try to inflate their asset’s value to attract new buyers and earn a profit. NFT buyers should think twice and do their due diligence before making a significant investment into an NFT.

*NFT sales to self-financed addresses in 2021. Source: Chainalysis*

It may seem like they are getting a valuable asset because of the number or size of transactions in which the investment has been involved, but the truth may be that the asset was only bought and sold between two wallets owned by the same person making the asset appear more in demand that it actually is.

The SEC is probably already preparing to bag its first NFT traders

Even with laws and enforcement actions, we still see wash trading in the regular securities and commodities market, so you can be certain it exists in newer and evolving markets. Hopefully, the SEC is already working on enforcement in the NFT market. Investigations are generally nonpublic, so some traders may already be in regulators’ sights. It’s a safe bet that in the long run, federal regulators will catch up with this new asset class, and wash trading among NFTs will be reined in as well.

The SEC should move to protect investors, first by ruling that NFTs will be treated like securities, and then monitoring exchanges for signs of manipulation as they do for other asset classes.

Brendan Cochrane, Esq., CAMS is the blockchain and cryptocurrency partner at YK Law LLP. He is also the principal and founder of CryptoCompli, a startup focused on the compliance needs of cryptocurrency businesses.

This article is for general information purposes and is not intended to be and should not be taken as legal or investment advice. The views, thoughts, and opinions expressed here are the author’s alone and do not necessarily reflect or represent the views and opinions of Cointelegraph.