What is Wash Trading?

Explanation

  • The way it works is considered illegal by the Internal Revenue System (IRS) in the USA and bars any investor from indulging in any trading.One of the prime reasons for this type of tax deduction was that investment losses were tax-deductible before the IRS regulations in 1984. Therefore, investors found a way to benefit from this. They used to sell the securities at a loss and then buy the same securities immediately, which allowed them to get tax evasionGet Tax EvasionTax Evasion is an illegal act in which the taxpayers deliberately misreport their financial affairs to reduce or evade the actual tax liability. This includes using multiple financial ledgers, hiding or representing lesser income, gains, or profits than actually earned, overstating deductions, & failing to file returns. read more without changing their open position in the market.The new regulation allows investors to claim investment losses if the security does not repurchase within the thirty-day time frame, known as a thirty-day wash rule.The regulation limits equity investment, commodities, options, warrants, preferred stock Preferred StockA preferred share is a share that enjoys priority in receiving dividends compared to common stock. The dividend rate can be fixed or floating depending upon the terms of the issue. Also, preferred stockholders generally do not enjoy voting rights. However, their claims are discharged before the shares of common stockholders at the time of liquidation.read more, or short sales. The rule also applies to the investor’s spouse, where wash trading may consider illegal if the investor uses their spouse’s account.It means trades in the account are having beneficial ownership prohibited under the laws implemented by the IRS. The result and intent of the wash trade are defined clearly in these regulations.

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How Does it Work?

  • The series of trades that manipulate the market to claim false tax deductions come under the definition of wash trading.Initially, the investor has a position in the market with one of the companies and is trying to sell, eventually resulting in a loss.Then, within 30 days, the investor immediately tries to take a similar position in the market, which has identical exposure.With the second transaction, the investor makes a huge profit, considerably more than the loss he suffered from the last sale.The investor claims a tax deduction on the loss he made, which will eventually offset the tax he must pay from the second transaction’s profit.In this manner, authorities keep a close eye on investors and their beneficial ownership accounts, eventually prohibiting them from buying and selling securities with similar positions within the thirty-day timeframe.

Example of Wash Trading

  • Let us consider that Mr. Smith owns 500 shares at the price of $10 each in Alphabet Co. as of 20th September 2019, the parent company of search engine Google.The market reacted negatively on 21st September 2019. Subsequently, the price of Alphabet Co. shares comes down to $8. So, Mr. Smith thinks of an idea and sells his 500 shares at $8, making a loss of $1,000.Then, on 23rd September 2019, Mr. Smith executed his second phase of the plan by again buying 500 shares of Alphabet Co. at market price.So, currently, Mr. Smith still owns 500 shares of Alphabet Co. with the same exposure, and he has suffered a $1,000. Wash trading is still not in motion; it will be active when Mr. Smith claims an investment loss tax deduction for his loss of $1,000.Eventually, Mr. Smith is trying to pay less tax on his gain and wants a tax deduction on the loss he made by selling the initial 500 shares. However, his risk exposure in Alphabet Co. is still the same.This type of trading activity is prohibited under the IRS regulation for most asset classes Asset ClassesAssets are classified into various classes based on their type, purpose, or the basis of return or markets. Fixed assets, equity (equity investments, equity-linked savings schemes), real estate, commodities (gold, silver, bronze), cash and cash equivalents, derivatives (equity, bonds, debt), and alternative investments such as hedge funds and bitcoins are examples.read more. Investors must adhere to these laws to prevent offensive action against their trading accounts.

How to Track Wash Trading?

  • The most viable solution for exchanges to track wash trading is implementing technical solutions that enable self-trade prevention. For example, if the sell order of any individual perfectly matches their buy order, then the system will not allow the trader to move ahead with the second transaction.Authorities can regularly check the investment losses claimed at the party versus the tax on gains they are paying. In addition, one can implement a model to track such numbers, allowing them to raise a red flag on any suspicious transaction.Exchanges and institutions can restrict trading for an investor in a single account and adhere to a very strict and vigorous KYC process. Therefore, it will help traders trade from a single account, not multiple accounts.

Differences between Wash Trading and Market Making

  • A market makerMarket MakerMarket makers are the financial institution and investment banks which ensures enough amount of liquidity in the market by maintaining enough trading volume in the market so that trading can be done without any problem.read more tries to enable liquidityLiquidityLiquidity is the ease of converting assets or securities into cash.read more by making the market and allowing traders sufficient funds when transacting. They are the ones who help potential traders with their assets at a considerable pace and also reduce the risk of liquidity at the same time.On the other hand, wash trading duplicates a transaction with exposure to a tax benefitTax BenefitTax benefits refer to the credit that a business receives on its tax liability for complying with a norm proposed by the government. The advantage is either credited back to the company after paying its regular taxation amount or deducted when paying the tax liability in the first place.read more.Large banks or financial institutionsFinancial InstitutionsFinancial institutions refer to those organizations which provide business services and products related to financial or monetary transactions to their clients. Some of these are banks, NBFCs, investment companies, brokerage firms, insurance companies and trust corporations. read more are market makers that give investors a platform to buy and sell securities, infusing them with enough liquidity. In contrast, any individual can be a wash trader aiming to get false tax deductions.

Conclusion

Wash trading is a very common practice in a healthy market, but it exploits the intention of trading by the authorities. There are regulations and laws for the traders to avoid taking advantage of this loophole resulting in a fair-trading environment.

This article is a guide to Wash Trading and its definition. Here, we discuss a wash trading work example and its differences. You may learn more about financing from the following articles: –

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