The Differences Between Market Making And Wash Trading

What is wash trading in crypto?

The cryptocurrency market is still in its early days, with new regulations appearing frequently. While it does offer a lot of opportunities, there is also the potential for people to take advantage for their own gain. While cryptocurrency market making has become a staple, especially with the bear market, wash trading is still a reality in the cryptocurrency market.

However, this isn’t all bad news. While wash trading is bad no matter how it is approached, there is a legitimate need for market making services within the cryptocurrency market.

The Importance Of Liquidity In Crypto

No liquidity in crypto
An example of low liquidity
Crypto Liquidity chart
An example of liquidity

Liquidity is a major draw for potential traders. It reflects the ease at which assets can be exchanged. So, seeing an exchange with supposedly high liquidity would garner interest. The volume is a telltale sign of the liquidity of an exchange, as the more people that are trading the cryptocurrency, the easier it is to exchange it. This impacts confidence, and the perceived risk of traders because, if there is no volume, there is no trading.

However, ICOs face a major issue with liquidity. How can an unestablished project ensure that things kick off effectively? It would be near impossible for them to gather enough volume right from the get-go. First impressions are important, and so an ICO with a low volume, illiquid asset would quickly be neglected.

Ultimately, liquidity is necessary because the market needs to have liquidity in their order books to ensure the normal operation of the platform.

What Is Wash Trading?

Wash Trading in Crypto

So what is wash trading? Wash trading refers to the process where a trader generates misleading and artificial activity by buying and selling a cryptocurrency to themselves. This, in turn, creates fake trading volume and greatly inflates the appearance of demand. It is a form of market manipulation and aims to mislead traders.

As an example, a trader has 1 BTC and two accounts for an exchange. They place 50 sell orders and 50 buy orders. This will lead to the volume always being the same.

Wash trading is illegal, at least in the traditional exchange market. Having looked before into how the SEC is only focused on potential securities in the crypto space, the market remains mostly unregulated. Therefore, activities such as these can take place without any real repercussions.

The Impact On The Orderbook

This tactic can be identified through some means. Usually, it is characterized by a sudden spike in prices. While this is not entirely uncommon in regular trading, it’s sudden jump and unaccountability should make it appear suspect.

Wash trading can leave a distinct pattern on the order book. It can be possible to identify if looked at closely.

How Is Market Making Different From Wash Trading?

Market Making in CryptoMarket makers, sometimes referred to as ‘liquidity providers’, do just that – they make markets and provide liquidity. Their role in the financial market is important. They are the ones who help to provide potential traders with coins at a more satisfactory pace while helping to reduce liquidity risk.

Illiquid assets would leave the trader looking to buy waiting for a seller, and vice versa. This is understandably a massive turn off. The rules of supply and demand would also come into play, and any transaction would lead to a drastic shift in price, making it particularly volatile.

For new crypto projects and ICOs looking to take off, increase its exposure in the market, and bring in more investors, it can be an indispensable tool that helps to put it on the map. It is just another weapon in the marketing arsenal that, if used properly, can help these projects kick start trading and get the recognition they deserve, which they might not have otherwise been able to receive.

Can It Be Bad?

At the same time, it can be used just as easily for malicious means. By its very nature, it can be seen as a deceptive tool that hides the true demand and natural volume. Fraudulent ICOs can use it as a way to further build the deception of a successful project, for example. In the end, it is about finding the right balance.

One of the key differences between the two is that market makers only provide the liquidity to offer those who wish to buy or sell a normal book volume. Wash traders, on the other hand, simply access to the bids or have enough liquidity to make the bid-ask constant and cheat.

Market Making Best Practices

Market Making orderbooks
In Orderbook A, a regular pattern of the same amount is being traded. In Orderbook B, a very small amount is being traded frequently. Both examples provide liquidity for the market, helping to facilitate trading.

In order to best operate in the interests of all parties, there are several best practices that should be followed. Studying the past activity of an asset, if available, is one such example. While this should be a given, there are other practices that should be followed for maximum effectiveness.

Similarly, taking time to study the daily volume appropriate to each exchange in which they are operating would greatly improve its effectiveness. A sudden increase in volume would be a major deterrent for traders, so a more natural progression in line with the exchanges usual volume would be better received.

Choosing Trading Pairs

The pairs which will be provided liquidity is also a key consideration. Market makers are a service that generally works on a per trading pair basis where the project pays for the service to boost volume between selected pairs. It would be a waste of time and money to use such a service for an unpopular trading pair. Most commonly, these trading pairs would be between the asset in question and Bitcoin or Ethereum, two of the most popular cryptocurrencies.

Finally, perhaps the most important aspect is to balance the bid and ask. This is a key sign of the liquidity of an asset and one of the main goals of market making as a whole. Users will benefit greatly from a reduced distance between the bid and ask.

It’s All About The Research

As always, it is a case of users performing their due diligence into potential projects. All trading involves risk. If something seems too good to be true, taking some time to investigate is vital. Being alert and looking for signs of wash trading and manipulated volume will help reduce risks when trading.

There is an argument about the necessity of market making in the still budding cryptocurrency industry. Trading volume is what keeps cryptocurrencies alive. For ICOs, this can make or break the project. This is especially true in a bear market, where confidence is generally lower. For now, they can be a lifeline to projects.

Summary:

Wash Trading generates fake volume to create artificial activity in the market

Market making is an activity that reduces liquidity risk, facilitating users that sell and buy in the market

Flash Crashes are a potential side effect of wash trading

New exchanges could potentially face more wash trading than others already in the market

While Wash Trading is illegal in the traditional markets, it can still occur in the crypto market

Market Making plays an important role in increasing the liquidity within the market and between specific trading pairs

 


 

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References:

Baker, P. (2019, February 19) Exchange Wash Trading Continues To Stain The Crypto Industry. Retrieved from: https://cryptobriefing.com/crypto-exchange-wash-trading/

Gaevoy, E. (2018, August 7) The Good, the Bad and the Ugly of crypto market making. Retrieved from: https://hackernoon.com/the-good-the-bad-and-the-ugly-of-crypto-market-making-13a44bb2d207

Thrill, W. (2018, April 5) There Is A Huge Necessity For Market Makers In The Crypto Industry And Most Crypto Projects Still Don’t Understand Why. Retrieved from: https://hackernoon.com/there-is-a-huge-necessity-for-market-makers-in-the-crypto-industry-and-most-crypto-projects-still-725d9487f155

Bibliography:

Chen, J. (2019, April 23) Wash Trading. Retrieved from: https://www.investopedia.com/terms/w/washtrading.asp

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