What is NFT Wash Trading?
|— NFT wash-trading is when NFT traders buy and sell their own assets over and again to make them look valuable.|
— Wash-trading is not exclusive to the NFT market – it’s an old scam used by traders in securities markets. But the norms and notorious FOMO of the NFT space make it a perfect place for wash traders to part hopeful buyers with their hard earned crypto.
— Wash-trading harms you by making it hard to get transparency on the value and liquidity of an NFT. It also undermines trust in the NFT market as a whole.
— Here we explain how it works, and how to spot it yourself – so you can explore the NFT market in peace.
As the NFT ecosystem becomes more sophisticated, so do the scammers operating in the space. Wash trading is a well known type of market manipulation that also happens to be perfectly suited to the FOMO of the NFT space. But this damaging practice is damaging both to individual and the space as a whole. This article gives you the lowdown on wash trading, so you can avoid being scammed yourself.
NFTs – Tokens With a Life Story
Non-fungible tokens (NFTs) are unique, blockchain-based tokens with an internal smart contract, and that smart contract does something pretty cool – it keeps track of the token’s entire history.
This means that you – or anyone – can look into a token’s lineage, including previous owner wallets, sales volume and resale value. In one sense, this data gives prospective buyers a lot of power – being able to see key information such as sales history and pricing enables you to build a profile of the token and the demand for it – and by connection, how much you’re prepared to pay for it yourself.
But on the other hand, this data feed can be a vector for clever scammers to manipulate your impression of how much a token is worth to make a profit. Let’s talk about how that works.
NFT trading platforms don’t need any personal data from users – all users need to do is connect your wallet, and start buying and selling.
But this has a knock-on effect: it enables the same person to use unlimited different crypto wallets on the platform. This means a given user can simply buy and sell their own NFTs between their different wallets, with the money from each sale always staying with the same individual. This is known as wash trading.
Why do this?! That’s a great question.
To Suggest High Demand
As you know, our old friend the smart contract specializes in recording NFT activity. Every time a token is traded, the activity is recorded by its smart contract, to be displayed to anyone who wishes to check in future. So by continually trading an NFT, you can create the impression that there is demand for that token – in reality, there’s not.
To Imply An Inflated Value
And there’s another element of wash trading too. Smart contracts not only show data about prior trading activity, but also about sales price. So, say a seller continually traded a token with their own wallets at an inflated price: the trader loses nothing, as the crypto is always in one of their own wallets. But by doing this, they can record misleading information about the market value of that asset in its transaction history.
When a prospective buyer comes along, they will be more amenable to paying top dollar for the NFT based on its transaction history. The seller makes a profit (their only expense was gas fees for the transfers), and the buyer walks away with a very average, overpriced NFT.
The Curious Case of Crypto Punk #9998
To really show this dynamic in full force, let’s take a look at a recent – and frankly, pretty darn extravagant – example of wash trading in action.
In August 2021, Crypto Punk #9998 was purchased by a crypto wallet (wallet 1) for around $350,000. A bit later in, October 2021, the same NFT was transferred to a second wallet (wallet 2), before promptly being “sold” for – wait for it – $500 million to wallet 3. That’s right – according to this interaction, the NFT had increased to more than a thousand times its original value in the space of just 2 months.
But a funny thing happened immediately after the final sale: the NFT was transferred again. The recipient? The original buyer from August: the sales and transfers made between August and October were all being made by the same entity/person, and the set up was an elaborate stunt.
Let’s call a spade a spade – it’s pretty unlikely this strategy was going to convince anyone the NFT was worth half a billion dollars. But the case still clearly shows the logic of wash trading – and likely stirred up a great deal of attention. The real issue is that most wash trading strategies are not this obvious, and this is why they are such a convincing means for getting unsuspecting buyers like you or me to part with our hard earned crypto.
The Impact of Wash Trading
The negative effects of wash trading extend far beyond the individual sale, and can be seen and felt in a couple of different places in the NFT space.
It doesn’t take a rocket scientist to understand that NFT buyers are negatively impacted by wash trading – imagine buying a hot token for a couple of Eth after carefully researching its history, only to find it’s not really worth much at all. For the individual, wash trading is a raw deal, which is why DYOR and knowing the tools available to help you is so important.
For Artists and Projects
And the impact goes beyond just the buyer: genuine artists in the NFT space are also relying on the data within their NFT smart contracts to track their reputation and credibility over time, a process based on transparency. With bad actors taking advantage of this vector, smart contract history data loses credibility over time, damaging genuine artists.
For Newcomers and the Broader Marketplace
Crypto is a nascent marketplace many people are still uncertain about entering, and scams of this nature further suppress it credibility. So although one wash trade might not seem like much, its existence means people are less likely to trust NFT valuations going forward, or simply not engage with the space at all.
How to spot wash trading
Now we’ve covered the problem, let’s talk about solutions – how can you body swerve this nefarious trading trick?
What we’re really talking about here is being able to spot the telltale signs of an NFT “sale” that is really just a transfer between one person’s different wallets. Here, there’s good news: for the trained eye, some basic blockchain analysis makes it pretty easy to spot a self-financed NFT sale. Here’s a simple diagram of what that normally looks like by the way:
Here, you can see that the NFT appears to have been sold in a straightforward transaction between the marketplace and the buyer. But closer inspection shows that the “buyer” wallet actually received the purchasing funds from the seller wallet – the same person is behind both. There are a couple of things you should be looking out for.
In the sales history of the NFT, if the same wallet address has purchased the token more than once (as in the Crypto Punk #9998 example above) this is a pretty good indicator that sales manipulation might be at play, and can be seen on the interface of marketplace itself.
The other symptom of wash trading is previous crypto transfers from the selling wallet to the purchasing wallet, which indicates the sale is really self-funded. Here, blockchain explorer tools like Etherscan are powerful weapons, because they enable you to search the transaction history of tokens and wallets via public blockchain data. Here, you can see both the sending and receiving address for every transaction, and establish for yourself whether self-funding has taken place. Check out our guide for using Etherescan to investigate transactions for yourself.
Stay Sharp Web3 Frens!
Market manipulation is as old as trading itself, and with the NFT market being a nascent space and something that most people are still getting to grips with, too many opportunists jump in to take advantage of regular people like you and me.
The good news is that by educating yourself on the ins-and-outs of NFT trading and on the tools available to help you, you can arm yourself to avoid schemes like this – and focus on exploring instead.
At Ledger Academy, we’re here to help you do that. See you next time!
Knowledge is power.
Blockchain is about putting the power back in YOUR hands – here, we recap exactly how it works, so you can get the best out of the space. Thanks School of Block.