Is Wash Trading Permissible?

 

Have you heard of wash trading? This tactic is common in Cryptocurrencies and NFTs, and many are concerned about its impact on market integrity. In this article, we will discuss how wash trading works and its mechanics. On the other side, we will explain the Shariah perspective on this activity.

Wash Trading: What Is It?

Wash trading is a deceptive strategy used in financial markets, where traders repeatedly buy and sell the same asset to boost its trading volume and price artificially. This misleading activity creates a false impression of demand. Although it’s illegal in traditional markets, it is increasingly found in cryptocurrency and NFT platforms due to their weaker regulatory oversight. This practice distorts the market, misleads investors, and misrepresents the true value of digital assets.

Mechanics Wash Trading

In cryptocurrency, wash trading typically involves a trader using multiple accounts on an exchange, often with the help of bots. The trader places simultaneous buy and sell orders for the same token to ensure the trades match. For example, one account buys 10,000 tokens at $1 each, while another account sells the same 10,000 tokens immediately after the buy order is executed. Because the trader controls both accounts, these trades occur instantly, giving the appearance of high market activity without any real market risk. The trader repeats this process to inflate trading volumes and potentially attract other investors. Over time, they can gradually increase the token's price, tricking others into believing it’s gaining momentum.

 

Legal Perspective: Does Authority Take Action?

Securities and Exchange Commission US (SEC)

 

The U.S. Securities and Exchange Commission (SEC) has regulations to protect investors from wash trading activities, but the coverage differs between traditional capital markets and cryptocurrencies. 

1. Traditional Capital Markets: In traditional capital markets, wash trading is a prohibited practice that involves buying and selling the same security to create a misleading appearance of market activity. This manipulation is explicitly banned under various regulations, including:

• Securities Exchange Act of 1934: Specifically, Section 9(a)(1) prohibits wash trades and other manipulative practices.
• SEC Rule 10b-5: This broad anti-fraud rule can be applied to activities involving wash trading.
• FINRA Rule 6140: This rule prohibits members from executing wash trades in any security.

These regulations are designed to maintain market integrity by preventing deceptive practices that can mislead investors about the true demand and trading volume of securities, thereby protecting the overall fairness of the financial markets.

2. Cryptocurrencies: The regulatory environment for cryptocurrencies is complex and still developing. Most cryptocurrencies are not classified as securities by the SEC, which means the agency has limited authority to regulate them directly. However, if a cryptocurrency is deemed to be a security based on the *Howey Test*, then SEC regulations, including those against wash trading, would apply. For cryptocurrencies that do not fall under the securities classification, the SEC's regulatory power is quite restricted. This creates a unique challenge in ensuring fair trading practices in the cryptocurrency market.

3. Other Markets: The regulatory landscape for other markets involving cryptocurrencies is multifaceted. The Commodity Futures Trading Commission (CFTC) has claimed some authority over cryptocurrency markets, viewing many cryptocurrencies as commodities, and it prohibits wash trading in commodity futures markets. In 2022, the SEC proposed new rules to broaden the definition of "exchange," which could potentially include certain cryptocurrency trading platforms, thereby bringing them under SEC regulation. Additionally, while some individual cryptocurrency exchanges have their policies against wash trading, the enforcement of these rules can vary significantly, leading to inconsistencies in how wash trading is addressed across the market.

Securities Commission Malaysia (SC)

Although there are no specific laws addressing wash trading in the capital market in Malaysia, in general, there are existing regulations regarding market manipulation that are similar. For example, Market Misconduct provisions under the Capital Market and Services Act 2007 (CMSA) prohibit fraudulent activities, including practices like market manipulation, insider trading, and false reporting. This means that any form of market trickery or manipulation, such as wash trading, is likely to be illegal under the guidelines provided by the Securities Commission Malaysia (SC).

It's important to note that the rules for cryptocurrencies are changing rapidly. The SEC and other regulators are actively working on creating better, more comprehensive guidelines to address issues like wash trading in the crypto world.

Wash Trading in Shariah Perspective

As we have discussed previously, wash trading is an illegal activity, and investors are protected under the regulations set forth by capital market authorities in their respective countries. However, what is the Shariah perspective on this practice?

According to Irsyad Al-Fatwa Series No. 590 from the Pejabat Mufti Wilayah Persekutuan, deceptive practices, such as sellers buying their products to leave fake reviews, are classified as "gharar" (deceit) and are prohibited in Islam. While buying and selling are allowed, creating false impressions for profit is unethical. Sellers should promote their products truthfully and refrain from misleading others.

This applies similarly to crypto wash trading, where traders artificially inflate trading volumes by buying and selling the same asset to trick others into thinking there’s more demand. Similar to fake reviews, wash trading is deceptive and goes against Islamic principles of honesty, fairness, and transparency. Both actions mislead people about the true value of the product or asset, which is not allowed in Shariah. 

In Islam, deceitfulness is considered haram (forbidden) except in very specific circumstances. The Quran and Hadith emphasize truthfulness and condemn deceit. 

For example, the Prophet Muhammad said, 

إِنَّ الصِّدْقَ يَهْدِي إِلَى الْبِرِّ، وَإِنَّ الْبِرَّ يَهْدِي إِلَى الْجَنَّةِ، وَإِنَّ الرَّجُلَ لَيَصْدُقُ حَتَّى يَكُونَ صِدِّيقًا، وَإِنَّ الْكَذِبَ يَهْدِي إِلَى الْفُجُورِ، وَإِنَّ الْفُجُورَ يَهْدِي إِلَى النَّارِ، وَإِنَّ الرَّجُلَ لَيَكْذِبُ، حَتَّى يُكْتَبَ عِنْدَ اللَّهِ كَذَّابًا

“Truthfulness leads to righteousness, and righteousness leads to Paradise. A man keeps on telling the truth until he becomes a truthful person. Falsehood leads to wickedness, and wickedness leads to Hell”

(Sahih Bukhari)

Deceitful practices, such as wash trading, are not only prohibited in Islam but are also condemned in many major religions, indicating that such practices are unethical. 

Reasoning on why wash trading is prohibited:

1. Speculation (Maisir): Wash trading is often associated with speculative behavior, which is forbidden under Shariah. Islamic finance emphasizes that transactions must be based on tangible assets and genuine economic activity, rather than speculation or gambling.
2. Deceptive Practices: Wash trading involves executing trades where the seller is on both sides, creating a misleading impression of an asset's value and liquidity. This manipulation contradicts the Shariah principle of transparency and fairness in financial transactions, as it can lead to exploitation and injustice among market participants.
3. Asset-Backing Requirement: Shariah mandates that all financial transactions must involve real assets or services. Wash trading typically involves the exchange of the same asset without any change in ownership or risk, which does not meet the requirement for legitimate asset-backed transactions.
4. Prohibition of Bay’ al-Inah: The practice of wash trading can be likened to bay’ al-inah (back-to-back sales), which is specifically prohibited in Islamic banking practice nowadays because it involves trading the same object at different prices without a legitimate purpose.

 

Conclusion

From our standpoint, wash trading is illegal and against Shariah principles. It deceives investors by creating fake trading volume and prices, giving the illusion of demand. While traditional markets have rules against this, it happens more often in less regulated areas like cryptocurrency and NFT markets. We urge traders to be careful, avoid dishonest practices, and keep learning. Since deception is forbidden in Islam and other religions, it's crucial to be honest in all financial dealings.