Rinse, Repeat: Wash Trading and the Artificial Inflation of NFT Prices

The sudden boom of interest in NFTs was fairly evident in 2021 as it became one of the most searched items, and was even dubbed word of the year by Collins Dictionary. Likewise, it was found that at least $44.2 billion worth of cryptocurrency — a huge jump from the previous year’s $106 million — was sent to the two types of Ethereum smart contracts “associated with NFT marketplaces and collections,” according to the “NFT Market Report” of blockchain analytics firm Chainalysis.

NFT’s rise to prominence has significantly aided in the mainstream adoption of cryptocurrency. Along these lines, however, the space has also become ripe for scammers and fraudsters to conduct illicit activities on various platforms, especially because it is still largely in its nascent stage. “Money laundering, and in particular transfers from sanctioned cryptocurrency businesses, represents a large risk to building trust in NFTs, and should be monitored more closely by marketplaces, regulators, and law enforcement,” explained Chainalysis.

During the third quarter of 2021, Chainalysis found that funds sent to NFT marketplaces by illicit addresses amounted to over $1 million in cryptocurrency which later increased to just below $1.4 million in the fourth quarter. Moreover, NFTs that were plagiarized, fake, or spam were also rampant. This was evident in the widespread exploitation of OpenSea’s free minting tool, where at least 80% of tokens minted through it was considered as such.

On top of all of this, a practice known as “wash trading” has also become common within the NFT space, where creators aim to boost the value of their tokens artificially. Essentially, the practice involves putting a seller on both sides of the NFT trade to inflate a particular asset. “In the case of NFT wash trading, the goal would be to make one’s NFT appear more valuable than it really is by ‘selling it’ to a new wallet the original owner also controls,” explained Chainalysis.

Chainalysis took a look into wash trading activities on various platforms by analyzing sales of NFTs to addresses that were funded in some way by the seller as well. The analytics firm found that countless users sold their tokens back and forth across similar cryptocurrency wallets at least 25 times.

“Using blockchain analysis, we identified 262 users who have sold an NFT to a self-financed address more than 25 times,” Chainalysis cited in its report. While we can’t be 100% sure that all instances of NFT sales to self-financed wallets are intended for wash trading, the 25-transaction threshold gives us a higher degree of confidence that these users are habitual wash traders.”

At least 110 profitable wash traders have since been identified, collectively racking up around $8.9 million. Despite the apparent growth of this particular practice, Chainalysis director of research Kim Grauer notes that this isn’t exactly an effective strategy, especially given the exorbitant gas fees that these users are required to pay for every transaction made. “Many wash traders came out negative due to the amount spent on gas versus the amount generated from their sales,” added Grauer.

However, the results presented by Chainalysis are confined to wallets of the same address which might just be a small fraction of the larger problem. Wash traders who are well-versed in the act would most likely be able to conceal this if they use different wallets or conduct it across various platforms.

“What this data set looks at is, of the individuals who were selling NFTs at scale, how many of them are actually just funding their own wallets?” Grauer elaborates. “This is a risky type of crime to carry out, and even riskier given that people have to pay large gas fees. Those who do this at scale have to be experienced.”

Amidst the caveat of unprofitability, Grauer is firm in her belief that wash trading will most likely continue to spread throughout the NFT ecosystem precisely because it’s fairly easy to get into. Co-founder and head of product at Rarible — another NFT marketplace — Alex Salnikov attests to this fact noting that their platform has seen a similar pattern, as well as on other marketplaces that offer trading incentives.

Their LooksRare platform had previously planned to provide users with RARI, its native token, whenever transactions were made. Rarible’s decentralized autonomous organization (DAO) has since voted to stop the token distribution, fearing that it might add to the prominence of wash trading. Hence, “the issue is no longer relevant for our marketplace,” remarked Salnikov. He furthered that Rarible has launched its own verification system allowing them to review a creator’s profile.

“If this process is successful, the user will earn a yellow checkmark on their Rarible marketplace profile. It is important to note that collectibles from unverified creators do not appear in our search results or the explore feed. Users are also warned if they are about to purchase a collectible by an unverified creator or collection.”

OpenSea has also followed suit with the creation of its “NFT Security Group” which it announced on January 17. Chainalysis has also partnered with blockchain platform Dapper Labs to continue to monitor attempts of wash trading alongside other unauthorized activities. Regulating NFTs can be quite tricky, but oversight might not be such a difficult thing to accomplish echoes Shyft Network co-founder Joseph Weinberg.

“I think trading platforms that accept funds — like an OpenSea, for example — will inevitably become regulated as VASPs [Virtual Asset Service Provider], as they are in the business of matching to counterparties and they accept fees. As far as how NFTs could be regulated, you can do things like multi-address hop detection and address screening to cluster and determine if there’s a likelihood that people are wash trading,” said Weinberg.

He admits, however, that art markets are likewise highly unregulated environments, and the NFT space shares this attribute. “Historically, it’s known that art markets are not subject to KYC [Know Your Customer] and AML [Anti-Money Laundering] requirements. It’s also widely known that the art world is where a lot of money laundering takes place — and has for a long time. The question that needs to be asked is if the ‘form’ is different from the ‘function’ because a token has a different set of use cases than a piece of paper.”

Skale Labs CEO Jack O’Holleran believes that as regulators take time to release guidelines for NFTs, the community will most likely step up to plate. “End users will not want to purchase NFTs from sites that don’t clearly remove or call out overt wash trading numbers. NFT traders and purchasers will move their business to exchanges and data aggregation sites that give them real views of market data,” he explained.

Wash trading, along with other challenges, will most likely remain as the NFT ecosystem continues to develop. “My prediction is that the sector will get worse in many ways before it gets better with industry solutions. It’s possible that some NFT platforms will adopt compliance to help things progress,” predicted Grauer.

Nonetheless, it is important to understand that there are already certain actors making the necessary efforts to curb these activities, which could ultimately boost trust in NFT markets as it moves along. “Our report demonstrates that thanks to the inherent transparency of blockchains, NFT platforms with the right data and tools can effectively monitor their platforms to shut down and prevent abuse such as money laundering,” Grauer added. “NFT platforms should consider rules against wash trading on their platforms to build more trust in this asset class.”

References: CNBC, NBC News, Hypebeast, CoinTelegraph, Forbes