The vast majority of crypto transactions on unregulated exchanges are essentially fake, giving the false impression of a much higher trading volume.
A recent study featured by the National Bureau of Economic Research estimated, in fact, that an average of 77% of such trades are essentially wash trades — basically, investors simultaneously selling and buying the same financial assets to create artificial activity in the marketplace, which is known to distort prices, volume and volatility, and reduce investors' confidence and participation in financial markets. Sometimes this gets as high as 80%, depending on the exchange.
To find this out, researchers examined the cryptocurrency transaction information on 29 major exchanges, using a proprietary database maintained by TokenInsight , a data provider that offers consulting, rating and research reports for cryptocurrency-related businesses.
The final sample contained 448,475,535 transactions. The study examined only Bitcoin (BTC), Ether (ETH), Ripple (XRP), and Litecoin (LTC), which represent over 60% of cryptocurrency volume and are available on almost all exchanges.
Then, researchers examined the distribution of the first significant digit for transactions on each exchange against Benford's law . Next, they exploited a classical behavioral regularity in trading: clustering at transaction sizes of round numbers — cognitive reference points in individuals' decision-making. Finally, they explored whether the distributions of observed trade sizes have fat tails characterized by the power law as seen in traditional financial markets and other economic settings.
"These estimates translate into wash trading of over $4.5 trillion in spot markets and over $1.5 trillion in derivatives markets in the first quarter of 2020 alone," said the paper.
This serves to make the exchanges appear much more active than they actually are. For instance, one of the unregulated exchanges has an average volume of $50,944 million; in contrast, a regulated exchange in the sample had a volume of $15,212 million. However, while there is a tendency for unregulated exchanges to have higher trading volumes, the researchers said there can still be significant variation, pointing to one unregulated exchange that only has a volume of dozens of millions of dollars, versus a large number of similar exchanges that process tens of billions.
The paper said that one effect, though, of unregulated exchanges tending to display higher volumes is that people become more likely to choose that exchange, at least based on web rankings.
"We find regulated exchanges ... fall behind many unregulated Tier-1 exchanges in their ranking based on web traffic. ... Although trading-volume ranks cannot fully represent the quality and liquidity of exchanges, it is used by most ranking agencies. Thus, cryptocurrency investors are likely to choose an exchange based on these trading-volume-based ranks," said the paper.
Not all crypto exchanges, however, were found to have such rampant wash trading. The study said it was all but absent in regulated exchanges (which makes sense, as the practice has been illegal since 1936). Further, in the world of unregulated exchanges, the longer the entity has existed and the larger its user base, the less wash trading occurs; conversely, the less established the exchange the more likely wash trading is to occur, with the paper saying there are powerful business incentives to allow it.
"One would anticipate that unregulated exchanges, especially ones that are launched later, are motivated to engage in wash trading in order to achieve higher rankings and acquire more customers," said the paper.