Efficacious methods to tackle wash trading with NFT Marketplaces
There is no doubt that NFTs are selling like hotcakes (digitally). Christie’s sold a digital collage by artist Beeple for $69.3 million at the NFT auction in March 2021. When you start translating the real into hyper-real, you see endless scenarios that capture people’s imagination. Nevertheless, as with any shiny new toy, there have been fraudsters appearing within the binary code.
The manipulation of NFTs is similar to what we’ve seen with more traditional crypto assets, such as Bitcoins. Hacking wallets and stealing the NFTs is not just another scam, but a process through which it’s possible to assign multiple ownerships to digital designs using the NFTs.
Users have to submit their social media handles for NFT verifications, but the entity submitting these details need not prove ownership. Digital works have been fraudulently miss-sold due to this practice. Did we just create yet another avenue for crypto-crime instead of simplifying it?
Wash trading is widespread on centralized cryptocurrency exchanges, as well as the NFT industry. Our mission is to warn you about the possibilities that keep NFTs a bit too clean. Knowing how to recognize frauds and scams will make it easier to avoid them. Isn’t it? But first, what are NFTs?
Non-Fungible Tokens. Okay, we understand that doesn’t make it clear. Right?
NFTs are a new form of digital asset that operates on blockchain technology. In general, NFTs do not rely on Ethereum, but they use its blockchain. A concept known as non-fungibility is essential to differentiate their function and value from fungible tokens, such as Bitcoin and Ether, which can exchange like-for-like. You can dwell more on it here!
With that in mind, our next focus point is on how wash trading takes place in NFTs.
What is Wash Trading?
When traders engage in a wash trade, they buy and sell securities to create a misleading market signal. When traders and brokers collude, they can make wash trades. Investors can also make wash trades if they act as buyers as well as sellers.
To understand it better, let us see how wash trading happens in the crypto market.
Basically, cryptocurrency wash trading involves companies trading with each other in order to create the illusion of liquidity or manipulate the value of assets being traded. There are strong economic incentives for cryptocurrency exchanges to influence market prices and inflate trading volumes as cryptocurrency exchanges generate revenue by charging transaction fees to gain market share and attract traders.
As a concept, NFT wash trading applies to the purchase or sale of non-fungible tokens not intended for acquisition. Below are a few more concrete examples:
- Buying items to simulate artificial demand for a specific project
- Purchasing assets or rights to create false publicity for a publisher, artist, or platform
- Artificially inflating metrics by purchasing assets
- Collecting rewards with assets that are more valuable than the cost-of-attack
Cost-of-attack is an estimate on the losses incurred due to an illegitimate/wash trading that takes place in various industries, stocks, or NFTs.
As a result, the global ecosystem suffers in both the short and long term. How? Let’s dive deep.
How does Wash Trading happen with NFTs / NFT marketplaces?
Many buyers pay large amounts for the right to acquire virtual collectibles in the form of NFTs, which give them exclusive ownership of digital assets. Why these unique digital tokens have sold for such a high price is a concern for many people.
Some argue that the popularity of NFTs has risen primarily as a result of Bitcoin’s unprecedented popularity. Currently, BTC , the global leader in digital currency, has a market cap worth well over $1 trillion, with the current BTC price at the$45,000 mark. People who have made significant profits from holding cryptocurrencies may now use those funds to purchase digitally scarce NFTs.
It appears that there is a nefarious suggestion now being spread on various Twitter feeds, message boards, and blogs, alleging that the surging prices are due to wash trading, and we can’t deny that.
But, how does it happen? A lot of cases are difficult to prove, but let’s explore and dive deeper into the these issues.
Bloomberg reports wash trading as crypto’s open secret, and serious concerns have come up about these practices since the advent of crypto assets. It is easy for identities to become abstracted in an all-digital environment, where virtual wallet addresses can have complex alphanumeric symbols, so claiming wash trading may seem plausible but becomes difficult to prove.
It may be necessary to use forensic accounting methods such as Benford’s law as well as performing a careful analysis of trade size distributions to see how they correspond with mathematical principles such as Pareto-Levy.
The law of anomalous numbers, also known as Benford’s law, or the first-digit law, describes how fractions that appear in real-life numerical data are distributed, and numerical data can be used to detect fraudulent behavior.
As outlined in the Pareto Principle, roughly 80% of outcomes result from 20% of causes, suggesting that inputs and outputs are not equal.
Although the laws claim to help in detection, there is no evidence of something caught in the act of wash trading. But we can explain this better with the LIBOR example.
Examples of Wash Trading
A wash trade has no commercial value and cancels the other out. The LIBOR scandal used wash trades to pay off brokers who used the LIBOR submission panels to manipulate the Japanese yen. UK authorities alleged that they executed nine transactions with a brokerage firm to generate 170,000 pounds as compensation for its role in LIBOR rate manipulation.
It is also possible to use wash trades to pump out fake numbers for an NFT. Consider the case of a colluded buy-and-sell arrangement between a trader XYZ and a brokerage company ABC. ABC may witness activity by other traders, who may purchase the stock to take advantage of its price movements. The NFTs then become less valuable, resulting in profiting from its downward trend.
With that trend, if the NFTs wash trading is detected, it can affect the coin price dramatically. But, there is also a considerable effect on the marketplace.
Why is it a problem in the NFT marketplace?
Regardless of who is involved, illegitimate/wash trading is detrimental. Whether for projects themselves, traders, investors, or a global network of enthusiasts.
In terms of platform growth and reach — Projects no longer have reliable statistics. An essential part of their process is to determine and record the actual use versus fabricated use. It will be incumbent on project workers to maintain realistic expectations and correct misinformed users. Below are the groups affected by such, and why.
Due diligence becomes increasingly challenging as investors rely on measurable statistics. Specialists must review the data for discrepancies.
Collectors and traders
They can’t make an informed decision. It is easy for users to draw uninformed conclusions when misled by inaccurate statistics and history about a piece of art or collectible.
Amongst the most affected is the community as regulations and mainstream financial services proponents can now use wash trading to argue against decentralization. As we accept more social norms (property rights, financial practices, marketing strategies, etc), the technology will be adopted and more widely accepted.
So, with NFT markets and traders being widely affected by wash trading, is there a possibility to detect it in the first place? Theories prove it on paper. How’s that?
How is Wash Trading identified?
Early detection is primarily achieved through the use of graph clustering and nearest neighbor algorithms. However, a related phenomenon called “collusive cliques” has also been researched.
On aggregated order volume time series, hidden Markov models, spectral clustering, and correlation statistics are other methods that help. Check out more about how these models can help in identifying complex sequence data, fraudulent activities, and failure detection.
One of the first studies to explicitly examine wash trades in the markets was by Cao et al. According to Cao, prior studies focused primarily on collusive and correlated trading patterns rather than wash trading’s more specific form.
A given set of trades consists of subsets that result in no position change to the traders involved. Based on their topological structures, these trades comprise a closed cycle. A closed-cycle trade is one that does not engage in exchanges with other economies. Closed economies are completely self-sufficient, which means no goods are imported or exported.
Although this sounds very much sorted on paper, in practice, it needs an ecosystem that can detect wash trading in NFTs for real. Do we have a solution for that? Yes!
Detecting wash trading the Scour way!
With Scour, fraudulent activities can be identified with higher precision and practicality. However, with multiple methods to wash trade, wash traders continue to come up with new ways to wash trade, even when caught. Thus, new wallets are created to try new methods.
Still, Scour was able to reduce wash trading by over 40% within two months.
How does bitsCrunch’s knowledge graph provide a solution to Wash Trading?
Even though NFTs are easily distinguishable, the holders’ identities are still anonymous, making fraud detection difficult. To overcome this, Scour is upgraded every week to keep data relevant and up to date, so new possibilities and methods of wash trading can be detected and prevented through in-depth analysis on all NFT marketplace activity.
Scour is an all-encompassing product created by bitsCrunch, an AI-powered analytics company that can actively discourage wash trading in exchanges.
The Scour index compiles transactions, wallet addresses, and distributions of reward tokens and uses knowledge graphs and AI technology to identify bogus orders and complex patterns of wash trades. The technology not only secures investors and markets, but also solves the open secret of cryptocurrencies.
Together with industry leaders such as Covalent, Rarible, and Deeplearning.ai, bitsCrunch built Scour with a detailed knowledge graph that includes a complete index of transactions in NFT marketplaces.
At its core, Scour is an AI product that flags the spoofing activity among traders to protect marketplaces from its market-mining operations. Need to identify complex wash trade transaction patterns and prevent malicious trading wallets? Get in touch with bitscrunch!
bitsCrunch is the Guardian of the NFT ecosystem. We are one of the top 4 AI companies in Munich, Germany that excels in Blockchain technology. We believe that blending a proven technology like Artificial Intelligence with Blockchain technology can do wonders and make the ecosystem much more safer and reliable ! Our mission is to create impactful insights from intricate data sources, by harnessing predictive analytical systems which are empowering organizations with actionable intelligence.
- AI-Enhanced Safety Feature (SCOUR), An AI agent that acts as a watchdog to flag the spoofing transactions that manipulates both volume and price of the assets in the NFT ecosystem.
- Digital Asset Forgery Detection System (Crunch Davinci), An AI model that flags forgeries, copycats and bootleg digital art contents thereby protecting the artists and their creations.
- Fair Price value estimation for an Asset(Liquify), A fair value estimation & analytics for Digital Assets (NFTs) using AI to empower the community to embrace and value their assets in real-time.