The House Always Wins
Why cryptocurrency exchanges are complacent when it comes to fighting manipulation.
Imagine, for a moment, going out for a night of gambling at the new casino in town. You sit down at a poker table with your humble chip stack, joining a motley mix of players, none of whom you have met before. Each has their own playing style — some cautious, others aggressive — and as you battle on through the evening, your stack dwindles while the rest of your competitors slowly chip away at your funds, all while the casino partakes in a rake for its share of the pie.
Remember, in any successful casino, the rule stands: the house always wins.
As the evening comes to an end with your stack depleted, you head out, disappointed in your lack of fortune, but reassuring yourself of having enjoyed a fun night out for a few hundred bucks.
But what if it turns out that table full of players all knew each other? What if they were playing together, winning and losing here and there against each other, but ultimately playing as a team, motivated by their collective goal of winning your chips? And what if the casino knew this, but played along with the scheme, reaping their share of the winnings?
This scenario is happening, day in and day out, on cryptocurrency exchanges around the world. And it costs casual crypto traders much of their fortunes all while exchanges happily collect trading fees on every transaction.
So how is this performed in a manner that makes others big money all while your stack is slowly diminished?
The methods are varied and plentiful. Let’s examine a few of the major tools used to move your crypto assets into the wallets of your market rivals.
Wash trading, while illegal in traditional markets, is alive and well on cryptocurrency exchanges. Think back to that poker table in the new casino where you sat down to play. Now imagine every one of those players holds a dozen accounts on your favorite exchange, and uses programs called bots to execute trades for them. Just as those players move chips back and forth between each other in an effort to entice you into calling raises when you shouldn’t, for example, wash trading entices naive traders into jumping into artificial trading volume that is meant to paint a picture.
Perhaps the picture is one that creates a sudden surge in volume, boosting prices as market value climbs skyward on a given currency. This army of trader bots buys and sells a chosen currency back and forth between each other in an effort to attract attention. For these accounts, the trade is a “wash” — no money is collectively gained or lost other than the small transaction fees. This all changes when you join in the excitement with your precious funds, along with other hapless traders, FOMOing into a surging asset and watching excitedly as it climbs rapidly.
And then it drops. Hard. The manipulators sell in concert at a targeted top, causing an instant fall in prices. It turns out this was all just a pump and dump and you are left reeling, either with assets worth half what you put in, or with a loss as you sold your assets in a panic at a discount to your competitors who later gradually restore the price of the currency, again with wash trading, or just by letting the larger market correct itself.
Wash trading can be used as an effective tool to suppress prices by trading downward, as well. Once the price meets a targeted bottom, the wash traders can buy the discarded assets at a deep discount. Wash trading works well on currencies that have little volume and especially well on assets that have relatively small circulating supplies, since buying and selling action will move prices more suddenly in these cases.
It’s important to note that not all wash trading involves pumping and dumping. Often, it is more subtle and simply paints a picture of market movement, creating a self-fulfilling prophecy as other traders attempt to analyse the motions of the market and join in the action. It can even be timed to coincide with news events or fabricated rumors designed to create positive or negative sentiment in the market, thereby creating a believable narrative for market movement.
And the exchange makes a little bit of money on every single little trade as assets circulate from bot to bot, flowing from naive traders to those “in the know”.
Spoofing is a relatively simple tool of manipulation. It involves a trade command being issued that appears to be either a large buy or sell order at a certain targeted price. As the market trends toward this “buy wall” or “sell wall” (a large band of green or red shown on order books that psychologically encourages traders to move prices by buying or selling at a certain price point), the order is cancelled, the “wall” disappears, and trading continues. This can be done manually but can also be executed much more quickly and effectively with bots.
In this case, the exchange makes no money off the “spoofer” directly, since the order is cancelled, incurring no trade fees. However, the exchange does make considerable money off other traders who are enticed to trade by the appearance of greater (or less) demand than actually exists.
One of the most nefarious market cheats is the usage of insider knowledge in crypto trades. In the traditional market, laws against this behaviour are strictly enforced and violations can result in severe legal penalties, but this activity is given pretty much free reign in the wild west of crypto.
In some cases, it’s been alleged that exchanges themselves are taking advantage of the fact that they know trade orders before the general public gets to see them on the order book. When ordered by a user, trade commands can be sent to those “on the inside” in fractions of a second — before appearing to the larger trading public on the exchange. Within this brief opportune moment, a bot can order trades with that extra bit of foreknowledge that other traders do not have the privilege of enjoying. The exchange operator itself, for example, could take advantage of this knowledge to make their own fortune, or could dispatch this information to a select group of elite users — at a price. It’s quite difficult to prove any guilt on the part of participants in this kind of activity, of course, making it all the more attractive as a tool, and potentially very profitable for exchanges.
And there are more blatant kinds of insider trading where a few “on the inside” happen to know of a particular bit of news and can thus buy at a discount before others learn of the event. The most famous example of this in crypto is likely connected to the launch of Bitcoin Cash on Coinbase last year, during which traders witnessed BCH taking off in value just before being launched on the Coinbase platform.
So what is one to do in the face of all this manipulation?
Ultimately, now that you’re armed with a little knowledge, the way you react is up to you. Do your research on reputable exchanges. Trade less. HODL more. Avoid FOMO buying and panic selling, especially with assets that are experiencing relatively low trading volume. Instead, focus on investing in projects you believe have a good future and will, in the long term, provide strong investment returns.
Another way to keep safe? Set aside most, if not all of your crypto savings in cold storage like Ledger or Trezor hardware wallets, or even in paper wallets. This reduces the likeliness of making an impulsive bad trade as it takes that extra step for you to move your funds over to an exchange from the safety of your wallet.
And if you just have to scratch that speculative day-trading itch (trust me, I understand!), set aside a small portion of your crypto as your “play money”; money that you are prepared to lose that will not affect your budget or get you in hot water with your significant other.
It is likely that over the course of time we will see more regulatory controls put in place, but even the heavily regulated traditional stock markets are rife with all kinds of manipulation, so don’t expect any miracle fixes to solve this issue. It’s important to use your knowledge to protect yourself from monetary harm. Don’t count on exchanges, governments, or other regulatory bodies to eliminate this problem any time soon. Sadly, there isn’t a whole lot of motivation, especially for exchanges, to fix this problem as it stands now.
Remember, it’s just like that casino you imagined; in any successful cryptocurrency exchange, the rule stands: the house always wins.