The role of a matching engine is to match up bids with offers in order to execute trades. This is the core function of a digital asset trading platform such as LGO, and in order to uphold our values of fairness and trust, it is crucial to identify the best balance for all investor types and order sizes issued.

As described in Part 1, we have considered utilizing one or several algorithms (mainly FIFO and pro-rata) offering traders and investors a large set of trade allocation strategies among competing bids and offers at the same price.

Unfortunately, far too often, matching engine algorithms are used to manipulate the market, leading to a lack of transparency and simply unfair situations.

Drifts observed on the market

The cryptocurrency market is highly complex to manage and regulate, and some may even go as far as to say it is “easy” to manipulate the market. The fact of the matter is that all you really need is money… a lot of money to manipulate the price of cryptocurrencies on some of the trading platforms that currently exist. The top cryptocurrencies such as Bitcoin are highly traded but these market volumes are very low when compared to the stock market. This is understandable since cryptocurrencies are still considered relatively new, but that doesn’t change the fact that big players can potentially manipulate prices with relative ease.

A symbolic example is the malicious use of pro-rata algorithms. The pro-rata gives more motivation to small market participants as their orders are executed progressively at the same speed as major buyers in the trading platform. Unfortunately, we are faced with abusive behaviours which can quickly lead to a situation that benefits only a small number of participants.

Because the order lots are divided in proportion to their size, some traders can send orders with a substantial quantity of lots in order to acquire the majority of an order at a desired spot price. Some large traders generate huge lot sizes to increase their chances of matching first and then cancel the operation once a certain number of trades have been executed. It gives an arbitrary advantage to those who have the necessary capital to take the risk of buying or selling more shares than what they need.

In crypto exchanges, the most common methods used to abuse matching algorithms are known as “spoofing” and “layering”.

Spoofing

“Spoofing” is an illegal type of market manipulation that works like bluffing.

“Spoofing” is a practice in which traders attempt to give an artificial impression of market conditions by entering and quickly canceling large buy or sell orders onto an exchange, in an attempt to manipulate prices. — markets wiki

For instance, someone pretending to be an interested buyer in an art auction would be bidding on his own piece — this is Spoofing. A seller would place non- bona fide orders by always raising the bid in an effort to make the last remaining buyer pay more than expected. Of course, the spoofer here takes a risk of buying their own art piece, but that is the risk he/she knows they are taking and as mentioned previously, to manipulate the market, one needs a lot of money.

Ronnie Moas, founder of Standpoint Research, made a clear statement explaining how spoofing allows individuals to manipulate the market: “If you have $2 bln, you want a diversified portfolio,…But you don’t want to pay $20,000 for a Bitcoin, so what you do, you dump $20, $30, $40 million dollars on the market, and create selling pressure. People see those orders on the books, and they jump in front of them because they are afraid you are going to move and shake the market down, and this feeds off itself.”

Pressure leads to panic. And if a large holder chooses to spoof the market, all he/she would need to do is place an enormous number of sell orders with the sole goal of driving the price down. The visibility of these orders in the order book could push some market participants to sell their orders immediately, causing a significant drop in the price.

Layering

Layering is a variant of spoofing. Rather than placing a single large order, the layering trader places multiple visible non-bona fide orders to create the false impression of buying/selling demand in the order book. This mechanism will inevitably drive the market price down. The layering trader then quickly cancels the orders and makes real ones that allow him/her to obtain opposite-side executions at a more favorable price.

Traders use layering to change prices to work to their own advantage. They send fictitious buy orders (bids) to drive prices up and then they sell high; likewise, they introduce fictitious sell orders (offers) to drive prices down so that they are able to buy low. The malicious goal of layering is to distort market participants, as well as the public, perception of the true supply and demand levels within the market.

Regulation, traders, exchanges

The law is clear on the fact that placing orders with no intention of actually executing is completely illegal and punishable by law in most countries.

In May 2013, The Commodity Futures Trading Commission (CFTC) issued a staff guidance on disruptive trade practices and brought several civil spoofing cases.

However, despite efforts from regulators around the world, it continues to be a challenging and difficult task to characterize spoofing behaviour, as there are many justifiable reasons to cancel one or a series of orders. Given the relative infancy of the crypto market, this makes it a target for manipulation attempts, and it is up to the trading platforms to take responsibility and fight against spoofers by setting up monitoring features to detect spoofing/layering patterns, analyzing traders behaviours and applying the necessary measures. Market manipulation is attractive to some traders because of the potential to make a lot of money, but this practice undermines confidence in the cryptocurrency market as a whole by creating a climate of uncertainty and a lack of trust.

Of course, these practices are inconsistent with LGO’s values. We believe that a fair digital asset trading platform is built around a solution designed to spot and avoid phantom orders while rewarding both liquidity providers and market participants. This is why we will never define order matching priority rules that will permit malicious behaviour to occur on our platform — never creating a sense of frustration and disadvantage amongst our users.

Creating a trustful crypto market environment must be the goal of all actors involved in the crypto eco-system, particularly trading platforms by proposing fair and transparent order matching algorithms.

This really is a matter of exigency for LGO to be a leading fair by design platform.