The following are factors that contribute to market manipulation in cryptocurrency markets. I recently built a massive-multi-player trading game for cryptocurrencies as a research project for a (real) decentralized exchange that is launching in December to analyze order-flow dynamics, market making, trader psychology, trade execution strategies, bot interactions, risk management, spread dynamics, conflicts of interest, margin lending, market microstructures, etc.

As I worked on simulating all of these elements of the game, which operates as a futures contract market for volatility indexes made up of baskets of cryptocurrencies, a few things happened. I began cracking open textbooks like Trading & Exchanges: Market Microstructure for Practitioners (expensive, but highly recommended), performing quite a bit of machine learning processes on trade data, and talking with experienced derivatives traders in our network.

What I learned through all of this was the following, regarding market manipulation. This is not so much restricted to cryptocurrencies. This is punctuated in crypto-markets, as I’ll dive deeper into throughout the list. This could probably be its own book if I try to explain it all, so I’ll focus on the main point for each (vastly simplified). If any of these explanations are confusing, just leave a comment. I’ll try my best clarify in comment responses.

There is a misunderstanding about deposits

When you deposit funds with an exchange, you’re actually lending them money. If you ask for it back, they have to give it to you, right? It’s a loan from you to them (retail investor to exchange). Now, what if you knew that your car loan could go from $20,000-owed to $0? You would get the car, you don’t pay any money: Great. Crypto exchanges are giving you the ability to trade (the car). They are you in the car lending situation. Now, what if you knew that 90% of car dealerships actually reduced your loans from $20,000-owed to zero. Easy to take out the loan, right? Same for crypto exchanges. The more deposits people make, the more money they produce, because the majority of loans will not need to be repaid. As long as the exchanges can make sure this happens. Many of the lenders will come back after their loans are reduced to zero. This is the foundational element to the whole thing. Which leads us to the market makers.

2. Market maker credits lines & incentives are everything

Who are the market makers? In cryptocurrency exchanges, it can be the exchange itself and/or associates. 99% of exchanges don’t let you know who you’re trading with. Good luck trying to get that information. Call your regulator. They can’t tell you. Call the exchange: they will tell you anonymity is key. This is a major advantage for exchanges. When building my game, I realized that at any given time, you have a percentage of people on the long side and short side of any given trade. Your job, if you wanted to make returns, would be to make the biggest side of each trade the loser. How and why? House money. The exchange can move prices anyway it wishes, as long as it can pay back its “loans” from users. The best way to do that is by reducing the loans. On an exchange, money is just credit in a database that can be adjusted higher for the exchange to move prices to a place that reduce its loans (from where the largest positions are) and produce profits. Which leads us to the next factor.

By the way, you might have noticed there are “maker fees” (lower or negative) and “taker fees” (always higher). These incentives for market makers, which essential pay market makers to make markets for exchanges create a pretty huge conflict of interest between the massive makers/exchanges and everyone else, as the massive makers are required to provide liquidity so that everyone else can give exchanges “loans” for what they are paying for: the ability to trade (liquidity).

3. “Zero-sum” is a friendly phrase with serious implications

It’s a popular statement: “Trading is a zero-sum game.” On every trade, someone is ultimately winning or losing, unless the price never moves. Prices not moving is something that doesn’t really happen… ever. The exchange’s incentive is to make the largest side of most trades the losing side of those trade (less loan repayment). It’s kind of like a casino. Sure, you have those high-rollers who come in an sweep the house occasionally, but statistically, the longer they stay in, the more they lose. Unless, they understand the cardinal rule: just bet against the crowd. Problem is: exchanges make the data on how much margin, who is shorting (borrowing assets) in the sell positions, and so-on, which means you pretty much can’t know. The exchange and their associates can know. Major advantage. Major probably an understatement. The biggest cryptocurrency asset managers and brokerages also happen to build crypto exchanges. Coincidence?

4. There isn’t a “conspiracy”. It’s more “common sense”.

So, this could seem like a “conspiracy”. It might sound like the exchanges and the asset managers (that work closely with the exchanges) have it out for everyday people. I’d like to think of this more as common sense if you understand market dynamics. Market participants are volunteering to do this after all. Now, regulators have worked in traditional markets to create more transparency, which means that it is harder to do the kinds of things I’ve outlined. However, from many experts I’ve consulted, it is just a foundational element to it all. This is why the largest financial institutions seem to be mostly on the winning side of trades. If you look at job ads by the trading desks of these “winning”, “large” firms, they want candidates to have good knowledge of trade execution and market microstructures (which is fancy-speak for “know the above to work there”).

5. Spoofing, pump-and-dumps, wash trading is child’s play

Usually, when people talk about market manipulation, they are referring to the classic pump-and-dump. You really pump a market in order to sell it off for more than you bought it for, due to the “greater fool”. Then, there is wash trading where you take both sides of a trade at no fee to demonstrate volume. Sure, creating volume makes traders more excited about participating. It is kind of like a crowded restaurant makes you want to go inside. However, why gamble on market sentiment? It’s like witch-craft. Leave that to retail investors and their “technical analysis”. You honestly can’t know whether a market is going to buy a “pump”, or if you can “dump” at a good price. These things happen, but they pell in comparison to the collusion between market makers and exchanges to move prices up and down. These “manipulated” price movements, slowly crack away at the amounts of trader “loans” that need to be repaid by exchanges. Your proverbial car just keeps getting cheaper and cheaper. And more and more profitable.

Bonus: Margin Lending

There is a misconception that lending is involved when an exchange gives a trader margin. Or, in some cases, when traders “lend funds” to other traders for margin trading, as in the case of Bitfinex. From building the algos, I can tell you very much this is not the case. It took me a while to wrap my head around and a few long nights of coding as I was trying to work on a lending engine. Pointless. Going deeper into this will require another post; however, here’s the point: if you do 10x margin, and the price goes down 9%, all your funds are gone. Exchanges just analyze how many people are on both sides (buy and short-sell) of this trade. You move the price to where loans are reduced and all the “winnings” are just paid by the other side, plus of course the fat profit on the difference.

Some may ask about exchanges that don’t offer margin and shorting like BitMex (the largest). It’s not exactly clear that their market markets and other special accounts aren’t able to open short positions and trade on margin. This large transparency gap lends itself to market manipulation.

In Conclusion

People often point to the cryptocurrency Tether and their relationship with the crypto exchange Bitfinex as signs of market manipulation in cryptocurrencies. This could be seen as a distraction if you look at the broader credit picture with exchanges and their fiat. Bitfinex might be the most accountable, in fact. Bitfinex only takes up a small percentage of the market now (less than 5%) and have something that’s at least audit-able regarding the money supply (granted it might not be backed by anything). We have to remember that pretty much every bank has 10% or less of their deposits (fractional-reserve banking). If Tether is scamming people, they aren’t really doing anything regulated institutions are lawfully doing now. The bigger concern might be those exchanges that don’t use a fiat-pegged cryptocurrency with an audit trail… but that would be most crypto exchanges and traditional exchanges alike. Another topic, entirely.