The crypto economy: What is wash trading and why should I care?
A report issued by the Blockchain Transparency Institute (BTI) in mid-December (2018) alleges that the practice of wash trading is pervasive throughout the world cryptocurrency exchanges.
The Institute's conclusions were based on an analysis of volume data points and order books. If their analysis is correct, it would indicate that the crypto economy is not all that it appears to be.
What is wash trading, and why should you care? That is what we hope to explain in this post. Bear in mind that most of what you read relates primarily to cryptocurrency investments. It has little bearing on using something like bitcoins to play at your favorite online casino. There is no need to panic.
Cryptocurrencies as investments
It must be understood that the problem of wash trading is rooted in the fact that large-scale investors treat cryptocurrency as an asset rather than a means of conducting day-to-day transactions. It is no different than FOREX traders who look at fiat currencies as hard assets rather than a tool for paying their bills.
All assets traded by investors derive value through a combination of two things. First is the intrinsic value of that asset as demonstrated by its liquidity. For example, gold has an intrinsic value based solely on the fact that you can sell it for cash. Any asset with no intrinsic value is, in fact, worthless.
The second driving factor in asset value is supply and demand. Like stocks and shares, the value of cryptocurrency goes up as demand increases and supply decreases. The value goes down in the opposite scenario. This is where trade volume and wash trading comes into play.
How wash trading works
The simplest way to understand wash trading is to see it as a way of buying and selling assets solely for the purpose of increasing volume. In the cryptocurrency world, you could have an exchange owner set up a bot to continually buy and sell various coins back and forth. The idea is to buy and sell quickly in order to give the appearance that there are a lot of people buying and selling that day. Doing so artificially inflates volume.
It's called wash trading because the exchange isn't actually making or losing money. Transactions happen so quickly that daily profits and losses are essentially a wash. The question is, why would an exchange engage in such a practice?
It is all about volume. In the world of assets, volume is used by investors to gauge the interest in a given asset. If volume is high on any given day, investors know to look at the asset's value. High-volume and rising value indicate positive interest among investors. High-volume and declining value indicate a selloff.
The BTI speculates that exchanges are engaging in wash trading in order to manipulate the value of a few chosen cryptocurrencies. By artificially inflating volume in relation to current price, they can encourage investors to either buy or sell accordingly.
If the BTI is correct, upwards of 80% of the CMC top 25 BTC pairs are being manipulated by wash trading source. That is pretty significant. Their analysis suggests that the volumes being reported by most exchanges are not even close to being accurate.
Making money on listing fees
All of this begs the question of why exchanges would engage in wash trading if they do not actually own the coins being traded. The answer is found in listing fees. Exchanges make their money by charging sellers for the privilege of listing with them. Some of them even charge buyers a transaction fee.
Given that exchanges only make money when coins are bought and sold, it is clear that they generate more revenue by instigating more sales. That is the whole point of manipulating volume. If they can get more buyers and sellers to pull off transactions, they make more money in listing fees and transaction charges.
The other side of the coin is the reality that exchanges make less money when people are not buying and selling. This is a problem for an industry that already suffers from low margins to begin with. Exchange owners are allegedly trying to overcome those low margins by increasing the number of transactions they process. That is where the money lies.
Potential price manipulation
There is another story out there that seems to add weight to the BTI's analysis. According to Zurcoin co-founder Daniel Mark Harrison, the majority of crypto exchanges are engaged in practices that could be construed as purposely deflating the price of crypto in order to boost their own holdings source.
Harrison alleges that exchanges are massaging crypto prices lower with an eye on small investors and individual consumers who do not have a lot invested in their chosen markets. The goal is to eventually take possession of their holdings after said holdings are abandoned.
Let's say John purchased a single coin from Ethereum just as it was hitting its peak of $1,417.38 back in January 2018. At the time of this writing, that same coin is worth less than $95. John has suffered a considerable loss. So he lists it in an exchange in hopes of selling before his losses get any steeper.
Now let's say the value of Ethereum continues to fall over the next 6 to 8 months to eventually settle in at $25. John may simply abandon his coin out of discouragement and frustration. Abandonment would give the exchange on which his coin was listed the opportunity to seize it.
Although this scenario seems unlikely for a single coin, the illustration still works. An exchange would have a greater incentive to seize larger numbers of coins abandoned by holders who no longer cared about them.
This is exactly what Harris says is happening. He believes the majority of cryptocurrency exchanges are intentionally massaging some coins downward in hopes of taking ownership of abandoned assets. When markets eventually do rebound, they stand to make a good profit off those seized assets.
A blow to decentralization
At this point, it is too early to tell whether the dual accusations against exchanges are true. But let's say they are. What exchanges are doing is essentially a blow to decentralization. That is neither good nor acceptable. If the allegations are true, exchanges need to be held accountable.
One of the fundamental principles of cryptocurrency is decentralization. Bitcoin, the first among all cryptocurrencies, was designed around a distributed ledger that is owned and maintained by coin owners and miners. The ledger was coded in such a way as to prevent central banks and governments from manipulating it.
Decentralization serves to level the playing field among all coin owners. No single coin owner has any more power over the platform than any other. Until now, the system seems to have worked well. But if exchanges are truly manipulating both volume and price, they have found a way around decentralization. As such, they have the power to completely destabilize virtually any cryptocurrency they choose to manipulate.
What it means to online gambling
We started this post by explaining that the ideas being discussed mainly affect investors. They have very little impact on day-to-day users. This includes people who purchase bitcoins just so they can play online casino games.
Cryptocurrency experts generally concede that the principles and technologies that keep cryptocurrency alive are not endangered by exchange manipulation. The concept of cryptocurrency is as strong as it has ever been. Even if Bitcoin were to crash to zero at some point in 2019 (yes, there are people predicting it) there are still thousands of other coins out there.
The point is this: the cryptocurrency paradigm does not need Bitcoin, Bitcoin Cash, and the other big names in order to work. As long as there are people willing to buy coins and others willing to accept them as payment for goods and services, the crypto economy will carry on.
If you are a crypto participant that buys in small amounts for the sole purposes of conducting business online, you have nothing to worry about. If it looks like your chosen coin is on the verge of crashing, you can always get out of that coin and into another. There will always be another coin to take its place.
Likewise, online gambling operators sold on cryptocurrency for its security and privacy will find other coins to work with should the big names fail. And by the way, the big names are not likely to fail completely. They might still lose a little more value before all the dust settles, but the likelihood of them becoming completely worthless is slim to none. Anyone who might manipulate the market is smart enough to know that zero value makes coins just as worthless to them. They will not let things go that far.
In summary, it is alleged that cryptocurrency exchanges are engaged in wash trading and price manipulation. If true, they could be artificially manipulating the value of the crypto in your digital wallet. Your best protection against such manipulation is to buy in small amounts. Do not take a gamble on crypto by putting more money into it than you can afford to lose.