By Paul Vigna and Alexander Osipovich
Investors know bitcoin’s violent mood swings well. What they often don’t know is that unscrupulous traders, wielding purpose-built software, can be behind them.
Manipulation in cryptocurrencies is a growing concern for regulators-and even for some proponents of the digital coins. The Securities and Exchange Commission cited that risk in August when rejecting several bitcoin-based exchange-traded funds. The office of New York Attorney General Barbara D. Underwood highlighted the issue last month in a report warning that crypto exchanges were vulnerable to manipulation.
“When any venue tolerates manipulative or abusive conduct, the integrity of the entire market is at risk,” the report said, citing automated trading programs, or “bots,” as a source of price manipulation. Trading programs exist in other markets, like stocks, and they can be used for both legitimate and manipulative strategies. Crypto traders can create bots themselves or buy them online.
In crypto, the critical difference is the lack of oversight. While established markets like the New York Stock Exchange monitor for illegal trading and punish rule-breakers, crypto exchanges vary widely in their surveillance efforts. Most crypto exchanges are regulated lightly, if at all. The result is that crypto bots can be used to execute abusive strategies on an industrial scale.
“This sort of activity is rampant in the market right now,” said Andy Bromberg, co-founder and president of CoinList, a startup platform for issuing new digital tokens.
Abusive bots are a fact of life for Stefan Qin, managing partner of Virgil Capital, an $80-million digital-currency hedge fund that runs its own bots on dozens of crypto exchanges world-wide. He said he engages in a constant cat-and-mouse game with enemy bots.
“We’ve had to build in error-handling functions to check for hostile and potentially illegal activities,” Mr. Qin said. “Such is the Wild West of crypto.”
Earlier this year, Virgil lost money on certain trades in ether after a “harassing bot” targeted the fund, Mr. Qin said. Ether is the second-largest cryptocurrency after bitcoin, measured by market value.
Here’s what happened: Mr. Qin’s fund specializes in arbitrage-spotting when a digital currency is priced differently on different exchanges, and quickly buying where it’s cheap and selling where it’s expensive. At the time, Virgil was checking for such discrepancies about once a minute.
Seconds before that periodic check, the hostile bot would post orders to sell ether at a lower price than other sellers. That would prompt Virgil to attempt to buy ether. But before it could do so, the bot would cancel its sell orders. Virgil ended up posting buy orders that didn’t get executed, briefly boosting the price of ether on some exchanges, Mr. Qin said.
The bot’s strategy was similar to “spoofing,” a practice in which traders enter fake orders only to cancel them. The tactic, aimed at tricking other investors to buy or sell an asset by falsely signaling there is more supply or demand, was outlawed in U.S. stock and futures markets in 2010.
Virgil eventually tweaked its algorithms to stop being gamed.
Bitcoin was conceived in 2008 as an alternative to government-backed money, and many of its early adopters are libertarians who balk at regulation of cryptocurrencies. For people in this camp, manipulation isn’t necessarily wrong-and some openly promote it.
Kjetil Eilertsen, a Norwegian who started trading bitcoin in 2011, created a program called Quatloo Trader that he has touted as “the best market-manipulation tool in the world of crypto.”
Mr. Eilertsen says it is futile to ban manipulation in digital currencies. A better approach, he said, is to level the playing field by giving sophisticated manipulation tools to small traders.
“If everybody can manipulate, then nobody is manipulating,” he said in an interview. “You can’t ban anything from people who are dedicated to doing something.”
But many other crypto traders say abusive trading practices are slowing cryptocurrencies’ adoption. “It hurts the market’s reputation, and it hurts individual investors,” said CoinList’s Mr. Bromberg.
Among the most notorious abuses are pump-and-dump schemes, in which traders talk up the price of a cryptocurrency before dumping it for a profit, hurting investors who bought as the price topped out.
Similar schemes are banned in stocks. The Wall Street Journal reported in August that crypto “pump groups” had generated at least $825 million in trading activity over a six-month period.
Bots make it easier to pump digital currencies. For instance, Quatloo Trader has a special tab called “whale tools,” containing automated tools for executing several abusive strategies. The idea is to make market manipulation as easy as filling in a form and hitting a button.
One of those tools, called “ping-pong,” lets users execute simultaneous buy and sell orders to themselves, creating a mirage of intense activity in a particular cryptocurrency. The tactic is known as “wash trading” and is illegal in stocks and futures.
It isn’t clear that this Wild West environment will last much longer. The U.S. Justice Department and the Commodities Futures Trading Commission are investigating potential manipulation of cryptocurrencies, The Wall Street Journal reported in June. The Securities and Exchange Commission has been combating fraudulent token issuance. The New York attorney general’s office has not announced any subsequent actions. Moreover, an industry-led effort at self-regulation has been spearheaded by the founders of the Gemini exchange, Cameron and Tyler Winklevoss.
Among Quatloo Trader’s former users is Ryan Wright, a U.S. citizen living in Taiwan. He liked how the program allowed one person to execute trades across several accounts simultaneously. “It looks like people are buying and selling, but in reality it’s all one person,” he said in an interview.
But Mr. Wright stopped running Quatloo Trader last year, worried about growing regulatory scrutiny. “I’m not the market manipulator I once was,” he said.
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