- The US Justice Department has reportedly opened a criminal probe into cryptocurrency market manipulation.
- Business Insider highlighted the prevalence of "pump and dump" scams in the market last November.
- Crypto markets are unregulated, relatively small, and prices are driven by sentiment — all of which makes it ripe for manipulation.
- Regulators and exchanges are now starting to wake up to the problem and weeding out bad actors.
LONDON — The US Justice Department has reportedly opened a criminal probe into cryptocurrency market manipulation, an issue Business Insider highlighted in a major investigation last November.
Market manipulation is nothing new: spoofing and wash trading — the forms of market manipulation the probe is focusing on — have been around for years.
But the attributes of cryptocurrency markets make them particularly susceptible to this type of fraud.
An unregulated wild west
For one thing, cryptocurrency markets remain largely unregulated. The likes of the SEC and CTFC are beginning to try and get a handle on parts of the industry (ICOs, futures) but secondary trading on exchanges is still a wild west.
Most platforms forbid market manipulation but our investigation last year found it going on relatively openly on several major platforms. Manipulation is bound to proliferate if people can get away with it.
The relatively small market capitalization of most cryptocurrencies also makes them relatively easy to manipulate. There are over 1,400 coins in circulation but, outside the top 20, most have less than $100 million-worth in circulation. The organiser of "pump and dump" scams told BI in an interview last year that his group use just $5 million to manipulate prices.
'Driven purely by the mood swing of investors'
There's another peculiar feature of cryptocurrency markets that make them susceptible to manipulation: most prices aren't underpinned by fundamentals.
In most mainstream financial markets, such as stocks, bonds, or commodities, there tends to be data that influences the price of an asset: revenue figures, sales numbers, or, in the case of steel prices, even Chinese building activity. These numbers help establish a price range that the bulls and bears can play in.
But cryptocurrencies have few fundamentals. Morgan Stanley (NYSE:MS) said the true price of bitcoin could be $0 when it was trading at over $14,000 — how's that for a spread?
A working paper from the Warwick Business School published on Wednesday concluded that "cryptocurrency prices are not influenced by any economic factors and instead are driven purely by the mood swing of investors."
Dr Daniele Bianchi, who authored the paper, said in a statement: "These are not like normal currencies where a country’s economy will influence the price. Instead, they share similarities to investing in an equity from a high-tech firm.
"As a result, the market for cryptocurrencies may look similar to the dot.com bubble at the end of the 1990s, and it may be that only a handful of them survive, so for investors, it is like choosing who will be today’s Amazon (NASDAQ:AMZN)."
How does all this relate to market manipulation? Well, if there are no fundamentals and everything is driven by mood then it's easier to engineer price swings. All you have to do is convince people that the mood in the market is changing and you could trigger a stampede.
As we highlighted last November, a typical "pump and dump" scam involves jacking up the price of a cryptocurrency by placing high orders — real or fake "spoof" orders — and then convincing unsuspecting investors that this is the start of a prolonged rally. You then offload your holding to the new investor at an artificially inflated price, pocketing the difference between the prices you paid and sold at. Generally, prices come crashing back to earth minutes after the pump.
Dr Bianchi concluded that "pricing is entirely influenced by past returns and the hype and emotion of investors as they watch the price climb or drop." It's not hard to see how bad actors could exploit these market dynamics.
Time's up for scammers?
The victims in these types of scams are the investors who buy the assets at artificially inflated prices. When cryptocurrencies were a niche affair, investigating this abuse wasn't worth regulators' time.
But the explosion of the market over the past year has made an investigation more urgent. Mainstream investors, particularly in the US, have rushed into crypto and that's why the Justice Department is now turning up the heat.
Trading platforms where manipulation takes place are also waking up to the problem. At the turn of the year, as prices boomed and new members flooded to sign up to platforms, it was all the exchanges could do just to keep their heads above water. Now things have calmed down, they're starting to get their houses in order.
Bitfinex, one of the largest exchanges in the world, announced a deal in March with a market surveillance company to "identify and investigate manipulative behaviours and suspicious trading practices on its exchange." And Gemini, the cryptocurrency exchange run by the Winklevoss twins, recently signed a partnership with Nasdaq to do something similar.
Time could be running out for cryptocurrency scammers.