Recent events have shed light on several cases of BTC price manipulations by cryptocurrency exchanges, emphasizing the global absence of transparent price information. Institutional investors, in order to buy BTC and other cryptocurrencies, have to make sure that the price they are paying effectively represents the underlying supply and demand balance, and is not spoofed by malicious actors.
A recent paper showed that the price increase of BTC from $150 to $1,200 between February and November 2013 was due to market manipulation performed by two trading bots that seemed to be performing valid trades but did not actually own the bitcoin they were using. During the Mt.Gox hack a number of these bots were able to create fake trades and make millions while manipulating the price of BTC.
Cryptocurrency exchanges and Front Running
What is Front Running ?
As an example, let’s say Alice wants to sell 1 BTC for $10,000 and Bob urgently needs to buy 1 BTC at market price. Alice and Bob’s orders are sent to the exchange.
The exchange is now exclusively aware that Alice wants to sell 1 BTC for $10,000 and that Bob wants to buy 1 BTC at market price.
The exchange can now insert its own orders. One order to buy Alice’s BTC and another to sell that BTC to Bob. Instead of paying 10,000$ for 1 BTC, Bob winds up paying $11,000 and the exchange pockets $1,000.
As a matter of fact crypto-exchanges are best positioned to profit from front running: they can insert their own buy order before a trader’s large buy order and sell the purchased asset right after the trader’s order is executed.
The trader ends up paying more for his purchase and the exchange has pocketed a substantial profit piggybacking on the trader. Large order dark pools, like the one proposed by Kraken Exchange, are particularly exposed to front running.
Forums like Reddit, Bitcointalk and Steemit show hundreds of instances of crypto-exchange users complaining about suspected front running. Even though the allegations are impossible to prove because of the complete opaqueness of the order book, the mere possibility is a large deterrent for large and sophisticated investors.
LGO answers this issue, by decentralizing its order book using the blockchain technology. Transactions are verifiable and auditable, which makes front running impossible for LGO Markets.
The need for a transparent price formation
The issues mentioned above are major obstacles to transparent price evaluation and, consequently, to the creation of financial products like ETF.
On March 10, 2017, the U.S. Securities and Exchange Commission denied a request to list what would have been the first U.S. exchange-traded fund built to track Bitcoin. In its statement, the SEC stated:
The Commission is disapproving this proposed rule change because it does not find the proposal to be consistent with Section 6(b)(5) of the Exchange Act, which requires, among other things, that the rules of a national securities exchange be designed to prevent fraudulent and manipulative acts and practices and to protect investors and the public interest.
In other words, the commission found that the proposed fund was too susceptible to fraud.
In their report on virtual currencies, the EBA (European Banking Authority) listed a detailed number of possible regulatory responses to the challenges posed by virtual currencies. One of the main proposals was:
“Transparent price information and requirements against market abuse. To avoid market manipulation and insider trading, intermediaries must comply with existing regulation against such practices in the financial sector.”
Exchanges, through front running and spoofing, have crippled the cryptocurrency market by making a transparent price impossible to obtain.
It is crucial for modern exchanges to unquestionably prove that they cannot practice market manipulation. With its hybrid protocol, LGO Markets provides an elegant solution to this important issue.
LGO Markets (https://lgo.markets) is a demonstrably fair, bank-backed premium exchange for institutional investors. It incorporates a decentralized ledger within its proprietary centralized platform in order to guarantee the inalterability, temporality and transparency of the order book and ensure a fair trading environment.
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