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No Cryptocurrency Markets Without Manipulation


Patrick Tan
May 3, 2019 · 7 min read

James Eaden was pissed off. He stared slackjawed at his screen, dumbfounded by just how out of control things had gotten.

In the waning months of 2017, as initial coin offering (ICO) fever was gaining a stranglehold on the more speculative corners of the investing world, the transaction fees for Ethereum, GAS, had shot up dramatically as investors rushed to pour money into ICOs of all manner shape and size.

Eaden didn’t care a whack about ICOs, but was badly affected by the spike in transaction fees as he was experimenting with smart contracts on the Ethereum blockchain and running the contracts needed GAS.

“There was a time when GAS regularly cost more than the underlying transaction itself.”

Ironic, considering that one of the chief design features touted by cryptocurrencies is their relatively low (compared to traditional finance) or non-existent transaction fees.

Under normal circumstances for cryptocurrencies, transfer fees such as GAS are a nominal amount, but transferors who have an urgent need to update the blockchain and increase the speed of their transfer can increase the amount of GAS (an Ethereum denomination) they are willing to pay, in excess of the prevailing rate, to have their transactions prioritized and picked up by Ethereum miners who secure and update the blockchain.

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Fees had reached a point where James needed a second calculator to figure out costs. (Photo by Chris Liverani on Unsplash)

Those unwilling to pay the increased GAS rates would wait in line, but again, under normal circumstances, this was not inordinately long.

Until the ICO fever hit.

As deadlines for private ICO pools and exclusive airdrops and bonuses rained down, the Ethereum protocol was inundated with transactions and investors bumped up GAS prices so as not to miss out on the next “hottest” ICO, jacking up GAS prices.

The experience demonstrated the flaws inherent in the nascent cryptocurrency system and one which many cryptocurrency exchanges took notice of in their operations.

Centralization vs Decentralization

To improve the level of fairness and to level the playing field, many cryptocurrency exchanges took to rate limiting as well as fixing the transaction fees of trades as a fixed percentage of the transaction size as opposed to the bidding system inherent in blockchain protocols.

But centralized exchanges have their own limitations in the sense that all transactions are routed through a centralized authority and thus a single point of failure.

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Peer-to-peer transactions have been around for a long time. Not all are technologically supported. (Photo:

Given that the thrust and parry of cryptocurrencies is their decentralized nature, it made sense to consider decentralized exchanges, where the exchange was merely a facilitator of peer-to-peer or P2P trading in cryptocurrencies.

But P2P also suffers from unintended weaknesses which can be exploited for profit.

As quantitative hedge funds in the financial markets started to trade alpha out of the market, with copycat trading programs and high frequency trading outfits progressively whittling away what thin profit margins existed to begin with, many of the tech savvy programmers in the financial markets started to spot opportunities in the nascent cryptocurrency markets.

And given the level (or lack of) sophistication in the early cryptocurrency exchange setups as well as the absence of regulation, it was easy for these quantitative traders (“quants”) to start to funnel into the cryptocurrency markets for some easy profits.

As I have written before, even the most elementary and basic of trading programs can net some serious profit given the lack of regulation and sophistication in the cryptocurrency markets and the inherent and latent inefficiencies therein.

Like Stealing Crypto from a Baby

And a recent paper from researchers at Cornell Tech and several other universities has confirmed what many cryptocurrency traders have either known or suspected for a long time — that there exists trading manipulation on many cryptocurrency exchanges, in particular decentralized exchanges.

While it’s difficult to decipher how much manipulation exists, the revelation that there is manipulation in the cryptocurrency markets is nothing new.

And just as in the financial markets, it’s the retail players who are most likely to get burned by the manipulative market behavior.

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Profits were so good from arbitrage that the boys bought themselves a marble laptop. (Photo by Austin Distel on Unsplash)

An arbitrage bot is not difficult to build, and these bots have been running rampant on decentralized exchanges, anticipating and profiting from “regular” traders.

Because the exchanges are decentralized, trading outfits can trade with end traders more directly and because it’s peer-to-peer, many of the practices which are illegal in financial markets are de riguer on decentralized exchanges.

Unlike in financial markets, where the bulk of trades are done between hedge funds and financial institutions, cryptocurrency markets tend to have a more balanced mix of both, which leaves many retail cryptocurrency traders (with either less excess to bots or without the sophistication to create them) far more vulnerable than in the financial markets.

And not all of the market activity drummed up by these bots is organized the way a hedge fund is organized — they can also be informal pools or loose associations of cryptocurrency traders acting in concert.

Because a decentralized exchange or DEX is built on a blockchain, the same limitations experienced by the Ethereum blockchain during the ICO fever applies to a DEX.

In other words, traders can get priority for their transactions (or trades in this case) by paying higher transaction fees and they use that advantage for practices such as front running — where traders can see order from others and manage to jump the line, placing their own orders ahead of other traders.

Imagine you already knew a trade that was going to be made, you jumped the line and acted on that trade before someone else to profit from it — that’s in a nutshell what front running is.

The concept of the DEX was that by trading directly on the blockchain, there would be no centralized point of failure — recall Mt. Gox, the world’s first centralized Bitcoin exchange that also represented a single point of failure.

But the limitations of blockchain-based decentralized cryptocurrency trading exchanges also lies in one of the design features (flaws) where transaction fees are discretionary.

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Lines are not for everyone on decentralized exchanges. (Photo by Denys Nevozhai on Unsplash)

Because transaction fees are discretionary, traders can bid just that bit more to have their orders prioritized.

Imagine a stock market where the prices are published, but only those first to the line get the prices advertised while everyone else gets the less favorable prices.

And while decentralized exchanges still only account for a small fraction of overall trading volume, their usage is expected to grow and even Binance, the world’s largest centralized cryptocurrency exchange is building out its own decentralized exchange.

Many other cryptocurrency exchanges are following suit.

Dangers of Decentralization

But before exchanges start diving headlong into DEX (it seems that the cryptosphere has a tendency to dive headlong into the latest trend, be it stablecoins or security tokens) it would serve the entire community well to examine more closely whether or not a DEX serves the trading community or unduly prejudices particular sections of the trading population to the advantage of others.

In an industry where allegedly as much as 95% of volumes on cryptocurrency exchanges is fake or driven by bots, manipulation of orders on DEXs will do little to draw in greater trading volumes to cryptocurrency exchanges.

To be sure, the bots that are manipulating trading on DEXs are not new — front running, aggressive latency optimization — these were all common on Wall Street long before the first Bitcoin was ever mined.

But to try and map out and to uncover the full extent of the alleged manipulation would be near impossible at best, even if smart contracts are used.

Because electronic exchanges allow traders to buy and sell instantaneously, the nanosecond nature of the market means that to pinpoint manipulation is nearly impossible.

Furthermore, it’s not an established rule of law what “front running” constitutes, with some traders arguing that it denotes advantages that professional market makers have always possessed over investors needing real-time execution.

And therein lies another issue on cryptocurrency exchanges — market makers.

Because the space is not regulated, there is no official definition, licensing or regulation of a market maker — meaning that a market maker can trade against other traders, whilst still receiving fees from the cryptocurrency exchange itself for providing market making services in order to provide liquidity for an exchange — an obvious conflict of interest.

If cryptocurrency markets are ever to shed their shadowy image, designers of future cryptocurrency exchanges, be they decentralized or centralized, would be better served by considering all of the factors which make the current financial markets perceived as unfair.

A level playing field for both institutional and retail traders would attract a more grassroots-led participation in cryptocurrency trading, which will ultimately benefit the legitimacy of the industry as a whole.

If the raison d’être of cryptocurrencies was to provide access and increase equality of participation, more consideration needs to be given to the drivers which push people to participate in cryptocurrencies to begin with.

As the starting point of cryptocurrency participation, cryptocurrency exchanges play a big role in the ecosystem and would do well to consider the limitations of the current decentralized exchange systems.

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Patrick Tan

Written by

CEO of Novum Alpha, an all-weather digital asset trading firm that uses Deep Learning tools to deliver dollar-returns in all market conditions.

The Capital

The Capital is a financially incentivized social micro-publishing business platform

Patrick Tan

Written by

CEO of Novum Alpha, an all-weather digital asset trading firm that uses Deep Learning tools to deliver dollar-returns in all market conditions.

The Capital

The Capital is a financially incentivized social micro-publishing business platform

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