Look Out, Investors: Cryptocurrency Values Slide As Warnings Take Off

Bitcoin and other cryptocurrencies have seen dramatic but volatile price surges during the past year. But this month their billions in estimated market value are eroding, amid widening suspicions against one trading platform, a half-billion-dollar heist from another exchange, and an awakened global regulatory community. Warnings are on the rise from regulators, researchers, banking executives—and even crypto-insiders—that the value of these virtual currency holdings may be a mass illusion, because the market is so easily manipulated.

These sentinels point to a variety of gambits and players that can influence the perceived value of bitcoin and other digital coins. The possible culprits range from purveyors of fraudulent initial coin offerings (ICOs) to coordinated botnet traders that pump up prices to lure inexperienced investors to buy, and hackers who can make millions of dollars by stealing coin deposits.

The motives for market manipulation could be as murky and intricate as the network of unsupervised entities that create digital coins, deal in them—and share only some of the transaction details with the public.

China has been cracking down on cryptocurrency exchanges, and signs that South Korea might also ban trading further rattled the market for digital coins. (South Korea’s finance minister denied such plans on Wednesday, Reuters reported.) The current mood runs against an optimistic narrative among fintech investors who saw cryptocurrencies going mainstream during 2017 as their market cap rose to about $600 billion. Investments in the bitcoin ecosystem of startups and service providers have come not only from specialist VC firms such as Blockchain Capital, but also from mainstream Silicon Valley firms including Andreessen Horowitz, which backed digital currency trading platform Coinbase.

Banks are among the companies interested in the blockchain technology underlying virtual currencies, but bank executives are also sounding warnings. This month, former Wells Fargo CEO Dick Kovacevich called bitcoin a “pyramid scheme,” CNBC reported. While bullish on cryptocurrencies in a December interview with Xconomy, F-Prime Capital partner David Jegen also said he expected U.S. regulatory agencies to step up oversight and enforcement in 2018.

Suspicion is now focusing on the integrity of record-keeping at the largely unregulated cryptocurrency exchanges. Most recently, the mainstream press has picked up on concerns shared over social media that the digital coin trading platform Bitfinex may have taken part in complicated maneuvers to prop up the bitcoin price. The fear circulating among the crypto-cognoscenti now is that if the alleged scheme unravels, the value of bitcoin could crash. Bitfinex is one of the decentralized exchanges whose trading reports influence the perceived value of bitcoin.

The U.S. Commodity Futures Trading Commission sent subpoenas on Dec. 6 to Bitfinex and a related company, Tether, which claims that the value of its coins issued under the same name is pegged to the value of the U.S. dollar, Bloomberg reported Tuesday, based on an unnamed source. Doubts have arisen that Tether maintains the dollar reserves to back up its coins, which have reportedly played a role in reassuring investors that they could redeem their investments in bitcoin and other digital coins by receiving dollars in return.

On Tuesday, the bitcoin exchange rate fell through a $10,000 floor that had held since November.

Public alarms about Bitfinex have been streaming from an anonymous Bitfinex user called Bitfinex’ed, who communicates his or her suspicions through blog posts, tweets, and YouTube videos, according to the U.K. publication Express in a story Monday headlined “Bitcoin price CRASH ‘BLOODBATH’’’ Educated observers of the cryptocurrency landscape, such as a U.C. Berkeley computer science professor and a Unix system administrator, told the Express that Bitfinex’ed has real cause for concern. But such individuals can’t insist on an audit of entities such as Bitfinex and Tether.

What can investors believe?

The CFTC has issued warnings about the trading practices and price volatility in the largely unregulated markets for cryptocurrencies. The SEC has blocked questionable initial coin offerings and issued its own warnings. But so far, U.S. regulators haven’t established a comprehensive regulatory scheme that would monitor for fraud and police trading in digital coins.

Facebook on Tuesday announced a ban on advertising for all cryptocurrencies and ICOs as part of its broader policy to weed out misleading or deceptive promotional practices. The company says it may let some cryptocurrency ads through in the future if it can learn how to distinguish between fair and false statements about them.

Like stock market investors, digital coin buyers decide what to pay based on reports from exchanges and data firms about the going exchange rates in current purchases. But what if some of those transactions never happened, or not at the prices claimed?

Observers of the cryptocurrency world are finding patterns that remind them of characters like convicted Ponzi scheme operator Bernie Madoff and the “pump-and-dump” mastermind dubbed “The Wolf of Wall Street” in a Hollywood film.

This might be a limited worry if bitcoin purchases were still the domain of the tech kids’ treehouse they began in. But bitcoin and other cryptocurrencies are becoming integrated into the conventional financial system, a group of academic researchers warned in an analysis that has fed the current uneasiness.

“As mainstream finance invests in cryptocurrency assets and as countries take steps toward legalizing bitcoin as a payment system (as Japan did in April 2017), it is important to understand how susceptible cryptocurrency markets are to manipulation,” the group of professors wrote in a recently published study of suspicious trading on the Mt. Gox bitcoin exchange, which they linked to a steep spike in bitcoin’s exchange rate in 2013.

Mt. Gox—a cautionary tale

That study provides a rare inside peek at the realities behind the Wild West cryptocurrency market. The academic researchers analyzed a trove of leaked data from the Mt. Gox exchange, which was formerly the dominant exchange for bitcoin transactions. Mt. Gox collapsed in 2014, raising suspicions of stolen coin deposits, an insider cover-up, and fraudulent trading.

Mt. Gox is now the record-setter that all cryptocurrency exchange failures are measured by.

The researchers found evidence that a series of questionable or fake trades—possibly by a single person—boosted the exchange rate of bitcoin-to-dollars across all major trading platforms by at least 560 percent over two months in late 2013, from $150 to more than $1,000. At the time, such a surge was unprecedented for bitcoin since its introduction in 2009.

“We found clear evidence that the first meteoric rise in Bitcoin prices that took place in 2013 was likely driven by fraudulent trades,” says Tyler Moore, one of the co-authors of the research paper, “Price Manipulation in the Bitcoin Ecosystem,” published in the Journal of Monetary Economics.

What’s more, the overall trading volume also spiked beyond what could be traced directly to the suspicious trades alone. “This suggests that the fraudulent trades may have sent a public signal to the broader community to pile in and buy more bitcoins, further accelerating the price rise,” Moore wrote in an e-mail exchange with Xconomy. The exchange rate plummeted after Mt. Gox imploded, and took years to recover.

Granted, those were early days when bitcoin traded at much lower volumes and at fewer exchanges, and therefore might have been more vulnerable to manipulation by a lone individual or small group of malefactors. But Moore says the market might have been just as easy to tinker with in the 12 months ending in May 2017, when the bitcoin exchange rate ballooned by an even greater percentage, from $1,500 to $19,000.

“While we do not know what has driven the recent spike in Bitcoin’s value, we cannot rule out fraud,” wrote Moore, a professor at the University of Tulsa. His co-authors on the research paper were JT Hamrick, his colleague at the Tandy School of Computer Science at the University of Tulsa; and Neil Gandala and Tali Obermana of the Berglas School of Economics, Tel Aviv University.

Aside from bitcoin, Moore says the values of emerging cryptocurrencies could be as vulnerable to market manipulation as bitcoin was about four years ago, when the fraudulent Mt. Gox trades he and his colleagues studied represented a significant percentage of all trades in bitcoin.

A rare trove of leaked trading data

The team of researchers was able to root out suspicious trading activity on Mt. Gox because they could mine the leaked data on 18 million transactions that included the user ID numbers behind the buyers and sellers—part of the trading details that currency exchanges in digital coins don’t routinely reveal. The researchers analyzed the dates and times of trades, the price being paid for bitcoin, the way sellers on the exchange were credited for dollars paid by the buyer, and overall trading patterns.

The researchers found that a collection of 50 trading accounts were probably run by a single individual who, they maintain, drove bitcoin values up with a combination of illicit tactics, including fake, one-sided trades and bitcoin purchases from real sellers who were never paid. The trickster was allegedly credited with acquiring 600,000 bitcoins, then valued at $188 million.

The motive for all this hocus-pocus may have been simple profit, the researchers say. Outsiders may have taken advantage of a security weakness at Mt. Gox to drive up the perceived bitcoin exchange rate. As a result, people who had bought bitcoin at low prices could then take big gains by selling them, Moore and his co-authors speculate.

But other theories would implicate the operators of Mt. Gox themselves. At the time, some observers suspected that the questionable trades may have been an attempt to cover up a major bitcoin heist from Mt. Gox in 2011. The false trades might have been intended to inflate trading volume to simulate investor confidence, and prevent the exchange from imploding, the researchers theorize.

According to the academic study, the list of irregularities that somehow escaped the notice of Mt. Gox operators included:

—Unpaid transaction fees they themselves should have received from the suspicious traders
—Duplicate trading records that were later doctored to change the price paid for bitcoin
—One-sided transaction records
—Periods when Mt. Gox trading was offline, but the suspicious trading continued

One trading account, dubbed Markus for want of a real-world identity, was credited with acquiring a total of 335,898 bitcoin, then valued at $76 million, although no real Mt. Gox customer ever received dollars or other government-backed currency in payment.

Another set of 49 counts, attributed to an entity called Willy, who traded with legitimate Mt. Gox customers, acquired $112 million worth of bitcoin, but also never paid for it. The sellers’ accounts were “nominally” credited with the payments in conventional currency on the Mt. Gox books, but as it turns out, that didn’t mean they would later be able to withdraw it.

The legitimate customers might have had no immediate suspicion that anything was wrong, the researchers say. Customers often left their balances in bitcoin and dollars with Mt. Gox, because such exchanges operated something like a bank. However, as Mt. Gox tumbled toward insolvency, it allegedly stalled off customers who wanted to withdraw their dollars, according to the academic study. The net effect of Willy’s trades may have been to convert Mt. Gox’s losses in the bitcoin theft to a loss of dollars or other government-backed currency, thus depleting the reserves it needed for customer withdrawals, Moore and his co-authors say.

That theory foreshadows the current fears about the Bitfinex exchange—that digital coin purchases can become one-way transactions. Buyers’ gains on paper may never be redeemed in dollars.

The aftermath of Mt. Gox

Users of the Mt. Gox exchange were among the first to discover how difficult it might be to recover their losses from a failed cryptocurrency exchange.

The fate of the Mt. Gox creditors is still being disputed in a bankruptcy court in Japan, where the laws may have the ironic consequence of allowing Mt. Gox alone to profit from the upsurge in bitcoin value since 2014, Fortune reported in December.

Mt. Gox has apparently found more than 200,000 of the 850,000 bitcoins allegedly stolen from it, and the creditors who lost deposits in the heist now want their share of those coins. But Mt. Gox shareholders might be able to pay the creditors only the dollar amount each bitcoin was worth when the exchange went into bankruptcy in 2014—-less than $500. They could then sell the recovered bitcoins at current rates and possibly reap billions. Japan’s bankruptcy laws might permit this.

A similar uncertainty now faces users of the Tokyo-based Coincheck exchange, which revealed Jan. 26 that it had suffered the theft of millions of tokens called XEM, valued at up to $530 million, Marketwatch reported. Coincheck’s CEO has said the company will help customers recover assets.

The SEC has issued alerts advising prospective buyers of cryptocurrency assets to find out who’s behind the transactions, how much trading data is made public, and what happens if something goes wrong. SEC chairman Jay Clayton, in a wide-ranging personal advisory to Main Street investors as well as market professionals on Dec. 11, wrote of crytocurrency trading:

“Please also recognize that these markets span national borders and that significant trading may occur on systems and platforms outside the United States. Your invested funds may quickly travel overseas without your knowledge. As a result, risks can be amplified, including the risk that market regulators, such as the SEC, may not be able to effectively pursue bad actors or recover funds.”

Tyler Moore, the University of Tulsa researcher, says there is guidance to be found in the Mt. Gox story.

“The lesson for the broader ecosystem is that we need increased cooperation between financial regulators and trading platforms to share information about the trading behavior of individual actors with outsize positions,” Moore wrote in an e-mail to Xconomy.

“Greater assurances are needed that the trades taking place are in fact legitimate and reflect buying and selling by independent actors. Unless and until such oversight is implemented, we cannot trust the exchange rate to reflect only legitimate sources of supply and demand.”

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