In our Markets Series we’ve covered concepts essential to understanding crypto market structure. We started off by defining a market, explained the structure of an orderbook, looked at the different types of orders, defined a trade, and discussed the various types of orders. Using this knowledge as a framework, we then explained the concept of liquidity and discussed common misconceptions present in crypto industry news reporting. In this final post of our markets series, we will discuss advanced concepts that build on the fundamentals we have covered so far to equip you with the knowledge to understand market events and identify the quality of crypto markets and associated industry news.
How to spot bad markets
Using our newfound knowledge, we will now take a closer look at the practices employed by some exchanges to manipulate volume and create the appearance of liquidity and activity. Regulated exchanges like Kraken prohibit this activity and have been found to be free from wash trading by independent reports, but some exchanges seek to attract new users by posting fictitiously generated high volume on their market. The estimates of some independent third parties conclude that some exchanges wash trade up to 90% of their volumes, meaning most of the displayed trading volume figures are fictitious and do not represent legitimate trading activity. Some exchanges and token projects look to artificially boost volume to capture users and get listed on venues like CoinMarketCap where platforms or coins are ranked by trading volume.
How is fake volume created?
Though there are various methods to creating fake volume, in this post we look at the two most prevalent ways exchanges create fictitious volume:
- Wash Trading
- Transaction Fee Mining
Wash trading is any activity where a trader (or a venue) trades against themselves, generating volume for the exchange venue without taking risk. Wash trading involves entering limit orders on the order book and then submitting opposing orders to match against their previously entered limit orders. An example of this would be a user who places a limit buy order for 1 BTC/USDT at 10,000 USDT, and then submits a market sell order for 1 BTC/USDT, matching against their previously placed limit buy order. In this example, the exchange would show that 1 BTC was exchanged, but in fact, 0 BTC changed hands. Wash trading usually takes place with the cooperation of an exchange venue, who will waive transaction costs that would otherwise make wash trading uneconomic for a third party. Legitimate exchanges do not offer such arrangements and prevent participants from matching orders against their own account. In our view, some exchanges likely operate their own wash trading algorithms internally, giving themselves special privileges to conduct wash trading without accidentally matching against legitimate orders.
So we tried it ourselves…
Figure 1: demonstration of wash trading
We created an account on an exchange we suspected was engaged in wash trading. Figure 1 shows our team executing a small trade on the EOS/BTC market on this exchange that supposedly had $103M in 24-hr trading volume at the time of the trade; however, we submitted an order to sell 2.466 EOS (about $10 at the time of submission) and moved the market 56% from 0.00105 BTC to 0.00046 BTC. Interestingly, within the same 30 second window, 11,158 EOS was traded, all without impacting the price meaningfully. If the other trades were indeed the result of wash trading, then based on this snapshot, only 0.02% of the $103M in volume is real, and in reality, this figure is likely much lower.
Transaction fee mining
Other exchanges employ creative wash trading schemes and hide this activity under the guise of a transaction fee mining program. These programs rebate users for trading fees in the form of a token issued by the exchange, and sometimes these rebates are in excess of 100%, e.g. for every $1 of trading fees a customer incurs, they earn $1.2 of “XYZ” exchange token. These programs incentivize users to wash trade by providing them a benefit for transacting without taking risk. Exchanges with Transaction Fee Mining programs are easy to spot, because these exchanges typically advertise their programs publicly. Reported volumes from these exchanges are highly inflated and should not be used as a proxy for market liquidity.
These examples of wash trading highlight both the extent of fictitious volume schemes and the expensive slippage they create for uninformed investors. Consider yourself warned!
Having built a foundational understanding of markets through our Markets Series, we hope you now feel more comfortable forming opinions on market events. Let this guide act as a basis on which you can further build crypto trading knowledge, question clickbait industry news, and assess the quality of the markets on which you look to trade.
Check out the previous posts in our market series
- Part 1: Markets & Orderbooks
- Part 2: Explaining Crypto Trading
- Part 3: Crypto Trade Execution – What Type of Trader are You?
- Part 4: Liquidity & Market Impact
- Part 5: Misconceptions & Debunking