Making Sure "Number Go Up"

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Fake it till you make it is the way Silicon Valley works these days, as exemplified by Theranos, Uber, WeWork and many other role models. It is certainly the case with cryptocurrencies. Would you believe that an NFT of this image was worth $532M? How about nearly $1.1B? Most numbers that are quoted about cryptocurrencies are fake, in the sense that they are manipulated in order to fool the press, and thereby buy time until they become "too big to fail".

The credulous press reports make it look like the cryptocurrency market is much bigger and much more successful that it really is, further inflating the bubble. Below the fold, I provide a set of examples of the techniques that are used to fuel the mania.

Wash Trades

In regulated markets, wash trading is illegal, but the whole point of cryptocurrencies is to evade annoying regulations like this that prevent market manipulation. Nick Baker's An NFT Just Sold for $532 Million, But Didn’t Really Sell at All dissects a blatant example:

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The process started Thursday at 6:13 p.m. New York time, when someone using an Ethereum address beginning with 0xef76 transferred the CryptoPunk to an address starting with 0x8e39.

About an hour and a half later, 0x8e39 sold the NFT to an address starting with 0x9b5a for 124,457 Ether -- equal to $532 million -- all of it borrowed from three sources, primarily Compound.

To pay for the trade, the buyer shipped the Ether tokens to the CryptoPunk’s smart contract, which transferred them to the seller -- normal stuff, a buyer settling up with a seller. But the seller then sent the 124,457 Ether back to the buyer, who repaid the loans.

And then the last step: the avatar was given back to the original address, 0xef76, and offered up for sale again for 250,000 Ether, or more than $1 billion.

How prevalent is wash trading at cryptocurrency exchanges? The top three results I got from Google are all papers from this year.

First, Wash trading at cryptocurrency exchanges by Guénolé Le Pennec, Ingo Fiedler and Lennart Ante:

Suspicious volume of >90% is detected for most investigated exchanges.
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Cryptocurrency exchanges allegedly use wash trading to falsely signal their liquidity. We monitored twelve exchanges for metrics of web traffic and for their administered user funds. The exchanges were clustered in three distinct groups based on previous findings: (1) accurately-reporting exchanges, (2) exchanges that engaged in wash trading, (3) exchanges with mixed evidence of wash trading. A comparison of the reported to the predicted trading volume, calibrated on the accurately-reporting exchanges, suggests that group 2 exchanges exaggerate their true volume by a factor of 25 to 50, and exchanges of group 3 by a factor of 1.25 to 33.

Second, Crypto Wash Trading by Lin William Cong, Xi Li, Ke Tang and Yang Yang:

We introduce systematic tests exploiting robust statistical and behavioral patterns in trading to detect fake transactions on 29 cryptocurrency exchanges. Regulated exchanges feature patterns consistently observed in financial markets and nature; abnormal first-significant-digit distributions, size rounding, and transaction tail distributions on unregulated exchanges reveal rampant manipulations unlikely driven by strategy or exchange heterogeneity. We quantify the wash trading on each unregulated exchange, which averaged over 70% of the reported volume. We further document how these fabricated volumes (trillions of dollars annually) improve exchange ranking, temporarily distort prices, and relate to exchange characteristics (e.g., age and userbase), market conditions, and regulation.

Third, Detecting and Quantifying Wash Trading on Decentralized Cryptocurrency Exchanges by Friedhelm Victor and Andrea Marie Weintraud:

Cryptoassets such as cryptocurrencies and tokens are increasingly traded on decentralized exchanges. The advantage for users is that the funds are not in custody of a centralized external entity. However, these exchanges are prone to manipulative behavior. In this paper, we illustrate how wash trading activity can be identified on two of the first popular limit order book-based decentralized exchanges on the Ethereum blockchain, IDEX and EtherDelta. We identify a lower bound of accounts and trading structures that meet the legal definitions of wash trading, discovering that they are responsible for a wash trading volume in equivalent of 159 million U.S. Dollars. While self-trades and two-account structures are predominant, complex forms also occur. We quantify these activities, finding that on both exchanges, more than 30% of all traded tokens have been subject to wash trading activity. On EtherDelta, 10% of the tokens have almost exclusively been wash traded.

It looks like wash trading is quite a problem, which would make rankings of exchanges and volume numbers highly inflated, not to mention prices.

Pumps-and-Dumps

Three years ago Tao Li et al published a detailed analysis entitled Cryptocurrency Pump-and-Dump Schemes concluding that:

Pump-and-dump schemes (P&Ds) are pervasive in the cryptocurrency market. We find that P&Ds lead to short-term bubbles featuring dramatic increases in prices, volume, and volatility. Prices peak within minutes and quick reversals follow. The evidence we document, including price run-ups before P&Ds start, implies significant wealth transfers between insiders and outsiders. ... Using a difference-in-differences approach, we provide causal evidence that P&Ds are detrimental to the liquidity and price of cryptocurrencies.

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They were pervasive then and they still are now. For example, David Gerard documents one on 16^th December 2020 that took BTC to a new high over $20K:

We saw about 300 million Tethers being lined up on Binance and Huobi in the week previously. These were then deployed en masse.

You can see the pump starting at 13:38 UTC on 16 December. BTC was $20,420.00 on Coinbase at 13:45 UTC. Notice the very long candles, as bots set to sell at $20,000 sell directly into the pump.
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A series of peaks followed, as the pumpers competed with bagholders finally taking their chance to cash out — including $21,323,97 at 21:54 UTC 16 December, $22,000.00 precisely at 2:42 UTC 17 December, and the peak as I write this, $23,750.00 precisely at 17:08 UTC 17 December.

This was exactly three years after the previous high of $19,783.06 on 17 December 2017.

And another pump on 6^th October:

Someone bought 1.6 billion dollars’ worth of bitcoins in one lump on Wednesday 6 October in under five minutes, between 13:11 and 13:16 UTC. This pumped the Bitcoin price from about $50,000 to about $55,000.
Of course, they didn’t use dollars to buy the bitcoins — they used tethers to buy the coins on Binance, tethers that had been freshly created and deployed to the exchange a few days earlier.

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And another on 15^th October:

There was a similar tether-fueled pump, to a new all-time high, just before the CFTC settlement came out on 15 October. This pump continued for a few more days.

This new all-time high was followed by a flash-crash to below $10,000 on some exchanges. Bitfinex’ed blames trading bots being shut off. [Twitter] This also suggests that the un-pumped price of Bitcoin would be far lower than the present price in tethers.

When the price dipped from its unfeasibly-pumped peak, multiple major crypto exchanges coincidentally had simultaneous downtime.

Do these simultaneous outages look suspicious or not?

Transaction Rate

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The press claim that Bitcoin is widely used because it processes around 270K transactions/day. But Igor Makarov and Antoinette Schoar write:

90% of transaction volume on the Bitcoin blockchain is not tied to economically meaningful activities but is the byproduct of the Bitcoin protocol design as well as the preference of many participants for anonymity ... exchanges play a central role in the Bitcoin system. They explain 75% of real Bitcoin volume

So it is really only processing around 27K "economically meaningful" transactions/day. And 75% of those are transactions between exchanges, so only 2.5% of the "transactions" are real blockchain-based transfers involving individuials. That's less than 5 per minute.

Trading Volume

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Naively, the press multiplies the inflated transaction rate by the inflated "price" resulting from the latest wash trades or pumps to claim that the value of Bitcoins' daily transactions is around $5B. Doing so involves valuing the 90% of the not "economically meaningful" transactions like the meaningful ones. So this number is inflated by a factor of around 10.

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This inflation is obvious if we look at the trading volume on major exchanges, which is currently in the region of $400M/day. Thus it represents around 8% of the claimed trading volume of Bitcoin. Interestingly, this approximately matches Makarov and Schoar's 75% of 10% of $5B as the exchange-based "trading volume" on the blockchain.

Market Cap

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Similarly, the press claim that the "market cap" of Bitcoin is once again approaching a trillion dollars (as much at Tesla!) is arrived at by naively multiplying the inflated "price" by the number of Bitcoins that have been mined.

Back in January when Bitcoin's inflated "price" was only around $35K, Jemima Kelly took this claim to the woodshed in No, bitcoin is not “the ninth-most-valuable asset in the world”:

if you take the all-time-high of $37,751 and multiply that by the bitcoin supply (roughly 18.6m) you get to just over $665bn. And, if that were accurate and representative and if you could calculate bitcoin’s value in this way, that would place it just below Tesla and Alibaba in terms of its “market value”. (On Wednesday!)

The only problem is, as you might have already guessed, that’s not accurate or representative and you cannot calculate bitcoin’s value in that way.

Kelly points out that the whole idea of a "market cap" for a totally speculative asset is just wrong:

working out its “market cap” is a non-starter. As some of you might remember, it was originally designed to be a currency that could be used to buy actual things! And although it fails to meet all the criteria that would make it a currency, it does have one thing in common with it: its price is underpinned by sheer faith. The difference being that with fiat currencies, that faith is effectively placed in the governments of the nation states who issue them, whereas for bitcoin, the faith is placed in . . . the hope that other people will keep having the faith.

But even if it weren't, the number multiplying the "price" is just wrong too:

although 18.6m bitcoins have indeed been mined, far fewer can actually be said to be “in circulation” in any meaningful way.

For a start, it is estimated that about 20 per cent of bitcoins have been lost in various ways, never to be recovered. Then there are the so-called “whales” that hold most of the bitcoin, whose dominance of the market has risen in recent months. The top 2.8 per cent of bitcoin addresses now control 95 per cent of the supply (including many that haven’t moved any bitcoin for the past half-decade), and more than 63 per cent of the bitcoin supply hasn’t been moved for the past year, according to recent estimates.

What all this means is that real liquidity — the actual available supply of bitcoin — is very low indeed.

Which means that:

the idea that you can get out of your bitcoin position at any time and the market will stay intact is frankly a nonsense. And that’s why the bitcoin religion’s “HODL” mantra is so important to be upheld, of course.

Because if people start to sell, bad things might happen! And they sometimes do. The excellent crypto critic Trolly McTrollface ... pointed out on Twitter that on Saturday a sale of just 150 bitcoin resulted in a 10 per cent drop in the price.

Tether

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Finally, it is important to note that the press reports "prices" in USD but the vast majority of trading in cryptocurrencies, as shown in the graph, is not in USD but in stablecoins, primarily Tether.

Is 1 USDT really the equivalent of 1 USD? Originally, Tether claimed that it has 1 USD in a bank account for every 1 USDT it issued, but that claim was abandoned a long time ago. There has never been an audit to determine what, exactly, is backing Tether.

Zeke Faux's Anyone Seen Tether’s Billions? is the latest in a series of exhaustive attempts to answer that question. He saw:

a document showing a detailed account of Tether Holdings’ reserves. It said they include billions of dollars of short-term loans to large Chinese companies—something money-market funds avoid. And that was before one of the country’s largest property developers, China Evergrande Group, started to collapse. I also learned that Tether had lent billions of dollars more to other crypto companies, with Bitcoin as collateral. One of them is Celsius Network Ltd., a giant quasi-bank for cryptocurrency investors, its founder Alex Mashinsky told me

Clearly, much of the backing is in "commercial paper", i.e. debts owed by other companies. Some of the companies are apparently Chinese real estate developers, desperate for credit. Some is Bitcoin and other cryptocurrencies as collateral for loans to cryptocurrency exchanges. David Gerard is suspicious:

There is no reason to assume the tethers sent to Binance in early October were not just sent as a loan and then the loan accounted as the backing reserve, i.e., Tether sending tethers to a crypto exchange for free — because, as the CFTC settlement notes, Tether has routinely done precisely that, for years. And the Bloomberg story confirms that they still do this in 2021.

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As the graph shows, the issuance of USDT and the "price" of BTC are completely correlated. This is the "magic money pump" I outlined inStablecoins. Newly issued USDT sent to an exchange will almost certainly be quickly used to buy cryptocurrency. This pumps the price of cryptocurrencies, including those forming part of Tether's reserve. This allows Tether to issue more USDT, which can be sent to an exchange, used to buy cryptocurrency, which pumps the price, which ... Rinse and repeat.