Fake It Till You Make It

Size matters. Well, volume matters. In bitcoin, exchanges are judged by their volume, the relative portion of the market that passes between buyers and sellers on a specific platform. The consolidation of the bitcoin space has seen giants felled by way of scandal, regulation, and theft, and new giants that dominate the scene. Namely, Huobi and OKCoin, which account for about 90% of all bitcoin trade volume. That’s right. 90% of the decentralized currency is trading on two platforms with dubious transparency and order books that are never audited. Why?

Volume acts as a means to fix the price. Because the volume on a few exchanges dwarfs all outside volume, the folks that control the order books can exert direct control over the price. Outsiders often complain the mining is so centralized in bitcoin that the claim of decentralization simply becomes untenable. While the network of people using bitcoin may grow in size and offer actual decentralization, the entire protocol itself relies on a few massive pools, controlled by a token few. This has also become true of exchanges. In the desire to become legitimate and useful to the masses, regulation has shuttered many operations that existed when the bitcoin sphere was more of a wild west. The end result is that Chinese exchanges operating outside any legal requirements now control the price.

Fixing the price and price movements are attractive mechanisms for bitcoin users who need to move large amounts of capital from one currency into other currencies, or assets. There is some evidence that capital flight from China has spurred bitcoin growth, and the circumstantial evidence seems to support this; bitcoin miners dominate the market, bitcoin exchanges have massive volume, and many Chinese need to move their holdings out of China. Put the pieces together and the circumstantial picture makes logical sense.

It’s also an easy way to profit on unsuspecting traders who take long or short positions, especially using leverage. For instance, a trader that takes a short position using 20X leverage can lose their entire investment if the price moves 8-10% in the opposite direction, depending on how the exchange handles leverage. A price movement of + or – 5% happens almost weekly, and larger swings are hardly rare. If an exchange can manipulate the price it creates a huge conflict of interest. A user investing $100,000 is ripe pickings for an unregulated exchange that can dip the price at will, collect $100,000, and then increase the price again to realize a nice net profit. It is nearly impossible to prove that this is happening since the exchanges are unregulated and the trading engines and order books are proprietary, but the sheer opaqueness of bitcoin exchanges means traders have to approach them with wariness.

The price of bitcoin is constantly on the minds of believers. A higher price vindicates their faith; a lower price means some nefarious entity is targeting their beloved anti-government asset. What is less intuitively obvious is the threat posed by fake volume, and fake order books. While the influx of Chinese money is useful for legitimizing bitcoin in the short term, the long term effect of centralization among a few entities may lead to a destructive end. The use of bitcoin as a means of exchange was intended to act as a decentralized answer to an increasingly centralized, and censored world. That vision is not currently being realized, but users don’t seem to mind as long as the price is going up.

Image credit – Public domain image by Bitboy (he can be donated at 1BcQPKcvgLtBp8ZrRSHWewpd3h97BqEQb3)(Source: Bitcointalk.org forum)  (CC0 1.0)