Friday, May 17, 2019

Leveraged cryptoexchanges probably encourage price fluctuations

After reaching $20,000 in mid December 2017, the Bitcoin price went mostly down, dropping near $3,000 in December 2018. It was mostly stable for months but started to show signs of life in the recent month or two and reached levels above $8,300 (more than a one-year-high) a day or two ago. Two hours ago, it suddenly saw a drop from $7,800 to $7,000 in a few minutes.

The price behavior is extremely unnatural, showing the mood swings. For a long time, you may see a virtually constant price. Suddenly, a flash crash or a pump takes place. The magnitude of fluctuations may suddenly change. Most of these changes result either from some unusually large traders or from psychological changes of the traders – or a combination of the two.

What's funny is that some cryptoexchanges saw a more brutal drop within those ten minutes today. Bitmex saw the price decreasing from $7,800 below $6,370, almost by twenty percent in minutes. Bitmex trades real U.S. dollars. But you saw similar swings down to $6,500 or lower at exchanges that trade the Tether (USDT) instead of the real dollar.

Incidentally, according to the current view of, the Tether pegged to the U.S. dollar is the most traded cryptocurrency now!

From the beginning, I was saying that Tether – the most hated cryptocurrency among the cryptocultists – is actually the most meaningful one and is bound to be the most traded one. It's actually a currency because it's pegged to the U.S. dollar within one percent or so. It therefore serves as a cheaper version of PayPal, a global fast online transfer of actual predictable wealth that doesn't involve a huge amount of gambling at the same moment. says that the trading involving the Bitcoin was below $31 billion per 24 hours while the Tether had above $32 billion. These two were tied for quite some time. Ethereum was third, with $17 billion, and others starting with the Litecoin are below $6 billion a day per currency. I believe that a big majority of all these trades is fake – exchanges' efforts to pretend that they're important because they have big volumes.

The potential for arbitrage is still huge – the prices at various exchanges may easily differ by hundreds of dollars, several percent. But it's interesting to notice the differences in the variability. How does the presence of shortselling and leveraging affect the fluctuations of the price?

In true market conditions, the presence of shortsellers, futures, and leveraging – all of them, I think – help to stabilize the price. These markets attract new traders who are carefully calculating or estimating the sustainable price, with a big precision, even though they have nothing to do with the underlying "business" (think about the sugar price to make it really apolitical). These traders may temporarily have long or short positions that doesn't cost them almost anything. They believe that fluctuations are temporary, the prices will return somewhere, and they can make profit out of these moves. In effect, this expectation is a self-fulfilling prophesy. One has good reasons to say that the spot price at such natural yet sophisticated markets with shortsellers, futures, and leveraging really reflects some underlying fair price, and does so very precisely.

On the other hand, I think it's not the case at the unnatural cryptomarkets because there is absolutely no reason to think that there should be any nonzero "fair price" of the Bitcoin and similar entities. The only fair price is zero. The previous sentences may be disputed and labeled an "ideology" – by those who deny the importance of the calculations of the intrinsic value. However, this "ideology" is true and has real-world consequences.

In particular, I think that the managers at Bitmex have a simple incentive. During flash crashes such as this one, they want to add artificial trades that amplify the motion of the price. Why? Because many leveraged positions get wrecked. As shown at Bitmexrekt, hundreds of millions of dollars in long positions were liquidated. Many of those were at the final price below $7,000. So these amounts were amounts that were directly swallowed by the managers of Bitmex. By fabricated sales, they could push the price well below $7,000 and "force" some leveraged users to sell the Bitcoin for $6,500 or so, while they could only buy it again for a price above $7,000 minutes later. Assuming that the price returns above $7,000 shortly – and it did ($7,300 at Bitmex, some hours after the flash crash) – the closed positions at prices below $7,000 contribute an easy profit for the owners of Bitmex! When a long BTCUSD position worth $10 million is closed at $6,500, it may represent an easy profit of $1 million for Bitmex because the later inverse purchase (or the simultaneous purchase through another exchange where the price is still higher!) may take place at a price $7,200 that is higher by 10% in average.

Because I think that most of the leveraged positions at Bitmex are still long the Bitcoin or other cryptocurrencies, Bitmex is particularly motivated to increase the downward collapses of the Bitcoin price. If the trading at similar cryptocurrency exchanges becomes dominant, there will be a significant downward pressure on the price. Most of those who organize the trades want the price the drop because the long leveraged positions are closed and the exchanges make a predictable profit. On the other hand, they also prefer this business to be sustainable. But can it be sustainable? If there's some fixed profit to be made in the future, it's probably better to make it as quickly as possible.

Just to be sure, the deeper price crash at Bitmex may be partly or completely natural – the closed positions force additional sales of BTC on the market which wrecks other long positions, and so on. I don't claim that there is always an intent of the Bitmex owners to close as many positions as possible. But they may really choose whether they dump the BTC to the market right away or keep it and they have a very good reason to do the former if it leads to a large number of extra margin calls.

This is just an example of a strategy that is probably pursued by the cryptoexchanges to achieve or increase the profits. This whole trading is more or less a zero-sum game so the profits and losses look like gambling. The only problem is that the players don't have the same chance to achieve a profit or a loss. There are people who know what they're doing or who have the tools and who may manipulate things, and they're making an almost guaranteed profit, while the clueless "investors" who really believe that the purchases and panic sales of cryptocurrencies amount to "investing" almost universally lose.

They may be dismissed as stupid sheep who deserve to lose. And yes, I think that in an overwhelming majority of cases, they do deserve to lose and it's both just and very healthy for the overall economy when the money is transferred from such deeply misguided or irresponsible people to the wiser ones. On the other hand, I do think that they may be "innocent" – e.g. if they're beginners who just don't have an experience but they have the potential to become smart – and the "innocent" traders simply should be warned. Some explanations why they're the "underdogs" in similar zero-sum games should be written everywhere. You may find them on The Reference Frame. But if this cryptotrading were a part of sensibly regulated financial markets, I think that all cryptoexchanges and even "Bitcoin fan clubs" on the Internet would be obliged to present warnings – and perhaps some details similar to this blog post – explaining why the cryptocurrency trading is not only "risky" but also "more likely to produce losses to a naive investor than profits".

Even the companies and people who "think that they know what they are doing" may lose because their strategy is less careful and their model is less accurate or rigorous and someone else has understood their strategy and rips them off. But I won't reveal any details because it would could hurt someone's profits – that I consider rather well-deserved. But whether some methods to achieve a profit in the financial markets is "ethical" or "legal" depends on the laws and societal conventions and habits. As I said, traders are helpful when they look for a fair price and their profits – which are positive in average – are well-deserved in most cases. But if and when there's no point to a market, no fair price to be found – like in the cryptocurrency case – I think it also makes sense to say that all the players' profits are undeserved. But this is just an ethical judgement of a sort. Legally, the trading of the cryptocurrencies seems allowed, and if some people do it more cleverly than others, it's a sign of their intelligence and it is a legally OK outcome if they achieve a profit.

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