How to corner markets, Bitcoin style

If you think retail FX and spread-betting shops have a problem with one-way client risk, then don’t even dare to look into the Wild West stuff going on in crypto land. It’s the Bank to the Future Biff Tannen version of 1985 in Technicolor (Oculus Rift form naturally).

As we’ve noted before, Bitcoin markets are a hotbed for unscrupulous market practices. Everything from HFT, front-running, rebating, preferential order flow, poor margining, naked shorting, and now the truly popular one — active “collusion” by big players. It’s all there.

What’s really cute is that a lot of the time the cowboys think they’re being truly innovative with these strategies. (Michael Lewis obviously hasn’t penetrated their radar.)

On which note, unconfirmed reports come our way of the latest bearwhale scheme being hatched — this time being organised by a particular bearwhale called Benji — to corner the market with the cunning use of the “shake out the weak shorts and cause a short-squeeze” strategy.

Helping the bearwhales load up on CHEAP COINZ, to more efficiently front-run the pump they’re arranging, has been a barrage of negative news since the beginning of year, including some of the biggest names in the world of Bitcoin. Needless to say, some are suspicious about the timing of what were once Bitcoin evangelists suddenly coming over all concerned about Bitcoin’s volatility exposed punters. Furthermore, they note that the Wild West structure of the Bitcoin market has no insider trading rules or constraints on directors talking down stocks just to load up on CHEAP COINZ thanks to knowledge of carefully orchestrating pumping campaigns, or news of capital bailouts.

It’s a genius plan if you think about it, because there really is no one out there looking out for the little guy.

One thing the bearwhales may not have accounted for, though, are the perils associated with shaking out weak shorts in totally unregulated markets. Especially when they’re based in China. That peril is neatly encapsulated in two words: credit risk.

Let’s just say if Chinese counterparties don’t have a problem defaulting on major international commodity firms when derivative trades go the wrong way, it’s a pretty large leap of faith to expect them to stay true to contracts pertaining to crypto coupons.

Ask yourself the following: if a guy is talked into putting $2,000 on a short trade because an anonymous tipster says it’s a guaranteed trade but then the trade goes bad, generating mark-to-market losses more than ten times the sum he put in (because, you know, leverage) — is he likely to deliver the cash or is he going to walk away? If it’s the latter, who’s really the one left out of pocket?

Nevertheless, if you’re planning to ride the bearwhale wave, one word of warning. Cynk.

Cynk teaches the important story of why a stock-pump can go so far.

Eventually someone will want to cash-out against the inflated price and unless the stock’s real-world value matches what’s been engineered by the pump, all you’re setting yourself up for is an impossible to materialise mark-to-market gain (a problem for the bearwhales who still have dollar liabilities) or a cataclysmic drop in value back to where you left off from.

This is because at its fundamental level all a pump does is move around a finite pool of capital unequally between investors. For every owner to be able to cash out at the inflated price, a new entrant has to be willing to takeover his position at the same value. The more overvalued the price relative to the number of holders of the stock, the less likely all of them will be able to leave at the inflated price.

But with Bitcoin the situation is even more twisted than that. On one hand you’ve got elements evangelising about the need to accelerate user and merchant adoption for real-world transactions, and on the other hand you’ve got a community of colluding speculators out to destabilise the very people whose loyalty and trust must be gained if the thing is ever to achieve real-world transaction currency status. In that sense, it’s the equivalent of a parasite stifling the host it depends on.

Furthermore, you can be assured the bearwhales don’t have to provide precious identity details to the exchanges that take their flow. All their flow, conversely, is handled off exchange with OTC-level discretion and secrecy.

Strict identity requirements and credit checks are reserved only for those bringing real fiat money into the system, you know, so as to minimise the risk of defaulting against the bearwhales themselves. Oh the asymmetry. You couldn’t make it up.

Why a group of computer scientists (allegedly good at maths) can’t understand these fundamental facts is the really curious part about the story.

But it’s worth noting there’s a good historical account of genius mathematicians with poor interpersonal skills, true believer tendencies and obsessive alchemical desires being duped by pyramid schemes:

That, of course, is Sir Isaac Newton, discoverer of gravity, warden of the Royal Mint and South Sea bubble victim.

We’ll leave you with some relevant insight from Peter Temin and Hans-Joachim Voth’s paper on Riding the South Sea Bubble:

We examine one of the most famous and dramatic episodes in the history of speculation, the South Sea bubble. Data on the daily trading behavior of a goldsmith bank—Hoare’s—allow us to examine competing explanations for how bubbles can inflate. While many investors, including Isaac Newton, lost substantially in 1720, Hoare’s made a profit of over £28,000, a great deal of money at a time when £200 was a comfortable annual income for a middle-class family (John Carswell, 1993).

The behavior of a single knowledgeable investor can tell us much about the nature of bubbles and investors during periods of substantial mispricing. The bank did not profit simply by chance. It “rode the bubble” for an extended period while giving numerous indications that it believed the stock to be overvalued. Short-selling constraints and the difficulties of arbitrage that have been emphasized in recent work on the dot-com mania cannot explain the South Sea bubble. A zero-investment constraint, if it existed, did not bind market participants like Hoare’s. Perverse incentive effects arising from delegated investment management highlighted in recent work on mutual funds and hedge funds were not at work. We infer that the need for coordination in attacking the South Sea bubble was the key to allowing it to inflate to such an extreme extent, in line with recent theoretical work by Dilip Abreu and Markus Brunnermeier (2003).

———————–

We do not argue that synchronization risk was the only cause of the enormous rise and fall of South Sea prices. Hoare’s rode the bubble, while acting in other ways that betray a belief that the stock was overpriced; it helped intensify the boom without providing the stimulus for it. Artificial shortages of stock, partly engineered by the company itself through its loan transactions, might have contributed to the bubble, along the line of arguments offered for the dotcom mania (Ofek and Richardson, 2003), but the evidence is not compelling. There was substantial free float, and on average the subscriptions and lending operations probably increased the supply of South Sea stock in 1720.

Once the writing was on the wall in late August in the form of a scramble for liquidity after the fourth subscription, with prices beginning to decline, the bank liquidated its positions. The “coordinating event” for knowledgeable speculators to get out may well have been a growing credit shortage in August as a result of subscription payments becoming due (Neal, 1990) and the decision by the company to announce a dividend of 3 to 5 per cent at prevailing prices.28 Once investors were faced with the reality that additional investors were no longer pushing up prices reliably, and with evidence of how low the yield was, coordinating an attack suddenly was easy, and the bubble collapsed.

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