The damage that cryptocurrency trading bots could be doing to exchanges

Trading software and trading algorithms are not a new addition to today’s markets, especially if you consider the fact that most of the trading that happens on traditional financial asset markets is done by these “bots”. It makes sense for them to exist and operate in the markets the way they do. The bots are much faster than humans and they are much more efficient. THey trade according to raw data and do not succumb to the same level of bias that humans tend to have in their trading. There are certain parties that have been objecting to the use of automated trading algorithms, claiming that such automated systems are relatively easy to manipulate or, on quite the contrary, have already taken over the markets and are manipulating them to results that human trading would not have caused. The current objections of the traders might or might not be true, but the fact that automated trading is used in most of the markets, with “bots” controlling more than 80% of all stock on the US markets, means that there is little point in arguing against their existence. They have become an integral part of trading, and are a great help to the stock traders.

What we should be talking about instead is the fact that similar automated bots are starting to flood the decentralized and centralized cryptocurrency exchanges. While the fact that most trading is done by bots is accepted on the traditional markets, it might present quite a problem with most of the cryptocurrency exchanges.

How easy it is to manipulate crypto markets

Cryptocurrency markets are, in many ways, similar to traditional markets, with one significant difference. The volatility of the assets that are traded on these markets (cryptocurrencies) makes it so that they are much more susceptible to manipulation. While you might not necessarily agree, all you have to look at in order to see how easy it is to manipulate prices of cryptocurrencies is look at the recent developments in the industry.

Up until a month or two ago, cryptocurrencies and Bitcoin specifically were at an all-time low since the 2017 surge in value. The cryptocurrency “winter” was predicted to last for at least half a year, or at least some new blood was infused into the markets. Bitcoin fell to a point where many were losing hope that it could make a comeback, going to somewhere around the abysmal $3000 for the first time in two years. While many were sitting and considering how they were going to divest and take the losses, a sudden changed occurred. But when nobody was really expecting it to happen, a single buy order on Bitcoin, amounting to about $100 million caused a bull run the effects of which we see right now. Bitcoin quickly surged from being just around $4000 in value, to where it is right now, floating around $8000, with some thinking it will be hitting $9000 sometime soon.

Although the bull run was short, it showed something. All it takes is a single large scale buy order to increase the value of BItcoin at least twofold and to get the market bulls running at full speed again. And when Bitcoin happens to increase in value, the rest of the market follows, seemingly at exactly the same rate as Bitcoin is going.

The inherent danger of volatility

But how is the information above related to automated trading bots? Well, if cryptocurrencies are so easy to manipulate, it means there are ways to get the inherent volatility of cryptos to work for you. All it takes is a large scale buy order, either from a single whale or from a large segment of the market, in order to start building momentum and value for Bitcoin. While not that many people have millions of dollars, many are able to combine the forces of their bots and a little bit of manipulation, in order to create a surge of buy orders on cryptocurrencies.

How many bots would one need to create such a rush? Well, that is a deep question to explore. There are no specific statistics that would be able to identify the number of bots needed to start a rush. We know that it takes around a hundred million dollars to buy order to create a bull that increases value by 100%. Not that many people are capable of providing that kind of investment money when they are looking to manipulate the market. But what if we do not want a 100% rush. What if all a trader need is a short term increase in Bitcoin value, let’s say of 5-10%, in order to generate the income they desire? Theoretically speaking, all they would need is about 5-10 million US dollars. Now, this math is incredibly flawed - that is not how money works, you can’t just assume that an investment of one million is going to have the same power as the per million power of a single one hundred million dollar order. But we do not need this kind of power. What we do need is to make the market feel like a bull run is coming.

So you take a bunch of bots and get them to place a number of orders, all of which amount in value to about five million, altogether. Suddenly, the market seems like there might be a slight bull run coming, so more people place buy orders, nobody wants to miss out on the early signs of a bull run. With sufficient people catching on, the bots will have caused a small surge. They might not even need $5 000 000 worth of orders, maybe even two. But as the market follows and hundreds of other traders place buy orders, the value of Bitcoin increases by just enough that the person who placed the buy orders will now be able to sell all of their Bitcoin (or a chunk of them) for a handsome profit.

There is no evidence that anything like this is being done, or that it will ever be done. But there is evidence that bots are being currently used on the crypto markets, and many are saying that the current bullrush is nothing but a result of just that. The result is that the market, even the centralized crypto exchanges, are suspected of having about 90% of their trading being done by bots, and a number of those trades are coordinated in order to produce certain desired results. While there is no specific proof on the subject, the possibility seems to be just in there and it seems to be affecting the markets.

Solutions?

There are no specific solutions that can be suggested at this point, but there are some ideas. One possible solution would be the changing of the exchange structure, which would disincentivize high frequency, high latency automated bot trading. Other solutions include understanding these bots better in order to counteract the effects they have on the market. One more simple solution was to ban all such automated trading bots, although there does not seem to be one way to identify if a trader is a trader or a bot, without getting in the way of traders doing their jobs successfully. While this could be done by the introduction of third parties, such as cryptocurrency brokers, there is a possibility to abuse this mechanic otherwise and is not recommended to consider.

It is also hard to say that there is any direct effect on the markets on a daily basis, beyond the exchange becoming more friendly to high-frequency traders. There is evidence though, that such trading and behavior could be the cause of issues for a number of new entrants to the markets. It also means that a large number of large investors might find the markets to not be as attractive an investment as they used to think it is. For now, the only thing that can be done is to hope that such bots are not going to be used on a large enough scales to nefariously manipulate the markets for whatever cause, but the danger is definitely there.