One of the hallmarks of most digital currencies is extreme volatility. Frequent and significant price fluctuations were a concern particularly in the earliest days of some of the major cryptocurrencies, but the phenomenon continues up to this day. One need look no further than the largest digital currency in the world, bitcoin (BTC), to see evidence that this is the case; in late 2017, BTC rose to a record high of almost $20,000 per coin. By just a few weeks later, it had plummeted to roughly a third of that value.
Price fluctuations don't just occur on a larger time scale such as this one, stretching out over weeks and months. In fact, they also take place from second to second as well. It is this fact that has allowed some criminal operations to benefit from flash crashes of popular digital currencies, buying up the hottest tokens at low prices and then selling them once the prices are corrected. Now, a new trend has caused the cryptocurrency community concern as well. Called "spoofing," it is the process by which criminals attempt to artificially influence the price of a digital currency by creating fake orders.
A Spoofing Primer
As with all tradable securities, the price of a digital token depends on many factors, among them the overall sense of optimism or pessimism pervading the broader market and individual investors. While this sense of the momentum and potential of a cryptocurrency can be difficult to quantify, it is nonetheless something that savvy investors are highly attuned to. Because of the impact that a feeling of optimism or of pessimism can have on a group of investors' tendency to buy or sell that digital currency, these concepts are critical to the price of that token, even if they remain somewhat elusive.
It is the fact that these sentiments are elusive that allows spoofing to be possible and effective. Traders wishing to manipulate the market for a given cryptocurrency can create the illusion of optimism or pessimism by initiating fraudulent buy or sell orders. When traders generate these orders without the intention of filling them, they trick other investors into either buying or selling, and the price of the cryptocurrency stands the possibility of being adjusted accordingly. The trader cancels the orders once the price of the cryptocurrency moves in the direction he or she desires.
Spoofing in Practice
Bloomberg reported on an investigation by the U.S. Department of Justice (DOJ) launched to determine whether cryptocurrency price manipulation had taken place in the bitcoin network as a result of spoofing. According to the report, authorities at the DOJ are concerned that exchanges around the world have taken an active approach to pursuing traders engaging in spoofing. It may be that the investigation is focused on bitcoin not only because it remains the largest digital currency by market cap, but also because its massive price increases late last year drove hordes of new amateur investors into the space. These investors, keen to make what they see to be easy money off of a digital currency that seems destined for stratospheric heights, may be the most susceptible to spoofing.
When spoofing does take place, it often is accompanied by wash trading. Wash trading is similar to spoofing in that it aims to manipulate the price of a digital currency by artificial means, although the means of implementation are different. In wash trading, a cheater trades with him or herself in order to create the illusion of market demand, thereby luring unsuspecting investors into entering trades as well.
University of Texas finance professor John Griffin believes that the cryptocurrency space is particularly susceptible to spoofing. He explains that "there's very little monitoring of manipulative trading, spoofing and wash trading" in the cryptocurrency world, adding that spoofing the market and illegally manipulating prices "would be easy."
Guarding Against Spoofing
How is an investor best able to protect herself from investing in a digital currency while spoofing is taking place? Overall, caution is the central approach for many investors. It's best to beware of opportunities that seem too good to be true, and it's also worthwhile to ensure that any exchanges you trade on are vigilant to the possibility of fraud of all types, including spoofing and wash trading. At the same time, some exchanges are looking to ramp up their security and monitoring systems in an effort to guard against spoofing and protect customers.
The Gemini exchange, created by Cameron and Tyler Winklevoss, for instance, has recently announced a partnership with Nasdaq to conduct surveillance of digital token trading.
Ultimately, even the most vigilant investors can still be susceptible to price manipulation in the digital currency world. For that reason, it's crucial to keep in mind that this space remains a highly speculative one, and that digital currencies are not the be-all and end-all of any investment strategy.