Howard Marks


4 Ways Altcoin Exchanges Promote Fraud

The popularity of altcoin exchanges is causing grave concerns among regulators such as the SEC who are charged with protecting investors, and now the SEC has come forward saying that all unregistered exchanges are illegal. The problem is simple: these exchanges are unregulated, and there is no oversight on their activities. Unsuspecting investors are getting ripped off. Below are four of the classic fraudulent schemes operated by criminals who are more interested in greed than saving the world, and all four are possible on altcoin exchanges.

1. Pump and Dump Baby!

Some of the popular Pump and Dump groups on Telegram.

Telegram is the ultimate way for fraudsters to organize one of the classic fraud schemes called Pump and Dump. The idea is simple: get a large group of people to buy an altcoin at a certain time to drive up the price. Others see this frenzy and think there is an opportunity to profit from this price increase. These unsuspecting investors go in and start buying while the pump and dump operators sell their recently purchased altcoins. Inevitably the altcoin will fall back to its original value because there was no real reason for its rise in the first place.

A screenshot from a message in a Telegram Pump and Dump group.

This scheme is illegal regardless if the altcoin is a security or not. The defrauded investors can sue, and for that matter so can the SEC and the 50 State Administrators in charge of protecting investors. The problem is this: Telegram’s operations are relocated constantly, and it would be very hard for any authorities to subpoena and get information on the ring leaders. Even if they did, these people are probably masking their own IP address, making it that much harder to track down these fraudsters.

Talk about calling the kettle black.

2. Front Running Always Wins!

This photo is taken from Ivan Bogatyy’s informative article “Implementing Ethereum trading front-runs on the Bancor exchange in Python.”

There is another more quiet fraud scheme called front running. In this scheme fraudsters find a way to look at the orders placed on the exchanges before they are transacted. When they see a large order coming which could increase the price of a particular altcoin, front runners place an order in front of the original order to purchase that same altcoin. Once the real investor order is completed or in the process of completion, they simply sell to take advantage of the price increase.

Given the nature of this type of scheme, front running has traditionally most often been done by the exchanges themselves. However, given the nature of the blockchain, there are concerns about cryptocurrency front running vulnerability due to pending transactions being public and the lag time before confirmation. A front runner could pay a higher transaction fee to have their purchase order confirmed before another pending transaction. This means that altcoin exchanges are vulnerable to front running even if the exchange itself isn’t fraudulent.

3. Insider Trading — The Wolf In Sheep’s Clothing

Another classic fraud is the insider trading scheme, in which someone has non-public information about an exchange and uses it to their advantage. For example, take an exchange that is going to list a new altcoin as Coinbase did with Bitcoin Cash. Employees of Coinbase purchased Bitcoin Cash ahead of the public announcement that Coinbase would accept it on its exchange.

This is clearly insider trading, which is fraud and punishable by three times the profits made or losses averted, plus potential jail time. In Korea, the government announced they found the very people who regulated the markets to act on insider trading by purchasing or selling altcoins prior to government regulation announcements such as requiring all investors to be identified (KYC). It’s clear that insider trading is happening on these exchanges; the only question is how deep does it go?

4. Fake Flash Crashes

Exchanges offer investors margin accounts, with which investors can borrow buying power or cryptocurrency from the exchange to purchase more altcoins in margin. This is great while the prices of those coins go up and bad if they go down. If the margin account’s value goes down by a certain amount, usually stated by the exchange, the borrowed money becomes worth 50% of the account value. Then there is a margin call, and the coins are sold by the exchange to pay back the margin.

What can happen is a flash crash, where for a very short period of time the coin’s value goes down 90%. All the accounts get a margin call, and their coins are sold instantly. Quickly thereafter, the market price goes back to where it was, but the investors lost all of their coin value.

Cryptocurrency’s market volatility could easily mask an exchange manipulating flash crashes. Instances like Bitfinex’s flash crash last December also raise suspicious questions of how can a flash crash occur on a singular exchange without foul play? Who is to say the exchanges are not operating these flash crashes or hackers are not creating them to profit from the artificial coin value drop?

The Future of Exchanges is Regulation

In regulated marketplaces, which are operated by broker-dealers, the identity of every investor is known (KYC), and the activity of every investor is closely monitored. The goal of regulation is to protect the unsuspecting investors who are good actors. The bad actors are removed and prosecuted to the extent of the law.

Because the altcoin exchanges are not regulated, they are promoting fraud by letting any investor behave in any way they want to. It is not clear if exchange employees are also engaging in front running or not. In Korea, the exchange Coinpia had to halt trading because they had not been able to put in place an effective know your customers (KYC) program, as newly required by the Korean government. This is alarming because every major financial institution has such a program in place, so why can’t an altcoin exchange achieve this low-level requirement?

Now the SEC is speaking out against these exchanges in the current form. Soon, these altcoin exchanges will no longer exist. So what can exchanges do? The SEC has approved the use of Alternative Trading Marketplaces (ATS), which can trade alternative assets like altcoins. The operators need to be registered as broker-dealers, and the employees who are dealing directly with the investors or managing the operations need to be licensed.

What is the big deal with that? Yes, it adds additional costs to the company, but look at the value it brings to the table: assurance and oversight. Exchanges are making so much money that they can afford this regulation. So what is stopping altcoin exchanges from doing it?

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