Self-Regulating Markets in Cryptocurrency

This is where we find out that the people who said we couldn't have self-regulating markets were wrong.



Well, maybe they were right in a way. We couldn't have them in traditional economic structures, bound by complex webs of debt and top-down regulation. But we've been thrown into a new paradigm, the paradigm of Bitcoin and cryptocurrency. We, the participants in the many cryptocurrency exchanges and brokered markets, have, by all appearances, found ourselves forced by necessity to recreate sensible market forces.


Here are some examples of forex market action totally initially absent from Bitcoin and cryptocurrency instruments, and the equivalent or present day situation with regards to those actions. I'll give some pros and cons according to my understanding of the differences between regulated forex markets and unregulated cryptocurrency markets.

Market makers

Regulated forex markets generally employ market makers for each currency pair, or each trading instrument. The market maker accepts a lower trading fee in exchange for promising to buy or sell within a certain spread at all times. This results in a steadier price for the trading instrument, with smaller variations and shorter candle wicks and bodies.

In cryptocurrency, we see the "Evil Market Maker" at work in many brokerages: the spread on manipulated pairs will move vast distances up and down within short periods of time, making last hour's great buy a large loss as often as not. Automated trading systems are working these spreads, painting the tape, drawing the candles onto the chart to draw in unsuspecting marks.


To my knowledge, no public cryptocurrency exchange/broker employs official market makers, although some exchanges such as Cryptsy have expressed interest to casual inquiries from would-be straight market makers.


This is a situation where regulation in the absence of action from the brokers/exchange operators, could actually be to the benefit of the markets. If the participants in the market wish to avoid outside regulation, eventually imposed with the intent of avoiding widespread chaos and market manipulation, and its spillover to the traditional financial realm, they would do well to acknowledge the existing problems with manipulative market making, and demand the installation of proper market makers along the lines of traditional forex brokerages.

Arbitrage

Arbitrage is the practice of taking advantage of inefficiencies in currency pairs trading, such that one can simultaneously execute trades in three or more related pairs (triangular arbitrage) and realize a risk-free profit. In practice, slippage, liquidity, and competition place serious limits on the potential gains from arbitrage from new traders - not to mention the costs of fees eating into net margins. And forex brokers don't allow it within their systems - banks and brokers make a lot of money cornering the market on arbitrage in forex. Forex brokers also typically require traders exit trades on the same instrument they entered on, which makes inter-exchange arbitrage the only feasible option for retail forex traders (the little folks who are day trading through a broker).

Manual arbitrage almost certainly arose immediately as soon as Bitcoin was traded against multiple counter currencies, such as the US dollar (USD), Euro (EUR) and Russian Ruble (RUR). It's still possible to profit from arbitrage during periods of extreme volatility, but the unwary crypto trader is more likely to lose their shirt to slippage than to score a few satoshi. However, the established cryptocurrency market arbitrageurs perform an important role in the
markets by ensuring that no one ever overpays for a currency by buying
it through a certain pair or market, rather than another. These days they use automated solutions to the problem, and no inefficiencies exist for long.


In contrast to the aforementioned market making situation, there is no way to perform 'unfair' arbitrage, and therefore no government enforced regulation has been necessary in the traditional markets. Instead, there is merely ever-swifter arbitrage via better software and hardware - the regular customers of the exchange can only benefit from more competition at arbitrage, by being less likely to overpay for a currency.

Consumer protection

In the traditional finance world, Chuck Ponzi is infamous for starting an scheme that paid early investors with the proceeds from later investment. This is also known as a pyramid scheme, presumably where all the money accumulates at the top of the pyramid. In cryptocurrency, the rapid deflation of Bitcoin during its initial uptake (which continues to accelerate, with various deleterious effects to its economy) has been unfairly compared to such a scheme in the past.



The true comparison is to "premines", or cryptocurrencies where a large portion of the total coin base is reserved to the coin's founders. Those stakes are worthless until many people have contributed much hashpower in the mining of the coin, at which point the holders of the premined portion are in possession of much value that they did not have to mine for at all.

Premined currencies are rather commonplace in cryptocurrency, although only a few of them have managed to become accepted by Bitcoin exchanges. A common criteria for acceptance for trading instruments on the exchanges is that a currency not have been premined. Some exchanges do not differentiate between premined and non premined currencies, and list them next to coins which were 100% fairly mined. This could be construed as disingenous, perhaps.


The thing about open source and cryptocurrency is that it's a meritocracy of sorts. Everyone is free to choose the currency with the best fundamental features. Premining is a giant Black Spot on the hand of a currency. Naturally, most of the premines don't advertise the fact of their fundamental dilution as a feature- but you can read a partial list of coins noted as premines at https://bitcointalk.org/index.php?topic=134179.0. This list is now slightly out of date, but is still one of our first stops for researching up and coming coins.


In addition to premines, there are several out-and-out pyramid schemes which have been successful in separating many people from their hard earned Bitcoin. These schemes, exactly as in the equivalent illegal fiat currency con jobs, masquerade as legitimate investment or 'games', and promise lavish returns...just as soon as your investment 'matures' or is 'bought'. You'll never see the words 'pyramid schemes' on these websites, but that's all they are.



Promotion of these pyramid scheme websites, including cross-promotion with legitimate services, should be seen as a red flag for trustworthiness when choosing a vendor for Bitcoin or other cryptocurrency-related products or services. And if an investment looks too good to be true, or doesn't offer any stop loss/money back guarantee (that you can verify other people have had
honored), simply don't touch it.


Fair spreads (employing market makers) also falls broadly under the spectrum of consumer protection.

Conclusions

Market making has emerged for cryptocurrency markets. But it is prone to abuse in the current environment. Arbitrage is functioning adequately. And as with market making, consumer protection is an area where much is lacking in the way of self-regulation. Awareness of premines and pyramid schemes is growing, although more people still need to be warned about the nature of the scams. Fortunately most exchanges will not promote or trade premined currencies.



That leaves us with a dismal current score of 1 for 3 for deregulation, frankly. Perhaps a 1.5 if you count the Evil Market Makers providing some broad measure of stability, even as they generate a measure of whipsaw all day, grinding Jack and Jane into flour for their bread.


Can you attribute part of your trading experiences to these market forces? Do you have a special insight into some of the areas discussed? Let us know in the comments area.

This article was originally published in slightly different form under the title "The People Who Said We Can't Have Self Regulating Markets Were Wrong...Maybe" at Wall Street Crypto (http://www.wallstreetcrypto.com/2013/12/the-people-who-said-we-cant-have-self-regulating-markets-were-wrong-maybe.html).