Are Traders Manipulating The Price Of Bitcoin?

A Department of Justice criminal investigation into "spoofing" and "wash sales" is now underway.

In this photo illustration, a visual representation of the digital Cryptocurrency, Bitcoin sits on US mobile payment company Circle application in Paris, France, Feb. 27, 2018. Photo: Chesnot/Getty Images

By Sean Williams, Motley Fool.

In 2017, the cryptocurrency market simply couldn't be stopped. In just a 12-month period, the combined value of all virtual currencies added together rose from $17.7 billion to roughly $613 billion -- a gain of more than 3,300%. By comparison, it would have taken the stock market decades to generate the returns that virtual coins dished out in just one year.

Wait, bitcoin can go down in value?

However, 2018 has been a completely different story. Bitcoin, the largest cryptocurrency in the world by market cap, shed more than half of its value in just a one-month span toward the beginning of the year, and it's struggled to recover ever since.

What's behind bitcoin's struggles, you ask? Part of the blame can be assigned to a step-up in regulation. Investors tend to appreciate the anonymity and unregulated nature of virtual currencies. However, in South Korea, a market that's critical to the success of bitcoin and digital currencies in general, new laws in place require banks to verify the identity of their members before linking their bank accounts to cryptocurrency exchanges. This newfound transparency likely goes a long way to validating bitcoin as an asset, but it's not been viewed as a positive by some within the crypto community.

Bitcoin's woes may also be partially blamed on what I refer to as the proof-of-concept conundrum associated with blockchain technology. Blockchain -- the digital, distributed, and decentralized ledger that underlies most cryptocurrencies and is responsible for logging all data in a secure and unchanging manner -- has proven its worth in numerous small-scale projects, but has yet to catch on in the real world. Until businesses are willing to give this technology a shot, and blockchain can demonstrate its ability to scale, it'll remain constrained.

More recently, though, legal concerns have held back bitcoin.

Are traders manipulating the price of bitcoin?

Last week, the U.S. Department of Justice (DOJ) announced that it was opening up a criminal probe into whether cryptocurrency traders are manipulating the price of bitcoin and Ethereum for financial gain. The DOJ will be working side by side with the Commodity Future Trading Commission, which currently handles all derivatives trading tied to bitcoin.

The DOJ believes that bitcoin is susceptible to fraud for a number of reasons, as listed by Bloomberg. In particular, regulators question whether cryptocurrency exchanges have adequate measures in place to actively pursue those folks who attempt to cheat the system. They also point to the wild volatility in digital currencies as a lure for cheaters who are looking to manipulate the system. Lastly, the aforementioned lack of regulations could make it considerably easier for traders to move virtual coins like bitcoin.

According to sources familiar with the matter, regulators are looking into two specific types of manipulation: spoofing and wash-sale trades.

Spoofing involves a trader, or group of traders, placing an order that creates a new best bid or adds to the perceived liquidity of an asset. Shortly thereafter, the trader(s) will then cancel their initial bid (the spoof) and place a trade on the opposite side of the market. This is done so a trader can sell their stake in an asset, but at an improved sales price thanks to their spoofed bid, which may have offered the perception of downside liquidity and/or support and encouraged other traders to bid up the price of an asset.  The same can be done in reverse, with spoofed asks, ultimately allowing the trader(s) to net a more attractive purchase price on an asset.

On the other hand, a wash-sale would involve an individual, or group of traders, buying and selling an asset with themselves in the hope of pushing its price higher and giving off the perception of improved liquidity.

Given how little regulation surrounds most decentralized crypto exchanges, spoofing and wash-sale trades may very well both be occurring, but we won't have any confirmation on that until the DOJ's investigation wraps up, which could take some time.

Yet another reason to avoid bitcoin

It's become pretty evident as time has passed that bitcoin, while being an incredible creator of wealth over the past couple of years, is rife with risk. In addition to potentially being manipulated by cryptocurrency traders, bitcoin's network has slowed to a crawl, relative to its peers.

According to an analysis of transaction speed per second conducted by HowMuch.net, bitcoin peaks at a meager seven transactions per second. By comparison, leading global payments processor Visa can handle up to 24,000 transactions per second using its existing infrastructure.

Bitcoin's block-processing time of approximately 10 minutes also tends to be substantially longer than its peers, resulting in an average validation and settlement time of 78 minutes. Sure, this is still quicker than sending funds across borders using traditional banking networks, but it's substantially slower than practically all of its peers. Though the Lightning Network is supposed to resolve bitcoin's scaling issues, the damage may already be done.

What damage you ask? We've witnessed a small handful of merchants moving away from bitcoin as a medium of exchange due to its slow network. Payment processor Stripe, which was the very first major company to accept bitcoin in 2014, dropped bitcoin as a payment method last month.

And, just to round things out, there aren't any traditional fundamental metrics with which to value bitcoin. Unlike a stock, which has income statements, balance sheets, earnings reports, and management commentary that can be scoured, bitcoin offers nothing more than transaction speed and average daily transaction count, which tell us absolutely nothing about its long-term staying power.

As amazing as the gains have been, the writing appears to be on the wall to avoid bitcoin.

Sean Williams has no position in any of the stocks or cryptocurrencies mentioned. The Motley Fool owns shares of Visa, but has no position in any cryptocurrencies mentioned. The Motley Fool has a disclosure policy.