Crypto markets are once again under the regulatory spotlight, as the U.S. Commodity Futures Trading Commission (CFTC) is reportedly probing Jump Trading’s involvement in the crypto space, according to a Fortune article published on June 20, 2024. While media reports note the investigation is not evidence of wrongdoing, the resignation of Jump Crypto’s President Kanav Kariya’s just four days later further fueled speculations about the seriousness of the allegations.
This article explores the role of market makers in crypto markets, outlines what can often be a thin line between legitimate trading by market makers and manipulative trading patterns, and highlights potential steps the crypto industry needs to take to bolster regulatory compliance and ensure fairness and integrity in trading.
The Role of Market Makers in Crypto Markets
Market makers play a crucial role in the crypto ecosystem by providing liquidity to enable trading for new and established assets. They facilitate trades by continuously buying and selling assets, thereby ensuring there is always a counterparty for traders. This activity helps to stabilize markets and maintain fair pricing. Market makers have an obligation to provide liquidity on both sides of the order book at or close to the best market price, but not to influence price artificially. The significant power wielded by market makers thus raises concerns about the fine line between business-as-usual market-making and potential market manipulation, including tactics referred to as "cornering the market.”
Why Crypto Market Makers Are Prone to Cornering the Market
Crypto markets, particularly those with lower liquidity, are susceptible to cornering due to their relatively small size and the concentration of assets among large holders. Market makers, by virtue of their role, often hold substantial quantities of various cryptocurrencies. This positions them to influence market prices significantly. Additionally, the lack of comprehensive regulatory oversight compared to traditional financial markets creates an environment where borderline manipulative practices can be deployed more easily. The inherent volatility of crypto assets further amplifies the potential impact of market manipulation, making crypto markets particularly prone to cornering the market patterns. In contrast, in traditional assets like equities, market makers face more stringent listing requirements, such as maximum spreads, minimum liquidity requirements, etc., that help limit this kind of activity. One additional element involves listings—unlike the crypto markets, where market makers can take positions in tokens ahead of their listings and trading on decentralized exchange (DEX) liquidity pools, inflate the price, and then dump it on a centralized exchange, in traditional finance markets, not everyone can just launch an asset and get it trading.
What is Cornering the Market?
In crypto markets, cornering the market refers to the act of obtaining a controlling interest in a particular cryptocurrency to manipulate its price. This can occur when an individual or entity gains enough control to influence supply and demand dynamics, leading to price manipulation. While some instances of market control can occur unintentionally, some cases involve deliberate schemes to mislead and manipulate investors. To successfully corner a market, the actor must be able to purchase a significant portion of the market cap of a particular cryptocurrency, which typically applies to lower liquidity coins.
Key Characteristics of Market Cornering
- Control: The entity gains significant control over a cryptocurrency, often hoarding a substantial quantity.
- Manipulation: Using this control, the entity manipulates prices to their advantage.
- Market Impact: The manipulation leads to an artificial distortion of prices, harming other market participants, essentially the first step in a pump and dump scheme.
Market Abuse Typologies in Crypto
Market abuse in the crypto sector can take various forms, each with its unique tactics and impacts on market integrity. Below are three relevant typologies observed by the Solidus research team:
Cornering the Market and Ramping
As of today, disclosure requirements are not as stringent in crypto as they are in traditional finance. Solidus research has historically identified numerous instances where wallets potentially associated with market-making actors have accumulated as much as 60% to 70% of a token’s circulating supply over time, in line with a dramatic price increase. In many cases, when those wallets stopped buying, the price stopped increasing.
In the chart: An Illustration of a trading pattern of a group of wallets in a popular token identified by Solidus Labs, which may indicate potential Cornering the Market activity.
This is often the first step in a pump-and-dump scheme.
Pump and Dump
In a pump-and-dump scheme, culprits artificially inflate the price of an asset by spreading false or exaggerated information. Once the price rises, they sell their holdings for a profit, leaving other investors with overvalued assets. This manipulation often targets smaller, less liquid cryptocurrencies where the price can be more easily influenced. Solidus trade surveillance data flagged more than 6,000 incidents of pump-and-dump schemes on decentralized exchanges (DEXs) since January 2024 alone.
Spoofing and Layering
Spoofing involves placing large orders with no intention of executing them to create a false sense of demand or supply. This tactic deceives other market participants into reacting to the perceived market conditions. Layering is a similar strategy where multiple fake orders are placed at different price levels to manipulate the market. Both tactics are used to create misleading signals about the asset's true demand or supply, thereby influencing its price.
Due to layering and spoofing occurring when orders are placed on both sides of the market, the line between standard market-making activity and market manipulation is thinnest here. To address this specific challenge, Solidus has developed a new layering algorithm with over 200 parameters to allow market makers to fine-tune their parameters and minimize false positives while weeding out manipulative trading.
Conclusion
As financial regulators turn their attention to potential market abuses in the crypto space, it is imperative for market participants to adopt robust, crypto-native trade surveillance solutions. These tools can help demonstrate compliance and ensure that the thin line between legitimate market making and market manipulation is not crossed. The era of heightened regulatory enforcement in the crypto market is just around the corner, and future-proofing your compliance program is key to navigating this evolving landscape.
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