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Analysis: Exchanges’ mistakes could wreck the cryptocurrency markets

Bitcoin being eaten by a cactus because 2018

We have our own version of stock photos (photo by Ken Kurson for Modern Consensus).

Cryptocurrency prices have had a meteoric rise over the past month as established securities markets embraced the asset class. However, the exchanges that have opened cryptos to the retail public may be the rally’s undoing.

Bitcoin (BTC) in particular has had a tremendous run-up. On October 31, 2017, when the CME Group announced it was launching bitcoin futures, the cryptocurrency was trading at $6,128, according to Bitcoin.com. A little more than a month later, when neighboring rival Chicago Board of Options Exchange (CBOE) jumped ahead and launched its futures on December 10, bitcoin changed hands at $14,492.

To put it in perspective, it took the S&P 500 more than six years to gain 136 percent and reach recent record highs. Bitcoin did it in just those 40 days. Yet a series of mishaps at one of the largest retail cryptocurrency exchanges threatens to bring the bitcoin rally to a miserable end for many investors.

The Bitcoin Cash whiplash

On Tuesday, December 19, the Coinbase exchange announced it was going to immediately begin trading Bitcoin Cash (BCH), a spinoff of bitcoin. Those who held bitcoin with Coinbase on August 1 would receive an equal amount of Bitcoin Cash in their account.

That’s a big deal. Coinbase accounts for about one-fifth of bitcoins traded, according to the Kacper Cieśla, the number cruncher behind data site Bitcoinity. With over 13 million accounts, Coinbase is nearly 3 million users larger than fellow San Franciscan online trading behemoth Charles Schwab, which has a market cap of $70 billion.

When Coinbase’s Bitcoin Cash announcement was posted, the price of bitcoin, Ethereum (ETH), and Litecoin (LTC)—the three other currencies traded on Coinbase—took a huge dip. On the company’s flagship platform, the prices of bitcoin fell to $15,005 at 12:30am GMT (7:30pm Eastern) from $17,899 an hour before. It rebounded to just under $16,658 by 1am GMT. Ethereum and Litecoin suffered similar fates and all three experienced large spikes in volume, according to the company’s GDAX platform.

Presumably some post-August 1 accountholders (this author included) sold off a bit of their coins to diversify their holdings by buying some Bitcoin Cash. Alas, Coinbase gave those traders a swift punch in the gut. Those entering their purchase orders were met with notices that, “Bitcoin Cash purchase are temporarily disabled” though it was available to send and receive for those who had BCH in their wallets.

Many new Coinbase account holders could only watch wistfully as Bitcoin Cash soared. On December 17, the currency was around $1,855. Two days later it reached $2,972 at 12:30am GMT and made it over $3,397 just six hours after that.

Yet Bitcoin Cash, too, saw a whipsaw in price. At 8:30am GMT (3:30am Eastern), Coinbase shows Bitcoin Cash traded at $3,276. Within an hour, it crumbled in half to $1,634 but an hour later, it had shot back above $3,187. By mid-Wednesday morning Eastern Time, Bitcoin cash was up roughly 75 percent in 24 hours and 150 percent for the week.

Meanwhile, Coinbase’s price data on its app and site for Bitcoin Cash were all over the place and unreliable as the company announced it was going to start trading the coin. What’s more, the rally in BCH over the days leading up to Coinbase’s announcement raised a red flag all the way to the top of the exchange’s corporate structure.

Coinbase’s wearisome words

Volatile prices in cryptocurrencies are nothing new, as just about every central banker has gone through great lengths to warn. But Coinbase, which prohibits employees from trading on material non-public information, noted that the pre-announcement rally required the company to do some looking-into.

“Given the price increase in the hours leading up the announcement, we will be conducting an investigation into this matter,” wrote Coinbase CEO Brian Armstrong on the company’s blog. “If we find evidence of any employee or contractor violating our policies — directly or indirectly — I will not hesitate to terminate the employee immediately and take appropriate legal action.”

Those are strong words meant to reassure the investing public. However, given the nature of cryptocurrencies, it’s almost impossible to enforce and it may not even matter.

For one, tracking down the ownership of a cryptocurrency isn’t easy. Just ask the CIA, the FBI, the DEA, DHS, the Chinese government, the ECB, the Federal Reserve, the Japanese FSA…. The list goes on and on. Presumably, the type of people writing code at Coinbase know enough to find a way to trade cryptocurrencies on other exchanges where their accounts are protected from the prying eyes of one of the industry’s biggest retail player.

Terminating an employee who just pocketed a few million dollars is probably not going to be much of a deterent. What’s more, taking “appropriate legal action” is going to be an expensive course to pursue. Whether or not the SEC views cryptocurrencies as securities isn’t entirely clear. Sure, there are bitcoin futures trading on the exchanges but there aren’t Bitcoin Cash futures, so…? Who knows? Perhaps Coinbase would like to spend a few million dollars finding out if front-running Bitcoin Cash is somehow illegal. Or, in the event they catch someone on their payroll who bought up a few BCH they may decide to just pursue a breach of contract case.

Yet that wouldn’t be a good public relations move, either, as there’s a larger issue at stake.

The bigger problem

One of the innovations touted by blockchain advocates and evangelists is transparency. Of course, one may not know the identities of most buyers and sellers but every bitcoin and Bitcoin Cash transaction ever made is out there for the world to see.

Full transparency is the stuff that’s supposed to make markets efficient, stable, and trustworthy. Yet some of the biggest bitcoin exchanges may be adding inefficiency, instability, and insecurity to the market.

The quick gain in Bitcoin Cash prices prior to Coinbase’s announcement happened in open view on other exchanges. Something was afoot, an investor could surmise and given Coinbase’s previous statements, maybe conclude it was Coinbase-related.

Instead, what threatens the market is that platforms like Coinbase can make new investors more worried because of how they are structured. If getting into or out of a currency is somehow thwarted because of technical glitches on the exchange, retail traders may reconsider putting their dollars or euros or whatever into bitcoins, Ethereums, Litecoins, or Bitcoin Cashs.

Whether or not bitcoin fans like to admit it, Mt. Gox remains in the background for cryptocurrency exchanges in much the same way volcanic Mount Etna threatens the beautiful and emotionally chaotic island of Sicily.

For the uninitiated, Mt. Gox was once the largest bitcoin exchange in the world and was where most were traded. Then a series of hacks chipped away at its dominance and exposed flaws in its security and in bitcoin’s code itself. By 2014, the Tokyo-based exchange was out of business and hundreds of thousands of bitcoin (worth hundreds of millions of dollars) were missing. By early 2015, Bitcoin hovering around the $200 mark, a fifth of where it was a year before.

In a nutshell, account holders at some exchanges such as Coinbase or Bitstamp don’t hold the private keys for their cryptocurrency wallets; the exchanges do. And if those exchanges are somehow compromised or fail to provide customers with the assurance that their money and coins are tradable, safe, and accessible, fears that another Mt. Gox will erupt could cause another run on the currencies.

For the sake of market stability Coinbase, which has raised about $217 million, needs to manage its infrastructure as interest in cryptocurrencies grows. Flubbing the addition of a new currency may not be enough to permanently damage the market but it adds to the worries retail investors have about putting money in a volatile asset class.

All the fanboys posting on endless amounts of Reddit boards won’t be able to allay the fears of the average investor who is largely responsible for pouring billions into the cryptocurrency market in the past few months. Their concerns must be paramount for the industry if it’s to go beyond an experiment.

Lawrence Lewitinn, CFA is editor in chief of Modern Consensus. Disclosure: Lewitinn owns no cryptocurrencies in his portfolio.