How Bitcoin Prices Are Manipulated

The Study in a Nutshell

From 1 March 2017 to 31 March 2018, the actual Bitcoin price rose from around $1,191 to $6,929 for a return of 481.8%. Previous studies show that none of the exposures to macroeconomic factors, stocks markets, currencies, or commodities can explain these price changes. However, by ‘combining methodological approaches from computer science and finance, in particular, clustering algorithms and capital flow analysis’, a recently published Journal of Finance paper finds that Tether flows can largely explain Bitcoin prices.

By gathering Bitcoin and Tether blockchain data and information on pricing for a sample spanning 25 months from March 2016 to March 2018, the authors identified clear mechanisms by which abnormal returns on Bitcoin are achievable. The signals for such returns are related to Tether flows, Tether authorisation, Bitcoin price thresholds, the actions of one large entity and hourly moves in Bitcoin prices.

In short, their findings are:

• By mapping the blockchains of Bitcoin and Tether, the authors establish that one large player on Bitfinex uses Tether to purchase large amounts of Bitcoin when prices are falling and following the printing of Tether.
• Such price-supporting activities are successful – just examining 1% of the times with extreme exchange of Tether for Bitcoin reveals substantial aggregate price effects.
• The buying of Bitcoin with Tether also occurs more aggressively right below salient round-number price thresholds where the price support might be most effective.

The Journal of Finance has good reason for publishing these findings: as much as 60% of Bitcoin transactions are denominated in Tether or occur on Tether-backed exchanges (the rest are denominated in fiat currencies). Understanding Tether flows and how they are related to Bitcoin is therefore important for investors (see Appendix for more on Tether).

How Does Tether Influence Bitcoin Prices? Data and Linkages

The researchers obtain the price and the blockchain data from CoinAPI, Coinmarketcap.com, Blockchain.info, Omniexplorer.info, and CoinDesk. The intraday pricing data on major cryptocurrencies come from CoinAPI. The sample covers 25 months from March 2016 to March 2018, but the main tests are implemented after March 2017 when Tether experienced a large issuance.

Step 1: Analysing Tether and Bitcoin Blockchains – Algorithms

The Bitcoin blockchain up to 31 March 2018 is a 170GB network database of more than 360mn wallet addresses and billions of transactions. The paper adopts methods from the computer science literature to cluster-related Bitcoin wallets.

Figure 1, below, summarises the networks (Bitcoin on the left, Tether on the right). Note, the thickness of the edges is proportional to the magnitude of flow between two nodes, and the node size is proportional to aggregate inflow and outflow of each node.

Source: Pages 1916 and 1931 in Griffin and Shams (2020)

The main takeaways from the Bitcoin network:

• Bitcoin blockchain has many more major players than the Tether blockchain.
• Bitfinex, Poloniex, and Bittrex are considerable players on the Bitcoin blockchain in terms of the aggregate flow of coins, and there is a reasonable flow volume between these exchanges.
• There are substantial flows between Bitfinex and transitory addresses, defined as wallets with four or fewer transactions on the blockchain and zero net balance, and with the Bitfinex cold wallet.

The main takeaways from the Tether network:

• Almost all Tether printed by Tether Limited (the red node in the bottom of the graph) is first moved to Bitfinex and then distributed through the network.
• Poloniex and Bittrex, the largest Tether exchanges for most of 2017, are closely tied to Bitfinex through a large flow of Tether using an intermediary address.
• Kraken, the small yellow node at the top of the graph, was the only official marketplace for trading the USD-Tether pair for the majority of 2017.
• Most of the Tether flows to and from Bitfinex are through Bittrex and Poloniex.

Step 2: Tether and Bitcoin Interlinkages – Flows

The most important conclusion from the analysis above is that there is a main channel through which Tether and Bitcoin are related: (i) Tether is transferred from the authoriser (account 3MbY) to Tether treasuries (account 1NTM and 3BbD), coloured in red, in a process that is referred to as ‘authorisation’; (ii) once authorised, Tether flows to Bitfinex, in a process called ‘issuance’; (iii) Tether then flows from Bitfinex to two major exchanges (Poloniex and Bittrex); (iv) Tether is then exchanged for Bitcoin and then sent back to Bitfinex.

Step 3: Individual Accounts – Wallet ID’s

Blockchain data contain the entire history of Bitcoin and Tether transactions between wallets and include variables such as wallet IDs of senders and recipients as a string of 34 characters and numbers, amount of coins transferred, timestamp, transaction ID, and previous transaction ID where the coin was received by the sender of each new transaction. Typically, to electronically detect which user has deposited funds and to credit these funds to their account, each exchange user receives their own unique deposit wallet address. The results show the following:

• 81% of the Tether flows from Bitfinex to Poloniex and Bittrex are through one large deposit address for each exchange. This account is responsible for 47% of all Tether flows from Bitfinex to all Tether exchanges combined. The first four digits of these addresses are shown as 1J1d for Poloniex and 1AA6 for Bittrex in the figure.
• 52% of the Bitcoin flows back to Bitfinex from all Tether exchanges goes to a single deposit address on Bitfinex, which is labelled as 1LSg.

An examination of the correlations between the three accounts suggests that they are controlled by the same entity, which sends the printed Tether into the market in exchange for Bitcoin.

Tether’s Motives

From the above section, we see how Tether flows could potentially influence Bitcoin demand, and therefore prices. There are two ways Tether flows could vary. One is demand-driven factors which ‘pull’ Tether onto exchanges. In essence, new investors who hold dollars wish to convert their dollars to Tether and then into Bitcoin. This increased demand results in a higher market rate for Tether. The second way is supply-driven factors which ‘push’ Tether onto exchanges. In this case, an unbacked digital dollar is printed and used to purchase Bitcoin which can create inflation in its price not due to a genuine capital flow.

What may incentivise the ‘pushed’ hypothesis? Three reasons why Tether authorisers may enjoy Bitcoin inflation:

1. Early movers tend to be long in Bitcoin (as is Tether) and other cryptocurrencies, so they would generally benefit. Also, if the Tether issuers wish to legitimise Tether and avoid scrutiny, they can slowly convert some of their cryptocurrencies to USD and retroactively provide either full or partial dollar reserves for Tether.
2. Since Tether issuances are large, if traded strategically, Tether could have further price impact and lead to further manipulation of Bitcoin prices. Otherwise stated, by artificially raising prices around regionalised price floors, Tether could crowd-in demand for Bitcoin as speculators seek the next big win. This increases the price further.
3. The Tether issuers create a valuable put option in the case of a future cryptomarket downturn or other losses. In particular, the founders of Tether have an option to not redeem Tether to dollars and possibly experience an inside ‘hack’ when Tethers and/or their associated dollars suddenly disappear.

Results

The researchers find a number of interesting results:

First, they estimate a regression of rolling three-hour average Bitcoin returns on lagged average net hourly flow of Tether from Bitfinex to Poloniex and Bittrex and of Bitcoin back to Bitfinex, with average Bitcoin returns as dependent variable. They find this:

• On days right after Tether is printed/authorised, for a 100 Bitcoin increase in lagged flow, the three-hour average future Bitcoin return goes up by 3.85 basis points. This relationship between the flow of Tether and Bitcoin prices does not exists on days where no Tether is printed.
• This relationship increases to 8.13 basis points when conditioning on both Tether printing and on days after Bitcoin returns are negative. Flows from one account (1LSg) drive over half of this rise.
• This relationship exists across all coins when looking at both days after Tether authorisation and negative returns. For the equivalent of a 100 Bitcoin increase in flow, the average future return goes up by 7.89 to 10.19 basis points for different coins.

The paper then identifies 95 hours, equivalent to the top 1% of hours in the sample, where lagged combined Bitcoin and Tether flows are the highest. For the hours after high flows between Tether and Bitcoin occur, returns are significantly higher. Chart 1, below, shows that returns are large and negative between times −3 and −1. However, after the large flow, the pattern starts to change at time 0. The next hour’s returns are large at 80 basis points per hour, and returns are positive at 1.23% over the next three hours after the flow.

Source: Page 1942 in Griffin and Shams (2020)

The researchers find the price impact of Tether on Bitcoin to be economically important. The 1% of hours where flows are highest is associated with 58.8% of Bitcoin’s compounded return. Removing these hours shows that these returns did not happen by chance. The findings from their analysis indicate that a large player moves Tether out of Bitfinex in exchange for Bitcoin in such a way that she/he would either have to exhibit extreme market timing or is manipulating the price of Bitcoin.

Source: Page 1943 in Griffin and Shams (2020)

The authors then move towards identifying potential price floors. Cryptocurrency traders likely engage in this type of technical trading whereby past price movements generate buy and sell signals. If Tether is used to stabilise market prices during a downturn, one might expect a spike in the flow of Tether around thresholds because this might induce other traders, upon observing technical support at the threshold, to purchase as well.

To test this prediction, the authors divide hourly CoinDesk prices by 500 and then group the remainders into bins of $10 width to examine how the flow of Tether for Bitcoin changes near the round thresholds. They find this:

• Bitcoin purchases from Bitfinex strongly increase just below multiples of 500. This pattern is present only in periods following printing of Tether, is being driven by the single large account holder, and is not observed by other exchanges.
• On days following Tether authorization, when prices are below the round threshold, the future hourly return is 20.61 basis points higher on average. However, this return effect is not present on days apart from printing Tether.

Source: Page 1949 in Griffin and Shams (2020)

The paper subsequently goes on to show that Tether flows are generally consistent with Tether being printed unbacked and pushed out onto the market, which can have an inflationary effect on asset prices. The researchers do this by saying that negative end-of-month Bitcoin returns during months with Tether issuance are consistent with Tether not maintaining full dollar reserves at all times.

The Bottom Line

The findings indicate that Bitcoin prices are subject to gaming by a small number of actors. This suggests that Bitcoin does not yet make a solid basis for more complex financial vehicles such as exchange-traded funds (ETFs) or derivatives without greater external surveillance, monitoring, and a regulatory framework. It also, however, shows that there exist key signals (such as price floors) in the trading of Bitcoin where abnormal returns can be found.

Appendix: What Is Tether and How Does It Correlate?

The objective of Tether is to facilitate transactions between cryptocurrency exchanges with a rate pegged to the USD. Although one could do this with fiat currencies, Tether is advantageous because many cryptoexchanges have difficulty securing banking relationships.

Tether is issued by Tether Limited, and, according to the Paradise Papers, Philip Potter and Giancarlo Devasini are responsible for setting up Tether Holdings Limited in the British Virgin Islands in 2014. Originally, Tether representatives claimed that all currencies on its platform were 100% backed by actual fiat currency assets in a reserve account. Recently, however, Tether itself created ambiguity around this backing by noting that they do not guarantee redemption rights.

The two charts below: left, the cumulative authorization of Tether denominated in both USD and Bitcoin as well as Bitcoin prices; right, transactions of major cryptocurrencies in USD as compared with Tether, aggregated across all cryptocurrency exchanges available on CoinAPI.

Although cryptocurrencies were historically denominated in dollars or yuan, a large share of Bitcoin and many other cryptocurrencies transactions are denominated in Tether as of 2017. The first Tether was authorised on October 2014, but the market cap was only $25mn as of March 2017. Between March 2017 and January 2018, more than $2.2bn worth of Tether was issued.

Source: Page 1922 in Griffin and Shams (2020)

Tether exchanges account for a large portion of cryptocurrencies’ trading volume. Table 1, below, shows the total trading volume on major exchanges of major cryptocurrencies from 1 March 2017 to 31 March 2018. Tether-based exchanges are marked with ‘*’. Bitfinex has the largest volume, both for Bitcoin and across all major cryptocurrencies.

Source: Page 1927 in Griffin and Shams (2020)

Table 2 shows the cross-sectional correlation of cryptocurrencies’ daily returns. The daily returns are positively correlated across all of the coins, but there is variation across different cryptocurrencies. For example, Bitcoin’s correlation with Ethereum, Ripple, and Litecoin are 0.44, 0.20, and 0.45, respectively.

Source: Page 1928 in Griffin and Shams (2020)

To view the full paper, please click here.