How to track exchanges - and why we should care

Christian Gazzetta

So long, cryptoeconomy has shown to be a big opportunity for its investors, entrepreneurs
and final users. That’s because besides the profits earned by traders, arbitrators or value
investors, cryptoassets’ technologies can provide greater transparency, safety,
decentralization and technical efficiency to markets they’re applicable to.

But with the opportunity, also some challenges are brought before crypto becomes
mainstream. Some challenges we highlight on the demand side are digital exclusion, low
awareness and interest for new technologies, uncertainty, and distrust as a consequence of
previously mentioned hurdles.

By the supply side, we could mention the experimental state of DLTs and why not to mention
the lack of self or sovereign regulation. Presently, those two aspects make clear the need for
industry standards, that could facilitate the journey of new adopters and the entry of qualified
professionals into the space, as well as intensify knowledge spill among market participants.

The challenges pointed above are surely relevant, but maybe what today repels more
intensely the public is the “wild west” scenario in which cryptoeconomy seems to develop.
It’s often hard to distinct clean businessmen from fraudsters on the space, since not even
the game rules are clear enough.

Specifically in the exchanges field, recent years uncovered many good examples of hacks,
data leaks, market manipulation and fake volume schemes. And yet the publicity of those
events may still be a big ​hurdle for new entrants, it reveals some interesting opportunities on
the space.

That’s because some tools have emerged to increase the scrutiny of exchanges’ operation.
Some of them come from the analyses of order books, social media and activity on web
related to the exchanges, while other are based on the transparency of Bitcoin-like
blockchains, allowing for the trace of their on-chain activity and for the audit of their
statements.

This is important because many exchanges have reported fake trading volume to attract
investors and traders. ​Studies by Bitwise even suggest that 95% percent of volumes
declared may be forged, and that probably only a few of the biggest exchanges are not
making up their order books to look artificially liquid.

More than that, volume-weighted price indexes become more subject to manipulation when
volume figures can be handled to push prices on the wanted direction. Forging its
transaction volume and the current price of Bitcoin, it is possible to affect the price observed
in indexes by agents and, therefore, fabricate some trend for the market price.

One could then argue that, since exchanges won’t open up their track, it’s too hard to spot
these deceptive behaviors. But just by observing social media and other traces of user
interaction online, we can already figure out some relevant insights about the exchanges’
activity.

Some interestingly simple indicators are the number of twitter followers and the google
search results, for example. If a company declares this big volume but no one is wanting to
keep updated on them or to write about them, things start to look suspicious.

It’s also possible to check if the web traffic ranking is compatible with the numbers reported
by the exchange, and if its personnel on LinkedIn is enough to support such operations. All
these signals will be hard to assess without a good comparison basis, so for that it’s
important to have a trusted reference - like an exchange that’s fully compliant with rigid
regulatory requirements, for example.

When it comes to volume manipulation itself, a common practice is to fill up the order book
with evenly distributed buy and sell orders, very close in price, size and timestamp. These
operations roughly annulate themselves, generating a stable trading volume without pushing
prices in either direction.

One way to spot this artifice is by comparing volume and spread - the difference between
best sell and order prices - among exchanges. We find that, despite huge volumes being
stated, suspicious exchanges have broader-than-normal spreads, which means one might
have to give up on part of her gain or even realize some loss in order to execute the
intended trade on these exchanges.

This risk is by the way incurred not only on fraudulent exchanges, but in any market without
enough liquidity. Therefore, the analysis of order books - as the following ones - is useful
even when we can entirely trust the negotiation environment. So now let’s take a look on
how to gauge their activity directly on the blockchain.

Monitoring exchanges’ wallets brings totally new kinds of analysis that may go deep into the
flows of funds from and to exchanges. Many of these wallets are publicly known, thanks to
clustering techniques that indicate which addresses are controlled by the same entity. With
these methods we can trace the funds transferred, identifying companies that may be
assisting illegal activity perpetrators or just being too lazy with KYC and KYT procedures.

It can also be the case for checking if the exchange has enough funds to meet eventual
withdrawal requests. Though it’s not easy to estimate how much did the users initially
deposited, for exchanges manage client funds among many - some unknown - wallets,
suspicion can arise when there’s big discrepancy between traded volumes, client base size
and funds on the mapped wallets.

It has also been noted by Delphi Digital that prior to big price drops on BTC, net inflows of
bitcoin to exchanges have significant spikes - yet it is not true that sizeable net outflows will
lead to price urge. That fact is explained by the decision by holders to trade their bitcoins for
other crypto or more likely to fiat, which causes unusual selling pressure upon market prices.

So by tracking the transfers to and from exchange wallets we could sometimes anticipate
price movements downwards. Furthermore, with a complete toolset that enables on-chain,
social and order book analysis in real time, we could understand exchanges’ behavior and
track them in order to minimize some risks involved in crypto investing.