It is striking how cryptocurrencies are both similar and dissimilar to the more established asset classes at the same time. On the one hand, many findings from traditional asset classes also apply to this novel class. On the other hand, this “new” world with its own characteristics brings many novel “problems” that attract researchers. This week’s blog presents several research papers connected to the pump and dump schemes in cryptos. These pumps and dumps are nothing new, and we already know them from the stock market. However, there are some notable differences. In the stock market, manipulators tend to persuade other investors that they have private information and the stock is deeply undervalued. In cryptos, the situation is different. There are private and organized anonymous “pump” groups (using apps such as Telegram) where the administrators announce that at a given time and cryptocurrency exchange, they are gonna pump some (unknown to the public at that time) cryptocurrency. There is no claim that the crypto is undervalued, and it might appear purely speculative. This strategy allows for two key things: firstly, the manipulators can buy the cryptos in advance of the pump, allowing them to dump it to gain a profit, and secondly, other participants can transfer fund to the given exchange to be ready for the pump that is announced as the name of the crypto later. Moreover, the administrator might even offer “private” and paid information and might share the name of cryptocurrency in advance. As the research papers show, it is crucial to buy the currencies before the pump starts since the pumps are connected with negative expected returns.
With negative expected returns and the zero-sum game attribute of these pump and dump schemes, why would anyone want to participate in these speculations? According to the research, people are attracted to the gambling, excitement and expectations of big profits in a short time connected with these schemes. Additionally, they overestimate their abilities to time the pumps and dumps. People also might believe that they are the “fast” ones, and there would be slower buyers that will buy the crypto they are already dumping.
The general insights are excellent examined in the papers of Li, Shin and Wang (2021) and Dhawan and Putniņš (2020). Furthermore, Xu and Livshits (2019) research paper even study the possibility to predict the pumps and dumps. Using various features such as market cap, multiple volumes and returns, number of previous pumps or some sort of crypto rating, authors try to predict pumps in future using random forests and generalized linear models. Although the prediction accuracy is far from perfect, it might be interesting to build on this research and dive deeper. Given the scarcity of regulations in crypto markets, such schemes can be only hardly eliminated.
Authors: Anirudh Dhawan and Tālis J. Putniņš
Title: A New Wolf in Town? Pump-and-Dump Manipulation in Cryptocurrency Markets
We show that cryptocurrency markets are plagued by pump-and-dump manipulation, with at least 355 cases in seven months. Unlike stock market manipulators, cryptocurrency manipulators openly declare their intentions to pump specific coins, rather than trying to deceive investors. Puzzlingly, people join in despite negative expected returns. In a simple framework, we demonstrate how overconfidence and gambling preferences can explain participation in these schemes and find strong empirical support for both mechanisms. Pumps generate extreme price distortions of 65% on average, abnormal trading volumes in the millions of dollars, and large wealth transfers between participants. These manipulation schemes are likely to persist as long as regulators and exchanges turn a blind eye.
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