In an echo of the 2011 Libor scandal, Coinbase’s past manipulation of the bitcoin price impacted a key market benchmark.
On Friday the Commodity Futures Trading Commission (CFTC), which regulates the US derivatives markets, said it had levied a $6.5m penalty on cryptocurrency exchange Coinbase for fictitious trade reporting in bitcoin and litecoin.
According to the CFTC, between January 2015 and September 2018 Coinbase had run two internal algorithms that often traded with each other, without disclosing the fact.
Such ‘wash trading’—the buying and selling of a financial instrument or contract for the express purpose of feeding misleading information to the market—is illegal in the US.
According to the CFTC, Coinbase reported its fictitious trading activity to the wider market, including to Crypto Facilities Ltd (now CF Benchmarks Ltd), the index provider for the CME bitcoin futures contract, which was launched in December 2017.
“Transactional information of this type is used by market participants for price discovery related to trading or owning digital assets, and potentially resulted in a perceived volume and level of liquidity of digital assets, including bitcoin, that was false, misleading, or inaccurate,” the CFTC said on Friday.
According to CF Benchmarks, the CME CF Bitcoin Reference Rate (BRR) and CME CF Bitcoin Real-Time Index (BRTI) are intended to measure the underlying economic reality of bitcoin market transactions.
Any past practice of inflating the volume of the trades on a participating exchange is likely to have impacted the bitcoin reference rate
CF Benchmarks calculates the BRR daily, while the BRTI is updated in real time. The BRR serves as the reference price for the CME bitcoin futures contract, which is settled in cash at the end of each month.
Five exchanges provide pricing data to the BRR and BRTI: Bitstamp, Coinbase, Gemini, itBit, and Kraken. Kraken owns CF Benchmarks.
The methodology of the BRR makes it clear that any past practice of inflating the volume of the trades on a participating exchange is likely to have impacted the bitcoin reference rate reported to the wider market.
For an hour every day starting at 3pm London time, CF Benchmarks collects bitcoin trade data from the five participating exchanges, separating the data into twelve 5-minute ‘partitions’.
For each partition, the index provider then calculates the volume-weighted median trade price from the transactions reported by the exchanges, including Coinbase. The BRR is then calculated as an average of these twelve medians.
Contacted by New Money Review for comment about the CFTC fine levied on Coinbase, CF Benchmarks said that it had checked the historical data between January 2018 and September 2018 (the timeframe related to the CFTC settlement) and found ‘no material disparity’ in the price if the BRR had been calculated without using Coinbase data.
At the time, the BRR was calculated using input data from only four exchanges: Bitstamp, Coinbase, itBit, and Kraken. Gemini started contributing to the BRR and BRTI in August 2019.
However, CF Benchmarks conceded, excluding Coinbase from the reference rate calculation would have led on individual days to a change in the bitcoin rate underlying the CME futures contract of up to 87 basis points (0.87 percent).
The mean deviation from the reported historical figures for the BRR by excluding Coinbase from the calculation would have been 3 basis points per day, CF Benchmarks said.
In the case of Libor a successful manipulation was reportedly a 1-2 basis point change
The episode carries echoes of the Libor scandal, in which the banks contributing to a market benchmark submitted false data in order to manipulate it. The scandal cost the banks involved over $9bn in fines, brought jail sentences and led to a fundamental rethink of how market interest rates are calculated.
In the case of Libor, where up to sixteen banks were involved in setting the benchmark, a successful manipulation was reportedly a 1-2 basis point change in the wholesale interest rate—significantly less in relative terms than the likely past impact of Coinbase’s manipulation on the bitcoin reference rate.
However, while Libor rates underpinned trillions of interest rate derivatives and other financial contracts, bitcoin futures remained a relatively small market in the period during which Coinbase manipulated prices.
According to the CME, the open interest in its bitcoin futures contract averaged less than 4,000 contracts (equivalent to 20,000 bitcoin or around $270m at the average exchange rate) during 2018.
In a concurring public statement, one of the five CFTC commissioners, Dawn Stump, took issue with her own agency’s decision to fine Coinbase and said the CFTC did not regulate the cryptocurrency exchange.
“This fact leads me to express my serious concerns about the Commission’s dedication of resources to this matter involving an exchange for cash transactions in digital assets (e.g., bitcoin, litecoin), given that Coinbase has not offered any futures contract, option, or swap regulated by the CFTC,” Stump said.
“The settled charges are based largely on conduct that is several years old, has not been repeated, and in the case of the charge of secondary liability, is based on conduct by an employee who left Coinbase years ago and who is not being charged,” Stump said.
In its penalty notice, the CFTC also said that a former Coinbase employee had used a manipulative or deceptive device by intentionally placing buy and sell orders in the litecoin/bitcoin trading pair on GDAX that matched each other as wash trades, creating a misleading appearance of liquidity and trading interest in litecoin.
This employee has been widely named in social media as Charlie Lee, the creator of litecoin. Lee worked as engineering manager, then director of engineering at Coinbase, before leaving the exchange in June 2017.
However, CFTC commissioner Stump also said that Coinbase’s activities concerning bitcoin did not affect the trading of any listed derivatives product regulated by the CFTC “because there were no listed derivatives products on digital assets traded at that time.”
Given that the CME launched its listed bitcoin futures contract in December 2017 and that Coinbase’s price data fed directly into the settlement price of the CME contract, this statement from Stump appears incorrect. The CFTC did not respond to a request for clarification by our publication deadline.
CME also failed to respond to a request for comment by our deadline.
The listing could give Coinbase a public market valuation of $68bn, Bloomberg said.
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