Think what happened with $GME can't happen with bitcoin? Think again...

in LeoFinance3 months ago (edited)

The $GME and wallstreetbets saga has been the story of the year so far in 2021, and it has brought a lot of attention to cryptocurrency (bitcoin in particular) and defi as potential solutions to the myriad problems in traditional markets that were exposed in recent weeks.

While it's true that cryptocurrencies have the potential to solve these problems, it's also quite possible - if not likely - that large financial institutions will be able to control and manipulate bitcoin and other cryptocurrencies in the same exact same way that they currently manipulate stocks, commodities, and other traditional assets.

Allow me to explain.

I'm going to focus on the key initial problem with $GME which is the fact that more than 100% of the outstanding shares of the company were sold short. Here's a quick and extremely simplified example of how that happens:

$GME Example

Imagine a very simplified broker / exchange which we'll call RH that starts with one retail customer who we'll call Alice. Let's say that Alice deposits one share of $GME into her RH account that she actually owned (pretend that people actually own shares of stock). Then RH has one actual share and Alice's account shows that one share in her balance.

Now RH (or their hedge fund customers) want to short $GME and push the price down, so RH "borrows" Alice's share and sells it to a new retail customer we'll call Bob. Now both Bob and Alice show a balance of one share of $GME in their accounts (a total of 2 shares) even though RH only has one actual share.

Then they want to short it more, so RH once again "borrows" that same share from Bob (which was previously already borrowed from Alice) and sells it to retail customer Carol. You can hopefully see that this can go on an on basically creating and selling any number of "fake" shares and pushing the price down in the process.

The main way that this would be exposed is if the customers asked to take custody of their shares and withdraw them from the exchange. The exchange doesn't actually have those shares, and so it would be revealed that the shares purchased by Bob and Carol were fake. Of course, no one ever takes personal custody of stock shares (I'm not sure if that's even possible), so no one is the wiser.

The end result of this is that while there are a set number of $GME shares that exist in total, financial institutions can and do create and sell as many fake shares as they want, so if you sum up everyone's balances of $GME shares across all exchanges it will come to significantly more than the number of shares that actually exist. For some additional proof of this, see the following article: https://www.coindesk.com/dole-stock-crisis-reigniting-push-blockchain

Ok, we get it, traditional markets are screwed up and manipulated, but doesn't bitcoin fix this? Well, let's take the exact same scenario above, and replace "RH" with "Binance" and "share of $GME" with "bitcoin" and see what happens:

Bitcoin Example

Imagine a very simplified broker / exchange which we'll call Binance that starts with one retail customer who we'll call Alice. Let's say that Alice deposits one bitcoin into her Binance account that she actually owned (people do actually own bitcoin). Then Binance has one actual bitcoin and Alice's account shows that one bitcoin in her balance.

Now Binance (or their hedge fund customers) want to short bitcoin and push the price down, so Binance "borrows" Alice's bitcoin and sells it to a new retail customer we'll call Bob. Now both Bob and Alice show a balance of one bitcoin in their accounts (a total of 2 bitcoin) even though Binance only has one actual bitcoin.

Then they want to short it more, so Binance once again "borrows" that same bitcoin from Bob (which was previously already borrowed from Alice) and sells it to retail customer Carol. You can hopefully see that this can go on an on basically creating and selling any number of "fake" bitcoin and pushing the price down in the process.

The main way that this would be exposed is if the customers asked to take custody of their bitcoin and withdraw them from the exchange. The exchange doesn't actually have those bitcoin, and so it would be revealed that the bitcoin purchased by Bob and Carol were fake. Of course, most people never take personal custody of bitcoin (even though it is certainly possible), so no one is the wiser.

The end result of this is that while there are a set number of bitcoin that exist in total, financial institutions can (and maybe do(?)) create and sell as many fake bitcoin as they want, so if you sum up everyone's balances of bitcoin across all exchanges/wallets it could possibly come to significantly more than the number of bitcoin that actually exist.

Not Your Keys, Not Your Crypto

The above example can also be used with commodities like gold and silver (see the latest #silversqueeze trend) and is meant to illustrate that large financial institutions and exchanges can manipulate any asset that is held and traded at those institutions on behalf of customers. Bitcoin and cryptocurrency are no exception.

As an interesting exercise, you might also try the above example using dollars instead of bitcoin and a bank instead of Binance to help understand how fractional reserve banking works and the consequences of a "bank run" such as the one at the beginning of the great depression, but I'm not going to go into that in this post.

The key thing to understand is that the entire scheme hinges on the fact that the vast majority of customers hold and trade their assets at these financial institutions and are either not able or rarely choose to ever withdraw them.

This is precisely where bitcoin and cryptocurrency has an advantage over other assets. It is not only possible, but MUCH easier for people - anyone - to take personal custody of their cryptocurrency AND it is also possible to trade, lend, and borrow against cryptocurrency without ever having to transfer it to a centralized exchange.

This is what the "not your keys, not your crypto" movement is really about. If the majority of people keep their crypto on centralized exchanges, then it allows those exchanges to control and manipulate those cryptocurrencies just like they do with traditional assets. If the majority of people's "bitcoin" is just their balance on a centralized exchange, then the 21 million cap of total bitcoin that will ever exist is meaningless, since the exchanges can "create" and "sell" far more than that.

For the first time in history there is a class of assets that anyone in the world with an internet connection can hold and use without having to ask permission or cede control to a financial institution, but that will all be for naught if people don't choose to take advantage of it.

It means taking time, learning, and generally taking personal responsibility for your assets - which can be difficult and scary, I know - but it is vitally important to ensuring a future where large financial instutions are unable to constantly and consistently control and take advantage of the general population.

Not your keys, not your crypto (or your stock, or your silver, or your dollars). Thanks for reading.
@yabapmatt

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it's also quite possible - if not likely - that large financial institutions will be able to control and manipulate bitcoin and other cryptocurrencies in the same exact same way that they currently manuiplate stocks, commodities, and other traditional assets.

The reason why these manipulations are possible with other assets is that other assets don't actually gain much (if any value) over the years. Bitcoin is doubling in value every year, so shorting it long-term is out of the question. The epic short-squeezes that result from trying to short Bitcoin would be the death of any institution that attempted it. We don't need help from Reddit for that.

Shorts also require collateral. You normally can't borrow large quantities of stock or crypto on reputation alone. Bitcoin is turning into the best collateral in the world, so again, shorting it is silly... in fact (ironically) it may be used as the collateral to short everything else. That would make more sense going forward.

derivativeoptionfutures2.jpg

Great post, as I think all of us could use more lessons in traditional finance and the process of the options market. These things sound simple and then when you look at how they actually work it's pretty wild.

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The reason why these manipulations are possible with other assets is that other assets don't actually gain much (if any value) over the years. Bitcoin is doubling in value every year, so shorting it long-term is out of the question.

Maybe, or maybe not. Many would posit that gold and silver would be going up significantly in value were it not for significant price suppression by the financial institutions and possibly governments. Maybe bitcoin is doubling every year because "they" aren't trying to suppress the price - yet. I don't really know either way, but I think it's dangerous to assume that it can't happen with bitcoin.

In any case, the point is just that if everyone holds their crypto on centralized exchanges, then they have all of the power just like with other assets. If it's not shorting then it will be something else. Crypto allows us to not require centralized financial institutions and I really hope all this $GME nonsense opens people's eyes to the need to take advantage of that.

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Gold and Silver are physical assets, so when we create digital derivatives of them this is much easier to manipulate because it's all theoretical. Silver is silver and gold is gold, but crypto is constantly adapting and growing. The Bitcoin of 5 years ago is not the Bitcoin of today.

Bitcoin being a native digital asset puts it in an entirely new class. They are likely going to try to manipulate it pretty hard and I imagine they are going to faceplant directly into concreate.

so when we create digital derivatives of them this is much easier to manipulate because it's all theoretical.

This is a non sequitor. The physical nature of gold and silver does not make their derivatives any more or less 'theoretical' than Bitcoin derivatives.

What ultimately matters is how much people take personal delivery, and just like with gold and silver, the vast majority of Bitcoin and cryptocurrencies remain on exchanges, without people taking them into their own wallets.

Thanks for the explanation. I had no idea that's how it works.

it is also possible to trade, lend, and borrow against cryptocurrency without ever having to transfer it to a centralized exchange.

I need to learn more about lending I think since, my ultimate goal is passive income rather than capital growth. Both are nice of course! 😁

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Guess the need for immutable Blockchains grows by the day...

Banks do the very same thing for years...

And while I wouldn't be surprised if exchanges use the same methods which they probably do, I'd love to see some evidence that it's really happening before crypto take a massive hit. Which is what governments and political gangs want in the first place.

Sure keeping your assets safe in cold wallets is the best thing to do but the moment you one decides to bring them back in on an exchange to make a trade that's when the shit hit the fan...

PS. Good to see you posting Mat...you should do that more often

Guess the need for immutable Blockchains grows by the day...

The thing is that immutable, decentralized blockchains don't really matter if everyone just gives all the power back to centralized exchanges anyway. There needs to be both technological and behavioral changes to fix this mess. The technological side is coming along very nicely, it's the behavioral one I'm more worried about - although everything currently happening in the world is helping push things in that direction.

PS. Good to see you posting Mat...you should do that more often

I have tons of people yelling at me on a regular basis about all the things I "should" be doing, unfortunately posting about anything not related to Splinterlands is never one of those things...this is a post I think really sums up the situation: https://andrecronje.medium.com/building-in-defi-sucks-part-2-75df9ee7871b

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Also, when the token goes up, traders with their “TA” will take ~80% of the credit, it the token goes down, you will get 100% of the blame.

So much truth here.

LOL, that post was pretty amusing to read...

It already happened and is happening. Bithumb, at one point being one of the biggest exchanges, did EXACTLY what's described here. I haven't been keeping track but they only allow you to move your bitcoin only when they want you to (or simply will not process your order). Most exchanges in my country operate in a similar way. I experienced this personally when I tried to move bitcoin out of "my wallet" and the exchange denied it "for my own safety". Ofc you only have an "account" somewhere on their server with no access to any key whatsoever. Not your keys, not your crypto indeed.

Great analysis, but I think that the very fact that it is possible for people to move their BTC off exchanges (and indeed quite easy and is happening all the time) is a huge disincentive to institutions to engage in such manipulation.

The risks to them are so much higher because the percentage of BTC held on exchanges is actually very low - less than 11% of all BTC and many buyers (including big ones) are HODLers.

There is much greater transparency. It is not difficult to determine how much real BTC an exchange holds - its all on chain and traceable with the right tools.

Even a whiff of this sort of manipulation could cause a run of withdrawals and trying to shut down withdrawals would destroy the reputation of the exchange.

DEXs like uniswap might help with this.
Totaly agree on your point here .... the derivatives markets are the main game

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The 21 million supply is a nice catch-phrase but it is indeed meaningless. Even if the double-spending by exchanges wasn't a thing, people could always participate by buying ETN certificates. So, whoever wants a part can get a part.

just to start:
"which is the fact that more than 100% of the outstanding shares of the company were sold short"
i thing you are confused, that percentage, the short interest (round 140) is the proportion between the float(available shares on the market) and the demand to borrow shares(short)

In summary, liquidity pools and Dexes are the future

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Excellent points!

Self-custody of funds is certainly important for this reason. I've never heard anyone state this as clearly as you.

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I am always scared of this crazy volatile currency that has changed my life

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I've seen this as well, and I'm not entirely sure that's really the case. I'll preface this by saying I have absolutely no idea what hedge funds are doing, but if I had to guess I would say that it's likely they are just going short futures to hedge their even larger recent long positions.

I think you need to look at how much hedge funds have gone long bitcoin in the past few months (which appears to be quite significant) and compare the short interest to that to get a real idea of what's going on.

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I bet you remember
Not the same but exchanges did also something wrong (powering up costumers token) with Steem when JS take control of top witnesses

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The market cap on Bitcoin is actually still small when compared to stocks. It wouldn't be hard and I'm sure it already takes place often via pumps and dumps of bitcoin in the past that major holders very well have the capability to triggering flash crashes and then building up FOMO on a rally.

Biggest important thing though. KEEP YOU OWN DANG WALLETS PEOPLE! :)

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Excellent sum up of not your keys, not your crypto. Totally in agreement.

That's why we need DEX (Decentralized Exchanges) & New technology continuing evolving and solving these problems. If can have a DEX that allows it. DEX do need liquidity pool for quick transaction. Can there be other ways a dex can act like a smart contract in a decentralized way such that no one is able to give permission to others to handle crypto? It is a good question to start.

Regards.

Thanks for the simple examples, thanks to which even I understood what you were trying to say. I wonder what the solution is? Is there really only an option with decentralized exchanges?

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is simple what leverage is.

Someone, we call him bad guy cash in x amount of fiat. If Market maker 1 allows him to sell with fiat it is without traditional leverage, leverage. This factor x is how traditional markets work, and it will come more and more to crypto.

Remember: "IF big players come into bitcoin, it will become more stable".

It's always the difference.

@yabapmatt it would also work if they don't hold any coin to sell the coin, as long position can be resold and resold and doesn't get liquidated, they don't need to buy any.

I agree, almost nobody understands fractional reserve banking--or money in general, to be honest. Thanks for this post that makes a person pause and ponder. !WINE


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So say if there was a good sum of people shorting Bitcoin for sometime and the buyers outgrow the shorts that would double Bitcoin more than if there was no shorts and only outflow of people taking a roi or loss??

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In centralized finance this risk is mitigated by a huge apparatus of regulations, regulators and audits which cost a lot of money to maintain but minimize the risk to some extent. But who controls the regulators? What if they become corrupt? Blockchain and DeFi is the solution to this problem by removing the trust requirement and making everything transparent.

So, if I understand well, the takeaway here for someone like me who is not willing to trade is: hodl your BTC in a non-custodial wallet / cold wallet. Correct?

Thanks for the great post!

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Great post. Large financial institutions with a huge war chest will always look out for their own interest be it in traditional markets or in crypto. And since they have the money, they will be able to influence markets to a certain degree. Whether we like it or not.

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You can have the physical stock certificate. When you have an account at Robinhood they have your certificate in "custody". I know they don't hold a physical copy, but if you close your account and request a physical certificate they have to give it to you.

Of course you have to pay the fees associated with creating a physical copy, but you can get one and hold it yourself. This does make trading more difficult though as you would have to send your physical certificate when you want to sell your stock.

As far as shorting more than a 100% percent you are completely right in that it can be done in crypto and it can be done anywhere. Prior to regulation, banks were loaning out more dollars than they had on hand regularly.

Just as your example stated--the way you can expose this is if you withdraw the stock certificate. What happens in this case is that Robinhood will force the short sellers to cover and once the short sellers cover the short percentage will fall below 100% again.

Now that is the theory. What actually happens is that Robinhood does hold cash and if you request the certificate they will most likely cover your withdrawal on behalf of the short sellers and then the short sellers covers will go to Robinhood. Robinhood will act as a liquidity provider in the same way that crypto people provide liquidity to these liquidity pools on DeFi.

The same thing happens in banking with fractional reserve. If everybody tries to withdraw from Bank of America (BAC) at the same time then the Federal Reserve Bank will step in and provide liquidity on behalf of BAC to prevent a "Bank Run". Once BAC recalls some of their outstanding loans they can send money back to the Federal Reserve.

Now the Federal Reserve tries to protect against these kind of things by limiting how much Bank of America can lend, so that Bank of America can't irresponsibly lend and put the Fed at risk which puts the entire financial system at risk. They impose "Reserve Requirements".

Everything that I mentioned about with physical stock certificates applies to cryptos as well. You can withdraw all of your crypto and hold them yourself with your own private keys, but a lot of complicated financial actions are hard to do without intermediaries like Binance and Coinbase acting on your behalf.

I do think blockchain technology and smart contracts are getting better at helping people make transactions on chain, wallet to wallet, without intermediaries taking custody, but right now these intermediaries that are facilitating these wallet to wallet transactions are taking high fees. This same problem plays out in the housing market where people are more likely to hold physical title to their homes, but you generally use escrow to facilitate the purchase and sales and escrow charges really high fees. A lot of the Defi out there are acting like escrows.

Great article! There are very old historical examples of what you are saying and you see it in traditional banks which have existed long before stocks and crypto. These aren't new problems and we can learn from history. I think learning from history will allow blockchain technology to rebuild finance in a better way.

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EtBN6qSXAAI1krH.jpg
10 year who made the decision to sell and got 5000% on GME. Actual certificates are real.

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Manipulating cryptocurrency would be extraordinarily difficult to pull off. They're trying it now – manipulate the price – with DOGE and XRP. How is that working out? The thing is you can see the price swings in real time and react to them in real time. With GME the volume changed dramatically lower overnight so some – maybe most – were hamstrung to react until the markets opened. At least in the US anyway. Could be possible but the volume of people paying attention around the world make this more challenging.

Personally speaking, I use centralized exchanges a lot. There is some level of trust based on their reputation and I see how this plays out with the scenario given. My grasp of dex is little but if they do provide the type of services centralized exchanges provide then many more people will jump on it.

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People able to explain complex topics with simple words are the one understanding what they are talking about.
Thanks a lot for that !
I guess it's time for me to remove my assets from Celsius and Nexo (maybe let there only their own token).

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Excellent point, the way we're going the above scenario is pretty likely.

Ironic choice of platform to post the advice! This would be better off on Facebook, oh hang on!

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IIRC Quadriga was reported to have been involved in some market manipulation based on non-existent coins and/or funds.

Wow! I learned a lot from this post! Thanks, Matt!

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People have bitcoin but don't have it in their own wallet?

I guess they do, but it's pretty mind boggling...

Maybe they need to be vaccinated.

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