The article titled “What’s an Initial Exchange Offering (IEO)?” opened up the topic on what IEOs are and the contrast between them and ICOs. The article further touched on the advantages and the limitations of IEOs and how to raise funds through exchange offered tokens. While the advantages of IEOs further outweigh the disadvantages, a serious challenge exists in the process of exchange offerings.
In this article, we shed light on the challenge projects whose tokens are raised through exchanges face. This one persistent challenge that is creeping in the new fundraising method, is the manipulation of the price of the token by exchanges. We further look into how market-making mechanisms on the exchange cause this manipulation of price. Here, readers should be familiar with two terms mainly; Initial Exchange Offering (IEO) and margin trading.
Table of Contents
Initial Exchange Offering
The earlier blog explained Initial Exchange Offering in detail, to learn more on IEOs you can follow through this link. We will however provide a basic introduction to IEOs below.
Initial Exchange Offerings (IEOs) are a relatively new method of distributing cryptocurrency tokens during the startup crowdfunding stage. As described in the article, IEOs are closely related to ICOs. However, IEOs use exchange(s) as part of the distribution model.
“The first process includes minting the tokens and then distributing them to exchanges. Then, an agreement is generated between the developers and the IEO which is almost similar to the agreement that is developed in an ICO.”
The model utilizes exchanges instead of the conventional smart contracts, website or pool to disburse the tokens. The process provides the investor with better control of the token distribution by having an equal opportunity to purchase the token without competing using “gas fees”. The process also disparages the risk associated with scams and failed ICOs as exchanges require the investor to create an account, complete KYC and purchase their tokens.
The Market Making Loophole
Raising funds through an exchange token offering is posing a challenge especially when the initial price is not set on the agreement. This allows the market to determine the price of the token which can end up causing massive swings in the asset’s prices. Investors with greedy intentions can use market making strategies to pump the price of the token artificially.
When users are able to buy and sell the cryptocurrency from the get-go, the price may be manipulated by bad actors in the field. These actors may buy off the tokens in large proportions pushing the price up and sell it off once the price hits a higher price. This poses a challenge for initial exchange offerings as tokens are presented as overbought or oversold during the process.
Market making presents a fair method to decide the price of a token as opposed to assigning an issue value to the token. However, the problems brought about by the market making loophole problem is slowing the adoption process of IEOs.
How Money Makers Can Lose Money
When transacting large orders, the market maker operates under the hope that the opposing party is done transacting with that stock or that he has charged enough of a price concession to make up for any subsequent price impact from additional trades. But if the completed orders are only part of a larger decision to buy more shares, the market maker can lose money as the additional buying pressure causes the stock to rise further. Bagging, as the process is known, is a common phenomenon to new coins that are performing well.
The agreement signed between the exchange and the token developers sets the price of the token beforehand. A limited number of tokens are placed for the public sale and investors try their luck to grab the tokens.
An agreement is signed between the exchange and the token developers. Here, the initial price of the token is established. It also establishes how much tokens a person can get throughout the sale. As the tokens are limited, only a few can get hold of them. After that, normal trading is resumed.
The Margin Trading Loophole
However, given that market makers do not want to lose their funds on trading fees, they artificially cause liquidation on the open margin traded positions on the asset, in our case the new offered token. Traders place orders to buy and sell the token at which the exchange will liquidate once the liquidation price is met. Essentially, the exchange gets the entire stack they bet with and extracts a high market fee multiplied by the leverage.
Exchanges, however, are aware of the characteristics of the outstanding orders placed by the traders. Once the token is launched, most of them are followed by a pump on the price after which price moves sideways for some time. Once in a sideways trading move, the exchanges (with knowledge of the outstanding buy and sell orders) engineers a movement in price that creates income through closing the leveraged orders.
When there are lots of overleveraged shorts, an exchange can pump the price with bots briefly and collect the short position. It is similar to longs but in reverse, where the exchange will briefly dump the price and collect the long position.
The cryptocurrency industry is still young and unregulated, hence you should be wary of the scams and fakes in the industry. IEOs are an efficient way for the current startups to raise capital but with the exchanges and market makers desperate not to lose money you should check the project before investing. So, which IEO are you going to invest in? What precautions are you taking to avoid schemes such as the margin trading loophole?