A golden bitcoin in front of a red graph. The graph rises and then sharply drops, indicating a drop in value. The graph is outside the shallow depth of field.

Pump-and-dump schemes detrimental to cryptocurrencies and investors, UF Warrington research finds

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GAINESVILLE, Fla. – When it comes to investing, avoiding risk is almost impossible. No matter if you invest in stocks, bonds, mutual funds, or even cryptocurrencies, each can lose value. The difference between standard investments, like stocks, and new forms of investments, like cryptocurrencies, is regulation. While standard forms of investments are regulated by agencies like the Securities and Exchange Commission, regulation of cryptocurrencies is almost nonexistent, making it easier for investors to fall victim to schemes that cause them to lose value in their investment.

Tao Li and Baolian Wang

Assistant Professors of Finance Tao Li and Baolian Wang

One such scheme is called a pump-and-dump scheme (P&Ds), which is a form of price manipulation that involves artificially inflating an asset price before selling the cheaply purchased assets at a higher price. Once the assets are “dumped,” the price falls and investors lose money.

New research from the University of Florida Warrington College of Business finds that pump-and-dump schemes are not only pervasive throughout the cryptocurrency market, causing investors to lose tens of millions of dollars in a year, but also that pump-and-dump schemes are detrimental to the health of cryptocurrencies by lowering their value and liquidity.

“P&Ds in stocks are illegal in many countries and considered fraudulent by U.S. regulators,” write Warrington assistant professors of finance Tao Li and Baolian Wang, along with Princeton University Ph.D. candidate Donghwa Shin. “P&D groups are active on cryptocurrency exchanges, however, have been operating with relative impunity because cryptocurrencies are not necessarily considered securities and the exchanges currently are unregulated markets.”

Li, Wang and Shin, using a large sample of pump-and-dump schemes, found that they create “flash” bubbles that crash within minutes. For example, the researchers found that in the first 70 seconds after the start of a P&D, the price increases by 25 percent on average and trading volume increases 148 times. Given that the expected returns of these events are negative, the researchers question why investors would continue to participate.

“These findings make it puzzling why outsiders are willing to participate in P&Ds,” the researches write. “We conjecture that one plausible mechanism is that P&Ds attract overconfident investors who believe that they can time the market more accurately than others can. Another possible mechanism is that these investors are affected by the salience of short-term extreme returns, and overweight the possibility that they will realize similar returns in their decision-making or overestimate the skewness of token returns.”

Investors should be aware of P&Ds as they invest in cryptocurrencies while regulations are still being determined.

“It is important to understand scams in this new market and how our society shall deal with it to make better use of [cryptocurrencies],” Li, Wang and Shin said.

Read the complete research paper.