Bitstamp's big flash crash wasn't manipulation, exchange says, but the event spurred internal investigation

"Everything worked exactly as intended."

That's the message Hunter Merghart, head of Bitstamp U.S., wants to get out to the market regarding a May 2019 "flash crash" that some have tied to possible market manipulation on the European trading venue.

On May 17, a trader placed a large sell-order on Bitstamp, triggering a six-point market sell-off and the liquidation of $250 million worth of long positions on derivatives exchange BitMEX.

At the time, Bitstamp said that the system behaved as designed by "processing and fulfilling the client's order as it was received."

The firm also said that it would examine the large order behind the price decline to sniff out any sort of nefarious activity. The firm decided to reveal the findings from its investigation to quell any speculation about manipulation.

Earlier this month, CoinDesk published a piece maintaining that if the trade was indeed manipulating the market, then said trader (operating on both Bitstamp and BitMEX) could have "returned up to an 80x multiple over what the manipulators put at risk."

It's not manipulation, says Bitstamp

Still, Merghart says the conclusion that volatility should be equated to manipulation is a false one to make. 

"The entire market disturbance was caused by one market participant," Merghart said in an interview with The Block.

"The client who placed this sell-order was able to sell their crypto," he said. "They got filled on their entire order. And the buyers on the other side of that order got filled."

Merghart said the firm's in-depth investigation was conducted alongside their primary regulatory, the New York Department of Financial Services, and took several months. It was a process that involved legal, compliance, management, surveillance, and engineering teams.

The client who placed the large sell-order worked with Bitstamp, providing sufficient evidence that the entity didn't have positions on BitMEX. In traditional markets, exchanges have information sharing agreements to identify a trader manipulating an underlying spot market to profit from positions on a derivatives market.

In this case, the client offered information, including historical trading data, that proved they weren't trading on BitMEX. 

Market structure changes

Still, the event did result in Bitstamp dislocating from the market — a fact that forced the exchange to re-examine their market structure. In response, the company decreased the threshold to place a large order from 10% of the order book to 5%. 

Merghart said the change reflects the maturation of the crypto market, which doesn't have a defined market structure yet. Indeed, different crypto exchanges opt for different parameters to keep orders from having too big of an impact on their market. Bitfinex, for example, has speed bumps to prevent single orders from moving the market by more than 5%. The firm also offers so-call hidden orders, which are designed to allow market makers to place orders outside of the order book to absorb flash market movement for a profit, according to a source. 

"There is not one solution to prevent it all," one exchange executive said. 

At Coinbase, the maximum order size for a bitcoin trade in USD is 280 bitcoin for market orders and taker orders. There is no maximum for limit orders or maker orders.

As for Bitstamp, Merghart said, the firm is exploring other parameters to put in place such as a market cool down period. 

"Let's say someone eats up 5% of the order book," Merghart explained. "That market participant would have a 5 minute cool down."

Still, he noted that there are a lot of participants who want to trade aggressively and fast. So it's important to strike a balance.

"As soon as you put in cool down periods and circuit breakers, and we become an outlier. It could hurt the business," he contended.