The Hidden Role of Bots and Algorithms on Crypto Exchanges

Mathematical algorithms and bots operating behind the scenes make this activity possible, often without the traders even knowing about them.  Bots and algorithms shape the market's liquidity, allowing for seamless trade among various parties.  In this article, we'll try to explain how they work and what the average trader needs to understand about them.

Users should also be aware that the algorithms are fed the data they provide, and therefore, they tend to "learn" and improve as more users join the crypto market.  The role of AI and automation in cryptocurrency trading is expected to continue expanding in the years to come.

What Are Bots and Algorithms in the Crypto Context?

A bot is an automated software program used to execute trades on behalf of an exchange or an investor based on parameters set up by them.  The rules of trade are set by algorithms, which are step-by-step mathematical instructions used to analyze market data and inform trading decisions.

Many other features of crypto trading are automated to minimize the need for investor involvement.  For instance, crypto mining is often done through apps where people mine together without anyone directing the process individually.  It also allows the miners to create coins without investing in expensive equipment.

There are several types of crypto bots that investors should be aware of.  These include:

Market-trading bots – these are the most common bots used to execute trades when the market conditions set by the investor are met.

Arbitrage bots – which search for differences in price across different exchanges and allow the investors to choose the low-risk option.

Trend-following bots – use indicators that the price will change to alert the investors about the potential move they could make.  Such indicators include moving averages or even public sentiment.

Front-running bots are a more controversial bot used for trading.  They are designed to detect when a large trade is about to be executed and, therefore, make a trade before actual investors.  It's a tactic often used on decentralized networks.

How Widespread Is Bot Usage on Exchanges?

Bot usage is far more common than it appears, and most crypto exchange users are unaware that bots are operating in the background.  In fact, somewhere between 50% and 80% of all trades are executed by bots, at least on centralized exchanges.  Bot activity is somewhat lower on decentralized exchanges, but it is still widespread.

Small-time retail traders utilize bots as a means to establish their trading plans without requiring active involvement in their execution.  They are also used by large, establishment traders, such as hedge funds, institutional investors, and proprietary trading firms.

The type of exchange also determines how bots are utilized and how frequently they are used.  On centralized exchanges, bots can use APIs to execute strategies quickly.  On decentralized exchanges, however, bots are used to monitor blockchain mem pools and detect trades before they occur.  This allows the users to implement sniping or sandwich attack tactics.

Bot usage is, therefore, so common on cryptocurrency exchanges that many exchanges have developed their own native bot software solutions.  This is the case for almost all large cryptocurrency exchanges, while the smaller ones are still hiring third parties to perform this task.

Positive Impacts of Bots on Market Dynamics

Bots have a broadly positive impact on the market dynamics in the crypto markets.  There is a degree of skepticism towards bots and AI in general among the overall public due to the newness of the technology, but it does serve a purpose.

One of the most important features of using bots is to create market liquidity.  The bots continuously buy and sell crypto, thereby narrowing the bid-ask spread.  This means that there is less price slippage, as there is always someone to trade with.  A smooth trading experience is especially important for new crypto coins.

Bots are also a key player in price discovery.  Arbitrage bots identify the price difference across different exchanges.  That way, prices are aligned globally, and the value of coins is evaluated in a fair manner, and in most cases, this evaluation occurs instantly.

Crypto exchanges operate 24/7, unlike stock markets, and that's partly due to the use of bots.  The prices are updated in real time, and the bots execute trades without the typical biases that investors often exhibit.  In the long run, this also leads to a higher volume of trade across all exchanges and markets.

The Dark Side: Manipulation and Ethical Concerns

There is also a dark side to the use of bots, as they can be employed for less-than-legal and less-than-ethical purposes.  The exchange often monitors these activities, and they can be a reason to ban the user from the platform.  Bots are used to rig the crypto trading system and exploit its loopholes.

Wash Trading

Wash trading involves using bots to simultaneously buy and sell the same asset, thereby artificially inflating the trading volume.  That way, the traded token appears to be more active than it really is.  The traders then falsely believe the coins are worth more than they are.

Spoofing and Layering

Spoofing occurs when bots place a large order but don't actually intend to buy the assets.  These orders create a false sense of demand for the assets on which they are made.  It, in turn, inflates the price of the asset.  Layering is the more complex version of the same process.  It includes multiple fake orders to manipulate market sentiment.

Front-running and sandwich attacks

Front-running bots jump ahead of a large purchase and profit based on the sudden price movement.  In sandwich attacks, a bot places one order before and one after a user's trade.  That way, they trap the price in the favorable moment – in the middle of the swing.

Token Price Manipulation During Listings

Bots are also widely used to manipulate the price of a coin during the initial public offering (IPO) phase when the token is first launched.  When a new token is listed, a short process of price discovery occurs, during which market forces determine its price.  Bots flood the market during this phase, thereby impacting the price.

Gray Zones of Regulations

The use of bots in the ways we've described isn't regulated, as the processes are still new, and the technology used to facilitate them is also new.  In traditional financial markets, these practices would have been forbidden.  Retail investors typically aren't the ones using bots in this manner, as it requires technical skills they lack.

Algorithms behind the Scenes: Beyond Trading Bots

 While most attention is focused on trading bots, at least by those familiar with how the exchanges operate, algorithms play a significantly larger role behind the scenes.  They are the system that works in the background and allows for the exchange to function.

Matching Engines

The matching engine is at the heart of every cryptocurrency exchange, as it is its most important algorithm.  The system is used to pair, buy, and sell orders based on price, time, and the type of order set by the investor.  This means that the trades will be fair and easy to execute even when the market is volatile.

Recommendation and Routine Algorithms

Exchanges use algorithms to pair coins for trading.  This is especially important for novice users who are unfamiliar with the market.  They analyze user behavior, trends in token trading, and market movements to determine which cryptocurrencies to buy and which to sell.

Risk Management and Liquidation Systems

In margin trading, exchanges utilize algorithms to manage risk by continuously monitoring positions in real time.  They calculate the risk as it happens and trigger auto-liquidation when the conditions are met.  That way, the platforms remain solvent and protect the network from crashing.

Anti-fraud Automation

Machine learning algorithms are utilized to detect and prevent fraud in online trading.  This is becoming increasingly important as the number of traders continues to rise and the market becomes more complex.  In most cases, the exchanges employ the same principles for preventing money laundering that are used in traditional financial markets.  Know Your Customer (KYC) policies are now implemented on most exchanges, preventing anonymous trading.

Free Calculation

Both centralized and decentralized exchanges charge fees from their users.  These are based on the energy consumption needed to make the trade.  These expenses are calculated in the background using complex algorithms.

How Traders Can Recognize and Respond to Bots

Crypto traders should be aware that bots exist and are influencing the market.  That way, they can adapt their own behavior on the exchange.  It starts by knowing how to recognize bot-managed trading.

One of the most visible signs of using bots is the unusual activity on the order book.  For instance, you may notice multiple small orders appearing and disappearing within seconds.  It shows that the spoofing bot is working in the background.

Bots also offer predictable price movements.  For instance, spikes and dips will form a pattern and happen on a regular basis.  When humans trade, patterns also appear, but they are much messier and take a longer time to become noticeable.  Volume spikes with little price change are also signs of wash trading bots creating artificial activity.

There are also tools, mostly used on decentralized platforms, that can alert users to bot behavior.  These include Etherscan and Mempool Explorer, which are simpler, and some platforms, such as Glassnode and Dune Analytics, have integrated their own tools.

Some platforms also have anti-bot tools in place to prevent some of the malicious behavior we mentioned.  However, the key tool an investor has at their disposal is the ability to recognize the AI.

The Future of Bots and Regulations

AI bots are a relatively new technology in their own right, and they have already expanded and grown in recent years in ways that were unimaginable just a few years ago.  As crypto trading becomes increasingly widely accepted, bots will continue to improve and expand their uses as well.

However, it's safe to say that the bots will become smarter and learn from the data they collect.  This has been the trajectory so far, and it is likely to continue in this direction.  One of the areas where this is already evident is the ability to analyze market sentiment using social media data.

Bots will also become more present in the field of decentralized finance.  They will be used for strategies such as liquidity mining, yield farming, and liquidation hunting.  Decentralized exchanges are also expanding in terms of exposure and user base.

Another innovation that's coming soon is the increase in regulation.  That's happening in all fields related to crypto, and it's a direct result of the broader acceptance.  The field is new and was initially unregulated; however, there are now broad efforts by governments to regulate the trading of cryptocurrencies.  The use of bots, in particular, isn't among the first fields to be regulated, but experts will also focus on it.

Conclusion

Both bots and algorithms play a significant role in crypto trading, often operating in the background of crypto exchanges, even without users being aware of them.  They are used to keep the market liquid and well-regulated and to facilitate trade based on the rules set by the traders.

They can also be used to exploit a gray area in crypto exchange use.  Users should learn how to recognize these patterns, and they can also take advantage of built-in tools made to prevent such behavior.  The entire field is growing, and it will soon become more regulated.