A year ago, Finnish bitcoin entrepreneur Risto Pietilä attempted to compile a list of the top publicly known bitcoin holders.

Assuming his list is accurate (which it probably isn't), if you add up the alleged top-20 largest holders of bitcoin, these individuals control roughly 4.44m BTC.

Yet when coupled with self-identification of organizational wallets (like Bitstamp did last year), plus anecdotal talks at meetups, conferences and parties, it becomes clear that the sum total of bitcoins people and companies claim to own is greater than 21 million – even though only 13.5 million have been mined so far.

How can this be? What explains the exaggerated claims? To answer that we have to look more closely at the ecosystem and track down bitcoin flows.

Due to its pseudonymous nature, the bitcoin network itself is, for all intents and purposes, a dark pool. That is to say, the network divvies out its limited trust fund (money supply) to nominally unknown players (miners) in a black box that we are slowly deciphering. Ownership is ephemeral (see Jonathan Levin's new pipe analogy).

While an imperfect facsimile (a bitcoin is not equivalent to equity), one way to think of a real-world financial equivalent would be if Google issued its shares every 10 minutes to a pseudonymous dynamic-membership multi-party signature (DMMS), to use Blockstream's terminology. Or in other words, if Google issued its shares to random strangers on the Internet.

Imagine if two or three years went by and a broker-dealer (or in the bitcoin world, an exchange) was tasked with pooling together all the small batches of Google shares?

Their disparate nature would make tracking down and aggregating funds not only difficult, but potentially impossible. So, if you are trying to build a very large liquidity pool of Google shares, how do you track down funds to a non-identified source? How do you find the people who mined for the first couple of years and have forgotten they had them? Who do you call?

One solution is trusted third parties called 'liquidity providers' or 'brokers' and, sometimes mistakenly 'OTC traders' (OTC stands for 'over-the-counter' and is inaccurately used in the bitcoin world, but we will let that slide for now). In reality, they are inventory dealers; people who know people who know people.

Venture Scanner currently tracks 80 funded bitcoin-related companies that have raised $430m in total. Some of these companies hold inventory (bitcoins), others track the inventory for patterns, still others provide an API to access the inventory and there are even a couple that focus on hiring developers to build apps that interface with the inventory, and so on. Twenty-five of these startups are funded exchanges that have collectively raised $121m.

Why have exchanges raised so much money? In order to use the bitcoin network you need bitcoins and while there are several ways to obtain bitcoins (e.g., mining, acting as a merchant and receiving them for goods and services), exchanges provide another method to obtain bitcoins and are often seen as the easiest option to not only quickly buy or sell coins but also to do so in bulk.

How much activity does this include today? BraveNewCoin (BNC) aggregates and tracks the self-reported figures of bitcoin exchange volume globally. According to BNC, on any given day, from $40m to $200m (100,000 – 500,000 BTC at the time of writing) is said to be trading against 30 other currency pairs.

However, there are a couple of caveats with this number. The first is that the Chinese-based exchanges drastically skew the BNC daily total in part because the largest exchanges effectively double-count certain transactions, allow wash trading to occur and simply have no trading fee.

Not only do the doctored metrics above curtail tracking down accurate inventory of bitcoins, they may also expose some participants to market risks: if it costs you nothing to participate in an activity then there is no draw back to effectively 'spam' the exchange (which incidentally happened to the bitcoin network prior to the imposition of a 'dust limit' – now set at 546 satoshi).

However, increased faux volume is misleading and ultimately shortsighted, as it distorts market information (level of trading interest) for new participants. After all, without transparency, how do new market participants know if their orders will be filled as stated or if it will lead to similar misrepresentations explored by Michael Lewis in “Flash Boys”? If trading fees are zero, there is no accountability for exchanges to show revenues as volumes go up. That means exchanges can fabricate volume without having to show revenues in their income statement.

Even if the fee were some very small percent but positive, an exchange would have to show some revenue associated with the volume numbers they claim.

It is worth bearing in mind that the 0% trading fee is analogous to that applied in the forex markets where it is usually 0%, with traders just paying the spread. A traditional exchange makes money by extracting some small payment for order flow from the market makers.

Perhaps the most recent egregious example involves the futures products: in an effort to be perceived as competitive as their local peers, several of the large Chinese exchanges such as OKCoin and Huobi now offer margin trading with up to 20x leverage.

Yet due to a lack of financial experience operating these (they originally all used the same futures software), a sharp change in volatility can have unforeseen consequences.

For instance, two weeks ago Huobi (owner of the BitVC platform) ended up socializing losses across profitable traders to the tune of 46.1% to cover the losses of a levered 2,500 bitcoin trade.  And 796.com (which was the first to allow over 20x) is now purportedly allowing 50x.

In the months leading to its bankruptcy, Bear Stearns reached a 42:1 leverage ratio, thus another large ‘flash crash,’ “mistrade,” or blatant “manipulation” at 20x – not to mention 50x – could not only result in large socialized losses but also investigation from governmental organizations.

Without a full audit, it is difficult to identify which exchanges operate in this manner, inflating their volume numbers, however, the Chinese exchanges are likely not alone, as these types of activities may actually be taking place industry wide.

Another issue with the BNC figure is that these are self-reported figures from public exchanges.

An increasing number of exchanges have chosen to restrict access to qualified investors, for a variety of reasons including compliance issues. This has included Buttercoin, itBit, Mirror (formerly Vaurum) and Coinsetter, though Buttercoin and itBit are now open to the public.

In addition, some exchanges enable their users to effectively trade private keys off-chain, keeping large buy and sell orders from hitting the public market, which in turn masks trading strategies and theoretically prevents 'slippage' from occurring.

It is unknown what quantity of funds are processed daily through these trusted entities, including Sator Square Partners, Xapo, Pantera, Binary Financial and Second Market.

Rumors that CNY-denominated trading now comprises 75-90% of all bitcoin trades is likely incorrect, as BNC is unable to take into account the off-chain inventory trades that are largely denominated in USD or EUR.

Similarly, because BNC uses self-reported volume numbers from Chinese exchanges described above, it is likely that the CNY proportion of volume is heavily skewed and inflated relative to other trading pairs from markets that do not allow wash trading and double-counting.

On the sell side are payment processors such as BitPay, mining manufacturers such as Spondoolies-Tech and mining farms like BitFury. On any given day, miners are rewarded 3,600 BTC a day, most of which are resold to cover production costs. Payment processors collectively handle an additional 5,000–6,000 BTC a day.

On the buy side are family offices, high-net worth individuals (such as Tim Draper) and financial institutions like the private inventory dealers listed above.

And sitting on both sides of the supply and demand fence are bitcoin ATMs, which, while growing (currently around 300 globally), are likely have a only marginal impact on the equilibrium.

The chart above comes from John Ratcliff, who measures bitcoin value distribution by age of last use. Dialing into the bottom navy blue-colored 'one day' bracket, we can see that over the course of 2014, roughly 2–4% of all mined bitcoins are moving around daily.

If 'best practices' were being followed, traders would dramatically limit the number of coins that are left on an exchange in order to reduce their counterparty exposure, which has historically been high. Remember, nearly 50% of exchanges have absconded with funds.

That would mean that, based on the self-reported numbers fed into BNC, up to 500,000 BTC would be moving on and off exchanges daily. We know this is not true, simply from the chart above, as well as other metrics (such as bitcoin days destroyed and transaction volume).

In reality, the same coin can be traded several times a day, causing several multiples of the transaction volume. Ratcliff's chart just shows if a coin was used at all during a day.

To counter claims that the vast majority of the aggregate exchange volume is moving on- and off-chain daily, recall also that 500,000 BTC is approximately 3.7% of all mined coins, thus this purported exchange volume alone would equal all daily volume.

In reality, participants are not moving bitcoins out of exchanges for a night, as they would be creating a visible market phenomena. The bottom line is that there simply are not enough liquid bitcoins to actually equalize the amount that exchanges claim to be floating in terms of transactional volume.

So either exchanges as a whole are knowingly misrepresenting their trading volume and/or users are keeping large sums of deposits on exchanges.

Even with multi-signature, both situations are dangerous to the ecosystem. There are two caveats, however: some of the perceived 'bloat' in coins not being used may be sitting in the exchanges' wallets rather than the wallets of consumers. Also, withdrawal time from an exchange is not necessarily related to the price of bitcoin.

Unfortunately, the industry has not been very good at self-regulating. In fact, there is no self-regulatory organization for the exchange space or any kind of framework to promote best practices such as the transparency attributes in the Coinometrics survey.

This lack of transparency not only makes it difficult to identify real versus fake inventory but as all four divisions of power – exchange, broker, settlement and custodial – are often housed within the same organization with limited, or no, segregation of customer deposits, there is enormous potential for abuse and conflict of interest, such as 'front running'.

This has historically also led to counterparty risks explored in a early 2013 study that found 18 of the 40 exchanges it was analyzing closed their doors and absconded with customer funds.

Perhaps as the industry matures, participants will begin incorporating the advice from the Crypto-Economy Working Group 'BitLicense' comment (see 'Technology Solutions') including keyless wallets (such as segregating user wallets as Blockchain does), proof of reserves (like Reservechain from Bitreserve) and a type of Consolidated Audit Trail that the SEC's Rule 613 is promoting within the US securities industry.

These will increase not only transparency but also accountability – as financial controls will be separated within companies, reducing and mitigating the chances of an insider or group of insiders from colluding and abusing customer funds.

None of these solutions are perfect and they each have drawbacks as they impact fulfillment speeds and tracking may be out of sync with actual assets. Yet, as they mature, perhaps then the spate of heists and thefts most recently highlighted by the alleged actions of Alex Green ('Ryan Gentle') could finally taper off as sites like Localbitcoins (where Alex allegedly continues to off-load funds) will be able to prove (with Merkle roots) to the community and law enforcement, where funds originated and exited.

Until then, there is a lot more research to be done.

Special thanks to Anton Bolotinksy, Byron Gibson, Jonathan Levin, David Shin, Ryan Straus, Koen Swinkels, Simon Trimborn, Kevin Zhou and John Whelan for their assistance in drafting this article.

Disclaimer: The views expressed in this article are those of the author and do not necessarily represent the views of, and should not be attributed to, CoinDesk.

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