Daily Bit #181: Lock It Up, Exchanges
By: Daily Bit
Tags: Cryptocurrency, Bitcoin, Currency Exchange, Blockchain, ICO

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Lock It Up, Exchanges

April 17th, 2018, 9:48 AM — New York Attorney General Barbara Underwood announced the launch of a cryptocurrency exchange inquiry to shed light on consumer protections.

September 18th, 2018, 10:10 AM — Underwood shared the results of the investigation in a 40-page bombshell report.

The results? In short, exchanges need to lock it up. Not only are there potential conflicts of interest between their business segments and the corresponding parties involved, but most platforms are not as:

Welcoming to retail traders

In line with traditional oversight measures

Today we’re rattling through several findings addressed in the report. Before diving in, here are jump-off points of tweet threads from two lawyers if you’re in the market for their takeaways. After all, they helped shape our outlooks — give credit where credit is due:

1. Exchange business lines create potential conflicts of interest.

When running a business, there’s “wearing many hats”, and then there’s digital asset platforms. Specifically, six caps are highlighted by the NYAG Office:

Venues of exchange

Broker-dealer duties

Money-transmitters

Proprietary traders

Owners of virtual currency

Issuers of virtual currency

The NYAG Per the report, “each role has a markedly different set of incentives, introducing substantial potential for conflict between the interests of the platform, platform insiders, and platform customers.”

Naturally, that’s problematic. Platforms have a LOT of firing power in regards to how they run their business. For instance, take being both a broker-dealer and proprietary trader. If a platform is completing orders for a customer (#2), what’s stopping them from filling their own (#4) first?

The answer: Nothing (for now). Plus, the trades are taking place under their own roof (#1) nonetheless. That’s like dangling a flank steak in front of a bear… eventually it’s going to bite.

FYI — “front-running” by brokerages is illegal.

2. Complex order types disadvantage inexperienced traders.

Generally speaking, the most common ways that folks buy and/or sell assets is through “Limit” or “Market” order. But for some exchanges, that only scratches the surface. Imagine order types as controller configurations for Xbox, Playstation, what have you. More sophisticated layouts often tilt the favor towards pros and away from noobs.

The same goes for order types. Per the report, “Choosing the right order type has a significant effect on whether, and at what price, an order will execute.” On top of that, more complex orders essentially demand the use of an algorithm that will automatically place and cancel trades, allowing you to take advantage of its perks.

3. There are some iffy gaps in KYC

Most exchanges have tightened up their onboarding processes once regulators began cleaning up the space in late 2017. However, each platform has their own framework for creating, verifying, and granting rights to user accounts. We figure that’ll eventually be cleaned up in the long run.

Speaking of KYC: remember when Binance had higher quarterly profits than Deutsche Bank? Well… people forget that Binance doesn’t KYC its customers (s/o Preston Byrne). Plus, whereas Deutsche has a notable presence in Japan, Binance does not — CZ bagged plans for a Japanese expansion “following inquiries from the nation’s securities regulator that led to an official notice to stop operating in the country without a license.”

Along with Gate.io and Kraken, Binance is one of three platforms that didn’t share information on their business operations with NYAG. That has since prompted Underwood to refer each platform to the NYS Dept. of Financial Services “for possibly operating unlawfully in New York.”

Byrne’s hot take? “Whether Binance will even be able to continue operations in the medium-term.” With all due respect… we dig it. Can’t deny some of the dots that are connected.

4. VPNs allow folks to slip under the radar

We’ve mentioned before how exchange platforms can’t service users that live in areas where they haven’t received green lights from regulators. Although all exchanges track IP addresses to limit access to those within permitted areas, the bulk of exchanges don’t block VPN addresses.

Granted, we’re not security gurus, but our understanding of VPNs is that 1) they’re legitimately useful for security purposes, and 2) they’re hard to track down… which is why people use them.

So, maybe this is harder to waggle a finger at? Or it could be that exchanges simply make no effort to curb their use. If you recall, BitMEX was given flak recently for purportedly allowing Americans to access the platform through VPNs. And Americans 1,000,000% use the platform. After all… name a more easily accessible casino.

Regardless — the gap isn’t sitting well with NYAG.

5. Exchanges trade on their own platform

This was touched on in numero uno, but it’s worth repeating — several exchanges run proprietary trading accounts. That means not all trade volume comes from retail and institutional investors.

In some instances, a fair chunk of total volume comes from the exchange itself:

Circle (Poloniex): <1%

BitFlyer: ~10%

Coinbase: 20%

For the record, this happens in traditional markets via broker-operated alternative trading systems (ATSs). Where they differ — notably, mind you — is transparency. The practices are a far from readily accessible public knowledge.

Per the report, that “also calls into question whether the natural market for virtual currencies on those platforms is as robust as customers might believe it to be.” Another fair point that gives us déjà vu from past wash trading accusations thrown at various crypto exchanges.

The bottom line: Bet the farm that the SEC wrinkled their noses after reading NYAG’s report. We figure that exchanges have seasons of spring cleaning to catch up on before a Bitcoin ETF approval will be in the books.