Here it comes – the cryptocurrency exchanges are now under scrutiny. Last year, regulators in the United States were firmly focused on the mechanics and fairness of Initial Coin Offerings (ICOs). By now it seems settled that ICOs need to comply with the federal securities laws.
So now it is time for cryptocurrency exchanges to undergo their own scrutiny. Luckily, they have faced the regulators before. But in the past, regulators were primarily focused on money laundering, preventing terrorist financing, and currency exchange laws. Now regulators are focused on consumer protection.
Cryptocurrency Exchanges Must Be Registered with the SEC
Unsurprising to securities lawyers, the SEC recently declared that any venue trading securities tokens must be registered as an exchange or broker dealer. As I’ve discussed before, nearly every ICO and even possibly some airdrops constitute securities offerings. To be eligible to trade securities, the SEC confirmed that trading services must first register their platform. Trading companies can register themselves as an exchange or use an exemption for “alternate trading systems.”
The problem is, registration as an exchange is costly and can take years. Registration as a broker dealer with an ATS is comparatively simple. But none are currently live. Overstock.com’s tZERO seems to be ahead of the pack, but expect lots of competition coming in 2018.
The NY AG’s Virtual Markets Integrity Initiative
On April 17th, the New York State Attorney General announced that it “sent letters to thirteen major virtual currency trading platforms requesting key information on their operations, internal controls, and safeguards to protect customer assets.” Apparently the NY AG is on a “fact-finding [mission] into the policies and practices of platforms” as part of a “broader effort to protect cryptocurrency investors and consumers.”
This should come as no surprise. As cryptocurrency prices skyrocket, many vulnerable investors have been drawn into the space. Many have been burned. I personally receive dozens of complaints about major trading platforms. These complaints range from technological errors that cause crypto to be lost forever, to confusing interfaces, to bottlenecks and errors with conversion to fiat. Regulators I’m sure have heard many more. This is a problem both for consumers and the trading venues. Investors lose money and cryptocurrency exchanges risk sanctions, fines, and legal liability.
What Features Should Cryptocurrency Trading Platforms Have?
Best Execution
In the late 2000s, the SEC adopted Regulation National Market System (NMS). To grossly oversimplify, Reg NMS requires exchanges and ATSs to publish their trades (and sometimes bids and offers) to the market writ large. If the data coming from other execution venues indicates there are better prices elsewhere, all exchanges have to match those better prices or reroute the trade to the better market. NMS is intended to eliminate price discrepancies between exchanges and give every trader the best price.
Any crypto trader can tell you that there are often huge price discrepancies between the various cryptocurrency exchanges. While it is not clear whether NMS would currently apply to crypto trading platforms, expect regulators to push the industry in that direction.
Regulation NMS requires exchanges and ATS to get best execution vis a vis the market. Broker-dealers have additional obligations under the duty of best execution. A securities broker-dealer provides “best execution” when it seeks “the optimal combination of price, speed and liquidity for a securities trade[.]” Kurz v. Fidelity Manag. & Research Co., 556 F.3d 639, 640 (7th Cir. 2009).
SEC and FINRA rules require brokers to have “regular and rigorous review” of their execution quality. See FINRA Rule 5310. So exchanges should check their execution quality often, and on a security-by-security basis. This information should be available to traders upon request or published by the exchange on a regular basis.
Price Time Priority
Another standard feature of modern trading is a fair and rules-based order matching engine. A key feature of any electronic order book is “price time priority.” Think of an order book like a cue of buyers and a separate cue of sellers each trying to get to the front of the line. Price time priority means that the first order received by an exchange at any given price has priority over subsequent orders at the same price, even when the difference in arrival time is only a microsecond.
But if another order has a better price, it jumps ahead even if it came later. The price time priority rule ensures that the best price is always at the front of the line.
There are other rules for order matching engines that address issues such “crossed” and “locked” markets, that cryptocurrency exchanges should employ. But the point is, the systems should strive to be fair and non-biased. No market participant should be able to cut in line, or utilize special order types which allow cheating the system for unfair advantage. Such tactics resulted in liability for some trading venues a few years back. Cryptocurrency exchanges should expect that regulators will seek to hold them to the same standards.
Transparent Pricing Models
Another issue that cryptocurrency exchanges need to address is disclosure to their users about how the exchange makes money.
For example, many cryptocurrency exchanges operate on a “maker/taker” pricing model. This means they charge a fee to the party “taking” or accepting a bid, and pay a portion of that fee to the party “making” or posting the bid. The exchange keeps the spread between the two, often a fraction of a penny per token.
Other trading venues insert themselves between the buyer and the seller and capture the spread on a trade. This practice is described as “market making,” and usually occurs on most ATS platforms. (High frequency trading algorithms use this technique as well). It is also a practice that is frequently subject to abuse.
I suspect, though do not have proof, that the “market making” model is how most cryptocurrency exchanges make the bulk of their revenue. While not illegal, it is generally only available to broker dealers under certain circumstances. So crypto trading platforms should expect that regulators will be scrutinizing this business model. At the very least, platforms should clearly disclose their revenue model in their terms of service.
State Law Concerns
I just discussed some best practices that cryptocurrency exchanges should seek to integrate into their business models. The above dealt with major issues under the federal securities laws for those exchanges that trade ICO tokens.
But state regulators like the New York AG have a broader, though related focus. For example, the NY AG’s inquiry asked cryptocurrency exchanges to disclose information concerning six major topic areas, including (1) Ownership and Control, (2) Basic Operation and Fees, (3) Trading Policies and Procedures, (4) Outages and Other Suspensions of Trading, (5) Internal Controls, and (6) Privacy and Money Laundering.
Among other areas of interest, the questionnaires asked exchanges to describe how they combat suspicious trading and market manipulation; their policies on bots; their limitations on non-public trading information; and the safeguards they have in place to protect customer funds from theft, fraud, and other risks.
This should encourage cryptocurrency exchanges to be proactive and stay ahead of the regulatory curve. There are tremendous profits to be made for first adopters who can gain market share and network effects. But the law in this area is shifting and uncertain, which poses pitfalls for those intent on cutting corners.
In sum, cryptocurrency exchanges should realize that the law sets a very high bar. Billions of dollars in equivalent value are traded on these exchanges every day. Regulators and customers demand fairness, transparency and integrity. Anything less will bring the SEC knocking and cause customers to take their business elsewhere.
Be careful out there!
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I am not your attorney, and this is not legal or investment advice.