Crypto Exchanges

Are Crypto Exchanges Providing Best Price?

by William Restis

published October 18, 2018

Are crypto exchanges providing the best price?

How often have you traded on one crypto exchange, only to see a wildly divergent price somewhere else? I know many traders feel compelled to monitor several crypto “exchanges” simultaneously to ensure their trades are reasonably priced. I also know a few traders who use price differentials as an opportunity for arbitrage. This is the byproduct of a hopelessly fragmented crypto market.

While crypto exchanges may be the topic, I am not here to advocate a product or strategy to help you earn. Instead, I want to explain how crypto market fragmentation is not a new phenomenon. It has been comprehensively addressed in securities markets, which provide a good working template to analyze the problem.

Why are the securities markets relevant to crypto exchanges? Simple. The SEC’s position is that most, if not all, ICO’d tokens are securities. So an understanding of the securities laws is vitally important to understand what is wrong with crypto “exchanges,” and how those markets will be evolving in years to come.

The Birth of the National Market System

Before computers became commonplace, securities were traded, settled and cleared on paper tickets. But a stock market crash in 1969 caused a paperwork crisis that would change securities markets forever. Unprecedented trading volumes overwhelmed the cumbersome physical clearance and settlement process of paper tickets sent between brokers and exchanges.

The paperwork backlogs coincided with an effort by the SEC to encourage exchange competition, and thereby lower the cost of securities transactions. (Note: there are several different types of order execution venues including registered exchanges like the New York Stock Exchange, and NASDAQ, and registered broker dealers operating like exchanges such as Citadel and UBS. To stay on topic, I’ll refer to them all as “exchanges.”)

But simply having multiple exchanges did not solve the problem of effective competition. Each exchange had proprietary prices in the stocks they traded. Just like the crypto-world of today, there was no objective “price” of a stock, as each exchange was an isolated ecosystem. In addition, exchange membership rules often limited brokers’ ability to trade in different markets. So if a broker was a member of the NYSE, they couldn’t send customer orders elsewhere. And if a broker executed a trade by matching customer orders against each other (“internalizing”), or by taking the other side of a customer’s order (“market making”), these trades were generally not reported to the market at all.

In other words, there were substantial hurdles to investors finding the best market, and getting the best price for their trades.

The SEC’s solution was the creation of a “national market system” (the “NMS”) that linked exchanges together to share trade data and match prices. The NMS rules created “securities information processors” or “SIPs” to aggregate and disseminate quotations and reported trades from all the various exchanges. The NMS was introduced to give markets deeper price information, and ensure investors got the best price available anywhere. For the first time, brokers placing customer orders could access quotations in all markets. And real-time price data allowed brokers to effectively route customer orders to the exchange with the best price available. 

The National Best Bid and Best Offer – NBBO

In the early 1970s, the SEC began implementing the NMS by focusing on information linkages between exchanges. SEC rules require consolidated reporting of transactions through something called the “consolidated tape.” All the orders on all the exchanges are compared and integrated into THE price for any given stock.

Here’s how it works (in summary, ignoring exceptions, and with a ton of detail omitted). Each of the exchanges are required to adopt an SEC approved “reporting plan” for the dissemination of all transactions on its platform. For each security, all bid, offer, and last price transaction information is transmitted to the SIP. The four SEC approved SIPs collect trade data from various exchanges and determine THE trading price of each security in real-time. For trade data, this is easy. The SIPs look at the price of the last reported trade across all exchanges, and that constitutes the latest price for a security.

But wait. You may be asking “how does that ensure that prices will converge across various exchanges?” Good question. The answer gets complicated, but it all starts with an order matching concept called “price-time priority.” This means that, all else being equal, limit orders go into an exchange order book first according to their price, then according to their timing. If someone wants to buy a security, the order matching software will give preference to the person offering the highest price. They go to the front of the cue. If someone wants to sell a security, the lowest price goes to the front. That’s the “price” component. If two orders are entered for the same price, the one that was entered first, get’s executed first. That’s the “time” component.

In this way, there is always a “best bid” and a “best offer” for each security, for each exchange. These best bids and best offers from each exchange are then consolidated by the SIPs into the “national best bids and best offers” (“NBBO”) for each security in real time. The highest price bid to buy on any exchange at any any given time is the “national best bid” and the lowest price offer to sell on any exchange at any given time is the “national best offer.” 

Here is where it gets more complicated. Each exchange is required to compare their own bid and offer data against the consolidated tape’s NBBO to make sure the exchange is transacting at the best price available anywhere for that security.

If the bids and offers on a particular exchange are better than the NBBO, the exchange can execute the trade because the bid/offer would effectively BE the NBBO. If the exchange’s bids and offers are less favorable than the NBBO, the exchange must execute at the NBBO or reroute the order to a different exchange that has the better price. This is called the Order Protection Rule.

This is all tricky business that requires fantastic computing power and fibre optic or laser connections between exchanges. Exchange software both receives and transmits data in real time. Exchanges must be able to interface with each other so that trades can be re-routed. Each trading venue generates terabytes of trade data every day. Order execution quality is measured in milliseconds or microseconds.

And there are problems with the NMS regulatory structure that has caused much difficulty trying to interlink all the exchanges into a single “national market.” For example, the NBBO is delayed a few milliseconds because the SIPs need to aggregate the data and relay it back to the exchanges. Even at the speed of light, by the time it makes the round trip, the data may be stale because markets have already moved.

Some venues have attempted to “solve” the latency problem by creating direct linkages with other exchanges to create a synthetic NBBO. The implications of this border on the philosophical. Is the SIP generated NBBO REALLY THE NBBO or are the synthetics actually generating the “best” information. This has also raised concerns about “latency arbitrage” and the possibility to game the system. Some researchers have found that order execution quality decreased after the implementation of NMS. Many view the NMS as a failure, because the whole structure is one giant cluster****.

The SEC has attempted to address the inherent imprecision of the consolidated tape and the  NBBO by focusing on disclosure. Exchanges are required to disclose high level information about order execution quality such as execution speeds, prices relative to the NBBO, and average effective and realized spreads on orders.

Implications of Regulation NMS on Crypto Exchanges

So let’s bring it back to getting the best price on crypto exchanges. Why is NMS an issue? Let’s start with the assumption that many, if not all, crypto tokens were launched as part of an ICO. Much ink has been spilled about how “every ICO I’ve seen is a security.”

Billions of dollars in ICO securities are traded on crypto exchanges every day. So does it follow that these crypto exchanges must comply with all the trading protections of the federal securities laws?

Well, that depends on who you ask. We know from the July 2017 DAO Report that the SEC expects trading venues to comply with exchange registration requirements if they trade crypto securities. And in September 2017, the New York Attorney General issued a report (implicitly) describing how crypto exchanges fail to live up to the requirements of NMS. And in January 2019, the Financial Industry Regulatory Authority’s (FINRA) annual risk monitoring priorities letter, began to address “processes related to digital assets and assess firms’ compliance with applicable securities laws and regulations and related supervisory, compliance and operational controls.”

So this begs the question, how can crypto exchanges avoid the requirements of Regulation NMS if they qualify as “exchanges” under the U.S. securities laws?

Some may say that NMS does not apply to crypto securities, because the definition of “NMS Securities” are based on whether they are aggregated by a SIP, pursuant to a reporting plan.

So in a sense, NMS does not apply to crypto securities because there are no registered exchanges with reporting plans, and there are no registered SIPs for crypto securities. But here’s the problem, if a crypto exchange were to register as an “exchange” with the SEC, it would be required to work with a SIP and develop a reporting plan for every security that comprises at least one percent of all trades on that exchange.

So the only reason crypto securities are not covered by NMS is because the exchanges have failed to comply with the securities laws! In other words, if the exchanges registered with the SEC, and followed the rules for operation of an exchange, then many IPO’d securities would by definition fall under NMS. 

But the exchanges may say “but we can’t comply with the securities laws because the infrastructure is not available yet.” That may be true. Then perhaps – and this is a conclusion I hate to write down – it is illegal to publicly trade ICO securities in the United States until NMS compliance can be realized.

But maybe it’s not an all-or-nothing proposition. Let’s assume NMS compliance is not a requirement for crypto exchanges. Even if SEC rules don’t necessarily apply, they are being incorporated into the next generation of crypto exchanges.

For example, Founders Fund invested in startup Tagomi Systems, Inc. to develop smart order routers for crypto markets. This would allow traders (and possibly exchanges) to route customer orders to the best market as required by the NMS Order Protection Rule. A company called Coinroutes is developing a similar order router and a version of the consolidated tape for crypto markets. Sources report that former Wall St. heavyweights are building next generation crypto exchanges that incorporate NMS concepts. An example is the upcoming San Juan Mercantile Exchange. Another is Mercury Digital Asset Exchange.

This is just the beginning. But the stage is set, and we should all expect further evolution of U.S. based crypto exchanges consistent with SEC requirements. Expect exchanges to link themselves together to share quotes and transaction data. Spreads between markets should come down. Information processors will emerge that provide deep, consolidated data. Expect order execution quality to increase as Wall St. grade exchange platforms replace rudimentary order execution software. This isn’t MtGox. 

More to come. Stay safe out there.


I am not your attorney, and this is not legal or investment advice.

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