Who should we trust? Whether you find trust in “good people” figureheads you think are doing the right thing or you believe trust is best left to unemotional, unchanging math, you need to place your trust in someone or something. When it comes to crypto exchanges, how do regulations play a role in that trust? This piece is part two of a four-part series looking at cryptocurrency exchanges. The first covers differences between traditional and crypto exchanges here.
On November 8, 2018, the Securities and Exchange Commission (SEC) fined EtherDelta $388,000 for operating as an unregistered securities exchange. Just a week prior, the SEC charged Bitcoin-funded securities exchange 1Broker with failing to obtain a security-based swaps license and violating KYC laws. These federal interventions show regulation is coming to the largely untouched field of cryptocurrency exchanges. Despite the signs of regulators moving in, many public reports and analyses of market manipulation such as spoofing and wash trading remain.
Why We’re Waiting
Why is there such a delay in regulation for cryptocurrency exchanges? Jake Chervinsky, a lawyer who specializes in crypto-related legal issues, explained,
“There isn't an agency with clear authority over trading on crypto exchanges. Right now, there's sort of a shared responsibility between the US Commodity Futures Trading Commission (CFTC) and the SEC. While both of them have anti-fraud and anti-manipulation authority, neither has regulatory authority in the same way that they would over national securities exchanges in the case of the SEC or futures exchanges or other derivatives exchange for the CFTC.”
Since it will take a decision by Congress to formally put one of these agencies—or some new department altogether—in charge, both the CFTC and SEC have limited their regulation of exchanges to the most obvious types of violations. The burden of proof, it seems, is just slightly out of reach.
One of the hurdles for regulators is getting the data they need to make sense of the trading happening on crypto exchanges. Chervinsky said,
“They need the cold hard trading data from [an] exchange showing exactly when the trades were entered, who was entering them, and when they were cancelled. We just don't have that yet.”
While the SEC could order an exchange under its jurisdiction such as the New York Stock Exchange to turn over all the records needed to prosecute it for market manipulation, stepping in on crypto exchanges is much harder right now, so both agencies pick their battles.
OTCs Are Winning In The Meantime
While exchanges like Gemini and Coinbase are seeking to follow regulators the best they can, there’s a whole other world of million dollar plus trading happening. While regulators focus on exchanges, over-the-counter (OTC) markets like Circle and Cumberland Mining are flourishing.
These markets aren’t accessible to retail investors. and they make up a large amount of the trading volume today. They offer discounts on large-lot orders of $100,000 or more to institutions and investors. These large transactions have a high potential push and pull on prices far before the average trader has time to react, but this isn’t relegated to crypto trading, it can happen with any asset.
Chris Dannen, CEO of i2 Trading, an OTC desk based in New Jersey, says OTC desks are kind of old-fashioned compared to the electronic trading that’s taken over traditional capital markets, but that doesn’t mean they should be overlooked. “OTCs deal with smaller numbers of clients,” Dannen says. “It’s easier for them to vet individuals and institutions, preventing fraud and money laundering.”
While most floor trading and desk trading involve only the most illiquid of commodities like coffee, corporate bonds, and forex, Dannen said,
“It would stand to reason that crypto would behave like those illiquid commodities. Though electronic exchanges are in a regulatory grey area and are likely to require an onerous de-risking process, OTC desks, at least for now, are on the rise.”
As the crypto industry gains increasing attention from traditional investors, venture capitalists, and small family offices, it’s likely to see regulatory pressure increase. Douglas Bilyk, VP of Business Development at digital asset trading platform LGO Markets, said,
“We know that many regulatory agencies are still evaluating and gathering information about the space, but will eventually move forward with meaningful regulation. Firms which aren't preparing for this will find themselves in a very difficult position. Customers want to know that they are trading on a platform that meets the highest standards when it comes to compliance, security and fairness."
As centralized exchanges add sophistication to their market data collection and smaller decentralized exchanges eke their way towards a broader market, it’s likely regulators will have a clearer sense on where to step in. Until then, cryptocurrency markets aren’t likely to reach the masses.
