Analysis: Cryptocurrency Exchanges Struggle to Protect Clients

Cryptocurrencies , long the stuff of libertarian day-dreams, are coming under more and more scrutiny from regulators and other government bodies. This Tuesday, the Office of the New York State Attorney General (OAG) released a long, detailed report that provides some significant insights into the operations of cryptocurrency exchanges.

In its report, the OAG surveyed nine different cryptocurrency exchanges with four others refusing to participate. By no means unanimous in their responses, the exchanges’ answers to the questions the OAG put to them are both hopeful and worrying.

On the negative side of things, they reveal that for most exchanges, significant conflicts of interest exist amongst exchanges. At the same time, exchange customers receive little to no protection and exchanges are doing almost nothing to prevent abusive trading activity.

Having said this, some of the problems exchanges are facing are more down to the fact that the cryptocurrency industry is both new and changes rapidly. That means exchanges may not have access to adequate third-party products and services, such as insurance, that suit their needs and help protect investors.

Before we start looking at all of these problems in greater detail, it’s worth listing the participating and non-participating exchanges for any of our readers who are interested.

Participating Exchanges:

Bitfinex

bitFlyer USA

Bitstamp

Bittrex

Coinbase

Gemini

itBit

Poloniex

Tidex

Non-Participating Exchanges:

Binance

Gate.io Huobi

Global Limited

Kraken

Amusingly, the four exchanges that refused to take part did so because they claim New York State residents aren’t able to access their services. The OAG investigated those assertions and referred Binance, Gate.io, and Kraken to the Department of Financial Services for potential violation of New York’s virtual currency regulations.

The report indicates that the information contained within it is up-to-date as of September 2018. That would suggest an investigation by the Department of Financial Services is ongoing. Finance Magnates reached out to the New York regulator, but no comment was immediately forthcoming.

Anyway, back to the cryptocurrency exchanges that did participate in the survey. No, they aren’t violating New York’s currency regulations, but some of their practices leave a lot to be desired.

Conflict of Interest

Let’s start with conflicts of interest. Unlike traditional securities exchanges, employees of cryptocurrency exchanges are allowed to trade on their own platforms.

That means company employees can be privy to information that would give them a huge advantage in the market. Accusations of insider trading against exchanges, notably Coinbase, have occurred in the past.

To be fair to the exchanges, some do have good measures in place to prevent conflicts of interest from arising. Gemini and Bittrex stand out in the report as being committed to preventing their employees from insider trading.

The OAG noted that the two exchanges “require regular disclosures from each employee concerning their trading history and current virtual asset holdings.” Bittrex goes even further, “by restricting employee trading to a two-day window each quarter”

The level of proprietary trading on some platforms also raises questions about how liquid some cryptocurrency markets really are. On Coinbase, for example, 20 percent of the executed trading volume was attributable to the exchange itself. For Bitflyer USA, the figure was 10 percent.

This seems both a conflict of interest issue, exchanges may be trading against their clients and a Liquidity risk. Not revealing that so much trading is performed by exchanges themselves may lead customers into thinking a market is more liquid than it really is.

Professional Advantage

Liquidity isn’t the only thing cryptocurrency traders may be in the dark about. Exchanges also offer a significantly better set of products and services to their professional clients.

Co-location services, for instance, offer professional traders quicker access to an exchange’s order book. This is not an unreasonable service to offer but, if retail traders are unaware of this, they could be at a serious disadvantage.

The same is true of automated trading. These services are only available to professional traders. Moreover, they are allowed to access a plethora of trading options, fill-or-kill or post-only orders for instance, as opposed to retail traders who can only buy and sell.

Again, this is an entirely reasonable set of services for an exchange to offer. Retail traders should just be aware that they are trading alongside people with a potentially huge competitive advantage over them.

Preventing Abuse

More concerning is the fact that most exchanges make almost no effort to prevent abusive trading. Though all of the exchanges, except for itBit, have some processes in place to limit message rates, most had no practices in place to prevent abuse via small orders and no policy - at all - on preventing abuses via automated trading.

Another area that should worry traders is the lack of auditing on exchanges. Most exchanges reported almost no external auditing, meaning it’s difficult to determine if they have - either in fiat or crypto - the assets that they say they do.

Insurance may cover any fiat currency losses that traders incur, but this is not the case for cryptocurrencies. Some exchanges told the OAG that current insurance options for cryptocurrencies are simply not capable of meeting their needs.

To be fair to exchanges, this lack of insurance isn’t entirely their fault. If the products on offer to them aren’t up to scratch, there isn’t much they can do about it.

Stopping Regulator Overreach through Reform

In fact, this seems to be a theme that runs through the OAG’s report. There are certainly areas where cryptocurrency exchanges can do better.

Having external auditors and ensuring that they have solid policies in place to prevent insider trading could be done easily. Similarly, strategies against abusive trading could be implemented.

Exchanges could also ensure that their retail clients are aware of existing professional products that give users of them a competitive edge. That could help them redesign their trading strategies to ensure they aren’t competing against professionals that they are unlikely to beat.

Having said all of this, the OAG should not be too rash and leap into regulation mode. The massive growth and development of cryptocurrency products over the past few years has been helped by the fact that there are little to no regulations constraining entrepreneurs in the industry.

Many of the problems facing consumers are not necessarily down to exchanges acting maliciously. Instead, they are finding their feet in a new and fast-changing market. It wouldn’t be surprising if, for instance, adequate insurance for crypto assets was on offer soon.

In many ways exchanges - and the power of laissez-faire economic policy - should be admired. Without any regulatory pressure, many exchanges have adopted numerous customer protection measures.

Hopefully, the OAG’s report can push them into adopting more. We’ll just have to hope the regulators don't overdo themselves.