I was reminded, earlier this week, when reading about major crypto “exchange” proposing the creation of a crypto-asset SRO, of the famous proverb: Be careful what you ask for, for if you are not, you shall receive it…
I think there is a lot of merit in the idea of creating a new “Crypto” SRO, but such an undertaking will face many substantive issues and require wholesale changes at the incumbent “exchanges.” This is because many crypto exchanges have business models and practices that are at odds with principles of investor protection which have guided regulators for the past 75+ years. Specifically, many have issues with “Best Execution” principles as well as with some aspects of “Fair and Orderly Markets.” Some are even creating vertically integrated businesses that will run afoul of conflict of interest restrictions historically promulgated regulators. Let’s explain each in turn.
Best Execution: Best execution, simply defined, is the expectation that a client’s designated agent or the market centers those agents route to, will endeavor to get the best possible price for the client’s order. In the world of equities or options, this has meant, in practice, that retail brokerage firms separate themselves from owning market makers or the market centers that they route to, while establishing an infrastructure dedicated to achieving best ex. These firms have established rigorous, periodic statistical evaluation of the execution quality of the venues used and daily oversight of all orders being routed. Market centers, meanwhile have also created rigorous, periodic reviews of all executions provided to their clients along with daily oversight of all executions compared to other market centers. In crypto, however, this is structurally difficult and does not seem to be happening at all.
Structurally, while there are some valid reasons for it, several major players are vertically integrated in a way that is not tolerated in the equity market. There are major crypto firms that market directly to retail investors while owning trading venues. To make matters worse, in most cases, such firms route 100% of their order flow, without best execution review, to their own market center. This, sadly, is a conflict of interest that regulators have been extremely wary of in the equity or option markets, even when the firms built sophisticated processes to achieve best execution. Unfortunately, however, the major crypto markets each operate their venues independently of each other, without regard to the prices displayed on other markets. At CoinRoutes, we have created benchmarks and analysis tools investors can utilize to review best execution, and our tools show substantive issues in the current structure. While the market has improved substantially, even in Bitcoin, the best bid is still often above the best offer (a “crossed” market) and individual exchanges often lag the market. According to our data, in Bitcoin for the past week, for example, the market has been crossed by more than 0.25% almost 50% of the time as represented by the two following graphs:
In markets like equities or listed options, such statistics would be impossible, as exchanges are required, due to multiple rules, to either cancel orders back to clients or route to other venues when their own market would execute at an inferior price. In crypto, to my knowledge, the incumbent “exchanges” do not do so. It is worth pointing out, that there is one valid argument to be made in support of this model, which is the need for heightened security in the custody of crypto-assets. In addition, one could argue that the large exchange fees (more than 1000 times the bid offer spread in some cases) and time delay to transfer crypto-assets to a competing exchange with a better price, could, in many cases, excuse exchanges from routing. This is debatable, but retail brokers, however, should not be excused from this obligation, as their clients lack the sophistication to scan all available markets. As a result, those firms that market directly to retail, should, at a minimum disclose how their prices compare to other markets and provide statistics on the quality of their order execution. Any new SRO should, therefore, work quickly with the industry to implement rules and disclosure requirements that rectify this situation.
Fair and Orderly Markets: The concept of “Fair and Orderly” markets (also referred to as “Just and Equitable Markets”) is used to describe a set of principles designed to ensure markets can be trusted and represent a level playing field. Trusted, means that market manipulation will be deterred or punished by proper surveillance, and a level playing field means that the same information and market access is available to all participants on the same basis. Sadly, neither is followed completely in the crypto market.
Manipulation is the bane of all displayed markets, rendering the price discovery process suspect. That is why, in equities, options and futures markets the regulators have punished activities such as spoofing and wash trading so heavily. While I am not suggesting that incumbent exchanges facilitate manipulation, in an SRO structure, they would need to do more. This is one area where an industry SRO would be very helpful, as it would force pan-exchange data collection and surveillance standards. Exchanges should, however, offer anti-internalization (self-dealing) features and have robust surveillance systems themselves to look for manipulative behaviors, and it is likely that they have room to improve in this area. In addition to the exchanges, however, a major issue in the crypto-asset world is the development of alternative market models that lack even basic protection against manipulation. In some peer-to-peer markets, for example, uninformed investors could get taken advantage of quite easily, as such markets are not connected with the displayed markets and have no structural way to prevent participants from contributing misleading information.
The establishment of a level playing field means that exchanges would have both standardized data products and methods of connecting to the exchange with no undisclosed relationships. To be clear, I am not asserting that there are any “back room deals” between exchanges and their favored market participants, nor am I suggesting that exchanges block less favored firms from connecting to them. I am saying, however, that with the establishment of an SRO, a benefit would be the prohibition of such arrangements.
Conflicts of Interest: I have already pointed out one important conflict; that of retail facing firms also controlling their own trading venue, but there are others as well. There are firms who are looking to move into the asset management space, while also operating brokerage type operations, trading desks and trading venues. While it is easy to see the financial benefit of such a vertically integrated structure, it needs to be pointed out that there are very stringent requirements on the creation of such a setup in the securities world. Asset managers, which are part of banks with brokerage operations are required to maintain very strict information barriers and restrictions against trading through their affiliated trading departments. This includes restrictions on the use of their own alternative trading systems, restrictions on agency trading as well as strict prohibitions against most principal trading. In all cases, such transactions are subject to heightened scrutiny, including demanding best execution standards. In the current crypto-landscape, where exchanges do not generally consider pricing data from other exchanges when trading, these types of restrictions are very important.
In conclusion, while there are sufficient differences between the primary issuance and secondary trading of crypto-assets and securities such as equities, there are also similarities. Crucially, regardless of the legal designation of crypto-assets, they certainly are considered investments by the majority of those buying them. As a result, whether a new SRO is established, or existing SROs regulate the firms engaged in sales, trading, pricing, and matching such products, the industry needs to evolve. That evolution should be modelled based on the key principles described above and the result will be a far more robust and trustworthy marketplace for issuers and investors.