Howard Marks


Analysis of the NY Attorney General’s Report on Crypto Exchanges

On April 17, 2018, the New York Attorney General sent a list of questions to thirteen cryptocurrency exchanges, including the most popular exchanges Coinbase, Bittrex, Kraken, Bitfinex, and Binance. The request was voluntary, and some of the exchanges, including Kraken, refused to answer them.

I wrote an article about this in April, stating my belief that this inquiry was just the beginning of a long process to regulate the trading of cryptocurrencies. The SEC had also issued a bulletin in March 7, alerting investors of online trading platforms, the crypto exchanges that operated without regulation.

Now, after a few months of diligent work, the New York Attorney General office published a comprehensive report on these “virtual markets” for New York investors to read prior to selecting a platform for trading their cryptocurrencies. The report is alarming because it only scratches the surface of the issues plagued by a marketplace that is not properly regulated and is run by companies that can choose whether or not to protect their customers from theft, scams, and deceit.

If you look at history, this report is clearly just the beginning of the process led by every State Administrator and the SEC, the parties who are charged with protecting investors. Add to this list both FINCEN (the Financial Crimes Enforcement Network), which is part of the Department of Treasury, and the CFTC (the Commodities Future Trading Commission), which regulates commodities.

With this list of regulators more seriously analyzing these trading marketplaces for cryptocurrencies, you can see why the marketplace is going to change. It is receiving pressure on several fronts, and that pressure stands to only increase over time.

The NY Attorney General’s report on these virtual markets has five sections, and each section attempts to explain to investors issues found with the responses or lack thereof from the targeted “exchanges”. Here are some noteworthy findings:

Conflicts of interests

This is a big area of concern because it puts the company, the exchange or marketplace, at odds with its customers. The report found the following issues:

  • Employees of these companies have insider information on trades and are trading on the same platform or on competing platforms. This is known as insider trading. Everyday investors are losing money on these crypto exchanges because insiders are able to buy before the price rises and sell after the rally.
  • The fee structures of these exchanges favor professional traders over retail customers by charging the professionals significantly lower fees, which in turn allows professional traders to create artificial liquidity for specific cryptocurrencies.
  • The margin lending policies used by some of the exchanges can be punitive to investors, especially if the exchange experiences a flash crash, causing accounts to be liquidated and investors to lose all of their cryptocurrencies.
  • Hidden orders, which do not allow retail customers to see what is available on the order book, are permitted.
  • Exchanges provide no public information on the cost for listing a particular cryptocurrency or the rationale behind the decision to list it. Prior to listing a cryptocurrency, insiders can trade ahead of customers. There is no formal policy preventing this or for monitoring employee trades.
  • Some exchanges conduct proprietary trading, which conflicts with its customers because the exchange is trading against them. These exchanges also act as market makers (a huge conflict) with no formal rules in place to regulate them. This can potentially hide the true liquidity of the exchange as proprietary trading could account for the majority of the trades on the platform.

Abusive Trading and Fraud

  • Investors are allowed to use the built-in application programming interfaces, also known as APIs, to send automated trades. These trades can artificially affect the listed price of cryptocurrencies on the exchange. This type of trading requires diligent trade reviews to eliminate fraud. It does not appear that the companies are performing trade reviews.
  • Pump and dump schemes are not monitored, allowing fraudsters to create artificial rallies and price increases to catch the attention of unsuspecting investors. Once those unwitting investors follow the perceived market trend and invest, those involved with the pump and dump sell their tokens at a predetermined price. In the aftermath, those unknowing participants discover there was no real market interest in the tokens they bought, and they are left with large losses.
  • There is no formal policy to monitor and prevent abusive trading on these virtual markets.

Asset Protection

  • Platforms are not using best practices in the securities industry to secure and account for their customers’ cryptocurrencies. These practices include security standards, independent auditing, and insurance. Well-publicized hacks of these exchanges have caused significant losses in customers’ holdings.
  • During outages or trading halts, there are no formal policies protecting customers.

Money Laundering and Terrorism Protection

  • Not all exchanges are implementing comprehensive Know Your Customer (KYC) and Anti-Money Laundering (AML) processes, along with independent audits to assure compliance. This allows criminals to launder illegally gained profits into untraceable money. It also allows terrorists to move funds without any controls.
  • There is no IP blocking mechanism in place to prevent fraudsters from accessing the APIs to conduct fraudulent trades.

The logical next step for the New York Attorney General is to request the data: a complete list of all trades conducted on those exchanges. With this data, they can analyze the behavior of the investors and the management of exchange and determine the legality of the operation.

It’s possible the SEC may also pile in and request the same data for its own investigations. The 49 other states may want to sit back and watch how this unfolds before adding their own investigations and demands into the mix. Pandora’s box has been opened for these exchanges. Only time will tell what was in there.

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