Considering a Digital Asset Exchange?
Checklist for Institutional Investors Considering a Digital Asset Exchange
By Waseem Barazi, Seed CX
Following widespread enthusiasm in 2018 for developing digital asset trading infrastructure, some banks have recently tempered their approach, in part because regulators have yet to release guidelines on various areas of digital asset regulation. Given the current regulatory patchwork that applies to digital asset trading, investors must do their own due diligence when deciding where to trade digital assets.
That’s a tall order for most investors, including banks and other institutions; they are sophisticated financial industry market participants, but they may not have the background in digital assets necessary to evaluate exchanges, wallet providers, custodians, and other relatively new entrants. That task can be simplified by reviewing a few key questions when considering a digital asset exchange.
1: Does the exchange have a market surveillance team?
Established exchanges in the securities and derivatives industries have systems in place to monitor, prevent, and investigate any activity that appears abusive or manipulative or is otherwise potentially harmful to market participants.
Collectively referred to as “market surveillance,” these systems actively scan for and address activity that could threaten just and equitable trading principles. Surveillance staff then review the alerts generated by these systems to determine the extent and severity of any trading violations.
Although some digital asset exchanges conduct market surveillance, it is not yet standard across all exchanges. When considering whether to trade on an exchange, investors should ask whether it has a surveillance team and inquire about the team’s experience in conducting market surveillance investigations.
That team should be using the same tools employed by regulated securities and derivatives exchanges to identify and halt manipulative and abusive activity, including automated trade alerts, circuit breakers, and full-order-book audit trails.
2: Are there trade prohibitions for the firm and its employees?
In the securities industry, clearly stated and enforced rules prohibit trading with material, non-public information (commonly referred to as “insider trading”). This isn’t always the case in the digital asset space, where no similar legal prohibition exists and exchanges operate in a gray area with regard to this issue.
In the digital asset space, it’s common for exchanges to operate their own trading desks that trade proprietarily on their exchange against their own customers. This presents a conflict of interest, as exchanges are able to trade against their customers with superior information regarding trading activity and order flow.
Additionally, exchanges have come under fire recently for permitting (or failing to prevent) employees trading in advance of material, market-moving announcements, such as the listing of a new digital asset.
When considering an exchange, investors should look for clear guidelines about whether and under what conditions its employees are permitted to trade the assets it offers. Disclosure of these policies helps investors make an informed decision.
3: Is there an option for customizable user privileges and individual accounts?
In its Virtual Market Integrity Initiative (VMII) report released last fall, New York’s Attorney General highlighted the risks associated with single users creating multiple accounts because of the potential for market manipulation. While measures to prevent market manipulation are of crucial importance to institutional investors (see the surveillance section above), a “one person, one account” structure isn’t necessarily what institutional investors are looking for in an exchange; rather, institutions are more interested in account structures that reflect their organizational structures and hierarchies.
Institutional investors are used to a single account for multiple traders, with the option to assign customized trading privileges, including credit limits, trade controls, and withdrawal limits for their traders. This allows firms to ensure that no one trader exceeds his or her assigned trading power or risk limits. The practical effect is that firms can custom-tailor their trading strategies on a trader-by-trader basis and protect their firm’s capital.
Accordingly, when considering an exchange, institutional investors should consider the ability to create multi-person, segmented accounts a basic infrastructure requirement.
4: Does the exchange charge listing fees? If not, how does it determine which digital assets are traded?
Public stock exchanges publish their standards for listing a security so that anyone interested in investing in that security can investigate the exchange’s rationale for listing it.
In the world of digital assets, no agreed-upon listing standards exist and exchanges often do not publish their listing criteria. In many cases, in fact, exchanges list specific digital assets in exchange for payment in that digital asset, which can present a conflict of interest for the exchange.
Although institutional investors are typically sophisticated and conduct their own research regarding which digital assets to trade, it is conceivable that some market participants rely on exchange listings to ascertain the strength of a particular digital asset. Investors should exercise caution in this regard, and be aware that just because a digital asset has made it on to a well-known exchange does not mean that it is a viable project or reputationally sound.
5: Is the platform fully licensed and regulated?
Currently, there is no single standard for what kind of licensure digital asset exchanges must have, as digital asset trading may cross a variety of jurisdictional lines.
A patchwork of state and federal regulation may apply to an exchange offering digital asset trading. The relevant regulator may depend on whether the listed digital assets are securities or commodities, whether the exchange offers derivatives trading, and what states or countries the exchange accepts customers from.
Exchanges that are most serious about protecting investors will proactively seek the licensure that will make them eligible to host trading. Because regulatory licensure imposes strict operational, procedural, and cyber-security standards, investors should steer clear of those exchanges that seek to avoid regulation.
6: How does the exchange handle storage and settlement?
Roughly a billion dollars’ worth of digital assets was stolen from exchanges and other platforms last year, which isn’t surprising given the standard storage and settlement infrastructure many exchanges use: a single wallet or a handful of wallets to store assets from all platform participants, and a single access key to withdraw funds.
Even if a portion of assets are in cold storage, joint wallets present a tempting target for hackers and other potential thieves. And single-factor authentication is inherently easier to hack than 2-FA.
Institutional investors should seek an exchange that creates dedicated wallets for each exchange participant and enforces 2-FA and withdrawal IP whitelisting for all users. This setup means there is no one wallet that can act as a single point of failure and greatly reduces the likelihood that an unauthorized user can withdraw assets improperly.
7: Does the exchange have a credible leadership team?
Just as a VC would consider the track record of a potential portfolio company’s leaders, so too should investors consider the backgrounds of a digital asset exchange’s leaders. They can do this by researching public directors, founders, and others in high-ranking positions (often listed on the exchange’s website).
Do they have a background in finance? Fintech? Digital or emerging assets? Compliance? Leading or overseeing companies?
A strong leadership team increases the odds that the exchange will not only meet the criteria outlined above but that it will continue to evolve and adapt as needed for a changing digital asset space and put the interests of customers first.
Embracing Digital Assets
Regulatory and legal bodies will always lag the latest innovations, meaning that early adopters must engage in more due diligence than those who follow later. Armed with the right information, pioneering institutional investors can safely guide their firms and clients toward the best opportunities in emerging spaces, including digital assets.
About the Author
Waseem Barazi serves as Chief Compliance Officer and General Counsel of Seed CX and its subsidiaries. Mr. Barazi oversees a team of lawyers and compliance staff, who together ensure that Seed CX and its subsidiaries comply with relevant laws and conduct market surveillance to protect customers.
Zero Hash is a FinCen-regulated Money Service Business and Money Transmitter in over 26 States. Zero Hash is also applying for a BitLicense with NYDFS. Zero Hash custodies both fiat and digital assets with on-chain settlement.
Seed SEF is a CFTC-regulated Swap Execution Facility (SEF) that plans to offer a market for CFTC-regulated digital asset derivatives.
Seed Digital Securities Market is applying for registration as a Broker Dealer with FINRA.
Seed Digital Commodities Market is applying for a BitLicense with NYDFS.
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