By Rob Daly

Spot Crypto Market Plays By Its Own Rules

The new market comes with a new market structure.

Buy-side firms seeking to enter the cryptocurrency spot market should not confuse the nascent market with other more familiar financial markets despite common terminology, according to regulators and market participants.

Although many of the online trading platforms serving the cryptocurrency spot market call themselves “exchanges,” recent guidance from the US Securities and Exchange Commission’s Divisions of Enforcement and Trading and Markets, are anything but exchanges, registered alternative trading systems, or broker-dealers.

“The SEC staff has concerns that many online trading platforms appear to investors as SEC-registered and regulated marketplaces when they are not,” the regulator noted in a prepared statement. “Many platforms refer to themselves as ‘exchanges,’ which can give the misimpression to investors that they are regulated or meet the regulatory standards of a national securities exchange. Although some of these platforms claim to use strict standards to pick only high-quality digital assets to trade, the SEC does not review these standards or the digital assets that the platforms select, and the so-called standards should not be equated to the listing standards of national securities exchanges.”

The difference between the capital markets and spot cryptocurrency market do not stop at regulatory oversight or the lack of it. Firms also will notice that the highly fragmented cryptocurrency market lacks many of the essential features of mature capital markets as well.

Connecting to a subset of the approximately 20 online trading platforms involves deploying several one-off linkages.

Colleen Sullivan,
CMT Digital

“It’s a lot of ReST APIs and WebSockets,” said Collen Sullivan, a partner at CMT Digital Holdings an who participated in a panel at the DC Blockchain Summit 2018.

She was only aware of one trading platform that uses the industry standard FIX messaging protocol.

Once connected to the spot market, Sullivan noted that new traders should expect thinly traded order books that operate 24 hours a day, seven days a week.

Unlike SEC- and the Commodity Futures Trading Commission-regulated exchanges, most online trading platforms operate in a hosted environment, which makes high-frequency trading and co-location difficult, according to Sullivan.

However, the online trading platforms have restrictions on moving cryptocurrency and fiat currency off the platform as well as having higher fees than typical exchanges, she added.

The most significant pain point for CMT Digital found when it entered the spot cryptocurrency market was the lack of prime broker relationships.

It meant that the firm had to self-finance at each online trading platform on which it traded.

“You have to get comfortable with many different spot cryptocurrency exchanges, many jurisdictions, and, sometimes, with management teams that you cannot even find,” said Sullivan.

Without a prime broker on which to rely on for one instance of counterparty risk, CMT Digital internally developed a set of best practices and standards that consisted of extensive counterparty risk analysis when it trades on the spot cryptocurrency market.

“It starts with basic things like who the management is,” said Sullivan. “Have we met them?”

The firm then would examine a platform’s cybersecurity history, its limits on withdrawing cryptocurrency or fiat currency, its banking relationships, in which jurisdiction it operates, and whether it is subject to any investigations or enforcement activities.

“We ask ourselves if we want to trade on that exchange,” said Sullivan. “If the answer is “no,” we just do not trade there. If we decide to trade one and exchange, we evaluate how much cryptocurrency and fiat currency that we are willing to leave on the exchange. Then we constantly monitor those checkpoints.”

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