Plodding Mediocrity (Part VII)

These series are from April 2018

Exchange and brokers

In previous sections I tried to cover important topics that were related to the cryptocurrencies statically, from within. I’m sure I’ve left more ambiguity and questions rather than answers there. In this section I am going to cover everything that is exchange and broker related. As much ambiguity as cryptocurrencies might have within themselves, when they trade and constitute exchange or market they are even more vulnerable to interconnectedness that is defined by nonexistent regulatory enforcement. I will try to cover topics that are less regarded or again boring with some regulatory updates and infrastructural descriptions. Hold tight.

SEC Statement

SEC has finally issued non-ICO statement, where it clearly tells us that we trade on unregistered exchanges that are in business of trading securities. As a general rule you are protected when trading on ATS (Alternative Trading System), or through broker-dealer or on national securities exchange. But guess what, in crypto you’re not. This statement came after Circle has purchased Poloniex, so either lobbyism or not, SEC seemed triggered to address exchange issue finally. It was a pleasant surprise to learn that Circle has plans for Poloniex to become ATS (although this raises questions because Poloniex has extensive listing with some tokens that definitely will fall under securities and to enter Poloniex you need to purchase USDT, which is even more shadier). I see word exchange taken too lightheartedly, thrown here and there, sometimes people approach me for opinion regarding building crypto exchange in eastern Europe and most of the time what they pitch is a brokerage service. It is a simple truth that none of exchanges serve us the same way and are overseen in the same way as SEC registered ones do.

The statement was very concise and thorough, giving average crypto investor the scope of what SEC registered exchange can provide to him - mostly these are oversight and control of fair trade, knowing what kind of asset is being traded on the platform, how platform is wired and how does it display information. Although there were no U.S crypto exchange hacks that would leave investors with nothing, this statement still appears to be late. It shows how much effort was put into ICO name calling by SEC that it didn’t leave a room for other dialogue. It also shows efficiency, due to ICO stance the number substantially decreased over the time once SEC started to alert people. Now if crypto exchanges and brokerages will resort to registering their businesses we will further legitimize the industry and bring more confidence to the retail investors. Exchanges can do anything today with your funds and this is baffling.

Registering as national securities exchange is no candy for sure, seen that how many crypto exchanges we have, once SEC goes after them we will definitely get fewer of those. What most of the exchanges and brokers can do now is to register as ATS (for example Poloniex) or as Broker/dealer (for example Coinbase). Registration will put you under SEC oversight, will require you to comply with liquidity, custody and customer protection rules among others - this in turn anchors company as more legitimate and is going to appeal to wider consumer base. What you can not do although is to list unregistered securities and sell them, unless exempt by Regulation D or sold through Rule 144.

I want to make it clear that I’m not pro-regulation for everything and I do understand and love that blockchain is on a mission to remove as many of these regulations as it can. The reason that I keep coming to regulation is that it portrays our contemporary times and it delivers us a message that general audience is yet early in the game of trustlesness and that unless good self-regulation principles are in place, we’ll get hammered by bad actors, we can’t afford that as well.

Alternative Trading System Evolution

I consider that it is important to look at the evolution of Alternative Trading System regulation, because it definitely gives us a sneak peak at some technological developments in the exchange market, it illustrates the complexities that arise through technological developments and through the market needs. I consider this important because it will show us the path that SEC takes whenever tackling exchange regulatory issues and most importantly describes the challenges that any other exchange, decentralized or crypto would stumble upon. We do not solve all the problems through DLT introduction because actions of a man in the market are evasive in nature at some point and we have to account this factor. So far the best default rule in producing the fair environment is the disclosure mechanism, by enforcing the transparency we oblige parties to provide honesty in their behavior, upon which we can facilitate fair transactions. This is easier to say than to execute, but I think we lack the meaning of this statement when we want to overhaul the market with technological approach. I’d point to few issues of my interest while describing ATS and refer to some comments and thoughts made during regulation NMS and its European buddy MiFID II.

Dark pools (ATS) were operating by exemption to prior act and regulation but due to the increase of technological advancement the need to add more regulations arose. What happened is that institutional investors needed dark pools to trade large blocks of stocks without affecting the market by broadcasting their position and providing their identity. A number of ATS at that time lured institutional investors through privacy features and as well by removing HFT (High Frequency Trading) from their platforms. HFT in normal set-up could anticipate purchase of any given stock at any given price and resell it at higher price to the bidder or to put it short HFT could detect any move and game it in its favor. Dark Pools excluded HFT, but some ATS cheated and did installed their own HFT algorithms and in some instances blocked these algo’s reach to their large investors, this made these markets distorted and unfair. But there is a reason why ATS had to resort to this kind of operation, it was in order to offset the liquidity problem that it inherited due to the nature of its business. SEC eventually imposed stricter regulations over ATS in the forms of disclosures and customer privacies through regulation NMS. Dark pools were the results of demanded anonymity for the large block trading by large investors, but it inherited held the liquidity problem for the ATS, leading them to cheating.

Transparency question of traded stocks on exchanges (regulation NMS) was covered in comments of Reg NMS proposal, one research firm said that 69% of NYSE traded company executives were not happy with how their stocks were traded, requiring more transparency. This is interesting in the future application of the decentralized structure, because there are no company executives, there are developers and communities and yes speculators and unregulated exchanges can manipulate and distort their fair prices and values, hell knows maybe even corner them like Kosuga cornered Onion Futures market.

It is important to understand that by introducing Regulation NMS, SEC did not in any manner shattered HFT. Some think that HFT provides liquidity to the market, but truth be told they already trade on the liquid markets, trades are executed when you initiate the order and because it’s faster than you, it can do latency arbitrage and resell your desired stock for higher price that you put in order at first place. HFT changed the nature of stock markets by making renting out spaces for HFT more lucrative and that is the concern from critics saying that by doing so exchanges compromise on market integrity and inclusion. From a technological standpoint it makes us to rethink about the importance of latency in the network and how essential it is for the markets to be fair. It further stimulates speculation on the markets rather than capital raise. It resembles LTCM model in a sense, where HFT does a portion on the penny of its trades, in case of HFT speed is its LTCM’s leverage. Because SEC did not enact any new regulation that would kill HFT in the markets, a demand for slower exchange grew and resulted in IEX (investors exchange) that promises to execute trades fairly. Apart from this NYSE as well have implemented so called “speed bumps” that would slow down trades by a fraction of a second. Do not mix “speed bumps” with either trading halts or exchange circuit breakers that are company or market demanded.

I wonder if crypto exchanges globally can achieve this level of complexity. Market definitely becomes overwhelmed by number of regulations which complicates it further, but it does so to provide fair participation and not to stifle competition or freedom. we do not have any of these in crypto markets as of now, because they are not registered as ATS and because they are free to either implement thorough rules or run away with our money. My main concern is that it seems, that by removing intermediary costs through DLT we would remove the revenue that market participants generate through speed and efficiency of the centralized infrastructure and this equation might not at all favor us. Where we think that we’ll decrease intermediary costs and will provide speed, exchanges would see the high opportunity cost demonstrated in HFT outflow.

What Followed Reg NMS approval

Regulation NMS had intention to make markets more open and transparent, it has further put legitimacy through fragmentation by giving ATS SEC reviews. Now ATS could have level playing field with exchanges and they actually did so by increasing their overall market share in NMS stocks trading. It gave flexibility to the market in a sense that it can cater more specific investor needs and operate in a more competitive environment.

What Reg NMS did not tackle was the HFT controversy, which was followed by allowing speed bumps on national exchanges and by finally green lightning IEX - Investors Exchange that removed HFT from its exchange by channeling trades through 38 mile long fiber-optic cable. To understand the scale and efficiency of HFT I’ll quote founder of Tradebot who said that he "typically held stocks for 11 seconds and had not had a losing day in 4 years".

Apart from giving exchanges like IEX a shot, another bread of ventures started to show up. LTSE (Long-Term Stock Exchange) - a proposed exchange that changes listing requirements with tenure voting, broader disclosure and flexibility to avoid activist investor intrusion is one of them. While LTSE is only available through synthetic listing on IEX for now it plans to get registered with SEC.

This might seem like a small effort, but how I actually see this is that through Reg NMS SEC made it possible for entrepreneurs to think about bringing innovation to the exchanges market infrastructure. It is ambitious thought but in the wake of technological upheaval it is worth the effort. Regulation-wise supported, move towards digitization of the market, we would eventually reap more technological benefits, for now we see IEX combating HFT, later we might see LTSE combating old-school wall street activist investors wishing to take over future FAANG and I like this trend a lot. It humanizes capital markets, it democratizes participation and it shows that SEC does not want to stand against blocking out-of-the-box thinking (well a bit of lobbying and load of cash will help as well).

Now why this is relevant to me, because this gives a room for crypto exchanges to get registered as ATS, this gives a room to a competition even between the registered crypto exchanges. But of course first thing to ask is what are they going to trade, which is a token-centric question, but once that part is clear, we are definitely going to see an increase in crypto ATS, which in turn will highly increase liquidity of the the market. My only concern is that crypto exchanges, mostly decentralized ones are focused on providing better infrastructure and more controls while omitting realities that current systems have. Eventually today’s exchanges (ATS) go way beyond 20 page concept submissions and prototypes. The whole exchange is nothing but a set of thousand rules facilitated through infrastructure, once again to seep this reality in I’d recommend re-watching this video.

DCM Architecture

In the above subsections I’ve covered exchange environment through SEC angle, but there are as well CFTC exchanges that trade futures and options. Sometimes exchanges are registered within both federal agencies (stock options for example). In the following subsection I will cover how CFTC’s exchange infrastructure is built and what are crypto developments there.

In the world of commodity futures, exchanges are called DCM or Designated Contract Makers, meaning they can list new products through self-certification or through voluntarily seeking CFTC board approval. DCM must prove in self-certification that its product’s rules, terms and conditions comply with CEA. Most of the product/contract listing on DCM happens through self-certification. As far as contracts comply with CEA they can be listed on DCM. Self-certification must be provided to CFTC 1 business day prior to the listing. CFTC is limited in making DCMs to change the terms of the contract if it complies with CEA. In case of bitcoin futures, DCMs provided self-certifications earlier in July and October to cover the possible issues that could arise with these new products. Major thing that CME and CBOE did was to consider the margin requirement rule change following the CFTC recommendation during their self-certifying process.

I have following concerns - first is that the provision of providing self-certification 1 day prior to listing might lead to some complications in these kind of futures products, it was still good that DCMs took time before listing them, but still 1 day is very short notice, second is that self-certification would benefit market if it were more open to the public and transparent, so that it would make bitcoin futures more appealing to the general public and it would educate crowd about developing bear views and how to correctly trade futures instruments.

CFTC has a dedicated CFTC Lab that was created in early 2017 with the goal to improve CFTC’s general policies in fintech and crypto and to provide in-house knowledge and groundwork to its divisions for the future rule-makings. CFTC agrees that bitcoin is used as commodity (gold, oil), as store of value but that primary idea of bitcoin was to be used as settlement instrument (medium of exchange). From CFTC perspective, governance is risky and questionable in bitcoin, because there is no way if community comes to a harmful consensus for investors to reverse it. Another risk is the custody as we currently know it, custodianship of assets on blockchain does not have retrieval possibility, which is challenging to the current regulations. These risks make bitcoin a unique commodity. Nobody votes and changes the nature of gold or oil and because the commodity is not tangible its custodianship is less understood in the digital age. My following concern here is that this is an indication towards the fact that there is still a room to work on how to classify bitcoin correctly. This is further enhanced in this section by understanding that classification defines who is going to oversee and register exchange that you want to trade on, in case of Security it is SEC, in case of a commodity futures it is CFTC.

In CFTC, division of clearing and risk oversees clearing houses or DCO (Derivatives Clearing Organizations) which actually are Central Counterparty Providers between 2 futures contract participants. Clearing at this stage is risk management, which ensures that futures commission merchants can withstand a shock from volatility. DCO in crypto is represented through LedgerX. It went through a thorough registration, LedgerX is fully collateralized, thus it bears operational risks only and not the credit risks. It went through its operational workflow tests prior to the certification. CME is DCO and DCM at the same time so it doesn’t need a filing for the clearing, it clears its bitcoin futures itself. CME margin on S&P 500 is around 5%, while for bitcoin, at initial offer to CFTC it envisioned margin to be 27%, but after consultations with CFTC, increased to 35%. Although DCM does not need any regulatory oversight it still addressed CFTC in order to better understand how to manage risks in these new products.

Division of market oversight oversees the rules following in derivatives markets, it reviews DCM and all new products that it enlists as well existing products and rulebooks it keeps so that they are all in compliance with CEA. In case where and when it’s necessary it provides help in drafting recommendations, which was the case in bitcoin futures where division advised to increase margin requirement. Division of market oversight is not overseeing cash-markets for bitcoin, this was stated lot of different times in lot of different settings. They do not have authority in spot markets, unless there is a fraud or manipulation to detect.

Broker-Dealer and crypto exposure

It is not that straightforward and easy today to get sophisticated exposure towards crypto assets. Most assets do not enjoy regulatory clarity, there is a lack of regulated exchanges and these shortcomings have consequences. If investor is interested to get exposure to crypto assets he’ll have to relinquish his traditional safeguards. Some unregistered brokers are offering crypto options and/or futures, almost none of the registered brokers offer exposure except for futures contracts. It is worth following developments in regulatory field because it will indicate when these registered brokers might be able to list crypto related products. Chances are with CFTC giving green light to LedgerX to clear derivative transactions, the rising tide of self-certified futures contracts traded on CME and CBOE will follow soon, we’ll soon see major brokers introducing these options.

There are lot of shady options in crypto derivative space now, the safest brokers appear to be U.S based, ones with concise disclaimers and insurance, while others, even those based out of U.K do not provide sufficient information to consider them worth the shot.

If you want exposure through options contracts and you look for a broker service that offers them and is reliable and secure, has acceptable limits and fees and is regulated, then your chances of finding one is very low or non-existent. But as mentioned before you can gain exposure through registered brokers offering you CME, CBOE futures or by picking ETFs that have crypto as underlying assets.

Exchange Auditing

It is important to understand what the word audit means, not to drop it here and there and to know which audit applies to which circumstances. The importance and knowledge of this subject will make your judgement more rational when you will be inquiring whether or not any entity has audits. For more in-depth and philosophical understanding behind the reason of the audit you must read some legal history, but for now we’ll cover basics.

In crypto we often hear phrase security audit, these are related to the assessment of the underlying tech and per se they are not regulated, rated, mandated. These so-called security audits are related mostly to the technology, ICO project and usually smart contracts. When reading through security audits conclusions, you better check the background of the auditor, through his experience you can then proceed with your own assessment of the conclusion if auditor is credible or if auditor is a fraud. Andreas Antonopoulos shares the similar view that audit is not a word to be used interchangeably and that the domain where third party audits must be done to crypto exchanges will arise. It will need security experts, it will need CPAs, good accountants and technologists all brought together. A proper audit is anything that takes from one month onward and that is done on a repetitive basis. Andreas has done a reserve audit back in 2014 for Coinbase, he provided a snapshot at a time that Coinbase held its bitcoin reserves as promised and didn’t run on fractional reserve as Mt. Gox did.

Financial audited reports are conducted by certified auditors, who pass exams, climb the auditor ladder and tie their reports to the reputation of the companies that employ them. These are strictly overseen by regulators and must meet lot of criteria set out by tax codes and other.

Very simply put, your uncle who has worked at a software company can be asked to audit his neighbor’s tech project and he can deem it “secure”. If the project fails your uncle stays at home, will be probably yelled at, hated on but consequences are informal. Now your uncle has a small audit firm, he does cheap audits, has CPA license. He audited his neighbor’s business, stating that all financial reporting and bookkeepings were correct. Later it turns out that neighbor had a ponzi scheme, now your uncle has more inconvenience to deal with at to say the least.

Financial reporting and audit may have multiple reasons to exist, depending on your inquiry and perspective. Audit is to see if you are compliant with applicable rules, that you do not perform shady business follow accounting principles and do your taxes. For a business, especially exchanges, this is not the same as BSA, that forces businesses to do AML/KYC. There is a general misconception in U.S. that crypto exchanges that flaunt their licenses are “audited”, these licenses do not comply neither with SEC liquidity or disclosure rules, nor can they claim that exchange is somehow audited. What exchanges usually show are the AML/KYC state licenses. Having one of these does not mean that exchange have 1:1 ratio of your cryptocurrency to USD, it does not alert public if they run on fractional reserves. These things are not audits in any form, because audits are not created with ideology to serve BSA. You do audited report into your financial condition to see and say that the company is dutifully conducting its business. In a nutshell the purpose of audit and government is following: IRS will privately examine your tax filing, while SEC will publicly disclose the information. The reason why the SEC reports are made public is logical, although income-tax returns not being public is up to a debate. Even U.S. publicly traded companies do not disclose their tax reports, because Nixon and abuse. Companies argue that their returns contain vital information for their businesses, while others argue that tax return can not contain recipe for Coca-cola, or a proprietary line of code of Google algorithm.

A financial and operational report form must be completed by all dealer-brokers registered with the SEC. SEC form X17A-5 consists of three parts, including an annual audit that must be performed by a certified public accountant (CPA). This report is used to determine the dealer-broker's financial condition. Section 17 of the Securities Exchange Act of 1934 Rule 17a-10(a)(1) requires all broker-dealers to file Form X-17A-5. The idea behind this report is for exchange audits to disclose their assets. Once we have registered crypto exchanges, or broker services this will become compulsory, this is where I lost it when Bruce Kleinman was claiming that he looks into crypto exchange audits to assess them. The only annual audited report from the exchange that was easily available to the public was one of the Genesis Global done by Friedman LLP.

A report conducted by the auditing company might contain or not the full data that you are interested to look at. There are many categories that X-17a-5 report covers, the most interesting being the opinion by the auditor about the general financial condition of the company, but if any additional information is there like SIPC supplemental report (in case of brokerage) or computation of net capital or statement of cash flows, they all can be helpful, otherwise a look at the statements attached and opinions expressed should be enough. There are cases that confidential information will not make it to the public pages as well and this is why the reputation of the audit firm is important. Big 4s will not risk their reputation to audit shady bookkeepings. The report must also contain an oath or affirmation that validates the responsibility of the auditor towards the company it audited.

The following report is interesting because it looks into the auditor’s assessment of the the company that transacts/trades digital currencies. Genesis Global is the Authorized Participant of the Grayscale (private bitcoin trust company) whose shares traded by premium of 35% at specific times. Apart from this, this report provides, a first in such case, sneak peak into the reporting of digital currency exchange. It covers the reasoning behind valuations, it provides taxation outlook, fair value analysis, assets that exchange holds and exemptions towards the liquidity ratio set by SEC if any, it also provides from where exchange takes quotes on currencies it trades, risks that it can have and etc. The previous audit reports were conducted by the Ernst and Young, but the companies decided to part their ways, no disagreements were disclosed for the partition. When you look for the FDIC or SIPC sign in future, do as much as you can to understand what is insured by the company, usually digital assets are not insured while cash reserves are. Friedman LLP is an audit and advisor firm that provides audit and consulting to various sectors and firms. It is a well established firm overall, and it pioneers itself in providing audits to cryptocurrency companies. It does an annual financial audit to Genesis Global and was doing audit to the Bitfinex until they suspended their relationship in early 2018.

In recent years there were few other publicly circulating audits. For example the audit that Kraken conducted focused on how many bitcoins the exchange possessed, and how many it owed to customers. In a legitimate exchange environment, the former should be greater than the latter. This sort of audit called “proof-of-reserve” became popular and it helps exchange customers to verify that exchange does not run on fractional reserves. Another example is a high level internal audit performed by again Friedman LLP over Tether and this letter was also considered relevant back in 2014, we definitely have come a long way, but there are still mountains to climb and deliver audited reports that level up to the current ATS and broker-dealer published ones, fortunately transparent blockchain exchange can provide customers with enough assertion. Being in exchange business means to be receptive to the exterior events and to develop along with them and not to be enclosed within ones self. To see how far traditional exchange has moved I’d just bring up that terrorism financing was not even a topic in early 2000s casebooks, while last editions are detailing its challenges to financial sector. I find that successful exchange business is less narcissistic and more focused on entourage. ATS development is as well testament to that.

Insurance

“A fiduciary is held to something stricter than the morals of the marketplace." - Justice Cardozo

Crypto market lacks insurance mechanisms and before they are in place it is hard to think of any retail ready financial product for investor. The question of exchange is interesting because it entices various views on how immature crypto regulation is. It’s early for ETF, it’s early for brokerage, for custodial services and each and every of these lacks classification definition to have a proper oversight. One of the examples is the definition between commodity/security et al. once there is more guidance on this, more products will follow and probably SIPC coverage can be thought of to be applied to some crypto assets, with these in place we’ll see appropriate exchanges with respective assets being registered and listed on them and finally insured.

Due to the lack of regulation and clarity over the crypto exchanges, honest players have hurdles in providing the insurance such as FDIC and SIPC that brokerage firms do to their clients. This became even more apparent during the Senate hearing where more uncertainty showed up. The state licenses route, that businesses have chosen to follow, does not provide an understanding on federal frameworks and these businesses do not benefit in any way from insurance instruments, even more these two things are not related and serve different goals.

When insurance mechanisms become widely adopted, bullish players would move with even more confidence and more conservative investors would enter the market. Jumbo players such as Coinbase, Gemini, Circle are insured, subject to the type of their operations. Also crypto exchanges are not the exchanges such as CME, Nasdaq and they (crypto exchanges) within themselves provide the brokerage-type accounts. If an entity says it’s legally compliant today you must assume that they went through a thorough state-by-state licensing and what they mean is that they are compliant with FinCEN. You must give them a credit for it, for taking up this cost and complex route to keep money launderers off their platforms. But this is not a compliance that assures you as a customer that your funds are there and that you do not deal with a shady business.

We not only need the BSA implementation to offer insurance, we also need to understand what are the underlying tokens that we need to insure. Are they securities, commodities, currencies or something else. With this acknowledgement comes the regulatory oversight, with regulatory oversight comes the security in form of insurance. It is easy to say that today classification of any token is up to a debate, at some point we lean to the old regulations, refusing to outright ban them, but we might as well resort to drafting new regulations and challenge our beliefs in order to adapt to the new changing nature of our economy.

So far we can say that SEC deemed most ICOs to be securities, the most widespread and apparent way to raise funds and then enable the secondary market for these securities to trade can be the dark pool (ATS) then. Even though dark pools did have some backlash from the industry, the model at this stage can be well fitted for the crypto space. The uncertainty of the regulatory oversight and the current circulating SAFT proposal is an exact fit for the dark pool type of an exchange, we have tZero, and it offers securities trading, due to the current lack of regulation and classifications we can’t say we can have properly regulated spot markets for bitcoin, unless manipulation and fraud are detected there.

Compliance and slow step-by-step approach is what players like Coinbase do to get along and attract more people they are a good starting point for newly initiated, because of platform’s simplicity and integrity they offer new technologies to conservative investors, all while staying conservative in their operations themselves. Traditional market implementations must not be done through overriding decentralized promise and Coinbase is walking this line carefully.

In order to create safe crypto asset we can tolerate the high volatility of an asset deemed a “security”, but we must not tolerate of one deemed a commodity that is medium of exchange. Safe crypto asset implies it has stability (not enforced by third party token), then we must determine what forces in the market are manipulating its price (seen there is manipulation on exchange levels). Because its price discovery is left to the open market and because it is built on the dream of decentralization, the forced solution of stability of a token is only complicating the process and per se rejecting the compliance mechanisms. If price discovery is thought to be left open based on the free market principle, then stability must not be enforced on the asset that is fairly new. The stability must be brought into the market naturally as the demand on the asset grows. Stability is praised in up and coming entrepreneurs and token messiahs, but what they try to do is to remedy time of free market with a forced solution. Being commodity with implied high volatility makes it hard to build better investor products for it. The stability must be brought into the market naturally as it grows. Decreased volatility will enable better adoption overall, with implementation of much better instruments such as affordable shorting, better options and ETFs among the others.

We’ve seen importance of compliance for exchanges, speed bumps and privacy and SIPC. Insurance on the accounts is in some sort the door to the derivatives, which itself is the door to secure asset. A number of exchanges in the United States are now offering FDIC-insured dollar deposits, which should help to bring more credibility and stability to the entire bitcoin ecosystem. If individuals are going to interact with the exchange and other platforms dealing with bitcoin, then they need to at least be assured that their dollar deposits are not going to disappear. Merchants that hold accounts in both bitcoin and fiat within Coinbase can benefit from dealing with one entity, transact in bitcoin and have their fiat accounts insured. FDIC insurance has become available for bitcoin exchanges through partnering banks. At this moment there are FDIC insured bitcoin exchanges but there is a lack of FDIC insured bitcoin deposits (which comes in the form of a wallet), but assessing the risk associated with a lost or stolen bitcoin wallet it is still a work-in-progress for most insurance providers. SIPC Insures up to first $500,000 on one brokerage account. These funds are recovered in case firm goes bankrupt, it does not pay off your bad bet. The SIPC although is challenged by the new custodial paradigm that crypto assets introduce. If the assets are more stable and the rate of their appreciation is projected for long-term, people will start to stack it, in which case demand for the insurance will grow. Custodianship in crypto assets means a new user interface for crypto assets, which is more secure, but as well makes moving in and out of it a little bit more complex due to its decentralized nature. SIPC coverage targets: stocks, bonds, mutual funds, notes, other investment company shares, and other registered securities. It does not cover instruments such as unregistered investment contracts, unregistered limited partnerships, fixed annuity contracts, currency, and interests in gold, silver, or other commodity futures contracts or commodity options. Insurance means that counter-party who holds your assets has something at stake as well.

One of the important issues before anything is decided in how crypto assets must be insured is how custody will work. There are lot of institutional custody products such as XAPO, Coinbase and BitGo, but they are generally accessible to the large investors. The issue of custodianship for smaller investors is by its nature more political. Specific asset inclusion in insurance program might determine policy of an agency, due to custody specifications. Let’s say that a token with poor PKI might benefit custodianship, but a token that provides full ownership control to its holder might have issue to comply with traditional SIPC, due to funds irretrievability. Another question is if insurance covers asset classes by default how will it cover bitcoin? In a scenario where bitcoins are currencies then should it trigger FDIC mechanism? This is very unlikely and just one more reason to see how hard it will be for bitcoin to be a currency.

Observations and comments

My main observation in regards of exchanges and brokers is that they are very undeveloped. It is crazy to see importance of exchanges, how much disruption technology can bring to them and after all these years still see (and one major exchange crash) that we have not advanced much further. Although compared to scammish token sales, exchange business works, if you are able to put basic orderbook and lure market maker you can profit well, meaning incentives to provide fair services are there. Apart from disrupting technology and ideas that blockchain can bring, exchange is an existing and regulated concept, even though transactions might seem simple, compliant exchange requires far more effort and capital commitment from teams behind. One such exemplary team to me is Coinbase, which amid all the backlash it recently had still delivers transparent, regulated and forward-thinking products. By the end of 2017 and start of 2018 we’ve seen it was followed by other larger players such as Square, Robinhood and Circle. Robinhood, Square and Circle all offer zero-fees on trades to counter Coinbase, this is of course great and you can put this as a headliner, but we miss out the spreads, market quotes and states served, apart from other costs that each exchange/broker might impose. Circle had lot of activity apart from Circle Invest (that lets you purchase crypto assets) it has purchased Poloniex, some people consider that Goldman purchased the Poloniex, which is a wrong statement. In other news it is considerable that exchanges started to lower their fees for example Kraken and CEX both lowered their fees in the same time in 2018.

How much lower fees are reflective of market maturity is difficult to understand because recently the market has been in its bear cycle, apart from prices falling from January highs, the daily trade volumes subdued as well and hover around $12 billion daily, another visible point is how much assets in the market are correlated. As Bulkin has said “If we had more USD pairs we’d be seeing less correlation. Just a hypothesis.” This is a point of consideration, the more fiat pairs cryptos have, the more independent they seem, this is the side effect of immature market although and this negates digital Bretton Woods.

Markets have been declining for a while and the only news that drives the price seems to be regulatory, which turns out to be more negative overall compared to the previous year-end period where technological developments and speculation overshadowed other things. I think market is in disbalance towards the signals and it needs a lot of fine tuning. One of these find tunings I think are simple quarterly reports that we demand from listed stocks. This might seem as a small nuisance to some in the grander scheme of things, but these obligatory details drive the market and set impulses right. Now in crypto’s decentralized networks, who must be in charge and require these reports is not totally obvious but at this stage developer community can be in charge, again standardizing this would be prerogative of an exchange or SRO and there is definitely such a need in the market. Reporting timeline might be as well redefined, seen that crypto markets move way much faster than traditional stock markets, this should be accounted as well. As of now uneventful, “uncertain” market that is in hibernation mode and do not provide obliged quarterly reporting just shakes off on-boarded enthusiasts, thus such an obligation creates productivity growth. This of course is early to determine, we yet have to see in what secular cycle the market is, bear or bull but implementing milestones in achieving productivity growth would benefit market participants to be kept in check. You might have lost $4 thousand or more, but price signal is different than the excitement that crypto asset can evoke.

Another side effect of being unregulated in crypto is the tolerated risk of delisting. For example Bittrex is delisting 80 tokens. This of course will have consequences and this news should affect the market. Where is standardized delisting mechanisms or listing mechanism? Nowhere, the only guidance so far that I’ve seen thoroughly explained (except gimmicky polls) was provided by GDAX, but then again its transparency is not enforced and we are asked to believe the listing policy. This is a risk we all bare and with us the whole market. Listing is the result of thorough issuance, while delisting is the result of non-activity, we have to define these notions as well in crypto to start applying them.

This year (or by the end of it) I think we’ll see USDT fall. Tether is ugly when used to avoid AML/KYC procedures and used for illicit funding, but it’s useful tool on Poloniex and alike exchanges to secure crypto gains and then re-enter the market when there is a dip, all while avoiding withdrawal fees. Now this can be done with fiat currency, but in this case I’d personally prefer then exchange to insure my cash deposit while I hold it. Bitfinex’ed is very vocal actor in regards of Tether and I see as Poloniex will seek to get ATS registration we will see more enforcement directed towards this currency, OAG’s initiative can accelerate this process too. Now I’m not in position to analyze Tether fully, but in case it goes bust consequences can definitely stifle further market moves, because many exchanges rely on USDT as of now. In case you are interested to read more about war on USDT, Bitfinex’ed provides extensive writing on topics around it.

And finally as to what is left for decentralized crypto markets, I would suggest that we first look at Forex market problems, how asymmetric their nature is, what is the nature of their decentralization, what loose regulations mean to them and beyond that, the asset that these markets trade is interesting as well, are all markets treating these assets in the same fashion, otherwise I think more time must be dedicated to thinking how decentralized exchange can interact with outside world, events and demands, how it can accommodate things that we expect from centralized and regulated exchanges. It is a good thing to look at IEX rulebook and compare it to say OMG white paper. I am not rushing DEX teams to think and implement these things and I love Omise project, what I try to do is to point general public to a direction ahead., these rules are there for a reason, and this reason is the evolution and observation of the market. We must not reinvent the wheel when there are obvious things to consider. Another open question that I have is how DEX are going to circumvent HFT issues that might arise? We might need another SRO or better yet read and adopt MiFID II like rules. At the end of the day these rules will be translated into protocols, if not, then into support tickets (in case of DEX another question it is) and at some point decision must be taken and if we reject HFT completely, will there be incentive for traditional large traders to participate in DEX markets.

technology, law, financeGiorgi Gurgenidze