In April 2018, the New York Attorney General's office announced the Virtual Markets Integrity Initiative. As part of the investigation, the office sent a survey to 13 cryptocurrency exchanges to find out more about their practices and procedures and determine the markets' risk to investors.
Today the Office of the Attorney General (OAG) released its findings in a 40-page report. Here are some of the highlights:
Exchanges aren't able to combat abuse.
The report found that exchanges have not yet developed sufficient safeguards against potential abuse.
The report states:
"Platforms lack robust real-time and historical market surveillance capabilities, like those found in traditional trading venues, to identify and stop suspicious trading patterns. There is no mechanism for analyzing suspicious trading strategies across multiple platforms. Few platforms seriously restrict or even monitor the operation of 'bots' or automated algorithmic trading on their venues. Indeed, certain trading platforms deny any responsibility for stopping traders from artificially affecting prices."
Exchanges are allowed to do wash trading; people aren't (but probably do it anyway).
Most exchanges have policies that prohibit a single user from opening multiple accounts. These are intended to prevent wash trading, the practice of buying and selling (essentially to one's self) as a means of price manipulation. However, very few exchanges have any means of enforcing such policies.
"A prohibition against multiple accounts is only effective if a platform can actually detect customers attempting to open multiple accounts. That requires robust on-boarding procedures, including multiple forms of identification verification, and other countermeasures."
But few exchanges have extensive KYC polices. And, though customers are (at least theoretically) prohibited from wash trading, the exchanges themselves are not. Unlike in traditional exchanges, in which the exchange operators and employees are prohibited from buying and selling (or, at least, their participation is highly regulated), crypto exchanges operators have complete freedom to execute trades.
"In addition to permitting employees to trade for their own personal accounts, several platforms reported that they engage in proprietary trading on their own venue. In other words, customers who submit an order to buy or sell a virtual asset could have their order filled not by another customer, but by a 'trading desk' run by the platform itself, trading on behalf of the platform for its own account."
While some exchanges claim this is an attempt to ensure liquidity, it gives them a great deal of control over prices.
Conflicts of interest are rampant.
"Virtual asset trading platforms often engage in several lines of business that would be restricted or carefully monitored in a traditional trading environment," the report says.
Exchanges don't act only as exchanges. They not only frequently buy and sell cryptocurrencies on their own exchanges, but also act as brokers and even sometimes create their own currencies.
The report notes these situations create a web of conflicting interests for exchanges: "Each role has a markedly different set of incentives, introducing substantial potential for conflicts."
There's no "rhyme or reason" to the selection of currencies.
While the investigation found that some exchanges look at "market capitalization" when considering listing a cryptocurrency, the selections largely seemed random.
"Across the board, the OAG found that platforms' determinations of whether to list a given virtual asset were largely subjective. No platform articulated a consistent methodology used to determine whether and why it would list a virtual asset," the report says.
The report also states that, unlike traditional stock exchanges, which disclose fees and any other compensation received for listing a certain stock, cryptocurrency exchanges are typically opaque about such arrangements. "This compensation can come in the form of virtual currency, including a share of the new listing, fiat currency, or other inducements," the report says.
In other words, creators of worthless cryptocurrencies can simply bribe exchanges to feature their coin.
The OAG is dropping a dime on three exchanges.
The overall picture painted by the report should give investors pause. Exchanges can list questionable currencies (or create their own), don't need to disclose the compensation they receive for doing so, have the power to manipulate prices and can do so for their own enrichment – possibly at the expense of investors, who have little recourse if their assets are stolen.
The report does request that those who believe they've been defrauded contact the OAG, and also hinted that some of the exchanges that declined to complete the OAG's survey may soon be hearing from the New York Department of Financial Services (NYDFS).
Of the thirteen exchanges that were sent the questionnaire, four refused to participate: Binance, Gate, Kraken, and Huobi (though HBUS – the US-based "strategic partner" of Huobi did respond). All four claimed they don't allow trading from New York. The report states the OAG investigated those assertions, and though the report does not say what the inquiry revealed, it does say, "Based on this investigation, the OAG referred Binance, Gate.io, and Kraken to the Department of Financial Services [NYDFS] for potential violation of New York's virtual currency regulations." However, NYDFS may have little power over these exchanges, since all but Kraken are located outside the US.
The authors of the report were most alarmed by Kraken's response to the survey. The report reads:
"In announcing the company's decision not to participate in the Initiative, Kraken declared that market manipulation 'doesn't matter to most crypto traders,' even while admitting that 'scams are rampant' in the industry."
Correction: An earlier version of this article used the subheading "The OAG is dropping a dime on four exchanges." However, the OAG only referred three exchanges to the NYDFS: Binance, Gate.io, and Kraken.