In traditional financial markets, fairness, transparency — even liquidity — are taken for granted. They are seen as ‘table stakes’ conditions for any market or exchange to exist and are not even questioned.
Unfortunately, the same cannot always be said for cryptocurrency markets.
While there has been increasing attention from regulators in crypto — something that we support — it is still up to the exchange operators themselves to take the lead in this space.
Part of the work entails implementing best practices gleaned from regulated markets, but it also requires some bespoke measures that take into account blockchain’s unique nature and conditions specific to crypto markets.
We believe the key elements here include thorough identity verification procedures, specialized market surveillance, the articulation of a shared set of rules, proper infrastructure, and education.
What is market integrity?
Market integrity is broadly defined by the International Organization of Securities Commissions (IOSCO) as
“the extent to which a market operates in a manner that is, and is perceived to be, fair and orderly and where effective rules are in place and enforced by regulators so that confidence and participation in the market is fostered.”
In theory, markets are rational and efficient. Price discovery ought to unfold as new information becomes available to independently acting market participants. We expect such information to be equally accessible to all and as accurate as possible.
Left unfettered, however, as clearly demonstrated during the 2008 Global Financial Crisis, markets can spin out of control due to misinformation, opacity, malpractice or unreasonable asymmetries between, say, retail and institutional investors.
In 1934, soon after the 1929 stock market crash and the ensuing Great Depression, market integrity emerged as a key goal of securities regulation with the signing of the Securities Exchange Act in the US.
But while methods to safeguard market integrity in traditional markets have matured over the years, the crypto industry comes with its own set of challenges and solutions that all exchange operators should be mindful of.
The pillars of integrity
Earlier this year, Bloomberg published an article claiming that automated trading manipulation is rampant on certain decentralized crypto exchanges. Around the same time, Bitwise released a research paper, where it points out that a significant portion of Bitcoin’s trading volume might be artificially inflated (though effective arbitrage systems ensure that this does not necessarily impact the price of BTC).
The problem is that fairness, transparency and market integrity cannot be taken for granted in crypto markets. Investors need to be critical about where they trade, and exchanges need to make a sustained effort to create a trusted trading environment.
To operate a fair crypto exchange that investors can trust, we believe the following elements are pivotal:
Ensuring a clean pool of liquidity starts with having thorough Know Your Client (KYC) and anti-money laundering (AML) procedures in place. The main objective here is to keep the market free from bad actors who might engage in certain illicit activities or reside in high-risk jurisdictions.
The difficulty lies in the fact that while individuals may be sanctioned, wallet addresses are not. Beyond obtaining identity documents, earlier this year the Financial Action Task Force (FATF) therefore set the requirement that all Virtual Asset Service Providers (VASPs) — such as exchanges — must obtain and hand over client data linked to wallet addresses whenever a transfer is made in and out of the exchange.
Creating a rule book
One of the ways to move forward is for exchanges to collaborate on creating a legally non-binding rule book, similar to the FX Global Code document which was developed by banks and market participants in forex from 16 jurisdictions around the world.
Such a document could paint a broad framework around the ethics, professional standards, responsibilities, and other relevant principles that make for a properly functioning and fair market, and it could potentially form the basis for some kind of industry-recognized certification scheme.
The crypto market is still young and fragmented, making it relatively difficult to assess transaction and volume information, and comparing prices can be complicated. Furthermore, cryptocurrencies are characterised by a high degree of volatility and are less liquid than more established asset classes, which may make them more vulnerable to manipulation.
For all these reasons, having solid market surveillance systems in place is crucial to protect investors, instill confidence, and safeguard integrity. But such surveillance will have to operate differently, as compared to conventional systems.
In contrast to conventional markets, crypto markets operate 24/7. Furthermore, communicating with different blockchain protocols, the fractionary nature of crypto assets, the wide variety of trading environments across the world, ongoing innovation, and the absence of a shared code of conduct, all complicate oversight and call for dynamic blockchain-aware surveillance systems.
Fair mechanisms and infrastructure
Protecting integrity also comes down to the architectural structure itself. At AAX, for example, we have deployed LSEG Technology’s core matching engine, which is called Millennium Exchange. It is the same matching engine at the heart of first-tier capital markets, including the London Stock Exchange.
This technology is designed to be MiFID II compliant, meaning it allows for pre and post trade transparency, directly reflecting market activity in price movements — free from interference. Further measures include building robust pre-trade risk checks, to protect investors’ collateral and the wider trading community, as well as proper auto-liquidation mechanisms in futures markets that operate on the basis of an aggregate of price performances from across exchanges, rather than the local order book alone.
Lastly, in the absence of licensed financial advisors, it is extra crucial for exchanges to retain absolute impartiality and provide a rich body of educational material to market participants — especially retail investors — so as to empower them to do their own due diligence and come to a more informed view of the market.
AAX is the world’s first cryptocurrency exchange to be powered by LSEG Technology’s Millennium Exchange, the same matching engine at the heart of tier-one capital markets, and is a member of London Stock Exchange Group’s global ‘Partner Platform’. Offering OTC, Spot, and Futures trading, quoting more than 50 cryptocurrency pairs and listing 5 perpetual futures contracts for Bitcoin, Ether, Litecoin, Ripple, and EOS, which can be traded with high leverage, AAX provides a secure, deeply liquid, ultra-low latency and fully compliant trading platform. It offers an institutional-grade platform, for everyone. http://www.aax.com