Cryptocurrency trading platforms have a little secret: they masquerade as “exchanges” but they are mostly brokers.
In almost all respects, these digital asset exchanges are fundamentally different from traditional exchanges, although there are names that suggest that they are exact copies of existing markets for stocks and other securities.
In fact – and unlike traditional exchanges – trading platforms for bitcoin and other digital assets do more than just provide an electronic platform for investors to buy and sell securities. They provide custody, deal with clients’ money, act as a counterparty to trades, and – more recently – have begun lending and borrowing.
According to Simon Forster and Duncan Trenholme, co-chairs of digital assets at broker TP ICAP: “If you have an exchange that is doing custody, betting, lending and borrowing…it looks like a broker or a bank.”
This multifaceted role has raised concerns that platforms may not always serve the interests of the client. Instead of being a neutral party to transactions, like a stock exchange, a cryptocurrency exchange can trade against clients, creating a win-win situation – meaning that retail clients are at risk of unfair dealings.
Such risks have been identified in recent studies. In October, the National Bureau of Economic Research found that, unlike regulated exchanges, cryptocurrency platforms lack provisions to ensure investors get the best possible price.
Anton Katz, CEO of software company Talos, says that for professional investors entering the market, this is a problem because some have “best execution” commitments – that is, they are required to deal at the best price they can.
As a result, they feel more comfortable spreading transactions across different providers to reduce conflicts of interest and the scale of repercussions should the platform crash or be hacked.
Katz notes that “in cryptocurrency, most exchanges provide not only matching services, but also custody, clearing and settlement services to name a few.” “That means it actually looks more like [traditional] A broker because the customer is actually facing the same exchange to trade, unlike another customer on the exchange.”
And crypto exchanges do this with little, if any, regulatory oversight. Policymakers say this has become a problem, given the ever-increasing financial and stability risks in a market that is now worth $2 trillion. Many are making a concerted effort to bring the fungus industry under control.
As the largest holders of Bitcoin and other major digital assets, exchanges are among the most influential players in the crypto world, along with “miners” creating new currency units.
They hold clients’ funds and require traders to post funds to fund trades up front. They settle deals and make sure all parties are paid. But they do so in an environment where there is penetration and transparency about prices, and what happens on the exchange, is almost zero.
Regulators have been aware of the problem for several years now. Ashley Alder, chief executive of the Hong Kong Securities and Futures Commission, said in a 2018 speech that cryptocurrency exchanges can act as proxies for their clients in addition to their own personal interest when trading — making major conflicts of interest difficult to detect and monitor. He added that investors also face “additional weaknesses” because they trade with these platforms directly, rather than through an intermediary.
“These are activities of particular interest to securities regulators, as these platforms appear, superficially, to mimic traditional funds and stock exchanges,” Alder said. He also noted that preserving investor funds was an area of ”main concern”.
Last year, the Hong Kong regulator decided that all of these platforms must register with it, prompting FTX and others to seek warmer regulatory climates in the Caribbean islands.
Meanwhile, for traditional exchanges, the massive sums raised by crypto startups in a short time made it difficult to resist digital assets as a potential market. They also hope that their background in regulated markets will give them an advantage.
Crypto Asset Market Size
Jörg Schneider, head of media relations at SIX, the operator of the Swiss stock exchange, hinted equally when it received regulatory approval to launch the digital asset platform in September.
“We are a globally recognized and regulated stock market,” he said. “All of this constitutes a completely different architecture from the cryptocurrency exchanges currently in the market. From a regulatory point of view, they are not viewed as exchanges.”
But while cryptocurrency platforms face fewer challenges from regulators, they have another annoying stakeholder to satisfy: retail customers.
“Truth [is] Fadi Abululfa, head of research at London-based digital infrastructure provider Cooper, points out that dissatisfied customers are just a few clicks away from transferring their assets to a competitor.
With tightening regulations and intensifying competition from established exchanges, the ability for investors to roam freely could pose the biggest test for digital startups.
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