On Feb. 26, the Securities and Exchange Commission announced the rejection of yet another ETF submission from Wilshire Phoenix, a New York-based investment firm, citing a lack of resistance to market manipulation and fraudulent activity. The filing stated that the NYSE Arca had not demonstrated that the market was “designed to prevent fraudulent and manipulative acts and practices and to protect investors and the public interest.”
While Wilshire Phoenix aimed to base its ETF both on Bitcoin (BTC) and the United States Treasury bonds to hedge against Bitcoin’s volatility in a hope to break the trend of ETF rejections, the reasons cited by the SEC remain the same: a lack of a surveillance-sharing agreement with a significant market for the underlying asset or a novel demonstration of the market’s inherent resistance to manipulation.
While reactions were mixed even within the commission itself, the decision highlights the need for a more robust and transparent exchange ecosystem. It also highlights the importance of data and its interpretation within the Bitcoin ecosystem. This was one of the topics discussed at the CryptoCompare Digital Asset Summit, hosted in London on March 10, which CryptoX attended. The panel focused on data and analysis, and how these two could help bring much transparency to the space and pave the way to institutionalization and regulatory improvement.
Main issues in the Bitcoin exchange ecosystem
The cryptocurrency scene has been, for a long time, regarded as a lawless land, or the “Wild West” of finance. The lack of clear regulatory guidelines and oversight has allowed companies to engage in less than savory tactics to gain market share. This has also been aided by the absence of easy-to-digest information in the crypto space, making it possible for retail investors to be misled by malicious companies.
Crypto exchanges have often relied on volume manipulation in order to boost their visibility and position in the industry. While this has been done in part to attract traders to the platforms — as they often look at volume to understand how liquid an exchange is and how much impact their trades will have on the market — exchanges also use these tactics to attract projects looking to list themselves.
Fundamentally, not only does this hurt users and the projects that are listed on these platforms but it also develops a bad reputation for the cryptocurrency industry as a whole. Institutional investors will stay away from unregulated markets especially when manipulation is rampant. Indeed, this has caused some regulators to crack down aggressively on exchanges as, for example, in 2017, the People’s Bank of China’s actions saw China’s volumes decrease from the absolute majority (>90%) to only a fraction of the global trades.
Related: Countries That First Outlawed Crypto but Then Embraced It
Transparency, when it comes to volumes, is not the only issue found on exchanges. Fractional reserve practices have also been a problem. The infamous Mt.Gox fiasco that led users to lose 850,000 BTC collectively — valued at around $460 million at the time — also demonstrated the need for more transparency when it comes to solvency. Poor security has also been a weak point in the cryptosphere, as many of the top-tier exchanges have been hacked in the past.
While exchanges have been at the heart of some of the biggest issues in crypto, the 2017 initial coin offering craze, along with their resulting losses, also demonstrated a lack of accountability and transparency from projects and token issuers, and they’ve led the U.S. SEC to issue a crackdown on these activities, having filed lawsuits against multiple ICOs.
Volume manipulation, techniques and challenges
According to the panel, fake volume is certainly a common concern in the market but one that will most likely fade away as transparency grows and incentives for faking volume disappear. James Kim, co-founder of CrossAngle, a disclosure platform, said: “In the long run, faking volume is not going to be competitive, either for exchanges or investors.”
Efforts to bring transparency to the market are aided by the inherent public nature of blockchain technology. For example, Flipside Crypto, a research and intelligence firm, looks at on-chain data to analyze the inflow of Bitcoin onto exchanges and match it to the reported trading volumes to detect suspicious activity. Avi Meyers, director of business development of Flipside Crypto, stated:
“[Faking volume] is certainly going to damage the integrity of some of the exchanges, so, obviously, that’s why we’re focusing on it now because we want to increase legitimacy of these trading venues so we can drive institutional investment.”
Chainalysis uses a similar approach to identify fake volume. In a study published last year, the crypto forensics firm looked at 10 exchanges from the top tier and came up with a baseline ratio for reading volume when looking at incoming BTC and BTC being traded. Based on this metric, they found many discrepancies when looking at other exchanges. Although this ratio can serve as a baseline, analyzing the data requires some level of insight on different types of exchanges. Philip Gradwell, chief economist of Chainalysis, explained:
“Some exchanges are largely custodians so they get much more Bitcoin flowing into the exchange relative to the amount of trading they have and then you have some exchanges where people are happy to just leave their crypto on that exchange and just trade all day and so they have a much higher ratio.”
On the other hand, crypto market data provider CryptoCompare looked at off-chain data to determine how exchanges potentially fake volume while also analyzing their order books and other data points to assess reported volume.
Once again, these datasets are not always easy to interpret and are subject to the nuances of the cryptocurrency world. This is the case with novelty venues like zero-fee or transaction-fee mining exchanges. The monthly exchange report published by CryptoCompare in October 2019 demonstrated how these nuances make crypto hard to navigate for those who do not actively follow the space. It reads:
“This [zero-fee or transaction-fee mining trading] might give traders an incentive to trade more to receive more tokens which often have valuable features such as voting rights on the platform or a dividend. Both of the above can effectively lead to wash trading.”
Quality vs. quantity, bringing transparency and trust into crypto
While volume and market capitalization have been, for the most part, the main metric that stakeholders have worried about, new ways of categorizing projects and exchanges are being created to give market participants a better understanding of the ecosystem.
These efforts to find new metrics to evaluate projects include CryptoCompare’s Exchange Benchmark — which ranks exchanges from AA to F based on qualitative data like due diligence and quantitative measures like “market quality based on order book and trade data.”
FlipSide’s Fundamental Crypto Asset Score looks at on-chain and off-chain data to analyze various factors — like “User Activity,” “Developer Behavior” and “Market Maturity” — to rate assets from 0–1,000, and to assign a ranking score from “Superb” to “Fragile,” focusing largely on the first two points rather than the market itself, as the latter only contributes to 5% of the overall score.
Crossangle’s product, Xangle, provides a disclosure and governance system for crypto markets, bringing it up to traditional financial standards like the ones applied in the SEC’s Electronic Data Gathering, Analysis and Retrieval database. Xangle facilitates corporate filings and makes these readily available to the public.
These initiatives, and others like it, create a basis for serious investors to choose trading venues and assets and incentivize exchanges to report volumes accurately, focusing on improving ease of use, security and regulatory compliance. However, there are still some ways to go about this, and in many cases, the methodology may be a work in progress as Jenna Wright, head of LMAX Digital, an institutional spot cryptocurrency exchange and part of the LMAX Group, told CryptoX, adding:
“We think that industry players, especially research companies, need to ensure that their research and benchmarking methodologies capture an accurate picture of the market. This means that the methodology, used to measure volumes and market share, needs to be consistent across providers and must ensure it captures the different players in order to offer an accurate picture of the market.”
Data and regulation, a bottoms-up approach
Crypto is a completely new and uncharted territory that opens up a lot of questions for regulators and institutional investors — the latter of whom relies heavily on the former when considering investing in the space. This is another area where data companies are becoming essential as cryptocurrencies are largely misinterpreted by regulatory entities. Kim stated during the panel:
“I think most of the players are expecting governments to come up with clear guidelines to say it’s okay to trade, how to trade, it’s okay to do business in the crypto world, but more likely, I think it will happen the other way around. Governments are not experts, they’re asking the regional players and players who can provide research, who have seen responses from the market and investors to understand what’s happening.”
Data companies and some exchanges have been working with regulators to help them understand digital assets and their associated infrastructure. Chainalysis is known for working with agencies that fight crime to track illegal activity and money laundering. Flipside Crypto uses blockchain data to map wallets to foundations and bring transparency about what entities hold what assets.
CryptoCompare provides data services to a number of regulators, according to James Harris — another member of the panel — and has also publicly launched the Cryptoasset Taxonomy Report, which offers “a framework to help retail and institutional investors, regulators and the industry as a whole gain a holistic understanding of the crypto asset landscape.”
Related: Hester Peirce Says SEC Is a Partner to Crypto, as US States Chase Regulations
While some countries have outright banned crypto or taken other aggressive measures against it, others are working actively to understand and regulate it. When asked about it, the panel unanimously named the U.S. as the most advanced and forward-thinking country when it comes to crypto regulation, also citing other countries like Singapore, the United Kingdom and Germany.
The road to institutionalization
A previous SEC filing regarding the rejection of the Bats BZX Exchange ETF cited a lack of data over Bitcoin’s spot market resistance to manipulation due to arbitrage opportunities.
However, data and transparency, especially when it comes to exchanges, could hold the key for the regulatory approval of a Bitcoin-based ETF which, in turn, can be the start of an institutional-level cashflow into Bitcoin and cryptocurrencies. Gradwell said:
“If you want to get serious money into crypto, you have got to build up their confidence that there are actually good trading venues […] If you’re an exchange and you have good incentives to report real volume, you may actually get institutional money coming in, but if you don’t have those incentives, they’ll stay away.”
Initiatives like the aforementioned ones bring much-needed transparency to the market and allow institutions to access and understand large datasets from the cryptocurrency market — which is quintessential to driving institutional investment. Initiatives by trading venues like Proof of Reserves will also be a driving force despite carrying some security and practicality challenges.
While it’s still unclear how long regulators and institutional investors will take to jump on board the crypto bandwagon, the future looks bright. Institutional demand for regulated trading products seems to exist as signaled by the creation of Bitcoin exchange traded products and blockchain ETFs, and as the crypto world starts to become more aligned with traditional finance standards, this demand will be allowed to grow and to finally materialize into actual market participation. Nevertheless, there is still work to be done as noted by Wright: “The cryptocurrency industry has already gone a long way in disclosing volume data, but there is still a way to go.”
