18 Sep Kraken, Binance, Gate.io under NY State regulatory scrutiny
New York State Attorney General Barbara Underwood’s office today released findings from a report looking into the “integrity” of cryptocurrency exchanges that are accessible to New York residents.
In April 2018, the Virtual Markets Integrity Initiative was launched to examine the operations of global cryptocurrency exchanges in order to protect “consumers and investors who deserve to understand how their financial service providers operate, protect customer funds, and ensure the integrity of transactions.”
The OAG sent letters and questionnaires to thirteen major trading platforms requesting their participation and cooperation.
Nine of the thirteen platforms participated: Coinbase, Gemini, Bitstamp, Bittrex, Bitfinex (operated by iFinex Inc), bitFlyer (operated by Paxos Trust Company), Poloniex (owned by Circle Internet Financial Limited), and Tidex (operated by Elite Way Developments LLP). The OAG separately invited HBUS, the US “strategic partner” of Huobi Inc to respond, as the platform opened for trading in July 2018.
Four exchanges refused to cooperate
Four platforms – Binance Limited, Gate.io (operated by Gate Technology Incorporated), Huobi Global Limited, and Kraken (operated by Payward, Inc) – claimed they do not trade from New York nor service New York residents and refused to participate.
Kraken moved its offices from New York to San Francisco in 2015, citing onerous regulations including the new BitLicense at the time. Kraken refused to participate and in April CEO Jesse Powell tweeted, “Having the requested information ‘on-hand’ is not the same as having the resources to compile it neatly to fit the framework of the request, within 2 weeks.”
Three exchanges – Binance, Gate.io, and Kraken – were referred to NY State Department of Financial Services “for possibly operating unlawfully in New York.”
Kraken trades $133 million in daily volume. Binance is the largest exchange in the world, with more than $1 billion in daily trading volume and Huobi treats $670 million daily, according to CoinMarketCap data.
Data gathered to protect consumers
The New York office of the Attorney General (OAG) analyzed data from the nine cooperating cryptocurrency exchanges in five key areas:
- jurisdiction, acceptance of currencies, and fees
- trading policies and market fairness
- managing conflicts of interest
- security, insurance, and protecting consumer funds
- access to consumer funds, suspensions, and outages.
Key areas of OAG concern
The OAG report found three key areas of concern with cryptocurrency exchange operators.
First, the report voices concerns with potential conflicts of interest between the interests of the platform, platform insiders, and its platform customers.
Second, the analysis shows some cryptocurrency exchanges have done little to prevent abusive trading activity and lack policies in place to protect investors from such activity. Mechanisms to monitor and identify suspicious trading are not in place. Most exchanges do not have the ability to prevent bots and other automated algorithmic trading.
Third, strong protection of consumer funds is limited or simply not in place. Acceptable audit programs are lacking.
“Customers are highly exposed in the event of a hack or unauthorized withdrawal. While domestic or foreign deposit insurance may compensate customers for certain losses of stolen or misappropriated fiat currency, no similar compensation is available for virtual currency losses. There are serious questions about the scope and sufficiency of the commercial insurance that certain platforms purport to carry to cover virtual asset losses. Other platforms do not insure against virtual asset losses at all.”
Jurisdiction, acceptance of currencies and fees
The OAG says it is extremely difficult for consumers to compare even basic information on the features of virtual asset trading platforms.
This includes the legal jurisdiction of the cryptocurrency exchange, which fiat and virtual currencies are available, and a wide range of fees and charges for services, including deposits and withdrawals and other fees.
The report noted, “Binance moved its operations to Malta, after initially locating in Hong Kong and then Japan. Huobi is reportedly based in Singapore. The location of the operator of Gate.io – which transacts tens of millions of dollars’ worth of virtual currency per day – is unclear from public sources. The company, however, represented in writing to the OAG that the platform is based primarily in China.”
Verifying & monitoring access
The OAG said most cryptocurrency exchanges claimed to verify and monitor access using KY see/AML. Not all could do so effectively and trustfully. Bitfinex and Tidex for example, required only an email to begin trading.
For IP address monitoring, only Bitstamp and Poloniex (Circle) purported to limit VPN access, often used by criminals and consumers to circumvent IP address verification.
Fiat currency acceptance
Most trading exchanges do not have banking relationships. While six exchanges accepted fiat currency, three did not – HBUS, Poloniex, and Tidex. To trade on these three exchanges, virtual currency must be acquired elsewhere and then with all the fees and charges externally before bringing it to a customer account and submitting to additional fees at the cryptocurrency exchange target.
Fees & fee disclosure
As anyone who’s ever traded cryptocurrency knows, the disclosure of fees is a dog’s breakfast. Some exchanges are transparent but comparing fees between competing exchanges is difficult. Different actions trigger different fees for example. Some exchanges favor larger traders with discounts.
“Five participating platforms – bitFlyer USA, Bitstamp, Bittrex, HBUS, and Tidex – purport to charge the same trading fees to all customers with the same trading volume. Bitfinex, Coinbase, itBit, and Poloniex (Circle) employ a so-called “maker-taker” fee model. Gemini employs a hybrid fee structure, offering the same trading fees for low-volume customers, but applying maker-taker pricing to high-volume traders. Although HBUS’s fee schedule lists separate fees for makers and takers, it currently charges the same rates to both,” the report said.
OAG also cautions consumers that the four exchanges not participating may not fully disclose their fees in advance.
Trading policies & market fairness
Cryptocurrency exchanges like to compare themselves with traditional exchanges for marketing purposes. While traditional exchanges have stringent regulatory guidelines and obligations, the new virtual exchanges are not currently registered nor regulated in ways that fully protect consumers.
Several prominent platforms provide incentives for professional or high-speed electronic traders. Some do not have policies in place to prevent or monitor algorithmic or automated trading.
Bot trading can lead to abuses and that is of grave concern to the OAG. Numerous exchanges had no policies in place to guide automated trading or protect investors.
Policies to Prevent Market Manipulation & Abusive Trading
Only four exchanges had formal market manipulation policies – Bittrex, Gemini, Coinbase, and HBUS. The OAG noted a serious lack of surveillance capacity with most exchanges but did note Gemini’s collaboration with NASDAQ to improve market surveillance.
The report said with concern: “The OAG could not review the practices and procedures of non-participating platforms (Binance, Gate.io, Huobi, and Kraken) concerning manipulative or abusive trading. However, the Kraken platform’s public response is alarming. 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.”
Only Bitfinex and Poloniex offered margin trading.
Managing conflicts of interest
Managing virtual exchange conflicts of interest is also a big concern for the OAG, just as it is in traditional securities markets. Among the concerns:
- lack of information on how and why cryptocurrencies are listed and the lack of disclosure or transparency in listing fees
- owners and investors are often large holders of cryptocurrencies leading to potential conflict
- platform employees often also trade cryptocurrencies and at the same time have access to information the public does not; exchanges employee trading policy varied or did not exist and were deemed problematic
- some exchanges execute proprietary trades on their own exchanges and the volume varied widely including Poloniex (1%), BitFlyer USA (10%), and Coinbase (20%) creating the potential for investor liquidity risk.
“Those practices put the interests of customers in tension with the interests of platforms and their employees. In order to protect themselves, customers should seek out platforms that pay careful attention to these issues and use appropriate means to ensure that all traders on the platform are being treated equally and fairly. At the industry level, appropriate management of conflicts of interest is critical if virtual assets are to be integrated into the commercial and financial markets,” the report said.
Security issues abound
Theft, hacking and fraud are ongoing concerns for currency exchange investors. The vulnerability of virtual assets is demonstrated by numerous high-profile multimillion-dollar cryptocurrency exchange hacks.
While all exchanges claimed to offer two-factor account authentication, not all exchanges required it. Bittrex and Bitfinex also offer IP “white lists.”
Most platforms claimed they engaged external security consultants to conduct penetration testing but Bitfinex and Tidex did not.
Most operators claimed to have insurance protection in place but itBit did not. Determining whether insurance is adequate is an ongoing challenge and investor risk.
The OAG noted,” To date, relevant authorities (such as the Financial Accounting Standards Board in the United States) have not developed generally accepted accounting standards for virtual currency. A number of platforms – Bittrex, bitFlyer USA, Bitstamp, Coinbase, Gemini, itBit, and Poloniex (Circle) – reported that they have retained outside firms to conduct audits of their virtual currency holdings using the approaches currently available.”
Access to Customer Funds, Suspensions & Outages
Widespread customer complaints about access to funds problems, questionable suspensions, and outages have been received and reported.
High-volume or volatile trading outages have made customer funds inaccessible at several exchanges in the past. Unfair suspensions with no recourse have also been reported.
Most exchanges reported that customers could not make withdrawals during suspensions or outages. Some cancel trades without notice and the OAG recommended investors investigate these policies carefully.
“Only four participating platforms (Coinbase, Gemini, Bitfinex, and Poloniex) publish a history of prior outages. The others (including Bittrex, Tidex, and itBit) do not. At the time of publication, HBUS has only recently opened its platform and has yet to experience an outage,” the report said.
Key questions for investors to ask exchanges
The OAG report concluded with a list of questions investors should ask when considering investing using a virtual currency exchange. These questions follow for reference:
This Report set out to provide customers with easily accessible information about virtual asset trading platforms, and to arm customers, with the basic questions they should expect every platform to answer:
- What insurance or other policies are in place to make customers whole in event of a theft of virtual or fiat currency?
- What insurance, capital buffer, or other policies are in place to make customers whole in event of a theft of virtual or fiat currency?
- What guardrails or other policies do the platform maintain to ensure fairness for retail investors in trading against professionals?
- What controls does the platform maintain to keep unauthorized or abusive traders off the venue?
- What policies are in place to prevent the company and its employees from exploiting non-public information to benefit themselves at the expense of customers?
- How does the platform notify customers of a site outage or suspension, the terms under which trading will resume, and how customers can access funds during an outage?
- What steps does the platform take to promote transparency and to subject its security, its virtual and fiat accounts, and its controls to independent auditing or verification?
- Is the platform subject to, and registered under, banking regulations or a similar regime – for instance, the New York BitLicense regulations?
All in all, the report is a valuable analysis and comparison of the nine larger cryptocurrency exchanges that participated in the survey. Within the report are several interactive tools and charts that allow investors and consumers to compare features and availability within the US.
The report does also provide insight into New York State regulator concerns which may very well influence other jurisdictions within the US and abroad.
You can view the complete New York state Virtual Markets Integrity Initiative report here.