Wash trading – the practice of creating artificially inflated trading volumes –gained traction (and headlines) with the rapid rise of electronic trading in the early 2010s, as algos and electronic trading programs became able to churn trades at unprecedented speeds. But cryptocurrency has opened up a whole new world of opportunity, which is having serious consequences on price transparency.

A report from the National Bureau of Economic Research in the US, published in December 2022, found that illegal wash trading may account for almost three quarters (over 70%) of average trading volumes on unregulated exchanges.  

Researchers from Cornell University in the US, Newcastle University in the UK and Tsinghua University in China conducted systematic tests exploiting robust statistical and behavioural patterns in trading to detect fake transactions on 29 cryptocurrency exchanges. 

“Abnormal first-significant-digit distributions, size rounding, and transaction tail distributions on unregulated exchanges reveal rampant manipulations unlikely driven by strategy or exchange heterogeneity,” reported the study.  

These fabricated volumes, effectively the result of firms (and exchanges) illegally trading with themselves, can amount to trillions of dollars annually. The fraudulent practice can offer a false impression of liquidity, resulting in an improved (but inaccurate) exchange ranking, as well as temporarily distorting prices.  

But regulators are cracking down.

“Regulators – particularly in the US and the UK – are now deploying sophisticated market data analytics to identify all forms of market abuse, including wash trading,” said compliance and reporting specialist SteelEye. “Never before have regulators had such technology firepower at their disposal to combat market manipulation.” 

Wash trading was first banned in the US in 1936 through the Commodity Exchange Act, while the Commodity Futures Trade Commission (CFTC) also prohibits brokers from profiting from wash trading, which it views as a form of market abuse. The US Securities and Exchange Commission (SEC) prosecutes wash trading through the Securities Act 1933 and the Securities Exchange Act 1934; while in the UK and EU the practice is banned under the Market Abuse Regulation.  

Now, the regulators are turning their attention to crypto markets, and prosecutions are on the rise. In March 2021, the CFTC fined Coinbase $6.5 million for “false, misleading or inaccurate reporting and wash trading”, claiming that between 2015 and 2018 the exchange operated two automated trading programs, Hedger and Replicator, which generated orders that at times with one another in certain trading pairs, resulting in trades between accounts owned by Coinbase. This “potentially resulted in a perceived volume and level of liquidity of digital assets, including Bitcoin, that was false, misleading, or inaccurate,” said the CFTC.  

“Reporting false, misleading, or inaccurate transaction information undermines the integrity of digital asset pricing,” added acting director of enforcement Vincent McGonagle. “This enforcement action sends the message that the Commission will act to safeguard the integrity and transparency of such information.” 

In the same month the UK’s Financial Conduct Authority (FCA) fined Adrian Horn, formerly a market making trader at Stifel Nicolaus Europe, £52,500 for market abuse and wash trading. 

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The prime brokerage world from a traditional asset class perspective is well established – with a wide range of bells and whistles, its USP is its holistic approach, covering everything from custody to capital introduction, and assisting its client base to source liquidity they couldn’t find themselves. But in the digital assets space, what role can prime brokers really play – and is it realistic to try and shoehorn the current model into this new decentralised world? Panellists at Blockworks’ Digital Assets Summit (DAS) this week discussed the concept of prime brokerage, and how it can be updated to apply to the new paradigm.

“Not everyone with a lending service can call themselves a prime broker,” warned George Zarya, founder, CEO and head of sales at crypto prime broker BEQUANT. But the problem is that, unlike in traditional finance, prime brokers in the crypto space have not yet evolved to offer everything that their clients need.  

“In crypto, it seems that ‘prime’ and ‘brokerage’ are two different things. Brokerage is just people buying crypto off each other,” agreed Maja Vujinovic, managing director of blockchain advisory and investment firm OGroup. “But Prime is a whole bundle of services. It depends on the seat you’re sitting in.”  

So what is a crypto prime broker, and is anyone filling that role yet?  

“There are some firms out there that are doing some parts – the custody role, for example – but right now I don’t think we have yet reached the finished article,” said Edd Carlton, institutional digital asset trader with Flow Traders. “The use of the word ‘Prime’ is usually because it’s a one-stop shop. If you don’t do all the pieces, you aren’t hitting the target.”   

Fragmentation 

“The two key variables we need to place importance on, when discussing the difference between crypto and tradfi, is fragmentation and pre-funding,” stressed Omid Zadeh, head of business development EMEA at Matrixport.  

“The crypto market is so fragmented, there is liquidity across hundreds of different venues, and you need to pre-fund them, which is very different to the traditional space. Pre-funding and fragmentation of liquidity is where the real value proposition of a crypto prime broker comes in right now – we can offer access to each exchange, and top tier fees to each exchange, which is very important in this low volume environment. We can also give the key advantage of offering one margin to play with – cross-margining services can be key for firms.”  

The panel agreed, however, that while there are currently numerous players in the market, we are likely to see significant consolidation going forwards – the question being, who buys who.  

Acquisition 

“It’s not an easy feat, to build a crypto specialist firm, such as crypto custody – there’s a lot of coding and technical architecture involved. Those pieces will inevitably get acquired. You can’t have a one-stop prime shop without offering a complete parcel and there are only two routes to that – you build or you buy. The Goldman Sachs approach has been to buy it, and we’re already starting to see more big tradfi names aligning themselves with specialist firms, either through acquisitions, licensing agreements etc. One of the roles of a prime brokerage is to be a rock to stand steadfast in turbulent times, and in times like these, balance sheet is important.” 

Zarya, however, disagreed. “Balance sheet is important, but it’s not everything. It’s all optics. What happened to Credit Suisse? To Lehman Brothers?” 

Disruption 

The concern appears to be avoiding a simple copy and paste of what is being done in the traditional world of finance. “Early adopters went into crypto because they were passionate about decentralisation,” stressed Vujinovic. “Now, we’re just trying to cram that back into a centralised model again. But I think technology is going to evolve to a point where it disrupts that. Yes the tools, the picks and shovels at the coal face, are being acquired by bigger institutions. But banks will end up just being software-as-a-service platforms. They’ll offload crypto custody, just like they do KYC. We’re in a place now where we have to change it up, think outside the box and create a different system that works better – not just do the same old thing, just because Goldman Sachs are doing it.” 

Carlton, however, pointed out that acquisitions could also work the other way – with big crypto firms buying smaller banks in order to bring in regulated capabilities.  

Centralisation 

“We need to get capital into the crypto markets, and the way to do that is by creating a market infrastructure model that replicates the prime model, with centralisation of clearing and risk, but with the nuance of a hybrid model using DLT and smart contract applications. That’s the way we’ll see the tide move,” he said. “Would a full belt and braces prime brokerage in the crypto market help right now? Yes. Would it increase investor confidence and make the market more efficient? Yes. I think that prime brokerage services have a key role to play in moving this forward.” 

The biggest issue in the space, however, remains the problem of pre-funding. Right now, most of the liquidity in the crypto space is on centralised exchanges, and these require pre-funding, which all the panellists agreed was not efficient.  

In addition: “The netting side of things doesn’t exist yet in crypto, and that needs to change,” pointed out Zadeh. “For example, let’s say you have two exchanges: Binance and FTX. If you’re Hedge Fund A trading $100 million on Binance long, and $100 million on FTX short, if you had a prime broker in between, he would require minimal margin from you. Whereas currently in the crypto space, it’s different, because of pre-funding. You would have to have $200 million at both exchanges. Obviously, you’d have a prime broker in between leveraging you, but that funding would be on those exchanges.

“The only way I can see that potentially changing in the future is regulation as the first step; then after regulation the real money clients will come in, the banks will then come in, and then a big player – a Citibank or a JP Morgan, with a ginormous balance sheet that dwarfs the exchanges, that could PB, and net across all of the exchanges, and then all of the institutional counterparties (the big real money clients that have trillions under management) can really start to trade crypto full pelt.” 

But will institutional traders ever come in at full pelt? 

“We have certainly seen a shift with institutional traders coming into the space, but we still run on retail rails,” said Zarya.  

Evolution 

The move, for institutional involvement, is likely to be accompanied by a shift from on-exchange to OTC trading – similar to the trajectory in the FX markets a few years back. “Electronification, going from hi-touch voice-driven trading to an API, FIX-driven market – we are seeing the same trends apply,” agreed Carlton.  

“Retail flow lends itself to exchanges, but institutional flow sits a lot more happily on the OTC markets. When the barriers are removed to allow true institutions to enter the market, I’m not saying the exchanges will become defunct, but they will probably continue to service retail clients while institutional flow will direct more to the OTC space.” 

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With household names like Uber, eBay, PayPal, Visa, Spotify and MasterCard backing the project (and not a single bank in sight), Facebook’s foray potentially signals another nail in the coffin for the traditional banking industry.

For investors, both retail and institutional, that have embraced the world of digital assets, Libra has been touted as the means by which cryptocurrencies could be brought to the masses – 2.7 billion people to be precise. Bitcoin’s price surged to highs not seen in over a year following Facebook’s announcement, but questions from central bankers, regulators and other more traditional financial institutions may have cast some doubt on the potential impact of Libra.

First and foremost, what is Libra? Facebook’s whitepaper on Libra states that the digital currency will be built on a secure blockchain, backed by a reserve of assets, and governed by the Libra Association, the network of technology giants working alongside Facebook. The assets backing each Libra coin, according to the whitepaper, will be a collection of low-volatility assets including bank deposits and government securities, and the money for the reserve will come from investors in a separate investment token, as well as the users of Libra.

So, Libra differs greatly from the flagship cryptocurrency Bitcoin, which has no reserve and is not backed by any asset or currency (its value is derived from the belief that it has value). With this in mind, the Libra coin should fall into another category – stable coins or asset-backed tokens.

Alongside this uncertainty, questions have arisen as to where it will sit in the current financial and regulatory ecosystem, particularly in Europe and the US. But Libra’s launch could force regulators, who have already expressed concerns that Facebook’s coin might replace fiat currencies, in turn instigating mass financial instability, to seriously address the seemingly unstoppable rise of digital currencies.

As for the traditional banks, as most often is the case, they have been left behind. If Libra takes off without mass regulatory interference, what role does the bank play in the future? One indicator we can surely take from the Libra proposal, developed by a network of technology giants that have already collectively succeeded in changing the world we live in over the past decade, is that cryptocurrencies are here to stay.

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Cryptocurrency exchange Gemini, established by brothers Cameron and Tyler Winklevoss who are both renowned for having become two of the first Bitcoin billionaires in the world, put forward the proposal to launch the Bitcoin ETF which would be listed and traded on Cboe Global Markets.

Gemini and Cboe made the application in June 2016, but the proposal was rejected in March 2017 with the crypto exchange then seeking authorities to review.

The Securities and Exchange Commission (SEC) said that Gemini’s ‘traditional means’ of identifying and deterring fraud were not sufficient enough to meet the regulator’s requirements for launching the ETF. 

It added that traditional ETF proposals include measures to prevent fraud through surveillance sharing information agreements, but Gemini and Cboe had not entered into such an agreement.

“The Commission concludes that – unlike the listing exchanges for previously approved commodity-trust [ETFs] – [Cboe] has not established that it has entered into, or currently could enter into, a surveillance-sharing agreement with a regulated market of significant size related to Bitcoin,” said the SEC.

Supporters of the Bitcoin ETF argued that substantial liquidity provided by the over-the-counter (OTC) market can absorb liquidity shocks and resist manipulative activity, but the SEC countered that this theory is not supported by any data on record and raised concerns around Bitcoin’s spot market.

“Bitcoin markets are still evolving in significant ways,” the SEC said. “And because there is no comprehensive data source reflecting Bitcoin trading, it is not currently possible to state with confidence what share of volume any particular spot trading venue has captured or will capture.

“Bitcoin trading activity is dispersed across markets and OTC transactions worldwide, and there is no centralised, regulatory data source for Bitcoin trading statistics.”

The SEC has shut down several attempts from exchanges to launch a Bitcoin ETF. In January, the regulator cited similar concerns around the cryptocurrency’s susceptibility to manipulation, as well as with its valuation and market volatility. 

VanEck SolidX Bitcoin Trust, which has previously had two applications to have its Bitcoin shares listed as ETFs rejected, has another Bitcoin ETF proposal with the SEC. This is another product Cboe would intend to list.

A decision on the approval is set to be announced in September, but the authority’s latest rejection makes this bid look more unlikely.

“Although the Commission is disapproving this proposed rule change, the Commission emphasises that its disapproval does not rest on an evaluation of whether bitcoin, or blockchain technology more generally, has utility or value as an innovation or an investment,” the SEC concluded.

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Digital currency trading firm trueDigital was launched by Sunil Hirani, a capital markets veteran most recently known for founding swaps execution facility trueEx, a platform which took on some of the major players in the OTC derivatives world.

The rates can serve as an underlying reference for futures contracts, as the trend from firms looking to provide institutional-grade products continues.

The trueDigital reference rates, comprised of bid and offer pricing from top cryptocurrency market makers, include automated anti-manipulation safeguards such as outlier detection and price banding.

While reference rates such as Libor have gone through scandals in recent years, trueDigital said it has robust policies to “surveil potential manipulation and review the contributing sources on an ongoing basis in line with the IOSCO based methodology”.

“The digital asset market is still young, especially for financial institutions,” said Michael Moro of Genesis Global Trading. “trueDigital is methodically building the components needed to evolve this ecosystem and make it habitable for firms seeking exposure to digital assets. OTC indices are the next leap forward in the maturation of the market.”

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The report says that while the FSB does not consider crypto-asset markets to pose material risk of global financial stability, “supported vigilant monitoring in light of the speed of developments and data gaps” is necessary nonetheless.

In collaboration with the Committee on Payments and Market Infrastructures (CPMI), the FSB framework focuses on the transmission channels from crypto-asset markets.

“The objective of the framework is to identify any emerging financial stability concerns in a timely manner,” the FSB says in its report. “To this end, it includes risk metrics that are most likely to highlight such risks, using data from public sources where available. Supervisory data pertaining to crypto-assets are potentially more reliable and could complement data from public sources.”

The FSB’s framework includes a number of risk metrics that could impact financial stability, including trading volumes, pricing, clearing and margining for crypto-asset derivatives, as well as harder to measure metric such as confidence in the markets and the use of crypto-asset markets for payment or settlement.

However, the FSB also notes the complications of analysing crypto-asset market data, such as the lack of transparency concerning Initial Coin Offerings (ICOIs), unreliable data sources and the fragmented nature of crypto-asset markets.

“The crypto-asset market is rapidly evolving, as are public data sources. The treatment and characterisation of crypto-assets may vary across jurisdictions or may not yet have been clarified. Given that the proposed monitoring metrics are mainly based on public data, it should be stressed that the quality of the underlying data can vary, and might not always be satisfactory.”

The role of central banks will also play a pivotal role in the development of global crypto-asset markets, and the report recognises that central banks are currently reviewing the use of new technologies that underpin the use of digital currencies and central bank operated payment systems.

“However, responding directly to the challenge with a central bank digital currency (CBDC) would be an entry into uncharted territory,” the report concludes.

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CME Group saw a spike in Bitcoin futures trading activity last Thursday as daily volumes continue to rise on the Chicago exchange and its rival Cboe.

The exchanges both topped their average daily volumes (ADV) the day after Independence Day, with CME logging a high of 6,739 and Cboe registering 6,121 trades.

Cboe’s record day of activity remains 25 April when 19,000 contracts were traded. It has also topped the 10,000 contract mark in 14 sessions, according to market data.

Over the year Cboe has had higher ADV with around 5,820 contracts, compared to CME’s 2,600. CME said it’s volumes had risen 150% since the end of December 2017.

“We’ve seen a consistently narrow basis between bitcoin futures and the cash market, which demonstrates efficient price discovery,” said a CME spokesperson to The TRADE Crypto. “We’re also seeing open interest in all four expiries.”

This news comes as Bitcoin has experienced significant drop in value since the end of 2017 when the first futures contracts were launched. In early December, news of CME’s launch only pushed the price higher at the time. CME also reported that there is growing interest from institutional investors.

“Although this is still a relatively new market, participation is growing every day across a broad range of customer segments, including institutional investors.”

Industry participants have confirmed this supposed interest from the buy-side. Tim Pickering, lead portfolio manager at Auspice Capital stated: “Institutional investors are slowly and carefully taking to these new products with liquidity and safety of capital being the biggest concerns.”

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Robert Cornish has been appointed Gemini’s first-ever chief technology officer after spending just over a year at NYSE leading the exchange’s technology team. He previously worked at the International Securities Exchange (ISE) in various senior roles including chief information officer and chief information security officer.

On top of overseeing the exchange’s technology team, Cornish will immediately lead the deployment of Nasdaq’s SMARTS Market Surveillance technology to allow Gemini to monitor all order books and auctions which determine the settlement price of Bitcoin Futures on Cboe Futures Exchange. 

Cornish is globally recognised for his ability to lead engineering teams, according to Gemini’s CEO and Bitcoin advocator Tyler Winklevoss, with extensive expertise in exchange and matching-engine architecture.

“Rob is a tremendous addition to our team,” Winklevoss added. “He will ensure that Gemini continues to deliver the best platform experience to our customers as possible and set the standards of excellence for the cryptocurrency industry as a whole.”

Gemini has seen significant growth over the past year and it recently become the first licensed exchange for cryptocurrencies Zcash, Bitcoin cash and Litecoin.

Approval from the from the New York State Department of Financial Services (NYDFS) means the exchange can offer trading and custody of Zcash, Bitcoin Cash and Litecoin, which is expected to rolled out in the coming months.

Gemini was established in 2014 by brothers Cameron and Tyler Winklevoss who are both renowned for having become two of the first Bitcoin billionaires in the world.

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The MarketPsych indices will use machine learning and text analysis to quantify themes and sentiments which could influence price trends and movements of cryptocurrencies.

Following the addition of Bitcoin sentiment data in March, Thomson Reuters said it has now launched Thomson Reuters MarketPsych Indices (TRMI) 3.1 to monitor more than 2,000 global news and social media sites in real-time for the top 100 digital cryptocurrencies.

“Adding a cryptocurrency-focused sentiment feed to our suite of cross-asset solutions has therefore enabled us to provide our customers with invaluable insights that may help them make strategic investment decisions,” said Pradeep Menon, global head of investing and advisory at Thomson Reuters.

A survey published by the firm in April found that around 20% of financial institutions are considering trading cryptocurrencies over the next three to 12 months.

“The Thomson Reuters cryptocurrency survey revealed a shift in the market, with cryptocurrencies gaining some mainstream acceptance and financial institutions looking to start trading them over the coming months,” Menon added.

Thomson Reuters also introduced cryptocurrency trading through its REDI execution management system (EMS) earlier this year, allowing users to trade Cboe and CME Bitcoin futures with price discovery and charting functions.

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