As part of its Virtual Markets Integrity Initiative, on September 18, 2018, the New York Attorney General’s Office issued a report reviewing the platforms of various cryptocurrency exchanges. The initiative arose from the recognition that online virtual currency exchanges perform functions markedly similar to traditional stock exchanges and broker-dealers, but are generally not registered under state or federal securities or commodities laws and often have not implemented standards designed to protect investors.
The report details factual findings resulting from responses provided by 9 major trading cryptocurrency platforms in response to questionnaires issued by the Attorney General’s Office. While the report characterizes participation in the fact-finding inquiry as “voluntary”, the four trading platforms that declined to participate (claiming that they did not allow trading from New York) were referred to the New York Department of Financial Services for potential violation of virtual currency regulations.
The report is broken down into five sections, addressing the following topics:
1. Location and access policies of each platform
1. Where is the platform headquartered?
2. How do customers sign up for the platform?
3. Does the platform accept fiat currency?
4. What are the fee structures?
2. Trading policies and market fairness
1. What trading rules are in place?
2. What protections are there to ensure fairness for retail investors?
3. Availability of margin trading?
4. Policies on automated or algorithmic trading?
3. Managing conflicts of interest
1. What conflicts may arise between trading platforms, their employees and customers?
4. Security, insurance and protecting customer funds
1. Is independent auditing of holdings performed?
2. Security testing of platforms?
3. Insurance available to safeguard customer funds?
5. Access to customer funds, suspensions and outages
1. Policies regarding customer transactions and withdrawals?
2. Policies for suspending trading activity?
3. Notification to customers of outages and system maintenance?
Based on the responses provided by the nine participating platforms, the report details the following key findings:
1. There are significant potential conflicts of interest between various business lines of operational roles of trading platforms
1. In certain situations, platforms serve as: (i) venues of exchange, (ii) in a role traditional to traditional broker-dealers, representing traders and executing trades on their behalf, (iii) as money-transmitters, transferring virtual and fiat currency and converting it from one form to another, (iv) as proprietary traders, buying and selling for their own accounts, (v) as owners of large virtual currency holdings, and (vi) as issuers of virtual currency, with a direct stake in its performance.
2. Additionally, platform employees, who often trade on their own, have access to significant non-public information regarding customer accounts and trades.
2. Platforms have not implemented serious efforts to impede abusive trading activity
1. Platforms lack capabilities to identify and stop suspicious trading patterns
2. Concentration of virtual currency in hands of relatively small number of major traders leaves platforms susceptible to abuse
3. Protections for customer funds are limited or illusory
1. Generally accepted methods for auditing virtual assets do not exist
2. Difficult or impossible to independently audit virtual currency purportedly in their possession
3. Customers are highly exposed in the event of a hack or unauthorized withdrawal
4. No deposit insurance for virtual currency losses
5. Serious questions about scope and sufficiency of commercial insurance that certain platforms purport to carry to cover virtual asset losses
The report concludes in recommending that customers considering trading on cryptocurrency trading platforms ask the following questions:
What security measures are in place to stop hackers from unlawfully accessing the platform or particular customer accounts?
What insurance 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 does 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?