Insight – No, crypto exchanges are not like stock exchanges

US Securities and Exchange Commission (SEC) chair Gary Gensler (pic) has released a video explaining how the agency will regulate cryptocurrency trading platforms.

He lays out some sensible goals, but the proposals would prevent them from ever being reached.

Gensler is concerned about market manipulation, spoofing, front-running, phantom liquidity (orders that will be canceled before they can ever be executed), shadow liquidity (people willing to transact who will not expose their willingness in public orders), flash crashes and other ills.

He said the New York Stock Exchange does a good job on these points thanks to SEC regulation, so those regulations should be ported to crypto exchanges. Retail investors should have access to exchanges free from those problems.

But Gensler’s stated extension is that alternative exchanges should be outlawed. Most people want regulation to give people the ability to trade safely, but only “nanny staters” want regulations to prevent people willing to take chances from trying new things.

US Sec Gary GenslerUS Sec Gary Gensler

Crypto initially developed from dissatisfaction with regulated markets during the 2008 financial crisis.

Crypto exchanges introduced exciting ways to prevent Gensler’s problems naturally, without the need for detailed regulations and enforcement actions. These may not live up to their promises, but the experiment will at least produce useful insights for future progress.

While some of these ideas have been lightly tested in traditional markets, crypto offers faster and larger-scale implementation, in an arena where investors know they must protect themselves.

Gensler says regulation should be “technology-neutral.” But consider his assertion that electric cars should have the same seat-belt requirements as conventional cars.

Those reasonable-sounding words hide a stifling reality. There isn’t a single federal law stating: “Cars should have seat belts.”

There’s a huge quantity of regulations. One minor example is CFR-571.209, which defines seat belts in 10,000 words spread over 23 pages with detailed engineering diagrams.

Much of it assumes conventional vehicles and cannot be applied easily to alternative personal-transportation ideas, whether they be electric cars or “Star Trek” transporter beams.

Add up all seat-belt rules and regulations, including those from US states and foreign countries, plus all the other automobile regulations, and you have more pages than an engineer with a new idea for personal transportation could read in a working career, much less have time to design something consistent with all of them.

The right approach is for the engineer to produce the best design possible, and then check if it needs additional safety features.

Similarly, the SEC should look at actual problems from crypto exchanges and offer technology-specific solutions. That may mean importing from traditional financial markets, but it may require new approaches.

Traditional limit-order books like those maintained by the New York Stock Exchange (NYSE) have come under intense criticism in the last decade, including from Gensler.

In crypto, automated market makers (AMMs) are a fast-growing alternative to limit order books as the NYSE and many other exchanges use. Gensler rules AMMs out because they transact directly with the customer rather than matching buyers and sellers.

AMM customers execute immediately at posted prices, so there is no phantom liquidity and no one can spoof. Manipulation mathematically always loses money. There’s no front-running because orders are only exposed after execution. Flash crashes can’t occur.

No doubt problems will be discovered, but the crypto world has proven adept at making fixes and SEC lawyers will not speed nor improve that process. AMMs have disadvantages, such as no public exposure of liquidity interest.

But shutting them down due to a blanket prohibition on platforms that mix exchange services with direct buying and selling will close off a promising area of exploration.

Frequent batch auctions (FBAs) are a different approach to trading. Gensler has supported FBAs for retail stock trading, and they have been used in some traditional markets.

Rather than execute every time a bidder offers to pay a price a seller is willing to accept, all orders are batched and executed simultaneously at a single price.

This eliminates the problem of shadow liquidity and rules out spoofing, short-term manipulation, flash crashes, front-running and high-frequency trading games.

A trade-off is prices are updated only once per batch, not once per trade, but those revealed prices are more solid than individual transactions.

One of the most exciting crypto innovations goes by the scary name of “homomorphic encrypted orders”. Instead of sending an order anyone can read to your broker or an exchange, you first encrypt it so no one – not even the recipient – can know what it says. A computer algorithm can match up transactions without knowing what those transactions are, nor who made them.

From your point of view, a smart contract changes what you sold into what you bought and no one – not the exchange, not anyone who intercepted any messages, not the person on the other side of the trade – can know what you did. Only aggregated transactions are made public, giving price information to the market.

While this obviously raises money-laundering and insider-trading concerns – which can be addressed – it has enormous potential advantages.

People are incented to reveal their entire interests since that information will never be known to anyone else. There’s no value to games like spoofing, manipulating or high-frequency trading. No one can front-run, because no one sees the trade even after it executes.

Some of these innovations have been tried on small scales with traditional assets. But only in crypto are we getting full-scale tests of these and other innovations. After a period of evolution, I have no doubt that some of them will prove so useful that all financial markets will move to them.

This is a much more promising solution to ancient problems of exchanges than a few more SEC regulations on top of what we already have. Gensler’s determination to force crypto exchanges to look like the NYSE is in no one’s interest. — Bloomberg

Aaron Brown is a former managing director and head of financial market research at AQR Capital Management. The views expressed here are the writer’s own.

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