Cryptocurrencies are an exciting new market and they are developing in real-time, right before our very eyes. Borne from the world of technology rather than the realm of finance, they understandably lack most of the features and functions that are taken for granted in traditional financial markets. Many of these shortcomings have been examined – and often exaggerated – in the press but these items distract from the bigger story that cryptocurrencies have weathered the storm in the 10 years since bitcoin was conceived and they now seem poised to make a bid at entering the financial mainstream as the likes of Fidelity Investments, TD Ameritrade and Northern Trust are taking steps to offering cryptocurrency trading and custody to their customers. And yet, the regulation of trading in cryptocurrencies leaves more than a little to be desired. Entities that are referred to as “exchanges” in the cryptocurrency world often bear little or no resemblance to the regulated equity, options, or futures exchanges that comprise the infrastructure of existing financial markets and regulation of these products and markets is currently underdeveloped, at best. Recently, the SEC charged an ICO platform for running an unregistered exchange and further such action is likely. In this environment, we think it wise to take a step back and evaluate the opportunity at hand based upon experience and make a determination as to the best way to evaluate and pursue opportunities in trading cryptocurrencies.
We believe the current US equity market structure is a great analog to the emerging exchange space in cryptos, particularly with regard to the extreme fragmentation that exists in both markets. In US equities, the number of venues where you can trade the very same 100 shares of IBM are somewhere around 50, with ⅔ of the volume trading on the “protected” venues and the other third on alternative trading systems (ATSs). Within the ATS space, volume is concentrated on the top 10 venues. The crypto market is very similar: while there approximately 4x as many exchanges, the real concentration of volume and liquidity can be found in the top 10 or so venues.
In this light, we believe that the principles that inform the rules that guide trading in U.S. equity markets, specifically, the principles that underlie SEC Regulation ATS are particularly relevant when looking to evaluate and build best practices in compliance and surveillance of cryptocurrency markets. The principles that underlie Reg ATS were borne from real-world market experience and history. It is likely that these same principles will be applied as the regulation of cryptocurrency trading is quantified and developed. For this reason, we believe it would be wise to heed the examples of Reg ATS and apply them to crypto trading activities.
Reg ATS has a number of components to it and we take a look at the specifics and how they apply to crypto markets in our new white paper, An Approach to Crypto Regulation: Follow the Reg ATS Road.