No, Crypto Exchanges Are Not Like Stock Exchanges
Retail investors should have access to exchanges free of these problems. But Gensler’s stated extension is that alternative exchanges should be banned. Most people want regulation to give people the ability to trade safely, but only nanny staters want regulation to prevent risk-takers from trying new things.
Crypto originally grew out of a dissatisfaction with regulated markets during the 2008 financial crisis. Crypto exchanges introduced exciting ways to forestall Gensler issues naturally, without the need for detailed regulations and enforcement measures. These may not live up to their promises, but the experiment will at least yield useful information for future progress. While some of these ideas have been lightly tested in traditional markets, crypto offers faster and larger-scale implementation, in an area where investors know they need to protect themselves.
Gensler says regulation should be “technology neutral.” But consider his claim that electric cars should have the same seat belt requirements as conventional cars. These reasonable-sounding words hide a stifling reality. There isn’t a single federal law that says, “Cars should have seat belts.” There is a huge amount of regulations. A minor example is CFR-571.209, which defines seat belts in 10,000 words spread over 23 pages with detailed technical diagrams. Much of it assumes conventional vehicles and cannot easily be applied to alternative personal transportation ideas, whether electric cars or Star Trek transport bundles.
Add up all the seat belt rules and regulations, including those of U.S. states and foreign countries, plus all other automotive regulations, and you have more pages than an engineer with a new personal transportation idea could read. in a professional career, let alone have the time to design something consistent with all of them. The right approach is for the engineer to produce the best possible design and then check if it needs any additional safety features.
Likewise, the SEC should examine the real problems of crypto exchanges and offer technology-specific solutions. This may mean importing from traditional financial markets, but it may require new approaches.
Traditional limit order books like those maintained by the NYSE have come under heavy criticism over the past decade, including from Gensler. In crypto, automated market makers (AMMs) are a fast-growing alternative to “limited order books” (LOBs) like the NYSE and many other exchanges use. Gensler excludes AMMs because they deal directly with the customer rather than matching buyers and sellers.
AMM clients execute immediately at displayed prices, so there is no shadow liquidity and no one can usurp. Mathematically manipulation always loses money. There is no front-running because the orders are exposed only after execution. Flash crashes cannot occur. There is no doubt that problems will be uncovered, but the crypto world has proven adept at making fixes and SEC lawyers will not speed up or improve this process. MAs have drawbacks, such as the lack of public exposure of liquidity interests. But shutting them down due to a blanket ban on platforms that mix exchange services with direct buying and selling will shut down 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 executing each time a bidder offers to pay a price that a seller is willing to accept, all orders are grouped together and executed simultaneously at a single price. This eliminates the problem of phantom liquidity and rules out impersonation, short-term manipulation, flash crashes, front-run and high-frequency trading games. A compromise is that prices are only updated once per lot, not once per trade, but these revealed prices are more robust than individual trades.
One of the most exciting cryptographic innovations goes by the chilling name of “homomorphic crypto commands” (HEO). Instead of sending a command that anyone can read to your broker or an exchange, you first encrypt it so no one – not even the recipient – can find out what it says. A computer algorithm can match transactions without knowing what those transactions are or who made them. From your point of view, a smart contract turns what you sold into what you bought and no one – not the exchange, not whoever intercepted messages, not the person on the other side of the trade – can know what you have done. Only aggregated transactions are made public, giving market price information.
While this obviously raises issues of money laundering and insider trading – which can be addressed – it has huge potential benefits. People are encouraged to reveal their full interests since this information will never be known to anyone else. Games like impersonation, manipulation or high frequency trading have no value. No one can be on the forefront because no one sees the trade even after it is executed.
Some of these innovations have been experimented on a small scale with traditional assets. But it’s only in crypto that we get large-scale testing of these and other innovations. After a period of evolution, I have no doubt that some of them will turn out to be so useful that all financial markets will be heading towards them. This is a much more promising solution to old exchange problems 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.
More other writers at Bloomberg Opinion:
• Crypto’s Limp BlackRock response is clear: Jared Dillian
• Laser-Eyed Bitcoin King Blind at $1 billion loss: Lionel Laurent
• Crypto Bros has a plan to crack elite football: Trung Phan
This column does not necessarily reflect the opinion of the Editorial Board or of Bloomberg LP and its owners.
Aaron Brown is a former Managing Director and Head of Capital Markets Research at AQR Capital Management. He is the author of “The Poker Face of Wall Street”. He may have an interest in the areas he writes about.
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