Market Manipulation: A Cardinal Issue of the Exchange Ecosystem
A lack of regulation and transparency in the digital asset sphere has been cited as deterrent for institutional adoption of crypto, but this reticence is now receding with the emergence of trusted next-generation exchanges that place market integrity at their core.
Recurrent scandals and glaring market manipulation among digital asset exchanges has eroded trust in the industry and stymied institutional flow. A recent survey of 774 institutional investment houses found that concerns about market manipulation were cited as the most consequential obstacles by firms still hesitant to participate in the asset class.
Market Washing and Inflated Trading Volume Reporting
Many prevailing digital asset exchanges have avoided trade level data reporting, while others have been persistently involved in scandals over false volumes and trading anomalies. Such opacity is associated with ‘wash trading’, a form of market manipulation in which an investor simultaneously sells and buys the same financial instruments with the express purpose of creating misleading activity. This creates artificial volume and deceptively suggests higher levels of liquidity, which is then leveraged by exchange players to attract customers. While these conditions have bridled institutional participation in the asset class, many emerging market leaders are taking a stance of “ultra-compliance” and are forthcoming with data reporting in the appropriate granularity.
Suspected market washing among popular retail exchanges is, however, not the only transparency issue that has precipitated traditional investor discomfort — the industry is also plagued by market making conflicts of interest.
Market Making Exchanges
As in conventional securities trading, market makers in the digital asset sector drive liquidity provision by simultaneously placing two-side quotes — the price they are willing to sell at, and the price they are willing to buy at. Market makers respond to market demand for particular instruments, fulfilling orders as they are placed upon the order book and earning a margin for the same. Their activity is intended to decrease transaction costs for exchange users and allow them to trade with relative immediacy.
Market making was once commonly carried out by banks using client funds, but as regulations tightened, they moved out of this space, which has since been dominated by proprietary traders (traders using their own capital, including high frequency traders). Traditional securities exchanges offer special trading rates to attract independent market makers that comply with certain requirements intended to inhibit scope for abuse — rules such as delineated maximum bid-ask spreads, minimum times for two-sided quotes to be present in the order book, and minimum sizes for two-sided quotes.
Many incumbent players continue to act in a dual capacity as market makers, often using investor funds to trade. This creates market dominance — offering them ripe opportunity to manipulate market conditions in such a way that allows them to enjoy outsized margins. Corporate investors are wise to such manipulative tactics and favor dedicated exchange-only offerings, which provide them greater comfort in the integrity of their exchange partner.
Sophisticated investors are aware of the risks inherent in exchanges located in obscure jurisdictions with an unwillingness to disclose verifiable solvency reporting, as well as scandals involving asset co-mingling and fraud at some well-known exchanges. Given the large notional sums that institutional investors are trading and safeguarding on behalf of their clients, it is their fiduciary responsibility to ensure that exchanges with whom they trade can provide audited proof of solvency, historical trade level data, live order books, and End of Day and End of Month (EOD & EOM) Reporting — meeting the levels of standards that they are accustomed to in conventional securities markets.
Enhancing Market Integrity
Although the history of digital asset trading is peppered with controversies, the new market leaders are working to deliver greater trust, transparency, and security, engendering greater confidence in the investibility of the digital asset class for institutional players. These next-generation exchanges operate with formal market manipulation policies and are taking proactive steps to detect and prevent market abuse — leveraging advanced market surveillance technology to build protective frameworks for monitoring and investigating suspicious trading practices such as layering.
Furthermore, these emerging platforms are actively publishing proof of solvency and trading volume reporting, as well as offering segregated custody and supporting independent market making across their platforms, which is markedly improving investor confidence in the sector. While it may have been profitable for exchanges to engage in market dominating behaviors to capture margin in the industry’s formative years, as the sector matures, players exploiting such tactics are being weeded out. It is now recognized that there is greater capital to be earned from espousing transparent practices, reporting accurately and openly, operating under stringent compliance frameworks, and building trust for a new tide of investor participation.
EQUOS is committed to creating a more transparent ecosystem for digital asset investing, with the same levels of investor assurance that exist in conventional securities markets. To learn more visit: www.equos.io
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