The rapid pace of change in the digital asset market shows no sign of letting up, according to a November study by industry analysts CryptoCompare.
The London insights firm’s Q3 2019 report reveals an industry hyper-focused on adding more investor services comparable with mainstream equity exchanges. For example, ten percent more trading venues are now offering leveraged margin trading.
There is still plenty of room for institutional-grade infrastructure to grow, the report found, with only seven percent offering superior architecture via a FIX connection, which standardizes data as part of securities transactions.
But the document reveals that most exchanges are falling behind when it comes to protecting investors. Just four percent of the 160 trading venues surveyed had a formally approved cybersecurity certification. Almost one in ten scored poorly on their SSL rating, which indicates a critical flaw in their browser security protocols.
And only a tiny proportion, around eight percent, use external custody services to secure investor funds.
This point is particularly concerning given the frequent scandals dogging the industry over failed exchanges. Receivers investigating the 2018 collapse of New Zealand’s Cryptopia exchange, for example, discovered that the venue had failed to separate client funds into individual wallets. When the exchange went bust, investors were left with nothing.
More recently, the Vancouver-based Einstein exchange was seized by Canada’s securities regulator when it announced plans to close on 31 October, owing investors more than $12m. Investigators then discovered the exchange had less than $34,000 left on its books.
A question of trust
The grave issues that prompted CryptoCompare’s initial report in Q2 2019 are still failing to be addressed.
CryptoCompare’s first Exchange Benchmark report in June came in the wake of Bitwise’s much-discussed presentation to the SEC on the state of the cryptocurrency market.
Bitwise had told US regulators in May 2019 that illegal practices such as spoofing and wash trading were contributing to vast over-reporting of trading volumes. Instead of the widely-reported weekly volume of $6bn, the real size of the market was more like $237m, with an estimated 95% of all trading volume suspect or outright faked.
In the six months since that report, “it is far from clear that the market dynamics that prompted these concerns have substantially improved,” said CryptoCompare.
Trapping the unwary
Trading volume is still being faked by suspect exchanges, CryptoCompare found.
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“Volume and liquidity can easily be manipulated, researchers wrote, “and any untrusted exchange can provide data.”
Unscrupulous exchanges can incentivize trading activity through airdrops, trading competitions, or transaction-fee mining, where exchanges hand fees back to traders in the form of native tokens.
The unwary investor should take particular notice of:
- Whether they can trust the data reported by the exchange
- Whether the exchange is potentially engaging in market manipulation
- Whether funds are secured and insured
- What the quality of the exchange’s programming and API are
“Choosing the best exchange should not be based on the trading volume but the quality and trust in the services of the exchange,” Cryptocompare recommends.
Best of the best
A handful of exchanges are rising to the top of what remains a “typically opaque and abstruse marketplace,” CryptoCompare said.
Just three of the 160 exchanges analyzed were given the best ‘AA’ rating: New York-based ItBit and Gemini, and the San Francisco-headquartered Coinbase. The second-tier ‘A’ rated group includes Kraken, Bitstamp, Poloniex, OKEX, and Binance.
The greatest weights in the ranking are devoted to regulation, security, and data provision, followed by the quality of the team behind the exchange.
Only 12 percent of exchanges use an external on-chain transaction monitoring provider, 44 percent impose strict ID verification requirements on users, and 29 percent are registered as a Money Services Business or possess a crypto exchange license.
Two percent of the exchanges surveyed had been hacked in the past 12 months, the team found, and only 14 percent stored the majority of user funds in offline cold wallets.
Steps are being taken to reduce investor risk, with 94 percent now offering two-factor authentication, but there is much more to be done on the cybersecurity side, with only six percent of exchanges possessing an industry-standard ISO 27001 or SOC2 certificate.
Finding the right venue
Volume should not be investors’ first metric in choosing which exchange to use, because lower-tier exchanges with substandard security or inadequate regulatory standards make up 67 percent of trading volume across the market, the report concludes.
Traders have a difficult choice when deciding which digital asset exchange will best meet their needs, but quality will win out in the end.
Maxim Bederov is a serial entrepreneur, venture capitalist, and blockchain technology expert.