Regulate Me!

Generally, an abundance of adventurism can be found in any new market, or for any new technology. Mobile phones, the Internet, social media, and big data are all common and current catch phrases that capture the energy of investors. An element of investing is perhaps better known as speculating, deploying capital in search of huge returns based on unproven or untested theories. A speculator may predict an unlikely event, betting that a government will ban the internet, boosting a technology manufacturer who provides the government with devices to do so. The bet is unlikely to pay off, so the returns can be huge. But where can a speculator place a massive bet on questionable technology and keep his theory semi-secret? Well, lately, on an unregulated cryptocurrency exchange.

The danger posed by unregulated exchanges are many. The risk of fraud through trade manipulation, absence of legal requirements like KYC/AML practices, and outright thievery called an “exit scam” in the bitcoin ecosystem are endemic and occur so frequently that their risk is seemingly accepted by bitcoin believers. There are no good answers on the horizon for bitcoin and cryptocurrency users, and though many choose to avoid government involvement for personal or criminal reasons, achieving the world-altering goals they often espouse will be difficult without mainstream adoption. Such adoption is unlikely to occur as long as there is a distinct lack of regulation, and a corresponding increase in risk to users and traders.

Regulation aimed at order books, specifically for platforms that offer stock or commodity exchange services, is often focused on maintaining competing interests. This means the operator of a stock exchange should make their profit on facilitating quality trading, rather than the value of assets traded or participating in trading. Similarly, users can expect an order book that is audited, fair, and competitive. As an example, consider a trader with a short position on an asset, leveraged sufficiently so that if the asset hits $100, the short will be liquidated. In a regulated market, the market maker does not gain if the position is liquidated. Fees can be associated with trades, monthly membership fees, dollar amounts, or other independent factors. On cryptocurrency exchanges, the market maker keeps the profit from a liquidated position. This means the exchange has a rational profit motive to manipulate prices up or down, keeping the profit from legitimate traders.

In addition to this massive risk, traders face the potential for catastrophic scams or failures. No less than the SEC itself has warned about unregulated exchanges and the potential for disaster. As business professionals, especially investors, look for returns in cryptocurrency, the common thread in their written reports is about systemic risk and lack of safeguards. For professionals, this lack of confidence in the digital asset ecosystem will lead to avoidance. For amateurs, the irrational exuberance of previous bubbles seems like a good comparison to today’s bitcoin-driven bubble. Eventually it will pop, and those left holding the bag will have little recourse. While some exchanges have attempted to self-regulate to some extent, few are actively pursuing any kind of transparent order book.

While profiting from digital assets, especially bitcoin, continues to drive many believers to use services like exchanges, the risk they run from simply using these services is immense. Coupled with the price volatility common to the cryptocurrency ecosystem, and an outsider looking to buy becomes a speculator rather than an investor. This distinction may seem semantic, but speaks to the heart of the issue that digital assets face in becoming mainstream. Investors want risk proportional to returns, or roughly so. Bitcoin, and exchanges specifically, do not offer this. As an asset, bitcoin and cryptocurrencies are still trying to get the recipe right. Unregulated exchanges are not helping.

Image credit – Helperdz  (CC BY-SA 4.0)