Stadicus/OAG

## OAG
# Review of the "Virtual Markets Integrity Initiative" of the Office of the New York State Attorney General
## Mid-term assignment DFIN-522 by Roland Stadler, University of Nicosia


## Introduction
As one of the financial centers of the World, the State of New York has a defining role dealing with financial markets and its service providers. It is a leading player in creating legislation regarding consumer protection and prosecuting fraudulent market participants. The Office of the Attorney General (OAG) "is charged with the statutory and common law powers to protect consumers and investors" (1). As "People's Lawyer" it strives to protect customers of virtual currency platforms (exchanges) and to increase transparency by its "Virtual Market Integrity Initiative" report.

## Review of individual sections and key findings

### Section I: Jurisdiction, Acceptance of Currencies and Fees
Starting with the basics, like incorporation of exchanges and juristiction excluded, most questions are primairily of interest for regulators. Questions regarding measures taken to identify customers (KYC) and limit access for not authorized customers (e.g. detecting VPN usage) are mostly of regulatory interest. The OAG seems to establish juristictional relevance, but fails to address the fact that only six of fourteen exchanges questioned acutally serve customers in New York State, most likely due to the highly controversial BitLicense imposed in 2015. (2)

With questions relevant for customers (acceptance of fiat currency, fee structures), the report fails to go into specifics. Critizism of the "maker-taker" fee model, well-established on most exchanges, for distorting the overall trading environment seems very specific. While some researchers think it can create false incentives and distort price-finding mechanisms (3), this issue is not unique to virtual currencies and the SEC concludes that "maker-taker fee structures indirectly provide better prices to retail investors". (4)


### Section II: Trading Policies and Market Fairness
Virtual currency platforms provide direct access to powerful trading platforms, including functionality geared towards professional traders. The OAG sees this open access as problematic. This seems to be a clash of traditional and open-access business models. In my opionion there is room for platforms targeting different user groups: Coinbase has a intuitive interface useful for casual usage, while Coinbase Pro provides features useful for professional day trading. The real danger lies in the "everybody is a day-trader" mentality, without customers realizing they are simply gambling. (5) This danger is heightened exponentially by offering margin trading, which might by useful in slow-moving traditional markets, but is highly unpredictable in dynamic virtual currency markets.

The report is critical of automated access to data and trading functionality. While access to trading data is a necessity to calculate tax liabilities, the automation of trading itself is nothing new and can be benefitial in mature markets. Noting the lack of discrete policies on bot trading is correct, but fails to address the bigger issue: many of the tradable trading pairs (e.g. Monero/Bytecoin on Poloniex, an extrem example with trading volume of less than $200/day) have so little liquidity that large players can manipulate them at will. (6)

In light of how traditional business models involving privileged middlemen have been disrupted over the last decade, it is highly doubtful that these issue can be addressed by forcefully limiting access for consumers to legitimate trading platforms on a global scale.

#### Key Finding: Trading platforms have yet to implement serious efforts to impede abusive trading activity.
The report asks exchanges to take more active steps to monitor and stop suspicious trading patters, while not defining what these trading patterns are. Especially exchanges that provide a "crypto casino" service to customers have no incentive to stop this behaviour. This should be an ongoing task of proper regulatory oversight.

### Section III: Managing Conflicts of Interest
Conflicts of interest for exchanges are a reality and have the power to undermine honest business models. Listing fees are a major income for exchanges and have shaped the virtual currency space. New projects need to raise investor money for listings, otherwise no price appreciation can happen. Costs for listings can reach $3 million "for an opportunity to get quick liquidity" (7). This practice can incentivise listing the "long tail" of coins, without due diligence, real liquidity or customer demand, enabling ponzi (8) or pump and dump (9) schemes.

Insider trading is a serious issue, especially as prices usually soar on announcements of new listings. It is noteworthy that even on clear suspicion of insider activity, on exchanges under the supervision of the OAG, no official measures have been taken so far. A prime example is Coinbase's unannounced listing of Bitcoin Cash, causing heavy market turbulence and allegations of insider trading. Only an internal investigation was set up, unsurprisingly clearing the exchange and its employees from all wrongdoing. (10)

#### Key Finding: The various business lines and operational roles of trading platforms create potential conflicts of interest.
This issue is heavily understated and should be the prime area of regulatory supervision, as it can distort the whole modus operandi of exchanges against its customers.


### Section IV: Security, Insurance and Protecting Consumer Funds
Exchanges provide custody for customer funds. While fiat currency is usually kept in banking accounts, virtual currencies are managed by the exchange itself. Even mature companies like Fidelity recognize that "security solutions [...] continue to evolve" (11), meaning that these are among the best-kept secrets in the industry, hindering the evolution of industry best-practices.

Insuring virtual funds is difficult. "Only a few insurers sell such insurance. [...] The challenge is how to cover those risks for customers they know little about, who use technology few understand [...]." (12) This means that insurance solutions are still evolving and could be quite expensive due to missing competition.

The public nature of blockchains provides technological means to do publicly verifiable audits of custodial reserves. While most exchanges provide some sort of audit, whithout generally accepted auditing principles reliability varies. Kraken can be seen as a leading example in providing "proof-of-reserves" down to personal account level (13).

#### Key Findings: Protections for customer funds are often limited or illusory.
Funds should not be kept on exchanges longer than absolutely necessary. Exchanges with the demand for short-term availability of funds should currently be viewed as inherently unsafe and are not built as long-term custodians. It is to be expected that exchanges will over time use safe custody procedures, insurance and audits as a distinguishing selling proposition.


### Section V: Access to Customer Funds, Suspensions, and Outages.
Due to their public nature, exchanges are more exposed to disruptions than traditional, guarded systems. While outages can happen, customers should be made informed better what happens to pending trades.

One issue relevant for customers ignored in this report are the terms-of-service imposed by exchanges. There are many cases of account closures and frozen funds where no further information was provided. Exchanges also collect a lot of sensitive data and customers should be aware what happens with this data.


## Non-participation by trading platforms
The issuance of the BitLicense by the New York State Department of Finance (NYSDF) in 2015 was controversial, prompting virtual currency companies "to make a statement: rather than apply for the license, they left New York." (14) Neither Kraken, Binance, Gate.io nor Huobi serve customers in New York State (15, 16, 17, 18), and it is therefore highly questionable whether the OAG has any mandate to demand participation in this initiative, let alone instigating they may be operating illegally and referring several of them tot the NYSDF without providing additional details.

Jessie Powell, CEO of Kraken, "thinks the Attorney General’s report was good in that it highlighted important questions consumers should be asking exchanges. However, [...] calling out the exchanges who chose not to respond to the questionnaire unnecessary. 'After all,' he said, 'there are hundreds more exchanges which were never asked and are not named.'" (19) Later he was even more outspoken, tweeting "Somebody has to say what everybody's actually thinking about the NYAG's inquiry. The placative kowtowing toward this kind of abuse sends the message that it's ok. It's not ok. It's insulting." (20)

Kraken's official response was to "[...] object to the highly unprofessional/malicious implication that because we did not respond to the voluntary information request, we *might* be operating illegally. We told you we don't operate in NY. AG trying cases in court of public opinion now?" (21)


## Conclusion
The initiative is commendable, the questions asked are valid and demonstrate a good understanding of relevant challenges. The information provided in the report fall short of its goal, however, most is public information and could be compiled by every concerned citizen itself. In my opinion, the questionairre itself is the most interesting part.

I share the sentiment of Kraken that the OAG is overstepping its boundaries significantly. The report looks like an attempt to gain influence as a leading global regulator regarding virtual currency, with the OAG focussing more on public perception than actually taking effective measures. Seeking "voluntary participation" is not in line with calling out and warning the public of exchanges that "refused" to participate. There are many issues to be adressed, especially regarding conflicts of interests, but it is up to all proper regulators to work with the industry, define guiding principles and then act on them.


## References
## References


1) Website of the New York State Attorney General: Our Office
https://ag.ny.gov/our-office

2) Coindesk: Industry Reactions to New York’s BitLicense Proposal, https://www.coindesk.com/new-york-bitlicense-views-inside-bitcoin-industry

3) Investopedia: What Maker-Taker Fees Mean to You
https://www.investopedia.com/articles/active-trading/042414/what-makertaker-fees-mean-you.asp

4) SEC Memorandum: Maker-Taker Fees on Equities Exchanges, https://www.sec.gov/spotlight/emsac/memo-maker-taker-fees-on-equities-exchanges.pdf

5) Castle Craig Hospital: Cryptocurrency Trading: The Tale of the Modern-Day Casino
https://castlecraig.co.uk/blog/2018/07/11/cryptocurrency-trading-the-tale-of-the-modern-day-casino/

6) according to https://messari.io/asset/bytecoin#metrics, overall 24h volume for Bytecoin is $160'000, while the trading pair XMR/BCN on Poloniex had a daily volume in January 2016 below $200.

7) Bloomberg: Crypto Exchanges Charge Millions to List Tokens, Report Says, https://www.bloomberg.com/news/articles/2018-04-03/crypto-exchanges-charge-millions-to-list-tokens-autonomous-says

8) SEC, Ponzi Schemes Using Virtual Currencies, https://www.sec.gov/investor/alerts/ia_virtualcurrencies.pdf

9) The Outline, Inside the group chats where people pump and dump cryptocurrency, https://theoutline.com/post/3074/inside-the-group-chats-where-people-pump-and-dump-cryptocurrency

10) Fortune, Coinbase Finds No Insider Trading of Bitcoin Cash
http://fortune.com/2018/07/24/coinbase-insider-trading/

11) Fidelity Digital Assets, CUSTODY IN THE AGE OF DIGITAL ASSETS
https://www.fidelitydigitalassets.com/bin-public/060_www_fidelity_com/documents/FDAS/custody-in-the-age-of-digital-assets.pdf), page 11

12) Insurance Journal: Insurers Begin to Offer Cryptocurrency Theft Cover, Tackling Risks of Growing Sector
https://www.insurancejournal.com/news/international/2018/02/01/479202.htm

13) Kraken Proof-of-Reserves Audit Process
https://www.kraken.com/proof-of-reserves-audit

14) Behind the "exodus" of bitcoin startups from New York, http://fortune.com/2015/08/14/bitcoin-startups-leave-new-york-bitlicense/
Kraken Blog: Farewell, New York, https://blog.kraken.com/post/253/farewell-new-york/

15) https://support.kraken.com/hc/en-us/articles/360001368823-Geographic-Restrictions-Can-I-use-Kraken-if-I-m-from-
16) https://support.binance.com/hc/en-us/articles/360022204152-Restricted-countries-list
17) https://www.gate.io/signup
18) https://www.hbg.com/en-us/register/

19) https://bitcoinmagazine.com/articles/someones-got-be-voice-reason-kraken-responds-ny-ag-report/
20) https://twitter.com/jespow/status/986700932778934273
21) https://twitter.com/krakenfx/status/1042496022851739649
	# Review of the "Virtual Markets Integrity Initiative" of the Office of the New York State Attorney General
	## Mid-term assignment DFIN-522 by Roland Stadler, University of Nicosia


	## Introduction
	As one of the financial centers of the World, the State of New York has a defining role dealing with financial markets and its service providers. It is a leading player in creating legislation regarding consumer protection and prosecuting fraudulent market participants. The Office of the Attorney General (OAG) "is charged with the statutory and common law powers to protect consumers and investors" (1). As "People's Lawyer" it strives to protect customers of virtual currency platforms (exchanges) and to increase transparency by its "Virtual Market Integrity Initiative" report.

	## Review of individual sections and key findings

	### Section I: Jurisdiction, Acceptance of Currencies and Fees
	Starting with the basics, like incorporation of exchanges and juristiction excluded, most questions are primairily of interest for regulators. Questions regarding measures taken to identify customers (KYC) and limit access for not authorized customers (e.g. detecting VPN usage) are mostly of regulatory interest. The OAG seems to establish juristictional relevance, but fails to address the fact that only six of fourteen exchanges questioned acutally serve customers in New York State, most likely due to the highly controversial BitLicense imposed in 2015. (2)

	With questions relevant for customers (acceptance of fiat currency, fee structures), the report fails to go into specifics. Critizism of the "maker-taker" fee model, well-established on most exchanges, for distorting the overall trading environment seems very specific. While some researchers think it can create false incentives and distort price-finding mechanisms (3), this issue is not unique to virtual currencies and the SEC concludes that "maker-taker fee structures indirectly provide better prices to retail investors". (4)


	### Section II: Trading Policies and Market Fairness
	Virtual currency platforms provide direct access to powerful trading platforms, including functionality geared towards professional traders. The OAG sees this open access as problematic. This seems to be a clash of traditional and open-access business models. In my opionion there is room for platforms targeting different user groups: Coinbase has a intuitive interface useful for casual usage, while Coinbase Pro provides features useful for professional day trading. The real danger lies in the "everybody is a day-trader" mentality, without customers realizing they are simply gambling. (5) This danger is heightened exponentially by offering margin trading, which might by useful in slow-moving traditional markets, but is highly unpredictable in dynamic virtual currency markets.

	The report is critical of automated access to data and trading functionality. While access to trading data is a necessity to calculate tax liabilities, the automation of trading itself is nothing new and can be benefitial in mature markets. Noting the lack of discrete policies on bot trading is correct, but fails to address the bigger issue: many of the tradable trading pairs (e.g. Monero/Bytecoin on Poloniex, an extrem example with trading volume of less than $200/day) have so little liquidity that large players can manipulate them at will. (6)

	In light of how traditional business models involving privileged middlemen have been disrupted over the last decade, it is highly doubtful that these issue can be addressed by forcefully limiting access for consumers to legitimate trading platforms on a global scale.

	#### Key Finding: Trading platforms have yet to implement serious efforts to impede abusive trading activity.
	The report asks exchanges to take more active steps to monitor and stop suspicious trading patters, while not defining what these trading patterns are. Especially exchanges that provide a "crypto casino" service to customers have no incentive to stop this behaviour. This should be an ongoing task of proper regulatory oversight.

	### Section III: Managing Conflicts of Interest
	Conflicts of interest for exchanges are a reality and have the power to undermine honest business models. Listing fees are a major income for exchanges and have shaped the virtual currency space. New projects need to raise investor money for listings, otherwise no price appreciation can happen. Costs for listings can reach $3 million "for an opportunity to get quick liquidity" (7). This practice can incentivise listing the "long tail" of coins, without due diligence, real liquidity or customer demand, enabling ponzi (8) or pump and dump (9) schemes.

	Insider trading is a serious issue, especially as prices usually soar on announcements of new listings. It is noteworthy that even on clear suspicion of insider activity, on exchanges under the supervision of the OAG, no official measures have been taken so far. A prime example is Coinbase's unannounced listing of Bitcoin Cash, causing heavy market turbulence and allegations of insider trading. Only an internal investigation was set up, unsurprisingly clearing the exchange and its employees from all wrongdoing. (10)

	#### Key Finding: The various business lines and operational roles of trading platforms create potential conflicts of interest.
	This issue is heavily understated and should be the prime area of regulatory supervision, as it can distort the whole modus operandi of exchanges against its customers.


	### Section IV: Security, Insurance and Protecting Consumer Funds
	Exchanges provide custody for customer funds. While fiat currency is usually kept in banking accounts, virtual currencies are managed by the exchange itself. Even mature companies like Fidelity recognize that "security solutions [...] continue to evolve" (11), meaning that these are among the best-kept secrets in the industry, hindering the evolution of industry best-practices.

	Insuring virtual funds is difficult. "Only a few insurers sell such insurance. [...] The challenge is how to cover those risks for customers they know little about, who use technology few understand [...]." (12) This means that insurance solutions are still evolving and could be quite expensive due to missing competition.

	The public nature of blockchains provides technological means to do publicly verifiable audits of custodial reserves. While most exchanges provide some sort of audit, whithout generally accepted auditing principles reliability varies. Kraken can be seen as a leading example in providing "proof-of-reserves" down to personal account level (13).

	#### Key Findings: Protections for customer funds are often limited or illusory.
	Funds should not be kept on exchanges longer than absolutely necessary. Exchanges with the demand for short-term availability of funds should currently be viewed as inherently unsafe and are not built as long-term custodians. It is to be expected that exchanges will over time use safe custody procedures, insurance and audits as a distinguishing selling proposition.


	### Section V: Access to Customer Funds, Suspensions, and Outages.
	Due to their public nature, exchanges are more exposed to disruptions than traditional, guarded systems. While outages can happen, customers should be made informed better what happens to pending trades.

	One issue relevant for customers ignored in this report are the terms-of-service imposed by exchanges. There are many cases of account closures and frozen funds where no further information was provided. Exchanges also collect a lot of sensitive data and customers should be aware what happens with this data.


	## Non-participation by trading platforms
	The issuance of the BitLicense by the New York State Department of Finance (NYSDF) in 2015 was controversial, prompting virtual currency companies "to make a statement: rather than apply for the license, they left New York." (14) Neither Kraken, Binance, Gate.io nor Huobi serve customers in New York State (15, 16, 17, 18), and it is therefore highly questionable whether the OAG has any mandate to demand participation in this initiative, let alone instigating they may be operating illegally and referring several of them tot the NYSDF without providing additional details.

	Jessie Powell, CEO of Kraken, "thinks the Attorney General’s report was good in that it highlighted important questions consumers should be asking exchanges. However, [...] calling out the exchanges who chose not to respond to the questionnaire unnecessary. 'After all,' he said, 'there are hundreds more exchanges which were never asked and are not named.'" (19) Later he was even more outspoken, tweeting "Somebody has to say what everybody's actually thinking about the NYAG's inquiry. The placative kowtowing toward this kind of abuse sends the message that it's ok. It's not ok. It's insulting." (20)

	Kraken's official response was to "[...] object to the highly unprofessional/malicious implication that because we did not respond to the voluntary information request, we might be operating illegally. We told you we don't operate in NY. AG trying cases in court of public opinion now?" (21)


	## Conclusion
	The initiative is commendable, the questions asked are valid and demonstrate a good understanding of relevant challenges. The information provided in the report fall short of its goal, however, most is public information and could be compiled by every concerned citizen itself. In my opinion, the questionairre itself is the most interesting part.

	I share the sentiment of Kraken that the OAG is overstepping its boundaries significantly. The report looks like an attempt to gain influence as a leading global regulator regarding virtual currency, with the OAG focussing more on public perception than actually taking effective measures. Seeking "voluntary participation" is not in line with calling out and warning the public of exchanges that "refused" to participate. There are many issues to be adressed, especially regarding conflicts of interests, but it is up to all proper regulators to work with the industry, define guiding principles and then act on them.


	## References
	## References


	1) Website of the New York State Attorney General: Our Office
	https://ag.ny.gov/our-office

	2) Coindesk: Industry Reactions to New York’s BitLicense Proposal, https://www.coindesk.com/new-york-bitlicense-views-inside-bitcoin-industry

	3) Investopedia: What Maker-Taker Fees Mean to You
	https://www.investopedia.com/articles/active-trading/042414/what-makertaker-fees-mean-you.asp

	4) SEC Memorandum: Maker-Taker Fees on Equities Exchanges, https://www.sec.gov/spotlight/emsac/memo-maker-taker-fees-on-equities-exchanges.pdf

	5) Castle Craig Hospital: Cryptocurrency Trading: The Tale of the Modern-Day Casino
	https://castlecraig.co.uk/blog/2018/07/11/cryptocurrency-trading-the-tale-of-the-modern-day-casino/

	6) according to https://messari.io/asset/bytecoin#metrics, overall 24h volume for Bytecoin is $160'000, while the trading pair XMR/BCN on Poloniex had a daily volume in January 2016 below $200.

	7) Bloomberg: Crypto Exchanges Charge Millions to List Tokens, Report Says, https://www.bloomberg.com/news/articles/2018-04-03/crypto-exchanges-charge-millions-to-list-tokens-autonomous-says

	8) SEC, Ponzi Schemes Using Virtual Currencies, https://www.sec.gov/investor/alerts/ia_virtualcurrencies.pdf

	9) The Outline, Inside the group chats where people pump and dump cryptocurrency, https://theoutline.com/post/3074/inside-the-group-chats-where-people-pump-and-dump-cryptocurrency

	10) Fortune, Coinbase Finds No Insider Trading of Bitcoin Cash
	http://fortune.com/2018/07/24/coinbase-insider-trading/

	11) Fidelity Digital Assets, CUSTODY IN THE AGE OF DIGITAL ASSETS
	https://www.fidelitydigitalassets.com/bin-public/060_www_fidelity_com/documents/FDAS/custody-in-the-age-of-digital-assets.pdf), page 11

	12) Insurance Journal: Insurers Begin to Offer Cryptocurrency Theft Cover, Tackling Risks of Growing Sector
	https://www.insurancejournal.com/news/international/2018/02/01/479202.htm

	13) Kraken Proof-of-Reserves Audit Process
	https://www.kraken.com/proof-of-reserves-audit

	14) Behind the "exodus" of bitcoin startups from New York, http://fortune.com/2015/08/14/bitcoin-startups-leave-new-york-bitlicense/
	Kraken Blog: Farewell, New York, https://blog.kraken.com/post/253/farewell-new-york/

	15) https://support.kraken.com/hc/en-us/articles/360001368823-Geographic-Restrictions-Can-I-use-Kraken-if-I-m-from-
	16) https://support.binance.com/hc/en-us/articles/360022204152-Restricted-countries-list
	17) https://www.gate.io/signup
	18) https://www.hbg.com/en-us/register/

	19) https://bitcoinmagazine.com/articles/someones-got-be-voice-reason-kraken-responds-ny-ag-report/
	20) https://twitter.com/jespow/status/986700932778934273
	21) https://twitter.com/krakenfx/status/1042496022851739649