A new report from the New York Attorney General (“NYAG”) summarizes the findings of its recent Virtual Markets Integrity Initiative (the “Initiative”). The NYAG concluded that crypto trading platforms vary significantly in their risk management strategies and in the ways they fulfill customer responsibilities. The NYAG also identified three broad areas of concern: (1) potential conflicts of interest, (2) lack of serious efforts to impede abusive trading activity, and (3) limited protections for customer funds.

The Initiative began in April 2018 with a series of voluntary requests for information provided to major virtual currency trading platforms. Nine of the 13 firms that the NYAG contacted provided responses, and seven of them currently hold licenses from the New York Department of Financial Services (“NYDFS”). Each of the four firms that chose not to respond contended it did no business in New York state, but the NYAG nonetheless made enforcement referrals on three of the firms to NYDFS, with the implication that the NYAG uncovered evidence of those firms doing business in New York.

The report stressed the differences between virtual currency exchanges and traditional stock exchanges, noting repeatedly areas where the NYAG believed retail investors in particular were disadvantaged. The NYAG also detailed a number of other criticisms of the virtual currency trading market. For example, the NYAG expressed its opinion that the maker-taker fee model employed by most exchanges favors professional traders over retail customers, and may create incentives that distort the market. Similarly, the NYAG opined that many of the products and services developed in the crypto trading space favor sophisticated professional electronic traders to the detriment of retail traders.

Another area of the NYAG’s attention is the inability of virtual exchanges to prevent market manipulation and abusive trading. In that respect, the NYAG observed that the industry has yet to implement robust market surveillance capacities, akin to those of traditional trading venues, to detect and punish suspicious trading activity. The NYAG warned that a platform cannot take action to protect customers from market manipulation and other abuses if it is not aware of those practices in the first place.

Relatedly, the NYAG expressed concern about the lack of consistent listing standards for cryptocurrencies. The NYAG also found an uncertain landscape concerning whether, and how, virtual currencies are insured. Additionally, the NYAG found that trading outages and suspensions were common, leaving customers without access to their accounts.

The report concluded with a series of questions that the NYAG recommended all investors consider:

  • What security measures are in place to stop hackers from unlawfully accessing the platform or particular customer accounts?
  • What insurance or other policies are in place to make customers whole in the event of a theft of virtual or fiat currency?
  • What guardrails or other policies does the platform maintain to ensure fairness for retail investors in trading against professionals?
  • What controls does the platform maintain to keep unauthorized or abusive traders off the venue?
  • What policies are in place to prevent the company and its employees from exploiting non-public information to benefit themselves at the expense of customers?
  • How does the platform notify customers of a site outage or suspension, the terms under which trading will resume, and how they can access funds during an outage?
  • What steps does the platform take to promote transparency and to subject its security, its virtual and fiat accounts, and its controls to independent auditing or verification?
  • Is the platform subject to, and registered under, banking regulations or a similar regime—for instance, the New York BitLicense regulations?

The crypto exchange industry will no doubt debate many of the NYAG’s findings. Nevertheless, the NYAG has been an aggressive enforcer in the securities markets, and the report names three businesses whom it has referred to NYDFS. Based on the tone and detail of the report, it appears that New York state is about to open a new enforcement front against businesses in the crypto exchange space.