Bloc10 – Atlanta, GA 9/18/2018 — For those who have known us for a long time it should come as no surprise that Coinbase, the largest Crypto exchange by number of accounts (20 Million +) trades against its own customers. In this shocking report furnished by the New York Attorney General, Coinbase leads the pack in internal order flow:

Notably, “Coinbase disclosed that almost 20 percent of executed volume on its platform was attributable to its own trading.”

What does this mean? Let’s explain about market making, and what is brokerage. Firstly, these exchanges are not properly registered – as exchanges. The NYSE is an exchange. There are many exchanges registered in the USA actually, Coinbase is not one of them. So they are really a broker of sorts. Can’t be a money transmitter because Bitcoin is not money. They are either poorly categorized, unlicensed exchanges; or unlicensed brokers. A broker remember is a middleman, a real estate broker is just a middleman in a transaction (but perhaps an important one).

What does this mean?

To understand this fully we recommend our book Splitting Bits – as this topic is too complex to unravel in a single article. Let’s try to translate – volume based on its own trading means that Coinbase is acting like a market maker, principal to transactions – for its own account. You buy, they sell. You lose, they win. Get it?

Investors who have been exposed to FX markets have went through this before, and now only will trade with brokers who do ‘STP or Straight Through Processing’ meaning they are NOT principal to the transaction. You can see FX rates on Total Cryptos here: www.totalcryptos.com/fx

The problem for the past 10 years in FX is that the smaller firms have internalized their flows and ended up being ‘b-book’ market makers like FXCM, which is fine and dandy for 90% of the trading population that looks at trading as a small hobby similar to gambling, gardening, or sudoku. But for those who have tried to make a business out of it, 50 pip slippage, 1 hour delays in order execution – no FXCM we can’t trade like that. Finally they were caught, sued, and burnt to the ground.

How this seems like FX bucket shops

So hearing this about Coinbase is surreal – it is eerily familiar. But the problem with Crypto is that there isn’t a fair alternative. In FX, if you had enough money, you could trade with banks directly or with brokers who do truly offer an STP option. Now it’s commonplace. But with Crypto Coinbase is the best, the biggest – and there is no other option. So to hear this, that Coinbase is trading 20 percent of volume for its own account, however they are accounting for that flow, is not only suspicious, it’s causing a lot of heart burn in FX victims who have been dragged over the hot coals starting with Refco and leading into FXCM in a slow motion disaster cycle.

So what are Coinbase disclosures? They are very hard to find. Finding the legal page is easy, which magically waives customers legal rights:

7.2. Arbitration; Waiver of Class Action. If you have a dispute with Coinbase, we will attempt to resolve any such disputes through our support team. If we cannot resolve the dispute through our support team, you and we agree that any dispute arising under this Agreement shall be finally settled in binding arbitration, on an individual basis, in accordance with the American Arbitration Association’s rules for arbitration of consumer-related disputes (accessible at https://www.adr.org/sites/default/files/Consumer%20Rules.pdf) and you and Coinbase hereby expressly waive trial by jury and right to participate in a class action lawsuit or class-wide arbitration. The arbitration will be conducted by a single, neutral arbitrator and shall take place in the county or parish in which you reside, or another mutually agreeable location, in the English language. The arbitrator may award any relief that a court of competent jurisdiction could award, including attorneys’ fees when authorized by law, and the arbitral decision may be enforced in any court. At your request, hearings may be conducted in person or by telephone and the arbitrator may provide for submitting and determining motions on briefs, without oral hearings. The prevailing party in any action or proceeding to enforce this agreement shall be entitled to costs and attorneys’ fees. If the arbitrator(s) or arbitration administrator would impose filing fees or other administrative costs on you, we will reimburse you, upon request, to the extent such fees or costs would exceed those that you would otherwise have to pay if you were proceeding instead in a court. We will also pay additional fees or costs if required to do so by the arbitration administrator’s rules or applicable law. Apart from the foregoing, each Party will be responsible for any other fees or costs, such as attorney fees that the Party may incur. If a court decides that any provision of this section 7.2 is invalid or unenforceable, that provision shall be severed and the other parts of this section 7.2 shall still apply. In any case, the remainder of this User Agreement, will continue to apply.

That’s very interesting! When you are registered, with NFA or FINRA, they act as the Arbitrator, but they are also the regulator. Coinbase, uniquely – posts only disclosures by state. The most detailed disclosure – of course – is from New York:

New York Coinbase holds licenses issued by the New York State Department of Financial Services (“NYDFS”) to engage in money transmission and virtual currency business activity, respectively. If you have a complaint, please contact us at https://support.coinbase.com or 1-888-908-7930. New York consumers may also direct unresolved complaints directly to NYDFS at the NYDFS Consumer Complaint Portal or by contacting the NYDFS as follows: NYDFS Consumer Assistance Unit, One Commerce Plaza, Albany, NY 12257, 1-800-342-3736. Please note the following disclosures associated with virtual currency:

Virtual currency is not legal tender, is not backed by the government, and accounts and value balances are not subject to Federal Deposit Insurance Corporation or Securities Investor Protection Corporation protections.

Legislative and regulatory changes or actions at the state, federal, or international level may adversely affect the use, transfer, exchange, and value of virtual currency.

Transactions in virtual currency may be irreversible, and, accordingly, losses due to fraudulent or accidental transactions may not be recoverable.

Some virtual currency transactions shall be deemed to be made when recorded on a public ledger, which is not necessarily the date or time that the customer initiates the transaction.

The value of virtual currency may be derived from the continued willingness of market participants to exchange fiat currency for virtual currency, which may result in the potential for permanent and total loss of value of a particular virtual currency should the market for that virtual currency disappear. GOOD ONE!

There is no assurance that a person who accepts a virtual currency as payment today will continue to do so in the future.

The volatility and unpredictability of the price of virtual currency relative to fiat currency may result in significant loss over a short period of time.

The nature of virtual currency may lead to an increased risk of fraud or cyber attack.

The nature of virtual currency means that any technological difficulties experienced by Coinbase may prevent the access or use of a customer’s virtual currency.

Any bond or trust account maintained by Coinbase for the benefit of its customers may not be sufficient to cover all losses incurred by customers.

But even in this detailed disclosure – they failed to mention one important thing – the elephant in the room- Market Making!

What is Market Making

So when you trade with an exchange, understand what’s going on here. All the information you get is from the exchange. Do they really ‘transact’ your Bitcoin into Ethereum, or are they in fact betting that you are going to lose? (by the way, betting against retail investors is usually a winning strategy). The point is that if Coinbase is in fact doing this – that needs to be disclosed. What does 20% of customer volume for their internal account mean anyway?

“Self Trading” a big part of the report:

The wide-ranging report covered a range of topics, including whether the exchanges in question are allowed to operate in New York – and if they are doing so even without permission. Notably, the report said that Binance, Gate.io and Kraken had been referred to the state’s Department of Financial Services after an investigation into whether those exchanges are operating in New York. A fourth exchange, Huobi, was also investigated but not referred. “The OAG investigated whether those platforms accepted trades from within New York State. Based on this investigation, the OAG referred Binance, Gate.io, and Kraken to the Department of Financial Services for potential violation of New York’s virtual currency regulations,” the report stated. The NYAG’s office found that some exchanges could quantify how much trading activity on their platforms came from their own operations. Circle said it was responsible for less than 1 percent of the trading volume on Poloniex while BitFlyer USA conducts roughly 10 percent of the trades on its platform.

To compare for a moment, Circle said it was responsible for 1 percent of the trading volume on Poloniex which can be explainable to support market transactions. 20 Percent is indicative, but not proof of, market making. Market making is not necessarily a bad thing, but if that’s what Crypto has become, then buyer beware – the exchanges are incentivized to make you lose! Get ready to play cat and mouse games with them. -jg

We’ve uploaded the report here: VIRTUAL MARKETS INTEGRITY INITIATIVE REPORT NYAG

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