Crypto Exchanges vs Traditional Exchanges: A Brief Comparison
Despite all the focus on cryptocurrencies, little is written about the exchanges that trade them. Here, Dr. Ozair remedies the situation.
On March 7, 2018, the US Security and Exchange Commission (SEC) issued a “Statement on Potentially Unlawful Online Platforms for Trading Digital Assets”. In a nutshell, it states that all crypto exchanges are illegal unless they register with the SEC.
Why has the SEC been calling the crypto exchanges out?
First let’s understand what an exchange is and what a crypto exchange is.
An exchange is:
A marketplace where securities, commodities, derivatives and other financial instruments are traded. It can be a physical location where traders meet and conduct business (e.g., New York Stock Exchange (NYSE)) or an electronic platform (e.g., Nasdaq). As markets become more sophisticated, trading is increasingly conducted on electronic exchanges. Even at NYSE, most of the trading these days is done electronically (over 85% as of 2016).
The core function of an exchange is to ensure fair and orderly trading and the efficient dissemination of price information for any security trading on that exchange.
A stock exchange helps current and newly-formed companies raise capital, for building and expanding their businesses through selling shares to the investing public. The first sale of a stock by a private company to the public is referred to as an Initial Public Offering (IPO). A company could in the future raise additional capital through a stock exchange via a Seasoned Equity Offering (SEO).
A crypto exchange is:
A business that allows customers to trade cryptocurrencies or digital currencies for other assets, such as conventional fiat money, or different digital currencies. It can be a market maker that takes the bid/ask spreads as transaction commissions for its services or one that simply charges fees as a matching platform.
It seems that both traditional exchanges and crypto exchanges provide a platform for traders to buy and sell securities, commodities or any other assets. So, how are they different?
Main differences between traditional exchanges and crypto exchanges
The case of fund-raising – IPO versus Initial Coin Offering (ICO)
A company can raise funds from the public on a traditional exchange via an IPO. Before doing so, however, it must first go through a rigorous process of compliance and due diligence.
The company must comply with certain regulations and a due diligence process performed by the regulator such as the SEC or its equivalent in another country, (such as the Financial Conduct Authority (FCA) in the UK).
At the end of the due diligence process, the SEC approves the company’s prospectus. A prospectus is a disclosure document that describes the financial security for potential buyers. It commonly provides investors with material information about the investment, such as a description of the company's business, financial statements, biographies of officers and directors, detailed information about their compensation, any litigation that is taking place, a list of material properties, partnerships and other engagements, and any other material information that the SEC deems as material (which is specific to each company). In essence, the idea behind the final prospectus is to give all of the information a prospective investor would need in order to make an informed decision about whether or not to invest.
A company can apply to register on one of the stock exchanges.
Before a company can begin trading on an exchange, it must meet certain initial requirements or "listing standards." The various exchanges set their own standards for listing and continuing to trade a stock. The SEC does not set listing standards.
To be listed initially, a company must meet minimum financial and non-financial standards. Among other things, the standards cover total market value, stock price, and the number of publicly traded shares and shareholders a company has. After a company's stock starts trading on an exchange, it usually is subject to other, less stringent requirements. If it fails to meet those, the stock can be delisted. As with listing requirements, the standards for delisting shares are not uniform. Each exchange has its own requirements.
Once a company receives the approval of both the SEC and a stock exchange, it can set a price (for its stock) and a date (for the IPO) and start trading on a stock exchange from that day on. The first trading day is the IPO date.
An ICO, on the other hand, is not required to go through the rigorous compliance and due diligence process as described above. It is conducted independently of an exchange and is administered by the issuer (i.e., a company issuing its tokens rather than an exchange).
An ICO does have a white paper, which provides some information about the product/service, the team, the token structure, the risk factors, and any other information that the company deems material. An ICO white paper, however, should not be confused with an IPO prospectus. Unlike an IPO prospectus, which goes through an SEC approval process, an ICO white paper is produced at the company’s discretion.
After a company raises funds via an ICO, there is no guarantee that its tokens sold would be listed on a crypto exchange.
Thus, one of the main purposes of a traditional exchange – facilitating fund-raising – is eliminated from the business operations of a crypto exchange.
Regulations and Protections of Investors/Traders
Traditional exchanges are highly regulated (especially in the US) in an effort to ensure fair and orderly trading, transparency and efficient dissemination of information.
The regulations are applied to both parties involved – exchanges listing the securities on their platform, and companies listed on the exchanges.
On the company’s side
Regulators require that:
(1) investors receive all necessary information to make an informed decision on their investments.
- Public companies are required to publish quarterly financial statements – companies do not only provide information on past and current operating performance but also provide guidance on future performance.
- Public companies are required to immediately announce and report about any new material engagement (e.g., merger and acquisitions, filling for bankruptcy, lawsuit.)
(2) companies eliminate information asymmetry by providing the same information to all investors.
- Companies are required to perform quarterly earnings’ conferences calls, which must be open to the public.
- Insider trading is prohibited, and criminal penalties are applied in such a case.
On the exchanges’ side
Regulators require that:
Exchanges provide fairness in price execution and market efficiency.
The National Market System (NMS) (and the European equivalent Markets in Financial Instruments Directive (MiFID)) is a set of rules, which aims to improve the U.S. exchanges through improved fairness in price execution as well as improve the displaying of quotes and access to market data.
This regulatory ruling is comprised of four main components:
- The Order Protection Rule aims to ensure that investors receive the best price when their order is executed by removing the ability to have orders traded through (executed at a worse price).
- The Access Rule, aims to improve access to quotations from trading centers in the National Market System by requiring greater linking and lower access fees.
- The Sub-Penny Rule, which sets the lower quotation increment of all stocks over $1.00 per share to at least $0.01.
- Market Data Rules, which allocate revenue to self-regulatory organizations that promote and improve market data access.
Crypto exchanges are neither subject to any regulations nor are they required to provide fairness in price execution and market efficiency.
There are about 26 traditional exchanges. However, even though the equity market is fragmented, the SEC requires via The Order Protection Rule that at any point in time, there would be ONLY one Best Bid Offer (BBO) aggregating all the transactions on all exchanges. This ensures that investors receive the best price when their order is executed.
There are hundreds of crypto exchanges (and the number increases each day), but they all operate independently. There is NO one price rule (as described above) to aggregate them. Hence, a crypto trader does not necessarily know whether he/she receives the best price in the aggregated market (i.e., all crypto exchanges).
Since crypto exchanges are not regulated, it also means that companies listed on these exchanges are not regulated. Unlike public companies listed on a stock exchange, companies listed on a crypto exchange are not required to publish financial statements or disclose any information. Again, like in the case of an ICO, it is at a company’s discretion whether or not to disclose.
This may be a minor difference.
Any stock exchange has clear listing fees’ rules, published on its website. See for example NYSE listing fees’ rules.
A crypto exchange, on the contrary, does not provide such clear and public information about its listing fees. On its application form, it mentions that listing fees will be negotiated in the application process.
Therefore, when the SEC insists on calling a crypto exchange a Trading Platform, it is because it would like to remove any misimpression that a crypto exchange is regulated or meets the regulatory standards of a traditional exchange.
Although some of these platforms claim to use strict standards to pick high-quality digital assets to trade, the SEC does not review these standards, or digital assets that a platform selects. Hence, the so-called standards should not be equated to the listing standards of a traditional exchange.
It seems that the lack of regulation in the crypto market causes opaqueness. The crypto market does not need to be regulated like the equity market. Some self-regulations, however, might protect crypto traders and mitigate market uncertainty.