Author: Eventus Systems – eventussystems.com

Financial exchanges in established asset classes – equities, options and futures, for instance – have a well-defined process for trade surveillance and related best practices. The understanding that market integrity is paramount to attracting and retaining liquidity is baked in. Based on the regulatory structures associated with these markets, their participants also know they need to have sound processes and systems in place to comply with exchange rules and ensure they don’t run afoul of regulators.

In contrast, digital asset markets are still relatively new, regulatory structures are only beginning to take shape (and vary by jurisdiction) and there are still few traditional intermediaries. Digital asset venues and exchanges (“venues”) are discovering that a robust trade surveillance program not only reinforces the integrity of their markets but also helps attract institutional investors accustomed to operating in safer, more transparent environments. Those venues looking to appeal to institutional participants aren’t waiting for a regulator to tell them to do this; they’re identifying opportunities for implementing best practices, establishing rules and actively surveilling activity.

As our client footprint in digital assets has grown, we’re often asked: What’s different about trade surveillance for digital assets? My answer is that bad behaviors in digital assets are essentially the same as everywhere else, i.e., fraud is fraud in all of its forms, whether it’s market manipulation, money laundering or any number of illicit activities. The procedures and governance models required to operate an effective trade surveillance mechanism are the same. However, there are key distinctions that impact the effectiveness of surveillance for this growing asset class, including market structure, technology, data and activity coverage, and culture.

Market Structure

If there is one area where digital assets truly diverge from traditional markets, it’s market structure. The panoply of venues, disparate jurisdictional mandates and lack of regulatory clarity are significant headwinds for widespread institutional acceptance.  For example, potential fraud on digital asset venues is consistently cited by U.S. regulators in rejecting a cryptocurrency ETF, notwithstanding the recent approval of two ETFs in Canada. Therefore, from a trade surveillance standpoint, we need to pay close attention to a few critical distinctions in market structure that impact the effectiveness and coverage of any trade surveillance program, and closely track progress of this nascent but expansive ecosystem.

Digital assets trade 24×7. There is no consolidated tape and no settlement or fixed closing price. Digital asset venues must handle the level of specificity required of a typical self-regulatory organization (SRO) surveillance system while also tackling the challenges commensurate with an OTC market with fungible products trading on multiple venues. As this asset class becomes more widely adopted and regulated, we can expect an increased focus on cross-market surveillance.

Perhaps the most critical aspect to market structure in digital asset trading is the lack of traditional intermediaries. In the equities markets, surveillance regimes exist at the brokerage firm, the executing broker/dealer, exchanges and regulators. Similarly, in futures markets, trading firms, futures commission merchants (FCMs) and designated contract markets (DCMs) all play an integral role in detecting and mitigating problematic behavior. However, without layers of additional intermediaries that assume these responsibilities like we see in the equities and futures markets, the onus is squarely on digital asset venues to detect and deter potentially manipulative behavior. To an extent, digital asset markets parallel the FX markets which conduct surveillance in a distributed fashion, i.e. venue-by-venue.

While it remains to be seen how market structure evolves in digital assets, market participants continue to grapple with the lack of regulatory clarity. Who is regulating their trading activity? What are the requirements for trade surveillance? Historically, market participants have been laggards in applying best practices in nascent markets and regulatory regimes. On the other hand, we see leading venues applying best practices in trade surveillance. Ideally, this will drive market participants to do the same.

Technology

The frenetic pace of technological innovation is a major driver in digital asset markets. A 24×7 market with no pause drives technology teams to be agile in ensuring continuous up-time. Many digital asset venues are conducting surveillance in real time, requiring tremendous performance from their surveillance platform due to the vast amounts of transaction and market data. Due to cybersecurity and privacy concerns, some venues continue to grapple with on-premise vs. cloud solutions, despite the fact that cloud solutions are typically more cost-effective and flexible. Unimaginable a few years back, some venues are handling 2-3 billion messages per day, in real time, in the cloud. Because of these technical challenges, we find clients putting a premium on surveillance mechanisms that are fully adaptable, scalable and flexible.

Another technology challenge directly impacts alert generation and the number of false positives associated with legacy surveillance methods. Historically, the approach to a trade surveillance procedure might be to write a program to find violation X, and that’s all the program needs to do. The industry has moved away from this approach because there are too many variables and too much data; regulators want the exchanges to cast a wide net and clearly show how alerts are reviewed and/or mitigated.

Therefore, both ready-to-use and customizable surveillance procedures are critical. Market venues want the means to create and amend procedures quickly, and in many cases, they want self-control over their surveillance procedures in a more technical fashion, for example, by using Python scripts.

Data & Activity Coverage

Because of the evolving nature of digital asset markets, surveillance platforms need to be versatile and cover an expanding array of data and activity segments, while those overseeing the function should be prepared to quickly amend and improve their reports and procedures. Typically, surveillance platforms require transaction lifecycle data, position data, market data and relevant reference data, which suffices for the standard suite of market manipulation and risk monitoring procedures. However, surveillance platforms for digital assets also need to consider AML-related transaction monitoring and anomaly detection. So datasets must expand and include client data, account transaction information, money flows, etc.  Critically, this all ties in with the discussion above on the lack of intermediaries and the pressure on venues to detect and intercept bad behavior.

While also important in surveillance for more established asset classes, the issue of anomaly detection is worth highlighting here in the context of expanding data and activity coverage in digital asset markets. Venues cannot simply look for a specific behavior, write a program to find it, rinse and repeat. Compliance staff and surveillance platforms must be able to rapidly adapt to changing behavior and stay ahead of the fast-evolving environment. Unfortunately, when bad actors get caught, they typically move on to the next thing. Detecting anomalistic behavior is a critical way of staying ahead of the curve, along with the ability to adapt surveillance procedures on the fly.

Culture

By culture, I’m referring to the culture of the marketplace and the people who work in the field. I have learned that in designing any surveillance platform, compliance program or training session, it’s best to know your audience. One thing that struck me when I started looking at the digital asset space through the prism of trade surveillance was the expansive skillset of the surveillance and compliance professionals working at digital asset venues.

In addition to the traditional lawyers and compliance professionals who are skilled in maintaining a thorough understanding of regulatory developments in multiple jurisdictions, I would say the average professional overseeing surveillance in digital assets is either a technologist or at least incredibly comfortable with technology. Technological advancements in the space transcend legacy surveillance methods, and therefore, many of the people hired to operate surveillance mechanisms are quite skilled in coding and appreciative of the latest technologies.

Moreover, the entrepreneurs in digital assets think outside the box, and they are not necessarily accustomed to prescriptive regulation and market structure. This potentially opens the door for regulators and venues to work together, learn from past market structure experiences, and develop a surveillance and regulatory regime appropriate for this innovative market with a common understanding of the rules of this newly paved road.

 What does all this mean for digital asset venues?

If you operate a cryptocurrency market and haven’t yet adopted a comprehensive surveillance program, you should be taking steps to achieve this, whether or not it’s mandated in your particular jurisdiction. You should do this despite the fact that you aren’t yet being held personally responsible for violations or bad actors on your markets. Why? Because putting these systems and procedures in place is simply good business.

As our CEO likes to say, regulation brings safety, which attracts more investors, grows the overall pie and brings transparency and price discovery. In the history of markets, that formula has enabled venues to grow. If you’re doing things right and want to build on your success, don’t be reluctant to bring on the daylight. In fact, we increasingly join our clients in taking the initiative and sitting down with regulatory agencies that may claim jurisdiction over digital assets to walk through how our platform and the exchange’s procedures bring safety to these markets.

Building that program includes finding the right people – who are committed to ensuring the integrity of the markets, who understand the compliance and regulatory arena and who are fully comfortable with rapidly changing technology. And it means ensuring the people and platform are as flexible and adaptable as the virtual asset markets have proven to be.

Joseph Schifano is Global Head of Regulatory Affairs for Eventus Systems, an award-winning global provider of multi-asset class trade surveillance and market risk solutions.