Retail investors should have access to exchanges that are free from these issues. But Gensler’s stated extension is that alternative exchanges should be banned. Most people want regulations to give people the opportunity to trade safely, but only “nannies” want regulations that prevent people who are willing to take risks from trying new things.
Crypto initially evolved out of dissatisfaction with regulated markets during the 2008 financial crisis. Crypto exchanges introduced exciting ways to naturally prevent Gensler’s troubles without the need for detailed regulation and enforcement. These may not live up to their promises, but the experiment will at least provide useful insights for future advances. While some of these ideas have been lightly tested in traditional markets, crypto offers faster and broader implementation in an area where investors know they need to protect themselves.
According to Gensler, regulation should be “technology neutral”. But consider his claim that electric cars should have the same seat belt requirements as conventional cars. These reasonable-sounding words hide a suffocating reality. There isn’t a single federal law that says, “Cars should have seat belts.” There is a vast body of regulation. A small example is CFR-571.209, which defines seat belts in 10,000 words spread over 23 pages of detailed construction diagrams. Much of this is based on conventional vehicles and does not readily translate to alternative ideas for personal transportation, be it electric cars or Star Trek vans.
Add up all the seat belt rules and regulations, including those from US states and other countries, plus all other automotive codes, and you have more pages than an engineer with a new idea for people transportation could read in his career, let alone Time to design something consistent with everyone. The correct approach is for the engineer to create the best possible design and then assess whether additional safety features are required.
Likewise, the SEC should address actual problems faced by crypto exchanges and offer technology-specific solutions. That may mean importing from traditional financial markets, but it may also require new approaches.
Traditional limit order books, such as those maintained by the NYSE, have come under heavy criticism over the past decade, including by Gensler. In crypto, automated market makers (AMMs) are a rapidly growing alternative to “limit order books” (LOBs) used by the NYSE and many other exchanges. Gensler excludes AMMs because they deal directly with the customer instead of matching buyers and sellers.
AMM clients execute instantly at quoted prices, so there is no phantom liquidity and no one can forge. Mathematically speaking, manipulation always costs money. There is no front running as orders are only disclosed after execution. Flash crashes cannot occur. Problems will no doubt be discovered, but the crypto world has proven adept at making corrections, and SEC attorneys will not speed up or enhance this process. AMMs have disadvantages such as B. no public interest in liquidity. But their closure due to a blanket ban on platforms that mix exchange services with direct buying and selling will shut down a promising area of exploration.
Frequent batch auctions (FBAs) are another approach to trading. Gensler has supported FBAs for retail stock trading and they have been used in some traditional markets. Instead of executing every time a bidder offers to pay a price that a seller is willing to accept, all orders are bundled and executed simultaneously at a single price. This eliminates the shadow liquidity issue and eliminates spoofing, short term manipulation, flash crashes, front running and high frequency trading games. A trade-off is that prices are only updated once per batch, not once per trade, but these revealed prices are more robust than individual transactions.
One of the most exciting crypto innovations is creepily named “homomorphically encrypted orders” (HEOs). Instead of sending an order to your broker or an exchange for anyone to read, encrypt it first so no one – not even the recipient – can know what it says. A computer algorithm can match transactions without knowing what those transactions are or who made them. From your perspective, a smart contract turns what you sold into what you bought, and nobody — not the exchange, nobody intercepting messages, not the person on the other side of the trade — can know what you have done. Only aggregated transactions are published and give price information to the market.
While this obviously raises money laundering and insider trading concerns – which can be addressed – it has huge potential benefits. People are tricked into disclosing their entire interests as this information will not be known to anyone else. Games like spoofing, manipulation or high-frequency trading have no value. No one can run ahead because no one sees the trade even after it is executed.
Some of these innovations have been tried on a small scale with traditional plants. But only in crypto do we get full testing of this and other innovations. After a period of development, I have no doubt that some of them will prove so useful that all financial markets will switch to them. This is a much more promising solution to old stock market woes than a few more SEC regulations on top of what we already have. Gensler’s determination to force crypto exchanges to look like the NYSE is in nobody’s interest.
More from other authors at Bloomberg Opinion:
• Crypto’s limp BlackRock response is a clear statement: Jared Dillian
• Laser-Eyed Bitcoin King Blind to $1B Loss: Lionel Laurent
• Crypto Bros have a plan to crack elite soccer: Trung Phan
This column does not necessarily represent the opinion of the editors or of Bloomberg LP and its owners.
Aaron Brown is a former managing director and head of financial market research at AQR Capital Management. He is the author of The Poker Face of Wall Street. He may be involved in the areas he writes about.
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