Trade Surveillance of Digital Assets


Trading of financial assets in capital markets is subject to regulations and trade surveillance is an important step in identifying instances of market manipulation, fraud, behaviour patterning or other illegal activities. With cryptocurrencies being considered as securities in many geographies, it is only a matter of time before trade surveillance becomes increasingly popular for digital assets in addition to the traditional trade surveillance process. But how is the crypto surveillance process different and what are the likely challenges to be encountered? Let’s dive deeper to find out.

Type of surveillance

One of the choices to make is the type of surveillance to perform – “on-chain” or “off-chain” surveillance. On-chain transactions are those cryptocurrency transactions that occur on the blockchain and remain dependent on the state of the blockchain for their validity. Off-chain transactions don’t occur on the blockchain network, but instead, are transacted on other electronic systems such as PayPal. On-chain transactions offer security and transparency since they can’t be altered once they’re verified and recorded on the blockchain network. Also, for traditional assets, there is usually a data lake or warehouse to feed the trade surveillance mechanism and this feature will not be available for a public blockchain. Hence, the quality of the surveillance may be impaired.

Challenge – Fragmentation

Similar to stock markets but unlike futures markets, the same crypto currencies can be traded on multiple venues. This creates a trade surveillance challenge because a spoofer can enter fake bids on Venue A, wait for professional traders who consume quote data from multiple venues to react, and then trade opposite those professional traders on Venue B. In this scenario, neither Venue A nor Venue B, acting separately, has enough data to identify the subject activity as spoofing. In stock markets, Venues A and B solve this problem by agreeing to share their quote data with a common host (currently FINRA and soon to be the Consolidated Audit Trail) who can stitch their respective fragments of the market together, and can then use the resulting pooled dataset to identify cross-venue spoofing. No such common host exists yet for the crypto markets.

Challenge – Linking Accounts

Since a user can trade cryptos across multiple venues with different accounts, it is necessary to know the relationship among accounts via additional account linking information. For example, if the same trader opened both Account A at Venue A and Account B at Venue B, and Venue A and Venue B agreed to pool their order data with a common host, the common host would not know that Account A and Account B were related. Some relevant parameters by which accounts can be linked together is via the account holder’s social security number or the public key of the account holder’s secure cold wallet collectible.

Challenge – Direct Market Access

Unlike on the stock exchanges, individual investors can trade on crypto exchanges directly without holding an account at an intermediary broker and they can store cryptos on crypto wallet collectibles. This bypasses an important layer of trade surveillance. In the stock markets, brokers can effectively screen their own customers’ order flow for spoofing even when those customers are spraying bids and offers to multiple different exchanges. In futures markets, individual investors can access the exchange directly, but the instruments traded are monopoly products that can only be traded on one exchange. Since 100% of the market’s bids and offers for each instrument arrive at one exchange, that exchange is able to effectively screen for spoofing despite the absence of intermediary brokers.

The Final Statement

Surveillance of trades of digital assets is still in its infancy and it will take time to develop scenarios around market abuse behaviours in scope. Current surveillance processes of traditional assets are well developed and their best practices can be incorporated into the crypto trade surveillance model. Regulation around crypto trades is still evolving and, once there are robust guidelines and measures in place, companies may have to pay penalties in the event of violation of digital asset trading protocols. Hence, all company stakeholders in the surveillance operating model need to be on the same page while developing market abuse tracking processes for cryptocurrencies – since ultimately, it is the company which is responsible for protecting itself!