The World Federation of Exchanges (WFE), the global industry group for exchanges and central counterparties, has published the first of a two-part research project which analyses exchange engagement with crypto market developments. The objective is to improve understanding of the benefits and risks of crypto market infrastructures and how they function.
Crypto trading platforms have operated without the standards required from established public financial markets and with very little regulatory oversight. WFE’s team analyzed exchange interaction with the evolution of crypto trading platforms, estimated at 500+ globally, as well as the opportunities or challenges that these new technologies bring. It studies how demand for crypto related products and services is changing, and how regulated exchanges are responding to the opportunities and challenges posed by these technologies, including with the creation of regulated crypto trading exchanges or the provision of crypto related services.
The paper finds that the risks that unregulated crypto trading platforms bring are compounded by the fact that they frequently carry out further activities that would not be permitted, or would be closely regulated, in mainstream public markets.
The research studies the implications that the differences in model design between decentralized platforms (DEX) and centralized platforms (CEX) have on liquidity provision, price discovery and the custody of assets. It also analyses what these differences imply for fundamental aspects of financial markets regulation: anti-money laundering, prudential regulation, investor protection, and may imply for financial stability.
For example, allowing functions like clearing, trading, or lending to be managed by software protocols, as is the case in DEX, carries its own risks, such as that automated liquidation of collateral assets could lead to triggering or amplifying fire sale dynamics.
WFE researchers also contrasted the Central Limit Order Book (CLOB) model used by most centralized platforms (CEX) with the Automated Market Making (AMM) models that characterize decentralized platforms (DEX). From a market structure perspective, while the current automated market maker (AMM) protocols built on smart contracts do not offer the same levels of pre- and post-trade transparency and efficiency as an order book, they remain an active area of innovation and can be expected to develop further.
However, because in these protocols liquidity and price discovery are driven by algorithms, it is critical to fully understand how these automated mechanisms operate, especially in extreme market conditions (for example, when liquidity providers withdraw or when there is a run to the exit), what incentives they create, and whether they can guarantee market integrity and stability, and offer fair and transparent markets to their users.
Pedro Gurrola-Perez, head of Research at WFE, said in a statement: “There is a growing demand for crypto products and services. Crypto-related innovations are seen as an opportunity to advance technology development and increase investor choice, however, the lack of minimum governance and investor protection standards of unregulated crypto platforms, as well as the high volatility observed in these markets, and the risk of cybersecurity threats, is a concerning mix.”
Nandini Sukumar, WFE’s chief executive, said in a statement: “Crypto is at the forefront of all of our members’ minds and we are in constant dialogue with them about how to capitalize on the new opportunities in the area. As this industry and market matures, coming in to the mainstream of financial markets, the exchange-traded model which places investor trust, transparency, accountability and investor protection at the heart of platform, will gain further momentum. ”