Market Structure Regulation

Sep 27, 2023

In the first part of our series, “The Regulatory Trinity,” we discussed the emergence of Web3 — a transformative force redefining the digital frontier. We examined the many challenges accompanying its mainstream adoption and touched upon the trinity of regulatory goals designed to shape and govern its intricate ecosystems. Continuing our journey, this next segment dives into the foundational tenets of traditional financial oversight, examining their impact on market actors and their significance in the context of Web3’s dynamic financial terrain.

The bedrock of the global financial system is a vast network of institutions and intermediaries channeling capital to foster risk reallocation and ultimately economic growth. Comprehensive regulatory regimes have been put in place to ensure that these systems function persistently. They also seek to protect investors and the public interest, and ensure the overall stability and transparency of the financial system. Market Structure Regulation plays a critical role in shaping the institutional landscape of financial markets. It defines the responsibilities and obligations of market participants, and works to foster fair, transparent, and efficient markets.

In this post, we will explore the regulations governing exchanges and alternative trading systems (ATSs) in the United States, and their impact on market participants and investors.

It’s important to note that as we will demonstrate throughout this set of articles, while regulations have noble goals, TradFi systems are prone to failure and fail time and time again mostly due to moral hazard and their inherent opaqueness. It is the synthesis of web3 stack and ideals and TradFi regulatory regimes that has the best shot at a more resilient, equitable and transparent system.

Exchanges & ATSs: A Crucial Component of Market Infrastructure

In the United States, market infrastructure regulation is overseen by the Securities and Exchange Commission (SEC). Exchanges and ATSs are key components of this infrastructure, providing platforms for trading various financial instruments. Exchanges, such as the New York Stock Exchange (NYSE) and NASDAQ, play a central role in price discovery and liquidity provision.

The Securities Exchange Act of 1934 and the Maloney Act of 1938 set the foundation for self-regulation in the U.S. securities markets. They assigned self-regulatory responsibilities to national securities exchanges and strengthened the SEC’s oversight of self-regulatory organizations. These regulations aim to prevent fraud, manipulation, and unfair discrimination while promoting just and equitable principles of trade.

Regulatory Requirements for Exchanges

Exchanges that wish to operate within the United States must adhere to specific rules. These rules are designed to protect investors, ensure fair access, and maintain market stability. Likewise, exchanges are required to prevent fraud and manipulation, promote fair trading principles, and allocate fees reasonably. They also must not impose unnecessary burdens on competition or allow broker-dealers to become members, with few exceptions.

Exchanges are granted certain benefits under their regulatory regime, such as the ability to maintain protected quotes. This means that market makers must execute orders at their displayed prices and quantities, even if the market moves unfavorably. Protected quotes promote market stability and ensure fair execution for investors.

Regulatory Framework for ATSs

Automated Trading Systems (ATSs) offer an alternative regulatory framework for trading services that are similar to traditional exchanges. To operate within this framework, ATSs must register as broker-dealers, become members of self-regulatory organizations, and comply with reporting requirements to the SEC.

ATSs provide certain advantages over exchanges, such as the ability to offer unique services like dark pools, where securities can be traded anonymously. However, they do not receive the same level of regulatory benefits as exchanges, which can affect their appeal to businesses seeking higher regulatory oversight and protection. [1]

Impact on Financial Platforms

The impact of market data fees and regulations can be seen in the practices of financial platforms like Robinhood and Citadel. Robinhood, as a popular retail brokerage, relies heavily on real-time market data to provide seamless trade execution to its users. The fees associated with obtaining this data can significantly influence its business model and user experience.

Similarly, global financial institutions like Citadel heavily rely upon comprehensive and timely market data to optimize their trading strategies. The fees and regulatory requirements for accessing this data play a vital role in shaping their operations and profitability.

Cases of Violations

There have been numerous cases of violations within this nouveau financial industry. Firms like Kraken, Robinhood, Bittrex, and Binance have faced legal action for various violations, including failing to register certain services, misleading customers, and violating securities laws.

The SEC charged Kraken for failing to register their crypto asset staking-as-a-service program in 2023. This program promised investors annual returns of up to 21% in exchange for transferring their crypto assets to Kraken for staking. To settle the charges, Kraken has agreed to cease offering this program and pay $30 million in penalties. [2]

Similarly, the SEC charged Robinhood Financial LLC in 2020 for misleading customers about its revenue sources and failing to seek the best execution terms for customer orders. The SEC found that Robinhood made false claims about its execution quality, which resulted in inferior trade prices costing customers $34.1 million. To settle the charges, Robinhood agreed to a cease-and-desist order, a censure, and a $65 million penalty. Robinhood also agreed to hire an independent consultant to review its policies and procedures. [3]

The commission also sued cryptocurrency exchange Bittrex for violating securities laws in 2023. Despite Bittrex actively winding down its U.S. operations, the SEC has taken action against the firm and its former CEO, Bill Shihara, alleging that they operated a securities exchange, broker, and clearing agency without proper registration, among other charges. [4]

The CFTC ordered Tether and Bitfinex to pay $41 million and $1.5 million respectively, for making misleading statements and conducting illegal transactions in 2021. Tether falsely claimed its stablecoin was fully backed by US dollars, while Bitfinex carried out illegal transactions on their cryptocurrency trading platform. Both firms have been ordered to cease and desist from further violations of regulations. [5]

Conclusion

Market Structure Regulation is essential for maintaining the integrity and fairness of financial markets. Exchanges and ATSs operate under differing regulatory frameworks, with exchanges being subject to more stringent oversight. This regulatory fabric ensures that all market stakeholders comply with standards that safeguard investors, advocate for equitable data access, and preserve market equilibrium.

As the financial landscape continues to evolve, initiatives like Flashbots within the crypto space highlight the significance of fair execution and access to data in decentralized finance. By upholding transparent protocols and avoiding manipulative practices, we can create a more democratic and equitable financial ecosystem. Ensuring fair and open access to data and promoting fair pricing mechanisms will be crucial for fostering trust, integrity, and fairness in both traditional exchanges and emerging digital platforms.

Next time, we will delve deeper into the world of digital asset exchanges. Part 3 of this series will take a closer look at their regulatory needs, and offer insights on the pivotal role they play in Web3’s burgeoning financial ecosystem.

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