The nascent cryptocurrency industry is making headway with mainstream investors, but there are still big concerns over insider trading and other unethical behaviors.
Why it matters: Unlike the traditional investment markets, which are overseen by multiple government agencies, companies and funds dealing with digital tokens are largely left to self-regulate. This could leave retail investors unfairly disadvantaged without the same levels of information, and remain a hurdle to getting institutional investors comfortable with crypto-assets.
For digital token exchanges, like Coinbase and Robinhood, extra knowledge about individual tokens can have an out-sized effect on trading.
Flashback: For example, take Coinbase's bumpy addition of Bitcoin Cash last fall.
- Bitcoin Cash was created as a clone of Bitcoin, which meant that anyone who owned the cryptocurrency would automatically be entitled to the same number of Bitcoin Cash tokens.
- Coinbase eventually announced it would roll out support for Bitcoin Cash a few months later to enable its customers to access their tokens via the company's digital wallets.
- But just hours before the listing was publicly announced, there was a spike in the price of Bitcoin Cash, suggesting someone with knowledge of the plans may have leaked or acted on it.
- Coinbase hired two outside law firms to investigate the matter and recently told Fortune that it found no wrongdoing. However, a class action lawsuit against Coinbase over this is still ongoing.
How they’re handling this: For the most part, cryptocurrency exchanges are borrowing from rules that more traditional exchanges currently follow, and which often are implemented by regulators like FINRA.
- Many have developed their own internal policies that state that employees cannot share material non-public information with anyone outside the company, nor trade tokens their employer is about to list, with strict rules about trading.
- Coinbase last month released a list of five tokens that it may add in the future, which may have helped curb potential leaks as it investigates each token. And, on Tuesday, it announced the hiring of its first chief compliance officer.
Hedge fund managers trading digital tokens have also spurred whispers and concerns over potentially unethical behavior.
- As a tight-knit industry, it’s not uncommon for fund managers to be friends or in other relationships with folks developing token projects, giving them unchecked access to information or the ability to “pump and dump” a new token.
- Some fund managers advise individual token projects, undoubtedly giving them special access to information.
- “Those concerns are real… so many people in this group have capital with other people,” Ari Nazir, managing partner at crypto-hedge fund Neural Capital, tells Axios of the industry’s relationships.
- Nazir adds that he’s created ethics rules for himself and coworkers, even though there's no such requirement to obtain his broker's license. For example, he asks entrepreneurs not to tell him certain information such as plans to be listed on a particular exchange. His team also documents all investment decisions and only trades within specific parameters to ensure nothing is done because of improperly obtained information.
- Another question that comes up is the role of venture capital funds who purchase tokens—a much more liquid position than the startup equity they usually hold for years. Messari co-founder Ryan Selkis recently suggested that VCs, who often publicly praise their investments, should disclose their token sales to ensure they're not dumping tokens on retail investors.
Bottom line: "The government has a system for protecting retail investors and at the same time reining in fund managers—and the crypto industry can definitely learn from this,” says Nazir.