The Attorney General of the New York State just released a report on the integrity, traditionally speaking, of the crypto asset markets. The exchanges surveyed included Bitfinex, bitFlyer, Bittrex, Coinbase, Gemini, HBUS, itBit, Poloniex and Tidex. Notable, it excluded Binance, Huobi, and Kraken who refused to participate -- as well as another 100+ crypto exchanges that operate globally but steer clear of New York. Kraken is known for having rebuked the questionnaire from the Attorney General as overbearing and disrespectful, and at first glance we had agreed that perhaps it was overreach. But after reading through the report, we changed our mind entirely. It has great information and provides transparency around best practices, or lack thereof, helping investors focus on the right concerns and conflicts of interests.
Let's snooze the questions about KYC/AML, poor security or service, and instead focus on conflicts of interest. Unlike in traditional online brokers, crypto exchanges are both a venue connecting parties, broker/dealers that represent trades as agents, proprietary traders for their own accounts, large owners of the underlying traded assets, and also issuers of their own tokens. Why do we care about conflicts of interests like this? Because misalignment leads to rent seeking, corruption and manipulation. Think about the separation between equity research and investment banking that came about after the DotCom collapse (e.g., Henry Blodget). Or something simpler, like an exchange giving better pricing to large institutional traders that can trade ahead of retail sentiment. Or worse, an exchange using its own large capital to trade, creating the impression of volume or price movement. We care about things like this because the retail investor is literally having value transferred out of their pocket into that of an arbitrage robot, unknown and unpoliced so far.
Let's now take a 90 degree turn into Robinhood, the free trading app with millions of Millennial customers eyeing an IPO in the billions. A recent take down article on Zerohedge walked through the start-up's business model. How can you give away something that has hard marginal costs, other than burning venture money? Freemium and selling your customers. On the freemium side, Robinhood does have the margin offering and can earn interest on cash sweep. But on the latter, it certainly does get paid for the activities of its customers in the aggregate. How? By directing order flow (i.e., those millions of little trades for AAPL) to quant trading firms like Citadel (70%) and Two-Sigma (16%). In turn, those firms can use the retail sentiment to make directional bets, or to mask large block trades without moving the market, or perhaps to find another pricing advantage. Robinhood users don't see the costs, but they could be in the execution -- though we note that Robinhood has released a statement re-affirming they deliver best execution. Tense!