Crypto exchanges tackle insider trading after recent convictions

In January, the brother of a former Coinbase product manager was sentenced to 10 months in prison for wire fraud conspiracy in what prosecutors called the first case of insider trading involving cryptocurrencies. In September 2022, Nikhil Wahi entered a guilty plea for executing trades based on private data obtained from his brother, Ishan Wahi, a former product manager for Coinbase.

Most countries have laws against insider trading, which carry stiff penalties like jail time and heavy fines. The recent insider trading investigation against crypto exchanges by the United States Securities and Exchange Commission indicates that regulatory bodies are prepared to stop financial misconduct in crypto marketplaces.

Without clear regulation, many have questioned whether other exchanges and platforms have similar rogue employees participating in illegal trades.

Prosecutors raised a similar case against an OpenSea executive in a lawsuit filed in October 2022, with concerns growing in the wake of the FTX collapse and the alleged misconduct of its executives.

Binance listings-related token dumps became a hot topic weeks after the first insider trading conviction. Conor Grogan, a director of Coinbase, used Twitter to draw attention to the recent transaction activities of a few anonymous wallets. The unidentified wallets allegedly purchased several unlisted tokens minutes before Binance announced their listing and sold them as soon as the announcement was made public.

These wallets have made hundreds of thousands of dollars off price spikes in new tokens listed on Binance. The trade’s accuracy suggests that the wallet owners have access to intimate knowledge about these listings. According to Grogan, this could potentially be the work of a “rogue employee related to the listings team who would have information on fresh asset announcements or a trader who discovered some sort of API or staging/test trade exchange leak.”

Binance recently announced a 90-day token sale policy for employees and family members to fight insider trading. The policy prohibits the sale of any newly listed token on the exchange within the mentioned time frame. A spokesperson for the crypto exchange told Cointelegraph that it has a zero-tolerance policy for any employees using insider information for profit and adheres to a strict ethical code related to any behavior that could harm customers or the industry.

“At Binance, we have the industry’s leading cybersecurity and digital investigations team composed of more than 120 former law enforcement agents and security and intelligence experts who investigate both external and internal wrongful behavior. There is a long-standing process in place, including internal systems, that our security team follows to investigate and hold those accountable who have engaged in this type of behavior,” the spokesperson said.

How insider trading in crypto is different from traditional markets

The blockchain is a public, immutable database that stores all transaction histories for cryptocurrencies. While digital wallets conceal traders’ real identities, the blockchains’ openness and transparency enable researchers to access precise transaction data to examine crime and misbehavior.

Ruadhan O, the lead developer at token system Seasonal Tokens, told Cointelegraph that insider trading in crypto doesn’t happen in the same way it happens in the stock market. In the case of stocks, insiders are those with non-public knowledge of upcoming news about the company that will affect its performance.

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He added that these people are company employees, legislators and policymakers. In the case of cryptocurrencies, the people running the exchanges have the opportunity to front-run large trades and manipulate the market. In both cases, insider trading defrauds honest investors in a way that’s very difficult to detect. He explained how exchanges could work with existing policies to ensure fair price discovery:

“The United States could enforce strict regulations requiring incoming cryptocurrency orders to be processed by a public order-matching system, which would prevent front-running. This would help to create a safe system for cryptocurrency investors within the U.S., but it would also drive most cryptocurrency trading offshore. Fully stopping insider trading at the largest exchanges would require international coordination, and competing governments are unlikely to agree on measures that would harm their domestic economies.”

According to a study by Columbia Law School, a group of four linked wallets frequently bought cryptocurrency hours before formal listing announcements, which resulted in gains of $1.5 million. Before the formal listing announcement, the identified wallets bought the impacted tokens and stopped trading as soon as they sold their positions. The study found these digital wallets’ trade history to be precise, suggesting the owners had access to private information about cryptocurrencies scheduled for listing on exchanges.

The trading activity of wallets involved in potential insider trading. Source: Columbia Law School

The study found that 10–25% of the cryptocurrencies listed in the sample involved insider trading on listing announcements.

According to the study, cryptocurrency markets have a severe insider trading problem that is worse than traditional stock markets. Statistical data also demonstrates notable anomalous returns and run-up patterns before listing announcements. These trading patterns are comparable to those documented in insider trading cases in a stock market.

Jeremy Epstein, chief marketing officer at layer-1 protocol Radix, told Cointelegraph that a crypto exchange is no different than a traditional financial services company that deals in markets and should be regulated similarly. He explained:

“What this latest scandal highlights, again, is how superior a decentralized financial system, with transparency to all, will be for consumers and market participants who will need to worry far less about being fleeced by insiders. Insider trading won’t go away, but it will be easier and faster to spot, thus saving millions of dollars for the victims.”

Insider trading is a well-known phenomenon in traditional financial markets where someone carries out illegal trading to their advantage through access to confidential information. The insider trading frenzy in traditional markets is not often limited to former employees of a particular exchange. Many sitting politicians and policymakers have been found to be involved in such acts. According to a New York Times study, at least 97 current members of Congress made purchases or sales of stocks, bonds, or other financial assets related to their employment as lawmakers or disclosed similar activities taken by their spouses or dependent children.

Another prominent case was the 2020 congressional insider trading scandal, in which senators broke the STOCK Act by selling stocks at the start of the COVID-19 epidemic using information obtained from a private Senate meeting. On March 30, 2020, the Department of Justice opened an investigation into the stock transactions. All inquiries are now closed, and no one was ever charged.

This high-profile case of insider trading in traditional markets highlights that, despite all the measures and regulations in place, the same policymakers tasked with safeguarding investors’ interests were allegedly involved in the same activities.

Regulations alone cannot fix some of the inherent critical issues. Paolo Ardoino, the chief technical officer at Bitfinex, believes crypto shouldn’t be targeted for it.

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Ardoino told Cointelegraph that there would be opportunities for abuse in a young industry such as crypto until there are clear rules and guidelines to protect against such abuse. He said that there must be safeguards against asymmetric information flow so that there is true price discovery. He explained:

“I believe that crypto exchanges and policymakers should work together to create a regulatory framework that will allow the industry to thrive while protecting all participants against market abuses. As a cryptocurrency exchange which is at the forefront of technological innovation in terms of digital token trading, Bitfinex’s primary aim has always been to provide an environment that is safe for traders and transparent. We will continue with that ethos.”

With calls for regulations growing after the FTX collapse, crypto exchanges are taking extra precautions to track and ensure fair trading and better protect their customers.

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