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 to making 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 severe penalties such as imprisonment 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 who participate in illegal trading.

Prosecutors made a similar case against an OpenSea executive in a lawsuit filed in October 2022, with concerns heightened in the wake of the FTX collapse and the alleged mistreatment of the executives.

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

These wallets have earned hundreds of thousands of dollars off new tokens listed on Binance. The accuracy of the trades suggests that the wallet owners have access to intimate knowledge of these entries. According to Grogan, this could potentially be the work of a “rogue employee related to the listing team who wanted information about new 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 combat insider trading. The guidelines prohibit the sale of newly listed tokens on the exchange within the aforementioned time frame. A spokesperson for the crypto exchange told Cointelegraph that it has a zero-tolerance policy for any employees who use inside information for profit and adheres to a strict code of ethics related to any behavior that could harm customers or the industry.

“At Binance, we have an industry-leading cybersecurity and digital investigation team composed of more than 120 former law enforcement agents and security and intelligence experts who investigate both external and internal wrongdoing. “There is a lengthy process in place, including internal systems, that our security team follows to investigate and hold accountable those 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 cryptocurrency transaction history. While digital wallets hide traders’ real identities, blockchains’ openness and transparency enable researchers to access accurate transaction data to investigate crime and misconduct.

Ruadhan O, lead developer of the token system Seasonal Tokens, told Cointelegraph that insider trading in crypto does not happen in the same way as it does 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 performance.

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He added that these people are the company’s employees, legislators and decision makers. When it comes to cryptocurrency, the people who run the exchanges have the ability to front-drive large trades and manipulate the market. In both cases, insider trading defrauds honest investors in a way that is very difficult to detect. He explained how exchanges can work with existing guidelines to ensure fair price discovery:

“The US could enforce strict rules requiring incoming cryptocurrency orders to be processed by a public order matching system, which would prevent front-running. This will help create a safe system for cryptocurrency investors in the US, but it will also drive the majority of cryptocurrency trading offshore. Completely stopping insider trading on the largest exchanges will require international coordination, and competing governments are unlikely to agree on measures that will damage their domestic economies.”

According to a Columbia Law School study, a group of four linked wallets often bought cryptocurrency hours before formal listing announcements, resulting in $1.5 million in gains. Prior to the formal listing announcement, the identified wallets purchased the affected tokens and ceased trading as soon as they sold their positions. The study found that the trading history of these digital wallets was precise, suggesting that the owners had access to private information about cryptocurrencies that are planned to be listed on exchanges.

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

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

Jeremy Epstein, head of marketing at Layer-1 Protocol Radix, told Cointelegraph that a crypto exchange is no different than a traditional financial company that trades in markets and should be regulated the same way. He explained:

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

Insider trading is a well-known phenomenon in traditional financial markets where someone conducts 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 incumbent politicians and decision-makers 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 by their spouses or dependent children.

Another prominent case was the 2020 congressional insider trading scandal, in which senators violated the Securities and Exchange Act by selling stocks at the start of the COVID-19 epidemic using information obtained from a private Senate meeting. On 30 March 2020, the Ministry of Justice opened an investigation into the share transactions. All inquiries have now been 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 decision-makers tasked with safeguarding investors’ interests were allegedly involved in the same activities.

Regulations alone cannot solve any of the inherent critical problems. Paolo Ardoino, chief technical officer at Bitfinex, believes crypto should not be targeted for that.

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Ardoino told Cointelegraph that there would be opportunities for abuse in a young industry like 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 policy makers should work together to create a regulatory framework that will allow the industry to thrive while protecting all participants from market abuse. As a cryptocurrency exchange that is at the forefront of technological innovation in digital token trading , Bitfinex’s primary goal has always been to provide an environment that is safe for traders and transparent. We will continue with that ethos.”

With regulatory requirements growing following the FTX collapse, crypto exchanges are taking extra precautions to track and ensure fair trading and better protect their customers.