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CRYPTO
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Blockchain-based trading holds enormous promise. But market
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participants should be aware of the risks and opportunities it presents.
by Andreas Par!,
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BY NOW, MOST READERS ARE FAMILIAR WITH BLOCKCHAINS - the For venues that are connected to traditional networks, us­
shared ledgers that facilitate the recording of transactions and ers can fund their account by wiring traditional currency to the
tracking of assets. Although most of these assets to date are di­ exchange - much as one would do when opening an account
rectly related to blockchain-native applications and use cases, in with a traditional investment brokerage. Crypto-only venues,
principle they can be tokenized representations of anything tan­ on the other hand, don't accept wire transfers, although many
gible (a house, car, cash, land) or intangible (intellectual prop­ allow users to fund their accounts through credit card transac­
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erty, patents, copyrights, branding). tions. In most cases, users need to transfer blockchain assets to
The ability to exchange tokens on blockchains is a central these exchanges.
function of these networks. In this article I will review the two There are two ways to purchase crypto assets. First, many
categories for trading blockchain tokens and highlight some of venues allow users to buy directly from the exchange itself, using
the risks and opportunities in this space. their bank account or a credit card. This service is similar to the
money-exchange business in that users do not interact with one
Centralized Trading Platforms another. Second, crypto exchanges have a trading platform that
A centralized trading platform is one where all trades occur and is usually organized as a 'public limit order book' where users can
are recorded on a single, proprietary system that has only an ex­ trade with one another rather than with the exchange itself.
ternal connection to the blockchain. There are two main types On fiat-linked venues, users can trade crypto assets direct­
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of centralized exchanges: crypto-only and fiat-connected (tradi­ ly against fiat currencies, whereas on crypto-only platforms, all
tional currency). trades are between crypto assets. Most commonly, one of them
Some crypto-only exchanges are connected to traditional is a 'stablecoin' - a digital representation of a fiat currency such
finance - for example, Coinbase, FTX (more on them later), as the U.S. dollar. Examples of stablecoins include USDT (is­
Upbit and Bitbuy. But most are not, and remarkably, this latter sued by Tether Inc.) and USDC (issued by Circle Inc.). Cur­
category - which includes Poloniex, Binance and Kucoin - rently, Ontario-based platforms are not allowed to facilitate
processes more than twice the volume of fiat-connected venues. trades with stablecoins.

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In a sense, a centralized crypto exchange is closer

to an investment broker than a stock exchange.

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Following are some of the key terms and concepts from the realm crypto-trading platform that has been registered as a dealer with
of centralized trading platforms that market participants should the Investment Industry Regulatory Organization of Canada

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understand. (IIROC); and Bitbuy has registered with the Ontario Securities
Commission and received exemptive relief.
WALLETS. On public blockchains, crypto-asset ownership is asso­
ciated with a public address, similar to an account number. The TOKEN LISTINGS. Centralized exchanges decide which tokens they
public address is derived from a 'public key' which is generated enable trading for on their platform. Using Bitbuy as an example,
from a 'private key' as part of public-private key cryptography. in June 2022, users could trade 16 of the thousands of blockchain
The private key controls the crypto-assets and is used to sign tokens in circulation. For crypto projects, exchange listings can
transactions. be important to create liquidity for their projects and to enable
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Wallets are software tools that store private keys and enable users to obtain their tokens. Some, though not all, exchanges (e.g.
the signing of transactions. There are many forms of wallets, the Binance) charge token issuers a substantial fee for enabling the
most common being browser plugins and smartphone apps. The trading of a token.
terms 'wallet' and 'public address' are often used interchange­
ably, though technically a single wallet can handle many address­ CUSTODY RISK. Legally and functionally, using a centralized ex­
es. When a user controls the private keys, a wallet is referred to as change requires a transfer of custody of the crypto assets from
'self-custody'. the user to the exchange. In a sense, a centralized crypto ex­
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To use a crypto asset at a centralized exchange, users need to change is therefore closer to an investment broker than a stock
transfer the asset to the exchange. To facilitate this, centralized exchange, because the latter never handles assets directly.
exchanges issue users a unique public address, but the custody of Almost all centralized crypto exchanges are start-ups oper­
the private keys for this address rests with the exchange. Public ating on shoestring budgets. As 'children' of the 2017-18 crypto
addresses are also referred to as 'custodial wallets' because the boom, they grew fast and have been riddled with problems.
exchange has custody of the private keys. The key concept for us­ Keeping tokens at an exchange has proven to be risky- as dem­
ers to keep in mind is 'not your keys, not your coins': when a third onstrated by numerous hacking, fraud and theft scandals such
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party like an exchange controls the private keys, they - not the as Mt. Gox, QuadrigaCX and Thodex. Notably, even the biggest
user- control the asset. brand in crypto-trading, Binance, has been hacked repeatedly.
After a user transfers crypto assets to an exchange/custodial Moreover, it is often unclear how crypto exchanges handle as­
wallet, there is usually a second step whereby the assets are trans­ sets in their omnibus wallets, if users have real-time 24/7/365
ferred from the custodial wallet to one of the exchange's wallets. access, and if exchanges separate their own assets neatly from
After that, all transactions and transfers are recorded only in the their customers'.
exchange's own siloed system- not on the blockchain. For this
reason, assets in 'omnibus wallets' are often referred to as 'off CRYPTO WASH TRADING. Numerous websites publish information
chain.' about the trading activities at various crypto-trading venues -
and because liquidity begets liquidity, venues that want to at­
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FEES. Deposits and withdrawals from centralized exchanges in­ tract users may be tempted to overstate their volume. 'Wash
volve fees, which can be substantial - particularly in Canada. trading' is one practice that, allegedly, many crypto exchanges
For instance, Interac transfers in and out of Canada's first have either engaged in or tolerated to create fake volume. One
regulator-approved venue, Bitbuy, cost 150 basis points; wire study reported that up to 70 per cent of the volume on unreg­
transfers cost 50 basis points; and withdrawals to the Ethereum ulated crypto exchanges was fake - although it also reported
blockchain cost $15 to $20, depending on the price of the ETH that regulated venues such as Coinbase and Kraken do not en­
(the native cryptocurrency ofEthereum). Coinsquare is the first gage in such behaviour.

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PRICE MANIPULATION. Another concern relates to the general pro­ Tax-loss harvesting basically turns the law against the gov­
pensity of price manipulation at venues that have no regula­ ernment in that specially-designed crypto-assets (or strategies

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tory oversight. One alleged scheme involves stablecoin issuer that also fit the current law) create made-up capital losses that
Tether and is part of the lore on the backing (or lack thereof) of offset capital gains. One can argue that governments that seek to
the stablecoin USDT. The premise of USDT is that each token is collect rents from 'hot potato,' trading-induced, made-up price
backed by a USD or cash equivalent in a bank account; but for rises of meme coins must also accept equally made-up losses;
years, Tether has refused to have its books audited. but in some jurisdictions, losses can offset gains in traditional
Tether issues coins using the exchange Bitfinex, a crypto­ markets. With the large losses in the crypto markets in 2022,
only venue. Researchers have documented that USDT issuances I predict that we will see fierce taxation-related discussions in
were not followed by subsequent fiat outflows, raising the ques­ 2023 and beyond.
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tion as to the source of the funds to back these newly-issued
coins. Moreover, they have shown that, instead, USDT issuance KEY TAKEAWAYS: There are numerous concerns regarding central­
curiously coincides with massive rises in Bitcoin's price. In other ized crypto exchanges. For one, they hold assets in custody, and
words, it appears that USDT issuance may well have been used investors therefore have the reasonable expectation that their
to pump up the price of Bitcoin. funds will be available when they want them. But will they? Dur­
ing the May 2022 crash, Coinbase revealed that it does not al­
PUMP-AND-DUMPS. One common allegation in the crypto world ways separate its own funds and customers', exposing clients to
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is that there are plenty of pump-and-dump schemes. Indeed, losses, should it go bankrupt. Is this a risk that customers can be
research shows that there are Telegram groups (open to any­ expected to accept? I don't think so.
one but with a premium subscription) that coordinate pump­ The November 2022 collapse of FTX illustrates my con­
and-dump activities of particular coins on selected exchanges. cerns: among the many things that went wrong, it appears that
Boomtimes are often rife with such shenanigans, and develop­ FTX used its customer deposits for leveraged and ultimately
ments related to wash trading, price manipulations and pump­ loss-making investments. At press time FTX had filed for Chap­
and-dump attacks were all documented during the 2017-2018 ter 11, and its customers are likely no more than very junior cred­
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boom. itors in the bankruptcy proceedings.

As indicated, centralized exchanges make listing decisions
TAX-LOSS HARVESTING: The latest trend involves using trading and often charge substantial fees. They also invest in the crypto
strategies and crypto assets such as specialized non-fungible assets that they list- but such investments are not always trans­
tokens (NFTs) to create capital losses that investors can use to parent. While charging for listings and making investments
offset capital gains. In traditional markets, a capital gain arises creates trust for investors, it also possibly creates substantial
when a trader locks in the price appreciation of a firm's stock, conflicts of interest that are rightfully regulated in traditional
presumably obtained because the firm retained and reinvested financial markets.
its earnings. Governments have contributed to enabling these Let me also outline the perspective of crypto exchanges:
earnings by providing infrastructure, education, security etc., so Blockchains are borderless by design and aim to serve a world­
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it is fair that some funds flow back to the public when the firm wide clientele. But there are many regulators in the world, often
and its investors do well. Many tokens, on the other hand, have with conflicting requirements. Dealing with even one regulator
explicitly no relation to economic activity, nor do they serve any ties up lawyers for months. Therefore, even with the best inten­
economic purpose. One example is the Shiba-Inu coin, which tions and well-thought-out systems, it is expensive and risky for
its creator invented as a meme. Yet capital gains from trading a crypto exchange to serve a worldwide audience.
these tokens fall under tax law just as much as cap gains from Going forward, the likely best-case scenario for centralized
mining or banking stocks. venues is one where we see consolidation in the space, with a

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Well-functioning AMMs are crucial to
the long-term viability of the DeFi ecosystem.

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few international brands servicing a possibly worldwide clien­ Although blockchains can facilitate the exchange of crypto as­
tele. Their pockets would be deep enough to make it worth their sets, a blockchain is not a marketplace.
while to absorb the compliance costs from satisfying big coun­ It is possible to organize crypto asset trading on a blockchain,
tries' regulators. Alongside these big brands, we will likely see similar to a traditional stock market, by registering limit orders
smaller venues that only serve a clientele in their national juris­ as a 'smart contract'; but this approach is not practical because

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diction and deal with a single regulator. These will be jurisdic­ each new order submission costs a fee to blockchain validators.
tions that are too small and insignificant for the large exchanges Unexecuted orders also waste resources as all 10,000+ nodes
to deal with, and the big-brand venues may simply exclude users must process the order. That's why trades of blockchain-based
from these countries. items or tokens most often occurred on centralized, 'off-chain'
Personally, I would find such an approach problematic be­ exchanges, thus reducing the blockchain to yet another settle­
cause it would be concentrated and large institutions could be­ ment infrastructure. Nevertheless, the volume of trades on de­
come systemic points of failure, and because residents of small­ centralized exchanges has increased since the summer of 2020.
er countries would miss out on opportunities. The past few years The following explains why and outlines some of the key terms
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have shown that the general public has an appetite for crypto­ and issues in the decentralized realm.
assets. In my mind it is nai:ve to believe that people won't find
a way to get their hands on crypto-assets even if their domestic AUTOMATED MARKET MAKERS (AMMs). An AMM is a 'smart contract'
regulator tries to restrict access for non-compliant platforms. - a piece of code that is registered on a public blockchain. Once
Many Canadians had funds at FTX, and it was domesticized in deployed, this code is accessible by anyone who has access to
the Bahamas. the blockchain for as long as the blockchain exists. The code is
It is in everyone's interest that regulators develop frame­ operated by blockchain validators who follow protocol, not by
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works that recognize the general public's tendencies and provide the entity that has submitted it. Changes to the code are usually
a safe environment - while enabling innovation to thrive. The governed by a so-called Decentralized Autonomous Organiza­
big question is whether the benefit of regulation is worth the cost tion (DAO), and governance is DAO-token based, blockchain­
of the risks and missed opportunities that it creates. organized voting that can affect only a very limited set of contract
The emergence of a new eco-finance system provides op­ parameters.
portunities to rethink processes and rules to address and find These tokens are used in many ways. For instance, some­
an acceptable level of risk. However, a totally different scenario times users of a protocol get rewarded with DAO tokens- which
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is also possible: crypto-asset trading and token issuance could is akin to Canadian Tire rewarding its retail customers with its
move entirely 'on-chain' so that centralized exchanges, with all stock. DAO token holders sometimes receive a share of the fees
their associated risks, disappear. Users would still need to ex­ that the protocol generates. Overall, the arrangement presents
change their fiat money for crypto currency, but they would not many challenges for interested investors and regulators. When
need a high-powered trading system for this simple task. Instead, is a DAO token a security? When it is, who is responsible for re­
specialized service providers (or traditional financial institu­ porting and compliance once the token has been issued and the
tions) might allow users to simply swap digital representations protocol deployed? Who is liable if something goes wrong?
of fiat currency for real fiat currency directly from their deposit Despite the uncertainty, mid-2020 saw the rise of AMMs,
account. In this scenario, traditional financial institutions would and leading protocols such as Uniswap, SushiSwap and Pan­
likely absorb the technology from centralized exchanges. cakeSwap have seen tremendous user uptake. They now process
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billions of dollars' worth of transactions each day- often more

Decentralized Trading Platforms than the largest centralized exchanges.
A decentralized platform is a system that uses the blockchain's
inherent ability to process code: All trades occur directly on the AMM TRADING. Beyond the impressive user uptake, AMMs are in­
blockchain as 'atomic swaps' of tokens. It is ironic that, until teresting because they contain some novel institutional arrange­
recently, the trading of deliberately borderless, decentralized ments. First, they combine or pool liquidity so that liquidity pro­
digital items could only be performed in centralized venues. viders don't compete for order flow - a stark contrast to stock

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exchanges, where proprietary trading firms make billion-dollar but not settled transactions can be front-run. Lastly, although
investments to gain nano-second speed advantages. This setup AMMs are reasonably efficient in using the blockchain's capac­
allows retail investors to earn 'passive income' from contributing ity, they do absorb a large portion of its computational resources.
their assets to a liquidity pool because providing liquidity does Arguably, the success of blockchains as a financial infrastructure
not require specialized skills or equipment. hinders their use for other, non-finance causes.

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Second, AMMs don't directly rely on a market mechanism Recent developments in 'optimistic roll-ups' may solve
that equilibrates demand and supply and determines an order's many of the issues around AMMs, and they may also enable
cost. Instead, they use a hard-coded pricing rule, thus creating the same trading options that venues such as Binance offer with­
a constraint against which users optimize. Third, the pricing out increased security risks and without the costs of regulatory
function employed by almost all AMMs has never been used oversight.
in traditional financial markets (to the best of my knowledge). Lack of liquidity is one of the biggest problems plaguing
Therefore, this novel setup raises questions about the function­ securities markets. It makes trading more expensive and raises
ing of these markets, the informational efficiency of prices and the risk of not finding a counterparty, making it harder for inves­
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the possibility of arbitrage. tors to adjust their risk exposure. This, in turn, makes it harder
for issuers to raise funds and reward and motivate employees
HOW AMMs WORK. A swap exchange creates a liquidity pool by with stock options. A key innovation of AMMs is that they are
combining deposits of pairs of tokens A and B from liquidity a novel approach to liquidity provision. Their liquidity pooling
providers. To provide liquidity, a user transfers a set quantity of could improve the current situation, leading to more efficient
both tokens to the AMM smart contract. Usually, the user will capital markets.
receive a receipt token in return that they can then use in other
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applications - for example, as collateral for a loan. A liquidity In closing

demander can trade against this pool by sending one type of to­ It is possible to envision a future in which centralized exchanges
ken and receiving the other token in an 'atomic swap'. A pric­ no longer exist. Aside from the on-ramp service they offer, they
ing rule determines the exchange rate of tokens. The objective are arguably unnecessary. Instead, crypto trading in the future
of the rule is to keep the pool's liquidity invariant in the sense may occur exclusively on-chain.
that, when a liquidity demander removes one type of token from There is a real question as to whether the ecosystem sur­
the pool, they must deposit a quantity of the other type such that vives the current turmoil. In my mind, there are two possible
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the aggregate liquidity of the pool defined by a 'bonding curve' futures aside from total obliteration. One is that some im­
remains unchanged. mensely popular non-financial applications emerge. The other
is that, over time, most traditional financial assets- including
THE ROLE OF AMMs IN DEFI. AMMs play an important role in the fiat money and property registries - are either tokenized or di­
De Fi ecosystem and are often used in the strings of transactions rectly re-issued as new vehicles on blockchains so that they can
that are needed for the liquidation of DeFi loans that breach a be listed, used and transferred without borders. For all of the
collateralization bond. These multi-step transactions - which issues identified herein, blockchain-based trading holds enor­
also often involve so-called flashloans- are one of the reasons mous promise. RM
why DeFi holds such promise to yield a more efficient financial
system. Well-functioning AMMs are, therefore, crucial to the
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long-term viability of the De Fi ecosystem.

One concern is that AM Ms may be used for money launder­
ing. That narrative, however, has little merit, because for a token ---�� Andreas Park is a Professor of Finance at the Rotman
swap, the recipient public address of one token is the same as the School of Management, cross-appointed to the University
of Toronto Mississauga. He is also Research Director at
sender of the other. Therefore, transactions remain traceable. FinHub, the Rotman School's financial innovation lab,
Another concern is the possibility of 'sandwich attacks'. The which is studying the technological innovations that are
gist is that since there is no time priority on blockchains, cleared transforming the world of finance.

rotmanmagazine.ca / 39
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