Summary of New York Attorney General’s (Underwood) Report Pt. 1


Summary of New York Attorney General’s (Underwood) Report Pt. 1

Background Information

For those that don’t know, the former Attorney General for the State of New York sent out a formal inquiry earlier this year (2018) to several exchanges operating in the United States.

This was covered to some extent in the crypto community when it happened during the month of April.

Here’s an article that summarizes the nature of the original inquiry:

NY Attorney Genernal Launches Inquiry in Crypto Exchanges | CoinSpeaker

_The fact-finding inquiry into the practices of crypto exchanges is intended to ensure all mandatory procedures of…_www.coinspeaker.com

The article above summarizes the raw details of this initial inquiry that Eric Schneiderman sent out to thirteen different crypto exchanges operating in the United States.

Contents of the Letter That Was Sent to Exchanges in April

Here is the link to the actual letter that Eric Schneiderman sent out to the crypto exchanges:

A.G. Schneiderman Launches Inquiry Into Cryptocurrency “Exchanges”

_FOR IMMEDIATE RELEASE April 17, 2018 Attorney General’s Press Office / 212-416-8060 nyag.pressoffice@ag.ny.gov Twitter…_ag.ny.gov

In the letter, the A.G. states that they were sending the letter in the interest of promoting greater transparency in the crypto markets. In fact, the report specifically states,

“As part of a broader effort to protect cryptocurrency invesotrs and consumers, the Attorney General’s office sent letters to thirteen major virtual currency trading platforms requesting key information on their operations, internal controls, and safeguards to protect customer assets.”

The thirteen exchanges (companies) in question that the A.G. sent the letter to were(per the A.G.’s report):

  1. Coinbase, Inc. (GDAX)
  2. Gemini Trust Company
  3. bitFlyer USA, Inc.
  4. iFinex Inc. (Bitfinex)
  5. Bitstamp USA Inc.
  6. Payward, Inc. (Kraken)
  7. Bittrex, Inc.
  8. Circle Internet Financial Limited (Poloniex LLC)
  9. Binance Limited
  10. Elite Way Developmetns LLP (Tidex.com)
  11. Gate Technology Incorporated (Gate.io)
  12. itBit Trust Company
  13. Huobi Global Limited (Huobi.Pro)

The above list of exchanges are all very high volume in nature and have a major impact on the crypto sphere.

Nature of the Letter

Its important to keep in mind that the Attorney General did not state that there was any specific set of events or whiff of nefarious activity that prompted the sending of the letter to the aforementioned exchanges. Instead, the letter states that the A.G.’s probe was prompted by the foreboding sense that a largely unregulated, complex technical sphere such as cryptocurrency where billions of dollars in investments are being made in companies with little to no financial information on record could lead to serious negative consequences for investors, in particular residents of the state of New York in the United States.

The remainder of the letter uses this premise outlined in the former paragraph to justify its inquiry into the operations of the exchanges in question.

Nature of the Questioning by the A.G.

Below is the full pdf document of the attached questioning by Attorney General Eric Schneiderman:

https://ag.ny.gov/sites/default/files/virtual_markets_integrity_initiative_questionnaire.pdf

The questionnaire covers relatively innocuous questions such as:

  1. Ownership and Control
  2. Basic Operation and Fees
  3. Trading Policies and Procedures
  4. Outages and Other Suspensions of Trading
  5. Internal Controls
  6. Privacy and Money Laundering
  7. Protection Against Risks to Customer Funds
  8. Written Materials

Kraken’s Refusal to Acquiesce to the Report

Overall, there was nothing in the request that probed into information that the vast majority of companies don’t already have available through their website or public tax returns.

However, for some reason the request was received with vitriol by the Kraken Exchange in particular.

Kraken, in a widely publicized report in April, stated publicly that they would outright refuse to answer to the A.G.’s request for more information about the inner workings of their exchange.

The CNBC article cited below provides more detail on the nature of their refusal to comply:

Kraken cryptocurrency exchange says it will not comply with New York inquiry

_”This is very basic information that any credible platform should have on hand and be willing to share with their…_www.cnbc.com

Jesse Powell, in an explosion of tweets and press releases through the Kraken website provided a host of reasons for why he felt that his exchange was justified in ignoring the A.G.’s request for additional informatoin about the inner workings of his company.

Below is a link to one of Jesse Powell’s tweets, issued on his personal account, concerning the matter:

https://twitter.com/jespow/status/986700932778934273

According to Powell, “The placative kowtowing toward this kind of abuse sends the message that it’s ok.”

Somehow, the A.G. peering into the inner workings of crypto exchanges in order to garner enough information to assess whether the exchanges were posing an inherent systemic risk to those invested in the crypto sphere was something that Jesse Powell, owner of Kraken exchange, felt was a gross overreach of the New York Attorney General’s powers at that time. If he did not feel this way, then at the very least, he made his feelings clear that this was an action that constituted ‘abuse’.

Below is the posted copy of the press release that Jesse Powell wrote and attached to the aforementioned tweet as well:

The write-up, which was scathing in its tone, lambasts the New York Attorney General and the state of New York in general. The letter levies accusations against the office by calling it ‘hostile’ toward cryptocurrency, and makes insinuations of it being involved in a conspiracy with the ‘Fed’ of some sort by asking, ‘What ever happened to auditing the Fed?’

Jesse also claims that,

“Having the kind of requested information ‘on-hand’ is not the same as having the resources to compile it neatly to fit the framework of the request, within 2 weeks.”

This is an interesting assertion when considering the fact that the bulk of the questions on the questionnaires appear to be seeking information that the owner or any other C-suite executive at the exchange would be able to procure in a couple of hours at a maximum.

Resignation of New York Attorney General Eric Schneiderman

What put this request in limbo for a certain period of time was the fact that Eric Schneiderman, the Attorney General that had sent the original questionnaire to the exchanges ended up being forced to resign due to a scandal in his personal life that had broken out in the media:

Eric Schneiderman Resigns as New York Attorney General Amid Assault Claims by 4 Women

_Eric T. Schneiderman, the New York State attorney general who rose to prominence as an antagonist of the Trump…_www.nytimes.com

Specifically, as the title of the article cited above states, Schneiderman was accused of assaulting four different women.

This created a speculation within the crypto community that the chaos created by Schneiderman’s abrupt departure from his post would cause delays in the assessment of the crypto exchanges that were listed in the A.G.’s original report.

For those that do not know, the Attorney General of New York is responsible for hiring all of the staff in the office as well. So, when Eric Schneiderman exited, his entire staff was effectively displaced as well. Therefore, its plausible to assume that there would be some sort of backlog or delay in transition of information.

However, it now appears that this was not the case.

Enter the new, New York Attorney General: Barbara Underwood

Don’t let the nice demeanor fool you! Barbara is a cold-blooded assassin

While her name is unfamiliar to most in the political and cryptocurrency worlds alike, Barbara Underwood is no one to underestimate.

According to her Wikipedia page (which is accurate in the United States for public officials with restricted editing permissions):

  • “Underwood earned an A.B. magna cum laude from Harvard University”, which means that she was at the top of her class…at Harvard University ’66 (undergrad).
  • She also completed a J.D. (law degree) three years later at Georgetown University (‘69).
  • After receiving her J.D., she clerked for Chief Judge David L. Bazelon of the U.S. Court of Appeals for the District of Columbia Circuit and then clerked for legendary Supreme Court Justice, Thurgood Marshall. For those that do not know, this is one of the most prestigious positions that one could hope to attain in the legal field. Clerkships, in general, are one of the most difficult positions to earn and the chances are that much more infinitesimal when considering the possibility of earning a clerkship with a Supreme Court Justice.
  • When she finished her clerkship (voluntary leave), she then became a law professor at Yale Law School for a decade, which is currently ranked as the #1 law school in the United States at the time of writing (yes, ahead of Harvard).
  • Afterward, she then went on to teach at Brooklyn Law School before moving on to her final teaching post at NYU’s School of Law.
  • Once she finished her tenure in academia, she decided to move on to working in several different District Attorney offices across the state of New York. According to Wikipedia, “ Underwood left academia to work in the Kings County District Attorney’s Office.[5] She later served in the District Attorneys for three different counties in New York City: she was an Assistant District Attorney in New York County, Chief of Appeals and Counsel to the District Attorney in Kings County (Brooklyn), and Senior Executive Assistant District Attorney for Legal Affairs in Queens County. She then served as Chief Assistant United States Attorney and later Counsel to the United States Attorney for the Eastern District of New York.”
  • Before accepting her post as the Attorney General, Barbara Underwood had successfully tried 20 cases in the Supreme Court of the United States (highest court in the country). (Source: http://www.nydailynews.com/new-york/barbara-underwood-woman-head-ag-office-article-1.3977992 )

The facts above should render the following conclusion more than evident: Barbara Underwood is no slouch.

This is a reputable, well-respected individual in the legal and scholarly community.


New York Attorney General’s Report

Like it or not, the New York Attorney General has some sway in what goes on in the crypto sphere and their reports have a demonstrable impact on the crypto sphere.

Those in the crypto sphere, specifically, became acutely aware of the release of the report that the N.Y. A.G.’s office had compiled (under Underwood’s direction) through a series of tweets that she had put up a few days prior announcing some of the summarized findings/results of the report.

The thread of tweets can be found here:

Concerning Findings in the Report That Were Tweeted

Before even digging into the report itself, it is worth noting some of the more concerning findings that Barbara Underwood posted in the initial 140–280 character tweets that were put up.

Specifically, she stated that:

Obviously, this string of tweets does not bode well for the exchanges that were listed.

In particular, the worst news was received by Gate.io, Binance, and Kraken — all of whom were relegated to the financial authorities of the United States.

Analyzing the Actual Report

Here is the link to the actual report, in case you haven’t had a chance to view it:

Virtual Markets Integrity Initiative Report

_New York AG Barbara D. Underwood released a report on virtual markets, finding many platforms vulnerable to abusive…_virtualmarkets.ag.ny.gov

The report is split into five different sections, which are:

  1. Jurisdiction, Acceptance of Currencies, and Fees
  2. Trading Policies and Market Fairness
  3. Managing Conflicts of Interest
  4. Security, Insurance, And Protecting Consumer Funds
  5. Access to Consumer Funds, Suspensions, and Outages

What the Report Probes Into

According to the report, “Each section presents the responses of participating platforms to specific, targeted questions on topics relevant to retail customers. Examples include:

  1. Does the platform conduct independent testing to ensure adequate IT security against threats, including hackers?
  2. Does the platform allow professional traders to use automated or algorithmic trading?
  3. Does the platform trade against its own customers on its venue?
  4. Does the platform carry insurance that would cover virtual currency losses in the event of theft or hacking?
  5. Does the platform compile, disclose, and explain site outages or trading suspensions?”

Summary of Key Findings Within the Report

#1 — Conflicts of Interest Were Found Within the Exchanges

The report aptly noted that there were numerous conflicts of interest in the way that the exchanges were running.

According to the report, this stems from the fact that the exchanges surveyed serve an ‘all-in-one’ role, which means that they are responsible for; operating the platform on where buyers and sellers trade virtual and fiat currencies, fulfilling a broker-dealer role, operating as money-transmitters, becoming proprietary traders on their own platform (trading against customers), holding a substantial portion of cryptocurrency in general, and also having a substantial outside stake in some of the cryptocurrency listings on their platform without any divulgence of the potential conflicts of interest.

There are a few notable tidbits in the above paragraph that crypto investors actually should pay special attention to:

  1. It was found that exchanges are currently trading against their customers. While this doesn’t seem like a big deal, its actually something that puts the retail investor at a tremendous disadvantage. The exchange ultimately possesses all of the necessary information to be able to counter-trade against clients.
  2. In light of #1, its worth noting that several high-volume exchanges (including Bitfinex, which was listed as one of the exchanges being queried in the original A.G. inquiry) institute a policy called ‘iceberging’ orders. What this does is hide limit orders from the view of the retail customer on the client-facing side of the exchange’s interface. More information on this practice is located here: https://www.investopedia.com/terms/i/icebergorder.asp
  3. The fact that exchanges buy and sell cryptocurrency for their own accounts on their own platforms is also problematic for a number of different reasons. Once again, its worth noting that without any proper financial reporting, there is no way to guarantee that customer funds are not being traded by exchanges in a prop trading-esque setup. In this instance, the exchange ‘loses’ when the customer ‘wins’, which would prompt the exchange operator (the entity that is responsible for ensuring the ‘fairness’ of the exchange itself) to confront a conflicting situation where they must resist the urge to ‘rig’ the exchange (think Las Vegas casinos) in their favor in order to guarantee a favorable outcome.
  4. The fourth point that is worth touching upon is perhaps the most important. That point underlines the fact that there exchanges have refused to divulge any conflicts of interest that they may have in releasing a coin on their exchange. The most notable example of such malpractice can be found on the exchange, Coinbase (and GDAX/Coinbase Pro).

Conflicts of Interest

As the New York Attorney General’s report stated, there are multiple conflicts of interest among exchanges that are not divulged to investors.

The most notable example can be found by looking at Barry Silbert’s investment portfolio, his relationship with Coinbase, and their coin additions/listings.

To give background, Barry Silbert is the owner of Digital Currency Group — a major investment fund that specializes in acquiring companies in the ‘digital assets’ market.

One of DCG’s major investments is an exchanged called, Coinbase. In 2018, Coinbase announced that they would be adding support for a new coin on their exchange before subsequently allowing traders to purchase the coin directly off of their platform.

The coin referred to above is Ethereum Classic.

One of Ethereum Classic’s biggest investors is Barry Silbert, as evidenced by his tweets and other notable sources:

Despite the obvious conflicts of interest that Coinbase had in listing Ethereum Classic, none were divulged throughout any of its press listings and, unfortunately, the ‘mainstream’ cryptocurrency media outlets failed to divulge this information too.

On the topic of cryptocurrency media outlets though, it is worth noting that DCG owns CoinDesk, one of the industry’s most popular publications, as well. There has been a systematic failure to divulge the inherent conflicts of interest in some of the news and information that they have been promoting as well.

The same grievance that exchanges fail to divulge any conflicts of interest can be said of Kraken as well, which is yet another Barry Silbert/DCG investment that has listed several projects which Barry Silbert is also invested in.

The problem here is that the failure to divulge any of this information begs the question of whether Barry Silbert is simply abusing his ‘power’ as a major investor in these projects to orchestrate a series of events where his profitability is all but guaranteed.

#2 — Trading Platforms Have Yet to Implement Serious Efforts to Impede Abusive Trading Activity

This is another major point that the A.G.’s letter touched upon in their report. The lack of any preventive measures to reduce/eliminate manipulative or abusive trading practice is exemplified via the fact that rampant abuse has been observed and reported on many of the exchanges in question.

Specifically, the report states that,

“Platforms lack robust real-time and historical market surveillance capabilities, like those found in traditional trading venues, to identify and stop suspicious trading patterns. There is no mechanism for analyzing suspicious trading strategies across multiple platforms. Few platforms seriously restrict or even monitor the operation of ‘bots’ or automated algorithmic trading on their venue.”

To say that this is concerning would be an understatement. The fact that there are virtually no consumer protections, yields credence to the theories many have concerning market manipulation, wash trading, money laundering, and any other market abuses.

It is worth noting that 99.9% of the time, these market abuses tend to impact retail customers adversely rather than the exchanges themselves or larger ‘whale’ (high net-worth individual/business) investors.

Perhaps what is more troubling is the report’s assertion [that the exchanges have made hardly any efforts to stop the rampant abuses from occurring on their platforms.

This assertion is something that retail investors should pay special attention to, because it would be in an honest exchange’s best interest to ensure that their markets are being operated fairly in this context for the following reasons:

  1. Market manipulation hurts traders on the platform that it occurs on.
  2. Platforms (exchanges) themselves actively trade on their own platforms, as noted by the A.G.’s report.
  3. Therefore, platforms, if operating in an honest sense, should/would also be adversely impacted by rampant market manipulation and unfair trading practices.

Given the above facts, it is hard to justify why exchanges have refused to take any meaningful measures against market manipulators unless they are also a participant (or perhaps the main culprits) of said trade manipulation.

#3 — Protections for Customer Funds Are Often Limited or Illusory

This is yet another important point for investors to take heed of.

As noted in the subheading for this section, the A.G. report asserts that there are few, if any, protections for customer funds. This means that, in the instance that customer funds go ‘missing’ due to being lost, hacked, stolen, exploited by a software bug or the exchange’s insolvency, there is no backup plan for customers to be able to actually retrieve those funds.

This is yet another point that should be a major area of concern for investors as well as prospective investors.

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