Over the past five years, Solidus has been hard at work with our partners to commit code and release features that advance the state of the art in crypto compliance. In the process, we’ve identified three main pillars, solving for which makes a product crypto-native. Below is how we think about and compartmentalize these pillars.
- Engineering challenges
- Market structure and new manipulative scenarios
- Crypto ecosystem
Let’s break down each of these abstractions.
Engineering challenges
In 2014, Congress called for the SEC to create the Tick Size Pilot Program. This program was designed to determine whether trading small-cap stocks in wider tick sizes would increase liquidity in the stock.
The program was costly. It took two years to plan and two more to run, and in the end, it failed to produce statistically significant results, and the agency scrapped it.
Financial firms had a hard time implementing it, too. It required changes across the trading stack to multiple systems - reference data, order management systems, and controls, to name a few. Apart from the many millions of dollars it cost the industry, it also introduced aggressive operational risk, which is harder to measure.
Imagine - for thousands of stocks (or data points in databases), hundreds of financial institutions had to move a decimal point across their entire trading stack. It was not an easy feat.
Now consider cryptocurrencies, by comparison. A satoshi is a hundred-millionth of a bitcoin; a gwei is one one-billionth of an ether. These tokens are divisible up to eight and eighteen decimal places, respectively. That makes the difference between a penny and a nickel seem like nothing.
There is also another concrete challenge around market data. In traditional finance, the developers of detection algorithms for spoofing depend on market data points like liquidity tranches and average order cancellations to reduce their false positive rates. For traditional securities and commodities, companies like Refinitive and Reuters can provide this data. But in crypto, there is no service provider for these specific data points, and so Solidus has built out its own proprietary database. This capability is particularly important in times of high volatility, when extreme swings in asset price movements could result in erroneous spoofing alerts. In these cases, an intimate understanding of how crypto trades are executed must be coupled with access to the most relevant market data.
In short, The crypto market is a 24/7 operational market with different reading dynamics, that produces different data structures and requires, from an engineering perspective, a system that’s built for purpose.
Market Structure and new manipulative scenarios
Cryptocurrency markets are made up of two different exchanges: centralized and decentralized. Centralized exchanges match trades using good old order books, in the tradition of legacy stock exchanges. Decentralized exchanges (DEXs), by contrast, use open-source smart contracts – and vary widely in their approach to facilitating trades.
This is a huge innovation, enabling any individual to understand, use, and even replicate the mechanics behind peer-to-peer trades. But with any new technology comes novel risks. For instance, only a few DEXs block any of the 240,000+ scam tokens in circulation today.
In this fact lies the first major weakness of legacy risk systems: while they can identify order book anomalies, they lack visibility into risks that are native to blockchains. And without these sightlines, how can they expect to help crypto businesses or regulators detect insider trades that are executed anonymously on a DEX, or pump-and-dump schemes that occur both on- and off-chain?
Now let's explore the concept of the “crypto exchange” more deeply. In crypto’s current market structure, crypto exchanges are seldom just exchanges; many of them also provide prime services, like lending and borrowing. This means that their trade surveillance systems need to be just as dedicated to mitigating counterparty risk as to addressing compliance requirements.
Crypto’s market structure is made even more complicated by the fact that crypto exchanges serve a wide variety of retail, accredited, and institutional investors, all of whom might use multiple crypto wallets. This creates manipulation scenarios that aren’t present on traditional exchanges, where one individual corresponds to one account and companies maintain strict business unit and asset segregation.
In traditional finance, an exchange is just an exchange, a lender is just a lender, and a risk monitoring system is rarely tasked with solving the challenges of multiple business lines at the same time. In Solidus’ work with crypto exchanges and DeFi platforms, however, this issue is significant. Users could collude while attempting to gain a significant amount of a certain asset, inflate its price, and then borrow against it all on the same platform. Thus harming the business in a very real way.
To reiterate: there is a new market structure with services that are usually separated, on top of which there’s a variety of different users, which usually you wouldn’t have as a TradFi platform - when combined, that's a recipe for disaster. Monitoring for market manipulation in crypto, unlike in TradFi, isn’t just to please regulators – it’s to make sure that your platform isn’t losing significant amounts of capital.
Crypto ecosystem
If you’re a player within the crypto ecosystem and hold a hot wallet or plan to one day be a member of the ecosystem - then you’re exposed to the composability factor of the space and to attacks and manipulation scenarios that our frontier research team is categorizing.
A few public examples include Moola Market, a DeFi protocol on the Celo blockchain, which lost $9 million in a single day when an attacker manipulated the price of its Moola ($MOO) token upwards and then borrowed collateral in excess of what they initially paid. And Mango Markets, a DEX on the Solana blockchain, lost $116 million in 30 minutes when a trader inflated the price of its Mango ($MNGO) token on three centralized exchanges and then borrowed against his unrealized profits in much the same way. Cross-market manipulation is an unfortunate but inevitable byproduct of crypto’s composability; with trade surveillance, it’s solvable.
Users can also trade between cryptocurrencies with ease, either by bridging a token from one blockchain to another, or by swapping between two tokens on the same chain. The protocols that facilitate these trades add immense value, but again, some are excessively risky. Since 2020, cryptocurrencies worth over $3.6 billion have been stolen from cross-chain bridges, and over two million investors have been tricked into swapping legitimate cryptocurrencies for scam tokens.
A crypto-native risk detection platform acknowledges and recognizes how the crypto ecosystem operates - with CeFi and DeFi islands that are interconnected, facing upstream and downstream risks.
Our Vision, Mission, and Strategy
In February 2023, we held a company all-hands in which I shared Solidus' Vision, Mission, and Strategy. Those who know me personally can attest that I prefer to stay away from the spotlight and spend my time in the lab focusing on execution. But in the crypto-native spirit of openness, transparency, and collaboration, I want to share it with you today.
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