Navigating Legal Risks in Crypto Market-Making: Insights and Best Practices

Market-making services are essential for any crypto project aiming to enhance token liquidity, reduce volatility, and establish credibility. However, while these services are widely used and considered standard in the industry, market-making involves intricate legal considerations that projects must fully understand to ensure compliance with applicable laws.

This topic has gained increased relevance following recent investigations by the FBI into prominent market makers, including GotBit and CLS Global. These high-profile cases have sparked widespread concerns among crypto projects regarding the legality of specific market-making practices. At Aurum, we have received numerous inquiries from clients seeking clarity on these issues.

To address the most common questions and provide practical guidance, this article, authored by Associate Partner Illia Shenheliia, explores the legal and illegal aspects of crypto market-making. At the end of the article, you will find key insights from the FBI’s cases against market makers and our checklist for structuring your engagements with them.

The information provided in this article is for general informational purposes only and does not constitute legal or regulatory advice. For specific legal guidance tailored to your business needs, we recommend consulting with a qualified legal professional.

Market-Making in Crypto

Market-making is the process of providing liquidity to a market by continuously quoting buy and sell prices. Market makers aim to reduce the bid-ask spread, making trading more efficient and accessible for participants. For any crypto projects, a market maker is an essential and strategic partner in ensuring that their token remains tradable and attractive.

Market Making is Legal

Typically, legal market-making activities include:

1. Liquidity Provision

Continuously placing buy and sell orders to help stabilise token prices and improve market accessibility.

2. Order Book Management

Balancing buy and sell orders across exchanges to maintain market efficiency and ensure fair trading conditions.

3. Price Stabilisation within Market Norms

Managing price changes to reflect genuine market demand and supply, operating within established guidelines, and avoiding practices that manipulate or distort natural price movements.

4. Token Liquidations

Conducting token liquidations on the open market while minimising price pressure, ensuring that sales are executed efficiently and without causing unnecessary volatility.

5. Advisory and Implementation Services

Providing guidance and executing appropriate, compliant market-making strategies tailored to the specific needs of the project.

Red Flags

Illegal market-making practices often include the following:

1. Wash Trading

Some market makers engage in “wash trading,” where they artificially inflate trading volume by repeatedly buying and selling tokens between related accounts. This deceptive practice misleads the market regarding a token’s liquidity and popularity, creating a false impression of activity.

2. Spoofing and Layering

These tactics involve placing fake or manipulative orders to mislead market participants. Spoofing creates a false sense of supply or demand by placing large orders with no intention of fulfilling them. Layering involves placing multiple orders at varying price levels to influence token prices artificially.

3. Pump-and-Dump

This scheme artificially inflates a token’s price to attract unsuspecting buyers, only for the orchestrators to sell off their holdings at a profit once interest peaks, leaving other token holders at a loss. Note that this does not necessarily involve exit-scam.

Such activities are explicitly prohibited by crypto exchanges. Violating exchange rules can result in harsh consequences, including the token delisting, loss of trading privileges, or financial sanctions such as deposit deduction.

Additionally, depending on the jurisdiction, such activities may be classified as fraud, market manipulation, or violations of securities laws, exposing the team to severe penalties and imprisonment.

Insights From the FBI’s Cases Against Market Makers

The recent investigations into market makers by the FBI have highlighted certain insights and enforcement strategies that crypto projects and market makers must understand. These cases demonstrate that regulators are highly sophisticated and competent in detecting and addressing illegal market-making practices, regardless of attempts to obscure them.

1. Regulators Understand Key Tactics

Contrary to common belief, regulators are well-versed in the tactics often used to evade detection, such as illegal trading through unrelated accounts registered under third-party names. While such methods may complicate investigations, they do not render the activities undetectable or immune to scrutiny.

2. Substance Over Form

Regardless of what is stated in the agreement, regulators focus on the substance of the arrangement. They analyse actual market activity and communication between parties to uncover the true nature of the relationship. This approach ensures that neutral contractual language does not shield bad actors from accountability.

3. Access to Internal Communication

Regulators have significant investigative tools at their disposal, including access to email correspondence, internal documents, and even informal communications such as Telegram chats. Crypto projects should be aware that most of their communication is not entirely private or exempt from review during an investigation.

4. Undercover Operations

Regulators can act undercover, impersonating other market participants such as projects or market makers to gather evidence of illegal practices. This tactic enables them to infiltrate and expose unlawful activities that might otherwise remain hidden.

Market Maker Engagement Checklist

It is essential to choose and engage a market maker with caution and careful planning. Below is a checklist to help ensure your engagement with a market maker is compliant and aligned with your project’s best interests.

1. Due Diligence

Evaluate the market maker’s track record, reputation, and compliance policies. Look for a history of ethical practices and regulatory compliance. Conduct background checks and seek references from other projects if necessary.

2. Market-Making and Liquidation Strategies

Consult with a legal expert to confirm that your proposed strategies are lawful. While certain market-making practices may be common in the Web3 industry, some activities may fall into grey areas or outright violate regulations.

3. Clear Terms

Ensure the market-making agreement explicitly outlines obligations of both parties, payment terms and structure and KPIs to measure success. Clear and comprehensive terms help minimise misunderstandings and protect your interests in the long run.

4. Legality

Review your written and oral agreements with the market maker to ensure they do not include illegal practices, either explicitly or implicitly. Ambiguities can expose your project to legal risks, so seek legal guidance to verify compliance.

5. Transparency

You should legally oblige the market maker to provide regular reporting on their activities. You should also retain the authority to conduct reasonable audits and control measures to ensure compliance with the agreed terms and legal requirements.

6. Conflicts of Interest

Ensure that the market maker’s actions align with your project’s interests. Prevent potential conflicts by including robust confidentiality provisions and restricting the market maker from shorting your project’s token.

Closing Note

At Aurum, we are happy to provide expert advice on all matters related to market-making. Having worked extensively with numerous market makers, we possess deep insights into market standards and industry best practices.

We can help you with reviewing your market-making agreement and validating your strategy. If we identify any activities that may be illegal or carry potential risks, our team can help you explore legal alternatives to achieve your objectives while staying compliant. Protecting your project’s success and reputation is our top priority.

Feel free to reach out to us for tailored guidance and practical solutions.