Crypto Giant Binance Offered ‘Flash Boys’ Benefits, Regulator Lawsuit Claims

The CFTC also said the exchange knowingly allowed US-based trading firms to access its international derivatives market, Binance.com, despite publicly stating that this market was off limits to US customers. The companies used offshore entities and other methods to circumvent the ban, the CFTC said.

Binance called the CFTC lawsuit “disappointing” and said it had taken significant steps to comply with US and global regulators. A spokeswoman declined to answer questions about Binance’s approach to high-frequency trading.

The revelations in the lawsuit echo some of the concerns raised about ultra-fast trading in the US stock market over the previous decade, following the 2010 “flash crash” and the 2014 publication of the best-selling “ Flash Boys” by Michael Lewis. Critics of high-frequency businesses said they were making money at the expense of less sophisticated traders.

Public scrutiny has led to tighter regulation of HFT and greater awareness of practices such as colocation. In colocation, trading firms place their servers directly in the data centers of market operators such as the New York Stock Exchange and Nasdaq Inc.,

allowing them to reduce the tiny fraction of a second needed to transmit data to the exchange.

In messages to a New York-based trading company, Binance staff told the company that its VIP status would give it a 5-10 millisecond advantage over non-VIP participants, according to the CFTC lawsuit. The CFTC identified the firm as “Trading Firm B” and said it was one of Binance’s biggest clients, continuing to trade today.

Giving some traders a speed advantage is troubling, said Joe Saluzzi, a partner at stock brokerage Themis Trading LLC and a critic of high-frequency trading. “In any industry, you try to give big customers a discount,” Mr. Saluzzi said. “But it’s not a discount, it’s an advantage. They can use it to make more income. If I was one of their other customers, I’d be a little upset.

Crypto traders said Binance’s VIP program is typical of the industry and part of the normal process in which exchanges seek to win business from high-frequency traders.

Exchanges need HFT firms to engage in market making, strategy of buying and selling assets throughout the day and profit by collecting a spread between the so called bid and ask price . These market making activities can benefit investors by facilitating the buying and selling of assets while generating transaction fee revenue for the exchange.

Traditional exchanges such as the NYSE and Nasdaq also offer market maker incentives, such as co-location and fee rebates for high-volume traders. But these practices are strictly regulated and exchanges are required to ensure that market makers are treated equally, for example by ensuring that the length of fiber optic cable connecting traders’ servers to systems of the stock market is the same for all companies.

In the Wild West of crypto, traders say exchanges are more ad hoc in the incentives they offer market makers, which could give some companies an edge. These concerns are heightened when exchanges and market makers have the same owner, as with FTX from Sam Bankman-Fried and Alameda Research. In December, the CFTC said in a lawsuit that Alameda was able to execute orders on FTX several milliseconds faster than other clients. A spokesperson for Mr. Bankman-Fried declined to comment.

Binance Founder and Managing Director Changpeng Zhao worked in HFT technology before getting into crypto, including as a partner at Fusion Systems, a provider of high-speed trading systems for brokers.

The CFTC lawsuit indicates that Mr. Zhao sought to ensure that HFT businesses were welcome at Binance. A big problem: many big market makers were based in the US, which means that if they traded directly on Binance, it would violate the exchange’s ban on US clients.

In October 2020, a Binance employee questioned Mr. Zhao about a Chicago-based company that accounted for 12% of the exchange’s volume, according to posts cited in the CFTC lawsuit. Mr. Zhao told the employee to warn the company that it should not access Binance through a US internet address, the lawsuit says. He noted, according to the lawsuit, that the company had non-US legal entities and ordered the employee, “Do not put anything in writing.”

Crypto executives say it is common practice for some US companies to trade on Binance through offshore entities. One such company, Chicago-based Radix Trading LLC, revealed earlier this week that it was “Trading Company A” in the CFTC lawsuit. Co-founder Benjamin Blander told The Wall Street Journal that Radix traded on Binance through a series of arrangements, first through a Cayman Islands legal entity and finally through a brokerage. He said he believed Radix acted legally.

“We got legal verification of everything we did in terms of crypto connectivity,” he said. Asked about VIP programs, Blander said he thinks it’s normal for Binance to offer perks to higher-volume trading firms to incentivize them to provide liquidity on the exchange.

Still, the CFTC lawsuit suggests the agency is looking into how US companies access offshore crypto exchanges. He described the legal structures trading companies used to access Binance as “shell” companies, a sign that he can view them as having no purpose other than to circumvent US regulations. A CFTC spokesperson declined to comment.

Dan Berkovitz, a former CFTC commissioner, said regulators would likely examine the business purpose of such structures. “Is there an independent economic reason for structuring the transaction this way?” he said. “Or was this structure only designed to evade US rules?”

—Dave Michaels contributed to this article.

Write to Alexander Osipovich at [email protected]