Agreed - though I would argue that must exchanges do participate in insider trading. Example: High frequency trading is only available if select parties have 'inside' information unavailable to the majority of participants.
Whether "high frequency" trading should be considered "insider" trading is a philosophical debate that depends a lot on what you mean by "insider" and what it is that you don't like about "insider trading". I'm not going to get into such a philosophical debate at the moment (and I'm not going to indicate in this post which side of the debate I tend to agree with more).
However, when it comes to the specific type of "insider trading" I'm talking about where the exchange itself can easily take advantage with 0 risk, I'm specifically talking about using knowledge about orders that are being added to the order book before those orders are public knowledge. With "high frequency" trading, the traders know information faster than those that aren't a selected participant, but they still don't know the information before it is in the order book.
The exchange however receives a request to add an order to the order book from a user. At this point, their software knows about this order (and other orders) that WILL BE a part of the order book in a moment, but isn't a part of the order book yet. This puts them in a position to make automatic trading decisions that
guarantee a
risk free profit. They can effectively roll back time and place their orders before (or after) the orders that are being added to the order book, making sure that the orders are filled in a specific order that guarantees that they come out ahead with no risk to themselves at all.
As an extremely simple example:
Albert places a BUY order for 10 BTC at $250 each ($2500 order).
A fraction of a second later, Bob places a SELL order for 10 BTC at $249 each ($2490 order).
Under normal circumstances Albert's BUY order enters the order book, then Bob's SELL order fills Albert's BUY order. Albert gains 10 BTC from Bob, and Bob gains $2500 BTC from Albert. The exchange gets a small fee from both of them for maintaining the order book and trading engine.
Under circumstances where the exchange is engaging in "insider trading", Albert's BUY order is held in memory for a fraction of a second before being added to the order book. The software sees Bob's order coming in and holds that in memory as well. The exchange then adds Bob's transaction to the order book first, and inserts their own BUY order to buy all 10 BTC from Bob at $249. They then allow Albert's order into the order book and immediately following it they add their own order to SELL 10 BTC at $250. Now Albert has received his 10 BTC, and paid $2500 for them, but Bob only received $2490.
The remaining $10 goes to the exchange completely risk free since they knew that both transactions were entering the order book and could arrange them to their own benefit. Then on top of that, the exchange gets a small fee from both of them.
With many transactions being added to the order book, this process can be repeated all day long completely automated. The exchange can essentially take money out of the pockets of the people placing market orders without the users ever realizing it.
