PRIMER: regulating cryptocurrency exchanges
Exchanges have been blighted with negative publicity recently, but improvements have been made in recent years. Here crypto firms and lawyers explain the back story
It seems there has been nothing but bad news for cryptocurrency exchanges recently.
Amid the price collapse, a number of high-profile incidents have cast further doubt on the stability of the market. Most notably, the death of Gerry Cotton, chief executive of Canadian exchange QuadrigaCX, which allegedly resulted in $145 million of investors’ money being frozen in inaccessible cold wallets. Conspiracy theories have naturally followed.
This isn’t the only case to concern potential investors. In 2014 Mt. Gox, one of the first bitcoin exchanges, shut down its operations and filed for bankruptcy. At the time, the exchange handled 70% of all bitcoin transactions, and investors are still unclear as to the state of their investment.
The plethora of hacks on exchanges around the world has had a big impact on prices, contributing to bitcoin’s collapse. Its price is now down from $19,700 in December 2017 to $2,867 at the time of writing. In September 2018, Japanese exchange Zaif was infiltrated by hackers who stole almost $60 million worth of cryptocurrency.
These high-profile incidents have led many to believe that new cryptocurrency-specific regulation is required. It is said that doing so would help protect retail investors, as well as drive out some of the less scrupulous market players.
“Regulation defining minimum standards of risk management framework would address cyber risks and information security,” said a vice president at a regtech firm. “Doing so is important to mitigate operational risks and enhance customer protection.”
See also: Coinbase CEO says crypto-specific regulation is necessary
What is regulators’ current position?
Cryptocurrency exchanges are a digital marketplace where users can trade digital cryptocurrencies.
One of the major difficulties for regulators is defining precisely what cryptocurrencies are, and the technology associated with the market. There is disagreement as to whether they should be named cryptocurrencies or cryptoassets, for instance. The distinction will affect whether these are regulated as a currency or an asset.
Regulators were initially reticent to regulate cryptocurrencies, given fears that such a move would legitimise a market they were sceptical of. Yet across the globe, many are now putting in place frameworks that will offer clear rules for market participants.
The UK, for example, is in the process of establishing a cryptocurrency framework which is expected to mirror Switzerland’s approach. The Financial Conduct Authority (FCA) published guidance in January 2019, dividing tokens into three separate categories: exchange tokens, not within FCA remit; security tokens, regulated as financial instruments; and utility tokens, which would normally escape regulation.
France is also in the process of creating its own framework. French foreign minister Bruno Le Maire said in March 2018 that he wanted his country to become the capital of ICOs. New regulation is expected imminently, which will force exchanges that conduct fiat to cryptocurrency trades to complete a registration form with the Autorité des marchés financiers.
"A growing number of jurisdictions are recognising cryptocurrencies as something they can use to promote their own financial centre,” said the regtech vice president. “They can attract new exchanges by providing a clear regulatory framework.”
Many exchanges had previously avoided fiat to cryptocurrency trades, as it would mean complying with anti-money laundering (AML) regulation. Yet to improve user convenience, more exchanges are beginning to offer these kinds of trades, even if it does mean they are subject to AML rules. This is part of an increasing trend towards more actively compliant cryptocurrency exchanges.
See also: Japan’s separate rules for crypto could be the answer
What changes are being made?
Exchanges have begun to put more emphasis on improving their security after a series of high-profile hacks on platforms. The security demands from users have risen because of an increased awareness of risks in the market. In order to be successful, exchanges need to offer a certain level of trust, and are now beginning to realise this and take active steps to address the issues.
According to Sarah Lewis, counsel at Cleary Gottlieb, to establish trust with market participants exchanges are seeking to differentiate themselves by taking into account the position of regulators. “They are acknowledging that the regulatory position may be uncertain in some jurisdictions, but also that it is evolving,” she said.
There is a risk that too much regulation could disincentivise exchanges from operating in a certain jurisdiction, and even stifle the developing industry. While opinion from governments on cryptocurrencies or cryptoassets is mixed at best, almost all are in support of blockchain. Lawmakers will not want to inhibit the industry and disrupt distributed ledger technology in their country.
New York’s Bitlicence, which businesses need before they can deal in virtual currencies, drove a number of companies out of the state. As of January this year, only 14 licences have been granted to companies. The framework has received widespread criticism for being too restrictive.
“Due to regulatory uncertainty, some crypto exchanges have taken advantage of regulatory arbitrage, and based themselves out of jurisdictions with looser regulatory oversight,” Lewis said. For example, many exchanges are based in Estonia, home to arguably the biggest money laundering scandal in history.
In order to address concerns that bitcoin has been used to launder money, the European Commission adopted the Fifth Money Laundering Directive in April 2018 to include virtual currencies. The massive fall in the bitcoin price after the directive came into force could be coincidental, but it could also be indicative of the scale of the problem before the directive came into force.
Yet legitimate exchanges wanting to conduct business honestly have a difficult task trying to adapt to different rules in different jurisdictions. The situation is also constantly evolving, making it difficult to plan for the long term.
How are exchanges reacting?
Exchanges are responding positively, however. Many are customising their offerings for a selected jurisdiction, for example only offering fiat to crypto trades in selected jurisdictions that have more generous oversight. Some are offering selected tokens in a single jurisdiction. It is clear that overall, exchanges are taking regulation into account, and making changes in response.
There is however scope for improvement, according to Fern Karsh, general counsel at fintech company Catalystic AI. “More exchanges should behave like regulated financial entities,” she said. “They should be getting ahead of regulations and implementing best practices, even in jurisdictions where regulations aren't yet in force.”
Exchanges should implement risk management programmes, run external audits and implement anti-money laundering processes. It is also important to conduct vendor due diligence and cybersecurity checks to avoid the fate of failed exchanges in recent years.
That task is likely to become easier in the coming years after clear frameworks specific to cryptocurrencies have been adopted by the major economies. While the position of regulators is becoming clearer, it is still not certain until these have been implemented. Once it is, significant legal and regulatory risk will be reduced.
This would make it easier to establish important commercial relationships and drive out exchanges with inadequate standards. This could also help to change the negative perception some have about the marketplace.
According to Karsh, the main issues exchanges have to deal with include: securing banking relationships, understanding the regulatory environment, and implementing compliant anti-money laundering practices both domestically and globally. These issues could also be reduced considerably if an effective regulatory framework is implemented.
Yet for some, it is critical that existing banking regulation is not applied.
“The major problem is that regulators are applying existing banking or securities laws,” said Angel Versetti, chief executive of blockchain company Ambrosus. “This inhibits the sector greatly. These regulations were drafted many years ago and do not account for technical developments.”
While it appears that the US is going in that direction – in light of Jay Clayton’s repeated comments that he has never seen an ICO that isn’t a security – Europe looks to be adopting new frameworks specific to the cryptocurrency industry. If it does, this would most likely be welcomed. The hope is that it would arrest the price slide plaguing the industry over the past 12 months.
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