Cryptocurrency Exchanges: Balancing Innovation and Regulation

Cryptocurrency exchanges are a crucial component of the cryptocurrency ecosystem, allowing users to buy, sell and trade digital crypto assets. Being at the forefront of the crypto landscape, they constantly face the highest degree of regulation, with ever-changing challenges. How do they balance compliance and innovation?

While the crypto regulatory landscape is continuously evolving as a whole, cryptocurrency exchanges face the highest scrutiny when it comes to compliance. A study put together by The Cambridge Center for Alternative Finance reports that as of 2020, 37% of countries surveyed had implemented regulatory requirements for cryptocurrency exchanges, while only 15% had done so for crypto wallets.

Allowing fiat currency conversions, providing a liquid market for cryptocurrencies, and giving an easy entry point into the industry make crypto exchanges a critical part of the ecosystem. When it comes to regulation pains, there are quite a few particularities depending on the jurisdiction, but in general, the main culprits are the uncertainty regarding specific requirements and their applicability, extensive KYC and AML needs, as well as security risks.

Know Your Customer (KYC) and Anti-Money Laundering (AML) compliance are critical requirements for cryptocurrency exchanges, as they help ensure the integrity and legitimacy of the cryptocurrency industry. As with most financial systems, cryptocurrencies can and have been used in the past for fraudulent or otherwise unlawful activities. These types of compliance need help to prevent criminal activity and protect lawful usage by forcing exchanges to identify and verify users and their activity. Ultimately, they create a safe and transparent space for cryptocurrency usage, help to build trust in the industry, and fuel innovation by attracting new talent and investors.

While most other financial systems and institutions benefit from standardized and centralized frameworks for licensing, cryptocurrencies are yet to be under such a privilege. Instead, their licensing requirements vary greatly between geographies and can be a complex route to navigate. For example, when operating across the EU, exchanges are required to comply with 5AMLD, a European directive which focuses on combating money laundering. On the other hand, when operating in the US, cryptocurrency exchanges may be subject to more fragmented state-level money transmission licenses, as well as federal registration with the Financial Crimes Enforcement Network (FinCEN).  Given how the crypto world is a globally distributed venture, we can see how implementing a compliance strategy can turn out to be a nightmare, taking the focus away from innovation and growth.

Innovating and meeting compliancy demands

While finding their way through the regulatory maze, cryptocurrency exchanges manage to achieve a great deal of innovation through various initiatives throughout the years. From a horizontal scaling perspective, they continuously increase the roster of services on offer, with derivatives such as futures and options, as well as margin trading and lending. This allows them to establish a powerful brand alongside a positive trust relationship with their client base, providing them with a one-stop shop for all their crypto needs. Users get a great deal of convenience, but also potentially reduced risks and better accountability options for their assets and operations.

Additionally, in their push for innovation, exchanges support new blockchain projects, oftentimes acting as their starting line through Initial Coin Offerings (ICOs) or Security Token Offerings (STOs). On the other hand, they are pushing research in new security tech, a good example being cold storage, an approach which stores private keys offline, protecting against common attacks, such as phishing. Another noteworthy advancement is the concept of a multi-signature wallet, an approach in which the ownership of keys is split between multiple entities. This system makes it much more difficult for funds to be stolen, as all parties need to be individually compromised in order for the wallet to be accessed.

Security advancements such as these play a crucial role in pushing the industry forward, while at the same time increasing compliance with regulatory bodies, by bringing better control for users, increased traceability, and reduced risk of fraud.

Conclusion

There are numerous regulatory challenges facing the crypto space in general (and exchanges in particular). While nobody denies the need for a high level of trust, transparency, and security in the ecosystem, companies need to be allowed enough space for innovation, as well as an easier regulatory journey.  Players in the industry want to be licensed and carry out their business lawfully, but having such an ambiguous landscape only leads to reduced investor confidence, liquidity issues, and increased risk of fraud and theft. Ensuring the long-term success of this space can only be done through a robust regulatory framework which should carefully balance the need for security with the desire for innovation and growth. Such an initiative can only be carried out through a much-improved level of collaboration between governments, communities, regulatory bodies, and industry stakeholders.