Exchange core, liquidity and technology

Regulation
and compliance

It may not be the most glamorous thing to consider when building an excellent exchange, but the experts Cointelegraph spoke to were unanimous: Achieving regulatory compliance is “extremely important,” and it’s likely to become even more significant in the years to come as central banks and governments get their heads around digital currencies.

Common measures include Anti-Money Laundering, which aim to prevent digital assets from being used for illicit, criminal means.

Know Your Customer checks are another, and this process involves verifying the identities of those who use a crypto exchange.

Olga Feldmeier, the CEO of the Smart Valor digital asset exchange, told Cointelegraph that compliance stands for security and trust. She added:

“To me, Anti-Money Laundering is at the core of compliance. This is important to society as a whole. It is about preventing malicious hackers, human traffickers, drug lords, extortionists and child pornographers from using exchanges and cryptocurrencies to launder their money.”

Feldmeier acknowledged that achieving compliance involves effort but stressed that exchanges that tick all the right boxes are making a “small yet powerful contribution to ensuring there is a better world with less violent crime.”

Intersection of interests
Regulation and compliance Chart

Effort is something of an understatement. For exchanges with international ambitions, achieving compliance across all of the jurisdictions where they operate can be nothing short of a nightmare. How can a business possibly operate in countries with strict and lax regulatory requirements at the same time?

Bryant says it is possible as long as an exchange is aware of how each jurisdiction differs in its attitude toward digital assets. BitFlyer has adopted what he calls the “highest common denominator” approach — meaning the strictest regulatory requirements it has to follow in one country are implemented across the whole global business.

Karin Lorez is a legal advisor for Lorez Legal and a co-founder of ScaleCompliance. She told Cointelegraph that exchanges need to have a compliance department so they can keep up with ever-changing rules and regulations, adding:

“In general, crypto exchanges are well advised if they comply with the local AML rules and maybe even with the rules of their main markets. I would suggest a risk-based approach.”

Bryant added that balancing compliance and commercial considerations is crucial. Compliance that’s excessively tight can ward off customers, but sizeable problems can emerge if there’s a light-touch approach to regulation.

Scalable’s Berger says white-label platforms need to offer enough flexibility to set rules and permissions based on an end customer’s jurisdiction.

But what exactly are the risks associated with non-compliance?

For Bryant, the biggest dangers for exchanges were too numerous to mention.His top four included the legal risks associated with mishandling operations, the financial impact of fines for non-compliance, the reputational damage that a hacking incident could cause, and the business disruption triggered by cease and desist orders from no-nonsense regulators.

Lorez explained that non-compliant exchanges are putting themselves at a long-term disadvantage, not least because banks will usually refuse to accept funds from platforms that fail to follow the rules. That’s bad news for customers, too, as it will become harder for them to transfer their assets with ease.

Berger agreed and warned there is a risk that regulators could end up going after the people who operate non-compliant exchanges. In some cases, these regulators could also issue warnings about these trading platforms, something that can result in users losing confidence and taking their business elsewhere.

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Feldmeier said a cursory glance at the global crypto exchange landscape shows a “large fraction” of companies are operating outside of legal and regulatory frameworks — but warned cutting these corners is ultimately bad news for these businesses. She added:

“Most of these exchanges are solely crypto-to-crypto as their veiled practices don’t allow them to establish partnerships with traditional financial institutions to handle fiat transactions and credit card payments. While it might be appealing to some to set-up such an exchange, one will quickly discover that the market for crypto-to-crypto exchanges is already quite saturated and there is intense competition.”

Regulation and compliance Approved

Feldmeier also warned of restrictions on “tainted crypto” often found on exchanges where users are unverified and mixers are used to mask the true source of funds, explaining:

“If you buy your crypto at one of the shady, no-AML exchanges, you’re actually buying ‘tainted’ crypto. It is like buying fake dollars in an exchange booth. You might not be able to send or sell these coins on other legal exchanges.”

“Very soon we will have a situation where one Bitcoin can have a different price depending on its previous history and where it came from. Trade on one of illegal platforms and most likely you will be collecting those reduced value coins in your wallet.”

So: In the quest to build an excellent exchange, what should regulatory compliance practices look like?

For Bryant, this involves accepting that there’s going to be a lot of paperwork to submit an application — and “several rounds of back and forth with the regulator or their agents.” The hard work doesn’t end here. Once an exchange has a license, the next step involves filing regular reports to maintain their accreditation, as well as training staff and looking for upcoming changes to regulation.

Feldmeier urged entrepreneurs not to underestimate the time and funding associated with obtaining proper licensing and building exchange infrastructure and said the process is often longer and more expensive than they might expect. Her top tip:

“One way to shorten your go-to-market strategy while improving your platform’s maturity at the same time is to partner with well-established and reputable companies. The second most important thing: Choose your jurisdiction right. The future of exchanges is regulated institutions. You should weigh carefully the advantages and disadvantages of each jurisdiction.”

New Eight’s Sauter encouraged new businesses to engage with regulators, understand the landscape, and hire professionals who have a background in finance and banking.

And Lorez predicted that, in time, only compliant crypto exchanges will survive and have an opportunity of becoming part of the financial system. She urged new platforms to develop a strategy and a risk assessment and ensure they are licensed for the types of digital assets they list for trading. An onboarding system can make it easier to comply with AML rules, she said. Her advice for getting off on the right foot:

“Proactively engage in discussions with regulators and banks. Explain what you do and how you do it. This helps them understand your business and reduces the defensive view of crypto.”

BEST PRACTICE

Engage with regulators, be patient, hire experts, know the differences between jurisdictions, and keep up with rule changes.

HUGE NO-NO

Know that failing to achieve compliance can result in lawsuits, fines, a lack of credibility among customers, extensive business disruption and even frozen assets.

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