Much Needed Regulatory Shake-Up Ahead for Digital Asset Exchanges

Digital assets have not yet gained the trust of investors, regulators and the public following several high-profile reports of theft, money laundering and market manipulation. For this industry to thrive, blockchain companies must be open to collaboration with financial regulators to enforce standards and best practices.

Digital asset exchanges have been one of the primary beneficiaries of the year-on-year increase in the market value of digital assets, which peaked at $800 billion in early 2018[i]. The top 10 exchanges are generating as much as $3 million in trading fees per day[ii].

The practices of many exchanges have drawn criticism, however, for compromising the interests of their investors. For example, even some of the top exchanges are suspected of front running their clients’ orders to profit at their clients’ loss.

There are also concerns around the security of assets held on exchange. In 2018, thefts from exchanges resulted in investors losing $927 million[iii]. Adding insult to injury, many of these centralised custodial exchanges did not have adequate insurance policies to compensate investors whose assets were stolen. The situation is compounded when such custodial exchanges abuse investors’ funds for market manipulation. We saw this with a recent case in which Huobi allegedly used its clients’ EOS tokens to orchestrate voter collusion in elections for EOS block producers[iv]. If the digital asset market is ever to attract institutional flows and establish itself as a credible alternative asset class, it will need a set of rules that weed out fraudulent activities and encourage stable growth.

In a bid to heal public trust, digital asset exchanges have called on government to enact regulation. CryptoUK, the world’s first self-regulatory body formed by UK exchanges, has requested Members of Parliament to endorse bills aimed at strengthening regulations. In Japan, digital asset exchanges have also formed a self-regulatory body, the Japanese Virtual Currency Exchange Association (JVCEA), that has been certified by Japan’s Financial Services Agency (FSA) to set up and enforce rules to guard against threats to the legitimacy of cryptocurrency. The association will give working guidelines to digital asset exchanges, introduce measures to protect customer assets, and elaborate on anti-money laundering (AML) policies.

While regulators adopted a wait-and-see approach for the most part of 2017, new sets of rules governing digital currencies are now being unveiled. Exchanges aiming to operate as an alternative trading system (ATS) in the US are required to obtain an ATS license, register with the Securities and Exchange Commission (SEC) as a broker-dealer, and become a member of self-regulatory organisations such as the Financial Industry Regulatory Authority (FINRA) and Municipal Securities Rulemaking Board (MSRB) depending on the transactions they engage in. Hong Kong’s Securities and Futures Commission (SFC) has proposed a regulatory regime known as the “Sandbox”, offering compliance waivers to exchanges for operating in Hong Kong in return for working with authorities to develop a longer-term regulatory framework for the industry. Malta, known as the first blockchain island, has introduced easy-to-follow regulations, that came into effect in November 2018, offering exchanges the legal certainty they need to flourish.

We believe there is also a need to introduce regulations in an effective and controlled manner at the intergovernmental level to prevent the use of digital assets for cross-border crime and terrorism. The Financial Action Take Force (FATF), supported by some of the largest economies in the world including the UK, the US and Japan, is tasked with publishing guidance (expected in June 2019) to prevent illicit activities in the digital currency space.

At the industry level, the adoption of standards by digital asset exchanges on issues such as relationships with clients, handling of money, and risk management will help regulatory bodies to develop a binding rulebook on the international level. This is already in progress. Global Digital Finance (GDF), a non-profit organisation created by leading digital asset companies including Coinbase, Diginex, and R3, is providing a platform to foster discussions on global policy and governance for digital assets. The industry body recently announced a new Code of Conduct for the digital asset industry that represents a set of standards that will be used by all companies partnered with the GDF.

It is pivotal for financial regulators to collaborate with self-regulatory organisations such as JVCEA and industry bodies such as GDF to introduce consistent rules that are effectively enforced throughout signatory states and digital asset companies. Such efforts will ultimately enable discussion of strategies to engage nations like India and China which have banned digital asset trading altogether.

About the Author(s): Andre Pemmelaar is Head of Exchange & Trading at Diginex. Jason Choi is a Strategy Manager at Diginex.

Theme: Accessing Digital Assets

[i] Andrew, M. (2018, Jan 07). Combined crypto market capitalization races past $800 Bln. CoinTelegraph, Retrieved from https://cointelegraph.com/news/combined-crypto-market-capitalization-races-past-800-bln
[ii] Camila, R. (2018, March 06). Crypto exchanges are raking in billions of dollars. Bloomberg, Retrieved from https://www.bloomberg.com/news/articles/2018-03-05/crypto-exchanges-raking-in-billions-emerge-as-kings-of-coins
[iii] Cryptocurrency Anti-Money Laundering Report (2018, Q3). CipherTrace Cryptocurrency Intelligence, Retrieved from https://ciphertrace.com/wp-content/uploads/2018/10/crypto_aml_report_2018q3.pdf
[iv] EOS voter collusion – Huobi denies receiving payments (2018, September 30). EthereumPrice, Retrieved from https://ethereumprice.ca/eos-voter-collusion-huobi-denies-receiving-payments/