The evolution of crypto exchanges — What’s next for the industry

From what started as something of a “technological experiment” with Bitcoin (BTC) over a decade ago, the crypto asset industry has become a significant driver for change in global financial markets. Cryptocurrency exchanges started as a means to enable crypto enthusiasts to trade digital coins outside the traditional financial system on a decentralized and largely autonomous basis.

It is likely that combined with regulatory recognition and development of digital market infrastructures, acceptance of essential Anti-Money Laundering practices, investment in security protection systems, and recognition of investor protection measures will see these businesses continue to expand and potentially merge or compete on an even footing with existing regulated marketplaces.

The success of these platforms in allowing an unregulated free-flow of value across borders has unsurprisingly resulted in interest from governments and regulatory bodies. Initial skepticism was replaced by concern over weaknesses in relation to AML, fraud and investor protection measures. As crypto exchanges have improved their systems to meet AML and investor protection requirements, there is a begrudging recognition that these platforms have brought much-needed modernization and democratization to a market that has generally been seen as remote and privileged.

Crypto exchanges have provided 24-hour, global access to trading venues with participants eligible from all walks of life and able to participate directly through accessing online trading tools and graphics, which have historically been available almost solely to a limited set of professional investors.

Crypto assets have generally been on the outer edge of the regulatory perimeter, but are increasingly facing pressure to be included within the regulatory framework.

The first key step in this direction at an international level was the extension of the AML standards announced in June 2019 for crypto-related businesses from the Financial Action Task Force, the global standard-setting body for fighting financial crime.

In the European Union, this was followed by the adoption of the 5th Anti-Money laundering Directive, or 5AMLD, which brought crypto-asset exchanges and custodian wallet providers into the scope of the EU AML regime. As a result, in-scope crypto asset firms operating in the EU and the United Kingdom are now subject to the full suite of AML obligations applicable to most financial market participants, such as the need to undertake customer due diligence checks when onboarding a new client. In addition, they are required to register with the relevant national competent authorities where they intend to carry on crypto-related business.

The general approach to the regulatory treatment of crypto assets has been more complicated. At an EU-wide level, the position so far has been to apply the existing regulatory framework to crypto assets that have the characteristics of regulated assets. Specific regulations such as outlawing the sale of crypto derivatives to retail investors are imposed, but more specific requirements are considered necessary.

Exchanges dealing in digital assets are therefore subject to regulation if the assets traded fall within this regulatory perimeter. To a large extent, this has meant understanding the application of the existing regulatory framework and applying this to relevant circumstances, relying on interpretative guidance where necessary.

As a result, two main categories of crypto assets, which function in a similar manner as regulated instruments, and their respective service providers have been brought within the scope of existing rules. These are digital assets akin to “financial instruments” (generally capturing crypto assets used as means for raising finance and derivatives), but are being treated with existing rules for tokens functioning as “electronic money.” This captures crypto assets designed to facilitate payment transactions or some stablecoins.

Importantly, this means that crypto exchanges trading digital securities, such as DLT-based shares, bonds, fund units or derivatives — often referred to as security tokens — are required to obtain authorization as regulated trading venues to do business in the EU. This would also capture EU-based crypto exchanges trading particularly popular instruments, such as derivatives referencing Bitcoin (BTC) or other cryptocurrencies as underlying assets. This has been supplemented by jurisdictions putting in place bespoke regimes for the crypto sector, for example, clarifying aspects concerning the use of the underlying DLT technology (e.g., Luxembourg) or closing gaps in existing rules (e.g., France).

In the securities space, significant steps are being made toward developing a credible digital market infrastructure for issuance, trading and settlement of digital securities. Most notably, the U.K. Financial Conduct Authority has recently granted a MIFlD licence to Archax Limited, which has become the first fully-authorized trading venue for digital securities in the U.K.

At the same time, established exchanges are building their own “digital versions,” such as the Borse Stuttgart digital Exchange in Germany and the SIX Digital Exchange in Switzerland. However, despite these developments, integrating digital solutions with existing market infrastructures remains challenging, not least due to constraints stemming from existing rules around settlement finality requirements in the post-trading systems.

In an effort to unlock opportunities for innovation in the space, the European Commission has recently published a proposal for a pilot regime for market infrastructures based on DLT, which aims to create a bespoke legal regime for the application of DLT in post-trade services and would allow for the creation of digital securities settlement systems.

Some of the largest crypto exchanges are looking to obtain regulatory licences across the world in order to be able to directly compete with incumbent financial institutions, adapt to user demand for more sophisticated services, and enhance their own credibility in the market.

For example, in March 2018, the U.S.-based cryptocurrency exchange Coinbase obtained an e-licence from the UK. FCA, as from the Central Bank of Ireland in 2019, allowing it to issue e-money and provide payment services, thereby enhancing its fiat-to-crypto services. Kraken has recently obtained a banking license from the State of Wyoming to create a special purpose depository institution (Kraken Financial), which will allow it to provide deposit-taking, custody and fiduciary services for digital assets.

With a view to enhancing market integrity and investor confidence, the EU Commission put out a proposal on Sept. 23 for a regulation on markets in crypto assets, or MiCA. The draft regulation captures crypto assets such as “asset-referenced tokens” (commonly known as “stablecoins”) as well as “utility tokens.”

Under the MiCA draft, crypto exchanges operating in the EU are required to obtain regulatory authorization and are subject to strict prudential and conduct requirements. In addition, the draft rules include prescriptive requirements around admission of crypto asset instruments to trading, including the requirement to publish a white paper with specified content.

European Commission proposals have to go through a long legislative process before they become binding law. The MiCA however, is likely to be a significant step toward establishing credibility and structure in creating a viable crypto asset industry in the EU, which will identify the contrasting regulatory framework for security-type crypto assets and non-security-type crypto assets. For many, the process of imposing regulatory requirements at all in the pure crypto assets sector will be an anathema that stifles innovation and creates barriers to entry for smaller fintech firms. However, this is the most likely approach to establishing a long-term, viable marketplace.

There is significant interest from large institutional players in entering the crypto asset space. Some of the biggest European institutions have extensive digital asset programs. As an example, ING is currently working with Industry participants on a digital custody and safekeeping solution within the FCA sandbox that will provide institutional-grade security for digital holdings and transfers of digital assets. The U.S. Office of the Comptroller of the Currency recently gave the all-clear to the U.S banks to provide cryptocurrency custody services for their customers, a development that could put crypto asset service providers (including exchanges) in direct competition with traditional players.

Going forward, the innovation, democratization and expansion of access brought about by crypto exchanges, as well as an improved financial regulatory recognition of their services, will be combined with the digitalization of traditional asset securities and development of market infrastructure for digital trading. This is likely to lead to a powerful dynamic for combinations and mergers between rapidly developing crypto exchanges and incumbent institutions.