Legal Regulation of Centralized Crypto Exchanges in Some Countries

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Analytic platforms like Blockspot.io and Crystal show that as of 2020, the greatest number of crypto exchanges was in the USA, the UK, Singapore and in Hong Kong. Among European countries, the highest concentration of crypto exchanges was in Estonia, Malta and in the Netherlands. The heaviest crypto trading volume (approx. 43% of the total volume in 2020) was demonstrated by Seychelles.

Centralized crypto exchanges (CEXs) choose certain jurisdictions because of their facilitative and transparent legal frameworks for the crypto industry or access to their customer markets (CEXs may need to have an office in a particular country to serve their citizens). Nowadays, more and more governments issue crypto exchange licenses or require specific registration (in the USA, the UK, Hong Kong, Japan, Singapore, etc.). To set up a crypto exchange there, founders need to register a company (or open an office), prepare and implement adequate AML/CFT programs, and provide the authorities with a business plan and other required information. Among the advantages of obtaining a crypto license is that crypto companies have:

• Legal certainty in relation to their compliance obligations.
• Access to financial services, financial institutions, and a wider choice of business partners.
• Higher ratings and good reputation (an exchange may be better ranked in various compliance performance assessments and risk mitigation, e.g., performed by Coingecko).
• The trust of customers (an exchange should have security systems and documented policies and procedures to manage financial crime risks).

Some CEXs are attracted by jurisdictions where legal frameworks for cryptocurrencies are lax, unclear or lacking (or at least crypto activities are not banned). By operating undisclosed, the crypto platforms may avoid time-consuming and costly licensing procedures and strict AML requirements that can impact their customers who do not want to give their data or wait when verification procedures are completed.

Other CEXs are continually moving from one jurisdiction to another to ease the business’s burden being created by constantly increasing scrutiny from regulators.

There are also crypto exchanges with a diversified organizational structure under which in one jurisdiction their entities deal with money transmission or deposits, while in the others, they focus on the respective consumer markets. Although such a legal structure is most commonly not against the law, it may cause inconvenience to their customers. In particular, in an interview with Coindesk, a CEO of a blockchain analytics company Coinfirm P. Kuskowski noted that “If, for example, you lose your money and think it is a UK company and that you can have recourse for this money, if this entity is some dodgy jurisdiction and you don’t know who is the owner, it’s very difficult to have recourse.”

In 2019, the Financial Action Task Force (FATF), in its Guidance for a Risk-Based Approach to Virtual Assets and Virtual Asset Service Providers, extended international AML/CFT standards to crypto exchanges (virtual asset service providers), prompting many countries to have amended their national legislation with the AML/CFT requirements regarding crypto exchanges. However, application of these requirements varies according to the legal systems’ specificities (in some countries, CDD procedures are initiated from establishing a relationship, in others — when a threshold is triggered, etc.)

Below there is a brief overview of different countries’ approaches for the supervision of CEXs.

The European Union

The fifth EU Anti-Money Laundering Directive (AMLD5) made fiat-to-virtual currency exchanges meet the same AML/CFT compliance obligations as traditional financial institutions have. For this purpose, from 2020, CEXs are required to register with their local financial authorities. In most EU members, the registration is mainly performed to ensure monitoring compliance with AML legislation, while it does not cover full supervision (e.g., they are not covered by a guarantee scheme or consumer protection). Compliance with these rules allows crypto exchanges to expand their crypto trading services throughout the EU (e.g., Bitstamp registered as a payment institution in Luxemburg, which is globally recognized as the leading banking and financial center in Europe). At the same time, these novelties turned out to be too high regulatory and costly barriers for some crypto exchanges, which led to several business closures (Simplecoin, Bottle Pay) and withdrawals of the operations out of the EU. For instance, the forthcoming implementation of the AMLD5 led KyberSwap to move out of Malta to the British Virgin Islands. Similarly, at the beginning of 2020, Deribit announced that it would leave the Netherlands for Panama due to the new regulations.

Estonia is one of the few countries that grants crypto exchanges licenses for both fiat-to-virtual and virtual-to-virtual currency exchanges (e.g., STEX has received such a license). Estonia is regarded as a comfortable climate for crypto businesses offering lower costs and faster licensing procedures than other EU countries (while ensuring strict adherence to the AML/CFT requirements). It also allows companies to obtain a crypto license without having to open an office there. It should be noted that some Estonia-based CEXs grant additional rights to their clients. For instance, BitBay’s ‘Terms of use’ expands the rights under the consumer law to account users and also provides consumers with the opportunity to “choose an out-of-court complaint and claims settlement method.”

The United Kingdom

In 2020, the UK introduced amendments in the Money Laundering, Terrorist Financing and Transfer of Funds (Information on the Payer) Regulations 2017. Cryptocurrency exchanges are now required to register with the Financial Conduct Authority (FCA) and are subject to compliance with a broad range of ongoing AML/CFT obligations. The body monitors the businesses to ensure that they are complying with AML/CFT measures. However, the FCA is not responsible for inspecting how exchanges treat their customers and whether customers’ funds are inadequately protected (the remit of the UK Financial Ombudsman Service and the UK Financial Services Compensation Scheme does not extend to crypto exchanges).

Singapore

The Monetary Authority of Singapore (MAS) (the country’s central bank and financial regulator), with an update of the Payment Services Act (PSA) of 2019 (amended took effect on 28 January 2020), brought the crypto industry under its oversight. The PSA makes it mandatory for crypto exchanges to register and apply for one of three licenses (as digital payment token service providers) depending on their operations. Failure to do so may result in severe punishment. To successfully obtain the MAS’s compulsory license, crypto exchanges must adhere to the strict AML/CFT compliance requirements (e.g., KYC/CDD procedures, account reviews, suspicious transaction monitoring/reporting, record-keeping).

Hong Kong

In 2018, the Hong Kong Commission on securities and futures (SFC) set up a regulatory sandbox and a comprehensive legal framework, under which crypto exchanges may voluntarily apply for an official license from the SFC (as for now, such businesses can serve only institutional investors). The new regulation covers concepts that are specific for the crypto industry like forks, airdrops, hot and cold wallets; however, to be licensed crypto exchanges must also meet the requirements from the traditional financial markets, including KYC, AML/CFT requirements, market manipulation rules, insurance and safe custody of assets. In December 2020, it became known that the SFC issued the first license to a crypto trading platform OSL Digital Securities.

Currently, the crypto licensing is optional in Hong Kong, but if a crypto exchange deals with fiat, it may be required to obtain a Money Service Operator license, which implies strict AML/CFT compliance.

In 2020, the government announced its plans to create a new legislative and regulatory basis that will require all crypto exchanges to apply for a license. This will affect the trading of any type of crypto assets (meanwhile, at present, the regulatory sandbox covers only exchanges trading assets classified as securities).

Seychelles

As per the data from Crystal, in 2020, Seychelles dealt with more Bitcoins than any other country (receiving $32.02 bn and sending $39.77 bn), where Binance and Huobi handled the majority of the transactions. Some small crypto exchanges are also located in Seychelles, apparently because of their low taxes and more lenient legislation. According to the Technology and Innovation Offshore Guide 2019, in Seychelles, there are no specific regulations for crypto-to-crypto exchanges, as well as for crypto-to-fiat exchanges. Yet, the companies need to adhere to national AML regulations and conduct operations through local banks.

According to a blockchain analytics firm, CipherTrace, as of December 2020, half of the crypto exchanges domiciled in Seychelles (about 26) had weak KYC procedures. One of them, a large derivative crypto exchange BitMEX, was under investigation by the US authorities. The US prosecutors claimed that BitMEX founders evaded anti-money laundering rules while serving US customers. In this process, it was stated that the BitMEX founders chose the place of the company’s incorporation allegedly because of Seychelles’ “seemingly less stringent regulations [than in the United States]”. Confirming this fact, one of the former BitMEX executives, when asked how much he had to pay Seychelles to register BitMEX there publicly said: “a coconut”. Following the BitMEX case and international press coverage about this, it was reported that the Seychelles authorities were going to examine the situation and tighten the requirements in this sphere.

The United States of America

In the USA, crypto exchanges are regulated both at the federal and state levels. In general, to start a crypto business in the USA, a crypto exchange is obliged:

• Register with the federal government (with FinCEN) as Money Services Businesses (it covers both crypto-to-crypto services and fiat-to-crypto services).
• Develop and implement an AML program complying with federal and state standards.
• Obtain a money transmitter license in each state where the exchange intends to provide services to this state’s residents (e.g., a BitLicense in the State of New York). Each state sets its own specific requirements, and complying with all of them may be costly. According to Blockchain Law Guide, the following criteria that range per state should be fulfilled: minimum surety bond requirements ($1,000-$500,000), application fees ($0-$5,000), licensing fees ($0-$3,750), minimum net worth requirements ($5,000-$2,000,000), as well as meeting local financial disclosure and consumer compliance requirements.

In view of the heavy legislative burden imposed on crypto companies, the State of New York came up with an alternative — a New York limited purpose trust company. This type of company is permitted to provide cryptocurrency exchange and custody services in many states, not being required to obtain their money transmission licenses (however, there are higher capital requirements and stricter supervision). For example, Gemini Trust Company, LLC and itBit Trust Company, LLC were chartered as limited purpose trust companies.

Moreover, in September 2020, the Conference of State Bank Supervisors announced new details on a simplified licensing process among state regulators (‘Multistate MSB Licensing Agreement Program’), which would eliminate the need for nationwide payments firms, including crypto exchanges, to maintain a money transmission license in every state through the introduction of a comprehensive state exam in 2021 (currently, the program covers more than 40 states).

The challenging regulatory environment (including some degree of uncertainty in the regulatory framework) and the costs of achieving the required level of compliance seem to be the main reasons why in 2019, many crypto exchanges scaled down their operations in the US by excluding US-based users from assessing their websites (e.g., Bancor, OKEx, Huobi Global, LBank, HitBTC and Coineal, Whitebit) or by limiting the scope of their services for US-based users (e.g., Bitfinex, Poloniex).

Nonetheless, the US is one of the biggest crypto markets in the world. In 2019, as per an analytics firm DataLight, US traders were the “most active across the majority of the exchanges.” The large exchanges endeavour to be fully compliant with the relevant US regulations. For example, Binance launched a crypto exchange platform ‘Binance.US’, focusing exclusively on the US market and its residents.

To sum up, it seems that currently crypto exchanges are subject to a greater extent to AML/CFT rules. However, more and more legislative norms of different fields of law are being implemented, such as, for example, requirements to obtain a license for trading security tokens (in Hong-Kong), the prohibition of the sale of some crypto derivatives to retail consumers (in the UK), or enforcement of marketplace requirements to prevent market manipulation or other fraudulent acts (see: Gemini’s User Agreement). As the global adoption of cryptocurrencies continues, it may be expected that CEXs will become more regulated in many regions due to introduction of detailed rules in relation to consumer protection, compensation schemes, cybersecurity, market manipulation, taxation, etc. Crypto companies that are financially unhealthy or poorly managed might hardly survive in the new environment, especially competing against large reputable CEXs on the one side and audited decentralized exchanges on the other.