All You Need to Know About Crypto Exchange Regulation
Today, most crypto activity takes place on centralized exchanges (CEXs). Companies such as Coinbase, Binance, and Kraken make it easy for users to buy, store, and withdraw dozens of digital assets. Since these platforms have high volumes, they draw the most scrutiny from lawmakers. And, as the crypto market cap rises, many regulators consider the legality of crypto exchanges.
Because crypto laws change rapidly, it's difficult to list the specific crypto rules in every nation. However, understanding the basics of crypto exchange regulation is essential for those involved with cryptocurrencies.
How are centralized crypto exchanges regulated?
Although global financial institutions such as the Financial Action Task Force have published suggestions on regulating crypto, every nation has a unique set of statutes for this industry. In the United States, crypto regulation is even more complicated due to the split between federal and state legislation. Local legislators can craft unique crypto laws that don’t fit the current national guidelines.
For example, New York requires all local crypto businesses to obtain a special “BitLicense” to operate in the state. Many U.S.-regulated crypto exchanges such as Kraken choose not to operate in New York due to the costly and lengthy BitLicense project. In contrast, some states like Wyoming, California, and Arizona have been more welcoming of cryptos. In fact, all three of these states introduced bills to allow residents to pay taxes with cryptocurrencies.
Every jurisdiction has different regulatory rules for crypto companies, but most governments require virtual currency exchanges to follow international anti-money laundering (AML) and counter-terrorism financing (CFT) laws. This often means that CEXs need to verify the identity of every customer with KYC (know-your-customer) info such as a driver's license, proof of residence, and social security number.
A few nations require crypto exchanges to submit formal audits to prove their solvency. However, following the collapse of the crypto exchange FTX in 2022, lawmakers are demanding greater transparency. Some CEXs publicly list their wallet addresses to prove the status of their crypto reserves, while publicly traded CEXs such as Coinbase release quarterly financial reports to shareholders.
Although KYC, AML, and CFT are standard aspects of CEX regulation, the laws governing crypto aren't as well-defined as in traditional financial markets such as ETFs (exchange-traded funds), derivatives, and forex. These unclear reporting requirements are partly due to crypto's novelty. Many regulators are still trying to understand and define the many aspects of this emerging technology.
Why do countries regulate crypto exchanges?
Most nations claim they want to regulate CEXs to make crypto trading safer. Safer means that users are less likely to engage with fraudulent exchanges which steal their money or suspect assets which can lose value almost instantly. Plus, since crypto exchanges are the primary sites for trading fiat currencies for virtual currencies, they help regulators monitor cryptocurrency transactions. Regulated CEXs with KYC data make it easy to track suspicious activity such as large crypto transfers. It's also easier for CEXs to monitor crypto transfers associated with blacklisted wallets.
The wealth of personal information on CEXs makes it simpler for organizations such as the FBI or IRS to suspend accounts associated with money laundering, terrorism, or crypto scams. These regulations may also enhance investor protection and consumer confidence when trading crypto assets.
Are decentralized crypto exchanges regulated?
Most of the news on crypto exchange regulations focuses on CEXs. Not only do CEXs hold the most liquidity in the crypto industry, but they’re also easier to regulate. Large CEXs have physical headquarters and a clear leadership structure, but the same can't be said about decentralized crypto exchanges (DEXs).
DEXs are cryptocurrency exchanges that run on top of smart contract blockchains such as Ethereum or the BNB Smart Chain. DEXs use self-executing programs called smart contracts that allow people to trade directly between digital wallets. The decentralized nature of these open-source platforms has made them more challenging to regulate.
However, lawmakers have introduced restrictions on DeFi (decentralized finance) in the past few years. For instance, the U.S. government banned using a "crypto mixer" called TornadoCash in 2022. Crypto mixers help DeFi users anonymize their transactions, and U.S. regulators believe hackers used TornadoCash. While TornadoCash wasn't a DEX, it was a major application in Ethereum's DeFi ecosystem. Also, many DEXs such as Uniswap agreed to work with regulators and blacklist wallets associated with TornadoCash. These new policies suggest more regulations will play a role in the future of DeFi.
Why is regulating crypto exchanges difficult?
Although more CEXs comply with crypto laws, it has been difficult for lawmakers to enforce these regulations. There are many features inherent to digital currencies that make them challenging to regulate.
- Rapidly evolving technology: Bitcoin (BTC) has only been around since 2009, and innovations such as smart contracts, NFTs (non-fungible tokens), and DeFi are in their infancy. Blockchain technology is evolving quickly, which makes it challenging for lawmakers to "catch up" with crypto.
- Deliberately non-sovereign assets: Digital coins such as Bitcoin and Ethereum aren't associated with any nation, government, or central bank. Even if one country "bans" Bitcoin, it won't stop BTC miners from operating the network. The non-sovereign nature of cryptos such as Bitcoin makes them more challenging to regulate.
- Headquarters in multiple nations: To avoid legal hassles, many CEXs have decided to build headquarters on islands––such as Seychelles, the Bahamas, or Antigua and Barbuda––to avoid answering to lawmakers in larger countries while still offering crypto trading to foreign clients.
- Open-source code makes "DeFi bans" impractical: The 2022 TornadoCash ban revealed how difficult it is to regulate DeFi sites. Although TornadoCash shut down, many faux sites began spreading shortly afterward. Since the code for most DeFi projects is open source, it's easy for developers to create duplicate sites whenever a regulator tries to "ban" a DEX.
- No internationally accepted regulatory framework: Every nation takes a different stance toward crypto legality. Some countries such as El Salvador embrace BTC as legal tender, while China banned crypto trading in 2021. No international legal lexicon for crypto terms, either. These confusing and contradictory crypto laws make it difficult to create an actionable enforcement policy.
Why is crypto exchange regulation important?
Crypto exchange regulation has many implications for purchasing in digital assets such as Bitcoin and Ethereum. CEXs have the most liquidity in the crypto market, and the more regulated CEXs are, the more personal data they’ll have in their possession.
People in favor of online anonymity are concerned the KYC requirements on CEXs could limit personal freedom in Web3. On the other hand, some argue that KYC might add transparency and trust to the crypto space. Either way, these KYC policies will put more personal info in the hands of CEXs.
Besides privacy concerns, regulation has implications for local crypto legality and taxation. How a country regulates CEXs will affect crypto's accessibility. The more stringent a nation's crypto regulations are, the less likely they’ll accept crypto payments or Web3 technologies. In contrast, countries with relaxed crypto restrictions, such as capital gains tax laws, often have greater crypto adoption.
Lastly, crypto exchange regulation can impact the crypto market’s health. The more nations move to restrict access to crypto assets, the greater the odds cryptocurrencies will enter a bear market. However, if more countries open up to legal crypto trading, it may encourage more people, investment firms, and businesses to explore digital assets.
How to find regulated crypto exchanges
Following the 2022 crypto bear market, many users aren't sure how to find a regulated crypto exchange. Although crypto platforms such as Voyager, Celsius, and FTX were all "highly regulated," they all filed for bankruptcy. Choosing a safe crypto exchange can feel intimidating, especially for those new to this market.
However, following the many crypto bankruptcies in 2022, more exchanges post proof-of-reserve audits to provide enhanced transparency. You can monitor the liquidity on these exchanges with data on third-party price aggregators such as CoinGecko and CoinMarketCap. Many reputable CEXs are also working with regulators to devise new standards for providing safety data to users.
Experts suggest it's safest to work with crypto exchanges with the longest history of success and transparency in the crypto industry. Reviewing customer feedback on third-party review sites and coin price aggregators can help you find a trading platform that's well-regulated and reputable.
Staying informed on crypto exchange regulation
Since regulation significantly influences crypto trading, staying up-to-date on local and federal crypto policies is important. One way to stay informed on crypto exchange regulation is to follow crypto news sites such as CoinDesk, CoinTelegraph, and Bitcoin.com. You can also sign up for your crypto exchange's official blog for the latest updates on policy changes. Major CEXs such as Coinbase, Kraken, and Binance have Learn Portals where you can stay on top of important crypto information.
Alternatively, you can turn to Worldcoin’s Resource Center to learn more about the crypto space.
Nobody's sure how regulation will affect cryptocurrency exchanges, but it's clear more nations want to introduce crypto trading laws. With the collapse of crypto sites such as Celsius and FTX, it's increasingly likely that regulators will devise new standards for both CEXs and DEXs.
At Worldcoin, we aim to bring greater accountability into DeFi without sacrificing user privacy. To do this, we're working on an eye-scanning technology called the Orb. With this device, we can prove there's a unique human identity behind each crypto wallet without collecting KYC data. Subscribe to our YouTube channel to learn more.