Time for crypto exchanges to roll over

Security exchanges are laying out the red carpet for institutional investors but they may wipe out exchanges like Binance in the process.

Crypto exchanges have been the primary on-ramp and off-ramp for investors ever since Satoshi used his digital quill to pen his whitepaper. Since then, exchanges have grown fat off the proceeds, in some cases making profits bigger than mainstream banks.  

But the SEC looks set to spoil the party. Over the course of 2018, it has started prosecuting companies for running ICOs, and has gone after exchanges for operating outside of the law. In order to keep the music playing, the crypto industry looks set to pivot towards selling tokens as actual security offerings, and creating dedicated security exchanges to trade them on. Great news for institutional investors looking to get into the space, bad news for people who aren’t able to meet a security exchange’s stringent investment requirements. Will they be a way out of crypto’s nuclear winter, or is it just another way for the rich to get richer?

Security exchanges are, quitely simply, an exchange for the trading of securities. They have strict rules, including anti-fraud measures and periodic reporting requirements, that makes them a less risky experience. Most crypto exchanges do not do any of these, which has allowed everything from wash trading to market manipulation to take place. They’re also not particularly safe; Nearly $1 billion has been lost to exchange hacks. This is why institutional investors have stayed out of crypto trading–they need these safeguards in place in order to bet with their client’s funds.

Upcoming security exchanges have promised to fix all that. Much hope is riding on Bakkt, a platform for digital assets, which is backed by Intercontinental Exchange, the owners of the New York Stock Exchange–itself a security exchange. This platform will meet regulatory requirements, providing a facility for institutional investors. However, its launch has been pushed back to January 24, partly due to securing regulatory approval.

“The problem is, at the moment, many of these cryptocurrencies are part security, part commodity, part something else,” says David Forman, chief legal officer at Fidelity, a British investment firm that is also planning its own institutional platform for Bitcoin and Ethereum. Speaking at “The Regulation of Cryptocurrencies” in London, he says it’s difficult to feel safe treating it as a security when another government agency might want to tax it for different reasons, such as the IRS treating it as property. It is this uncertainty that makes institutional investors so hesitant.

In fact, while many crypto die-hards hate the sound of regulation, it’s the one thing many in the wider community are crying out for. At the same event, Ben Sebley, head of brokerage at blockchain investment bank NKB, says, “All the traditional finance [players] are waiting on the sidelines for additional regulation.” When a later panel was asked which type of regulation each panellist would most like to see, the responses focused on what taxes to pay and which regulators are responsible for cryptocurrencies. Another quirk of crypto trading that many are worried about is airdrops. 

Typically, airdrops are a method of distributing tokens to users. They are commonly used to generate buzz around a project, reward users for certain behaviors and or create a community. But, from a regulatory standpoint, it is unclear whether such businesses have to spend manpower attributing the tokens to each customer and writing the code to allow them to be withdrawn–as is most likely to be the case with a security exchange. 

Another concern is you can’t stop someone sending you money. Dave Jevans, CEO at cryptocurrency analytics company CipherTrace, says, “What happens if that money comes from a high-risk agency? You can’t stop that money coming in.” He points out that you can’t simply send it back–because if it’s an exchange it may not get attributed to the right person–and even if you do, who pays the fees?

This uncertainty is not new. Current exchanges have been loosely operating in this unregulated market for years, making plenty of money. Yet their business model may be a risk as the SEC claims more and more tokens are securities. Once a token is deemed a security, exchanges will typically delist it immediately to avoid being in violation of securities law, as has happened in Hong Kong. How many tokens are on the regulatory chopping block is unclear. What is clear is that Bitcoin and Ethereum are, according to the SEC, not securities, meaning an exchange might only be able to trade two currencies instead of the dozens most do today.

A house of cards

Most crypto exchanges won’t stand up to closer regulatory supervision, according to John Kirtland, business development director at cryptocurrency analytics company Neutrino. “A lot of them don’t apply KYC to every single transaction,” he says. “There’s a lot who will apply no KYC to crypto-to-crypto at low value.” This means they do not know who some of their customers are, a key principle for preventing movements of illegitimate funds. Even ShapeShift, an exchange run by libertarian Erik Voorhees and which is fundamentally against KYC, had to implement it this year.

This has left the door wide open for security offerings with the backing of security exchanges but will they attract retail investors? Probably not. The minimum investment for accredited investors is $143,750, for retail investors it’s $230, that’s a big difference. Plus, all investors must pass KYC and AML requirements. This could scare the retail investors away, which so far have kept exchanges in the black. 

“I don’t think they’ll flop but I think the time for adoption is slightly unknown. I think around the middle of next year, a lot of companies will be working on their security tokens and the infrastructure will be more developed,” says Graham Rodford, CEO and co-founder at institutional-grade exchange Archax. Clearly he, like many others, are investing a lot of money, time and effort into digital securities and corresponding exchanges. Right now, crypto exchanges are king, but if security exchanges do materialise–and the SEC continues to crack down on unregulated tokens–they could quickly become paupers.

Read Next: A blockchain less blockchain