Legal Obligations of Crypto Exchanges: What You Need to Know
Crypto exchanges operate like conventional commodities and stock exchanges. They provide users a platform to trade digital currencies for other assets.
Like traditional exchanges, crypto exchanges enable price discovery and provide liquidity to crypto markets.
Albeit regulatory uncertainity, the role of crypto exchanges continues to grow in the financial world.
Their global reach complicates matters further, requiring international compliance strategies.
Crypto markets are at a crossroads. Their viability depends on their ability to balance legal obligations with innovation. A tricky undertaking.
The use of scorched-earth enforcement actions, coupled with regulatory uncertainity, make it hard for crypto companies to do business.
As scrutiny on these platforms increases, business threatens to grind to a halt.
⚡This article discusses seven legal obligations of crypto exchanges you should know. We will use case studies, stories, and analogies to clarify these obligations. Read on!!
Table of Contents
· KYC and AML Compliance Obligations For Crypto Exchanges
· Navigating Securities Laws Compliance Obligations
· Consumer Protection Obligations For Crypto Trading Firms
· What Can Crypto Trading Platforms Do To Enhance Consumer Protection?
· The Importance of Data Privacy for Crypto Trading Firms
· Tax Reporting Duties
· Licensing Requirements For Crypto Exchanges
· Cyber Security Obligations
· Final Thoughts: With Great Power Comes Great Responsibility
The significance of regulatory compliance in the crypto industry cannot be overstated. It serves as a bridge between the innovative potential of cryptocurrencies and the need for a secure, stable, and trustworthy financial ecosystem.
There are three types of crypto exchanges. These are centralized, decentralized, and hybrid exchanges.
Exchanges vary based on their security models (non-custodial and custodial), and the markets they serve (swap, futures, options and spot markets).
Crypto exchanges play a crucial role in the digital asset industry. Understanding the legal obligations they owe you helps you to pick the right exchange.
Below are 7 legal obligations crypto exchanges owe you.
1. KYC and AML Compliance Obligations For Crypto Exchanges
Consider a market where participants trade goods and services without revealing their identities.
As alluring as this may sound, it creates opportunities for financial misconduct.
⚡Fast Fact!
Blockchain tech enables the recording of transactions in an immutable and transparent manner. Authorities and exchanges can take advantage of this to spot financial misconduct.
Compliance with AML/KYC laws helps to prevent financial crimes, like fraud, terrorism financing, money laundering, sanctions evasion, tax evasion, etc.
Compliance legitimizes crypto exchanges, leading to mass adoption of crypto and market stability.
Non-compliance undermines the mass adoption of crypto, investor trust, and market integrity.
⚡Case Study: Binance
Binance is the world’s largest crypto exchange. Binance shows its commitment to compliance by partnering with global regulators.
Its recent alliance with the Global Travel Rule Alliance is proof. The partnership strengthens the company’s commitment to international AML and KYC rules.
Binance recognizes the importance of a regulated environment in dispelling negative perceptions about crypto, protecting users, and encouraging broader adoption of crypto assets. Their collaboration with GTR ensures user data remains safe and private.
Binance keeps a robust team of compliance officers to strengthen its compliance capabilities. It invests in analysis tools and technologies to flag dubious activities. Binance also partners with regulatory tech vendors to automate compliance.
As the industry grows, stakeholders realize the need for a global AML/KYC framework. In the US, for example, regulators require exchanges to uphold international regulatory frameworks.
A good framework addresses the industry’s borderless nature while ensuring uniform global regulations.
Some regulators burden crypto companies with anachronistic and insurmountable requirements, and refuse to provide legal clarity and guidance.
Regulations must not stiffle innovation by over regulating or by under regulating the industry. Regulators must also consider the cost of their actions.
For instance,
Regulation by enforcement may drive an industry out of a jurisdiction, causing it to lose out economically. High compliance costs may wipe out startups, jeopadizing livelihoods and innovation.
⚡Take Note!
The Financial Task Force( FATF) requires financial institutions dealing with virtual assets and crypto companies to conduct customer due dilligence and share the information with counterparties.
Per FATF’s guidance titled Virtual Assets Red Flag Indicators, transactions utilizing mixers should be flagged, as they obscure the transfer of illicit funds.
Tumblers expose crypto exchanges to AML/ KYC risks. Exchanges can avoid this by deploying proactive compliance strategies.
Apart from engaging a robust internal compliance team, they can chieve this by engaging companies like Merkel Science, and Elliptic.
These companies are blockchain intelligence service providers that help crypto firms remain compliant and sustainable.
They provide various services, including intelligence solutions and transactions monitoring services to virtual asset providers.
Important ⚡
While AML/CFT/KYC requirements help combat financial misconduct, they raise concerns regarding privacy rights.
Exchanges normally engage in extensive transaction monitoring and often require users to provide intimate personal information.
This has led to debates regarding the need to balance security and privacy rights. Privacy is a fundamental right protected by constitutions around the globe.
Privacy-focused cryptocurrencies like Zcash and Monero promise to remedy these concerns.
For instance,
Monero is a blockchain network that promises users anonymity and censorship resistance. Monero transactions (XRM) are unlinkable and untraceable. The nature of privacy coins excarbates KYC/AML/CFTC concerns.
Be as it may,
A leaked Chainalysis video (now deleted) suggested a possibility of tracing XRM transactions and their IP addresses via malicious nodes.
⚡Also Read: Crypto Investigations: Key Challenges & Solutions
2. Navigating Financial Laws Compliance Obligations
The crypto industry is notorious for financial misconduct. Many exchanges disregard compliance obligations with devastating consequences.
In 2023, regulators across the globe cracked down on crypto exchanges. They tried to reign exchanges through enforcement actions and by providing guidelines.
Financial products uphold various standards to ensure market integrity, stability, and consumer protection. Innovation is not enough to legitimize crypto activities.
Digital assets are now a permanent asset class. Transactions involving crypto assets raise various legal considerations. The absence of crypto-specific laws complicates matters. Most jurisdictions require crypto exchanges to follow rules that apply to TradFi.
Securities laws are the traffic laws of the financial world. Drivers must obey traffic rules to ensure safety, and to avoid liability.
Crypto exchanges must uphold securities laws to avoid regulatory crackdowns. Flouting commodities/securities laws exposes them to enforcement actions, among other penalties.
Are crypto assets securities, commodities, or a means of payment?🤔 Identifying where an asset lies is critical in ensuring compliance.
Regulators assess individual cryptocurrency offerings to determine whether they are securities. Courts use the facts and circumstances test ( Howey Test) to determine an asset’s status. That is, whether it’s a security. The asset’s underlying tech is immaterial.
If a crypto asset satisfies the Howey Test, it is a security. Securities laws apply to any offerings involving the asset.
Similarly, if an asset is a commodity, commodities laws apply to all offerings associated with the asset.
The US SEC’s stand that most cryptocurrencies are investment contracts (securities) is unsettling.
The US CFTC’s declaration that 70–80% of cryptocurrencies are commodities, contradicting the SEC.
The commodities markets watchdog declared that Litecoin, Bitcoin, and ETH were commodities in its fillings against KuCoin.
“When a new technology comes along, our existing laws don’t just go away.”
Gary Gensler, US SEC Chair.
The SEC has brought numerous enforcement actions against crypto exchanges and crypto token issuers.
In July 2023, the crypto industry celebrated Ripple’s partial win against the US SEC.
The court stated that,
The XRP token “is not in and of itself a “contract, transaction[,] or scheme” that embodies the Howey requirements of an investment contract……..The vast majority of individuals who purchased XRP from digital asset exchanges did not invest their money in Ripple at all.
An Institutional Buyer knowingly purchased XRP directly from Ripple pursuant to a contract, but the economic reality is that a Programmatic Buyer stood in the same shoes as a secondary market purchaser who did not know to whom or what it was paying its money.
Judge Anallisa Torres, presiding judge, SEC v. Ripple
Ripple did not breach securities laws by offering XRP tokens to exchanges.
It violated securities laws by offering institutional investors tokens. Despite the win, the SEC seeks to appeal the District Court’s decision.
The issue of whether a crypto asset is a security or commodity is critical. Securities laws demand securities issuers follow strict registration and disclosure rules.
Crypto exchanges trading securities must meet strict requirements. That is, disclosure, registration, and reporting requirements.
⚡Fast Fact!
On 7/8/2024, Judge Analisa Torres, ordered Ripple to pay a fine of $125 million.
⚡Learn More: Legal Considerations to Make Before Investing in Digital Assets
Regulators, crypto trading firms and digital asset issuers often quarrel regarding the application of securities laws to crypto.
Crypto companies decry that securities laws are incompatible with decentralized, disintermediated crypto assets.
For years, the US SEC has tried to expand the meaning of the word ‘’ exchange’’ in an attempt to bring DeFi under its control. This attempt has illicited alot of condemnation from industry players like Coinbase.
In a comment submitted to the SEC, Coinbase urgues that the SEC’s attempt to expand the meaning of the term ‘’ exchange’’ will have harmful effects on the nascent industry.
According to Coinbase’s Chief legal Officer Paul Grewal, the proposed rule, aimed at DEXs, will curtail innovation in the crypto industry by,
……saddling DEXs with anachronistic and impossible-to-satisfy requirements, by inexplicably banning side-by-side trading of digital assets and purported “crypto asset securities,” and by failing to conduct an adequate cost-benefit analysis of the Proposed Rule’s likely effects.
At the core of Coinbase’s urguement is the fact that DEXs are run by smart contracts and have minimal human management.
As such, they are by definition incapable of being subjected to similar rules and standards that apply to traditional exchanges.
Paul Grewal further stated that,
DEXs cannot comply with registration and disclosure requirements designed for legacy financial exchanges managed by centralized companies. And even if DEXs could somehow comply with existing registration and disclosure rules, the Commission does not explain how SEC-registered DEXs could facilitate the trading of digital assets.
🤔Are crypto companies right when they say existing financial integrity regimes are inapplicable and outdated? Tell us what you think in the comment section below.
⚡Also Read: Security Tokens and STOs: A New Frontier for Block Chain and Securities Laws
3. Consumer Protection Obligations For Crypto Trading Firms
The crypto industry is an interesting and edgy marketplace. Promises of high returns on investments are the order of the day. As interest in crypto grows, cases of financial misconduct rise.
The growth of crypto is outstanding in many ways. It influences economies and societies faster than any other emerging tech, with the exception of AI. Millions of people trade crypto daily.
Fast Fact⚡Only invest money you are willing to lose!
The global cryptocurrency market cap is $2.68 Trillion, with a daily volume of $80.84 billion.
As the industry grows, consumer risks grow too.
Below is a list of risks associated with the crypto industry:
- Crypto exchange insolvencies (consider FTX and Mt. Gox)
- Crypto scams
- Misleading advertisement
- Mismanagement of client funds
- Volatility
- Contagion risks
- Lack of enough reserves
- Lack of transparency
- Absence of redress mechanisms
The novelty of crypto caused regulators to approach it with a laissez-faire attitude. This is no longer the case. After the 2022 crypto winter, regulators have vowed to reign in crypto companies.
But how do you regulate an industry that transcends political borders?🤔 International regulatory frameworks!
There are efforts to establish global crypto regulations. International regulators like the Financial Action Task Force ( FATF) guidance on how virtual asset service providers should treat crypto assets.
Some countries like Dubai and Ukraine have crypto regulations in place.
‘’The determination of which businesses warrant regulation and which do not should be made by reference to what harm the business is capable or incapable of doing, rather than whether they — vaguely and metaphysically — “hold” or “store”units of virtual currency.’’
Coin Center
What can crypto trading platforms do to enhance consumer protection?
Below are afew things exchanges can do to protect consumer interests:
- Secure Storage of customer funds
Crypto trading firms can uphold consumer protection by ensuring secure storage. Cold storage is an effective way of securing customer funds.
- Efficient customer support services
Providing clients knowledgable and proactive customer support is necessary for consumer protection. Crypto trading platforms should provide clients various support avenues, including live chats.
- Transparency reports and regular audits
Crypto exchanges enhance consumer protection by conducting regular audits. Issuing a transparency report is an effective consumer protection technique.
- User empowerment
Exchanges should educate their clients on the risks of crypto trading. They should also raise awareness about trading best practises. Crypto exchanges must provide users transparent terms of service to boost trust.
- Fraud detection
Exchanges should use robust fraud detection systems to protect user funds. Monitoring transactions, and leveraging tech to detect dubious activities is critical. They must also set up a dedicated team for responding to fraud.
- Implement conflict resolution mechanisms
Crypto exchanges must incorporate dispute resolution mechanisms to boost consumer trust. Mechanisms like mediation and arbitration help solve conflicts fast and fairly.
⚡Fast Fact
While crypto ETFs are expensive, they reduce the learning curve for beginner investors. ETFs expose you to cryptocurrencies without dealing with crypto exchanges, or wallets. This reduces investor exposure risks.
⚡Related: Top 5 legal Considerations to Make Before Investing in Crypto ETFs
4. The Importance of Data Privacy for Crypto Trading Firms
Data privacy is a fundamental human right. People have a right to decide who can access their personal information.
Businesses protect customer data to ensure sustainability. Data breaches often lead to serious financial and legal consequences.
Granted, data protection is an expensive undertaking. But failing to secure client data undermines a firm’s reputation, leading to loss of revenue.
Data protection helps businesses avoid legal and financial pitfalls, and enhances their reputation.
While blockchain tech enhances transparency, it brings up privacy concerns.
Crypto trading companies have a duty to safeguard clients’ personal data. Crpto exchanges must do this to secure sustainable growth.
Data privacy protections apply to transactions that involve sharing of personal information.
Crypto exchanges must adhere to data security laws and regulations to avoid fines, among other enforcement actions.
Global data protection laws propose heavy fines to offenders. This requires crypto exchanges to review their data protection strategies.
Case Study: Coinbase Privacy Practises
Coinbase is a leading crypto exchange, which uses strong data protection techniques. The exchange’s data protection approach helps it meet global privacy requirements. This led to legal approval and enhanced user trust.
⚡Fast Fact
Cryptographic methods like zero kowledge proofs (ZKPs) help solve blockchain’s privacy issues. ZKPs also enhance security. ZKPs verify an indivividual’s knowledge of certain info without exposing personal details.
5. Tax Reporting Duties
Give unto ceasar what belongs to ceasar!!!
Tax regimes vary from place to place. It is hard for investors to keep track of their crypto investments for tax purposes.
Crypto exchanges ensure investors meet tax requirements by collaborating with tax authorities.
Collaborating with tax authorities involves sharing appropriate tax documents, and reporting transactions.
Case Study: Kraken
In the United States, the IRS (Internal Revenue Service) continues to scrutinize crypto transactions. Exchanges like Kraken work with the IRS to ensure compliance. Kraken provides customers detailed reports to help them file returns.
6. Licensing Requirements For Crypto Exchanges
Licensing plays an important role in finance. A valid license assures investors that a firm operates legally and upholds financial intengrity regimes.
Licensing demonstrates that a company meets industry standards. Licensed exchanges provide safe trading spaces.
A lincensed exchange is comparable to a licensed health institution. The license assures users that the instituion meets regulatory standards. This boosts its credibility and drives business.
Exchanges looking to offer their services in the EU must acquire lincenses under article 59 of MiCA. MiCA prohibits third-country firms from offering their products and services to EU residents.
Article 61 of MiCA introduces the ‘’reverse solicitation’’ exemption. Third-country firms may engage EU residents at their behest. Article 61 does not apply to firms that advertise or solicit within the region.
“Where a client established or situated in the Union initiates at its own exclusive initiative the provision of a crypto-asset service or activity by a third-country firm, the requirement for authorisation under Article 59 shall not apply to the provision of that crypto-asset service or activity by the third-country firm to that client, including a relationship specifically relating to the provision of that crypto-asset service or activity.”
Article 61 of MiCA
After years of uncertainity, the Nigerian crypto industry is seeing a paradigm shift in the government’s approach to crypto.
The Nigerian Securities and Exchange Commission (SEC) recently granted licenses to two exchanges, Quidax and Busha.
This change of heart comes after the Nigerian government launched a regulatory sandbox to understand the crypto industry.
On 3rd December 2024, Cambodia’s Telecommunication regulator(TRC) restricted access to 16 websites linked to unlincensed crypto exchanges.
Some exchanges whose websites were blocked included Binance, and Coinbase. This move comes after the nation was flagged as a hotspot for cybercriminal activities involving cryptocurrencies.
7. Cyber Security Obligations
The number of attacks crypto exhanges suffer is absurd. Exchanges have open-source code libraries, making them prime targets for hackers.
A successful attack could siphon million, or even billions worth of assets at a go.
You might be wondering, how does this happen if all transactions are recorded and can be tracked down?
The simple answer to this is, crypto mixers (also known as tumblers).
Tumblers add an extra layer of anonymity. According to Plasbit, ‘’tumblers divide users’ crypto into small amounts, and blend them with other users funds.’’ This makes it hard to for authorities and exchanges to track the origin of funds.
⚡Case Study: Mt. Gox
From 2011 to 2014, Mt. Gox, a Japan-based exchange suffered a spectacular hack that led to collosal losses.
In 2014, the exchange suffered a devastating loss due to a mega cyber attack. Hackers successfully stole 850,000 Bitcoin. Based on Bitcoin’s current price, the attackers went away with $51.09 billion worth of assets.
This loss was the final nail on the exchange’s coffin. The company filled for bankruptcy soon after.
Following a Tokyo District Court decision, Mt. Gox entered a civil rehabilitation plan headed by Kobayashi Nobuaki, a rehabiltation trustee.
The exchange faced numerous lawsuits from investors, customers, and even partners.
At the time, Mt. Gox was the largest exchange in the world, a beacon of renegade enterprenuership.
Investigations shows that the exchange took little or no action to fortify itself against attacks.
After years of court proceedings, the defunct exchange issued a press statement stating that it would commence to reimburse victims of the 2014 hack, starting early July 2024.
Commentators privy to the inner workings of the firm stated that the attack came as no suprise.
Investigations show that the exchange was a victim of inexperience, poor management, and gross neglect.
Crpto exchanges have a duty to safe guard clients’ assets. They must take all reasonable steps to do so. This involves deploying strong security measures to detect and counter cyberattacks.
What security measures should exchanges take to avoid cyber attacks?
- Secure storage
An exchange that values the security of its clients assets utilizes a combination of hot wallets and cold storage, balancing security with accessibility. Security concious exchanges store most of their holdings in cold wallets.
2. Implement two-factor Authentification ( 2FA)
2FA fortifies security by requiring users to link their accounts to authenticator apps or their mobile phones.
3. Conduct regular security audits and updates
Cyber threats evolve simultaneously with the crypto industry. Cyber criminals are always finding new ways to beat implemented security systems.
To remedy this, exchanges need to conduct regular security audits and updates to identify and remedy security gaps in their systems.
Final Thoughts: With Great Power Comes Great Responsibility
The role of crypto exchanges continues to grow. As investor appetite for crypto grows, crypto exchanges cement their role in finance. They enable price discovery and provide liquidity.
The most worrying thing about the crypto industry is incosistent regulations.
Most jurisdiction remain tight lipped on the issue of crypto regulations. The lack of clear and consistent regulations causes problems for crypto exchanges.
That notwithstanding,
Crypto exchanges have a duty to their customers. They must uphold the above mentioned requirements to avoid conflict with regulators, and to enhance user trust.
Observing securities laws, AML/KYC rules, licensing requirements, cyber security rules and data privacy laws is the secret to survival.
Upholding these standards help them boost user trust, and create safe trading spaces.
Compliant exchanges experience drastic increases in user trust, revenue, and business growth.
⚡Understanding the legal obligations owed to you helps you pick the right exchange.
There are many unregulated exchanges worldwide. These exchanges fail to uphold regulations, leaving users with no recourse.
Lastly, using reputable exchanges with a track record of security, reliability and high-integrity behaviour is crucial.
