Cryptocurrency exchanges are a crucial player in the cryptosphere as they are key to supporting prices of different cryptocurrencies, disseminating information, and facilitating transactions in digital currencies through their platforms. They are often in news for both right and wrong reasons. Some have grown beyond trading and diversified into payment processors and crypto lending platforms. A common target of hackers and scammers, they have attracted significant attention from securities regulators.
With cryptocurrency exchanges such as Coinbase looking to get registered as a licensed brokerage, an article delineating the concept and function of these exchanges may help you understand the digital marketplace better.
Here is a primer on cryptocurrency exchanges.
To put simply, cryptocurrency exchanges or digital currency marketplaces allow users to buy, sell, or exchange cryptocurrencies for another digital currency or fiat currency through their online platforms.
Crypto exchanges can be broadly classified into:
1. Trading Platforms – Similar to the traditional stock exchanges where one can buy or sell shares, crypto exchanges allow users to trade cryptocurrencies with other digital currencies or fiats for a fee or commission, based on their current market price. Trading platforms can be further divided into centralized, peer-to-peer and decentralized exchanges. All exchanges provide crypto/crypto pairing, while some additionally offer fiat/crypto pairing.
a) Centralized Exchanges – These are the most common type of crypto exchange and also the most common targets for hackers. They are owned and operated by a single entity and operate as a trusted middleman or third party between the buyer and seller. Users can create an account and deposit fiats or cryptocurrencies with the exchange that can be used to trade. Exchanges match buy and sell orders and allow users to store their money on the exchange, usually in a protected digital wallet. This way, it is possible for users to access their cryptos even if they forget the password or fail two-factor authentication (2FA). This type of exchange also ensures market liquidity and high trade volume.
Centralized exchanges may be registered with the securities watchdog of a particular country or regulated by the government. After the implementation of strict regulation in main crypto markets such as Japan and South Korea, anonymous trading is impossible on centralized exchanges. Popular crypto exchanges such as Coinbase, Gemini and Kraken are centralized exchanges.
b) Peer-to-peer Exchanges – This type allows users to buy and sell cryptocurrencies directly from each other or peer-to-peer (P2P) and are often faster and cheaper than the centralized ones. They match buyers and sellers of cryptocurrencies and the transaction is completed usually using out-of-band payment methods. The buyer and seller determine the price and the payment method, including over-the-counter dealing, between themselves. These exchanges do not hold users’ funds and, hence, are less attractive to hackers. They provide some level of privacy and anonymity.
Another important feature of P2P exchanges are their built-in reputation system, which is crucial to create trust between a buyer and a seller as the exchange does not have any control over the transaction. Popular P2P exchanges are LocalBitcoins, Paxful, Bisq (formerly Bitsquare), Bitquick and Coinffeine. Most P2P exchanges are allowing only Bitcoin purchases as of now, but new platforms are likely to host more cryptos.
c) Decentralized Exchanges – Decentralized exchanges (DEX) are advanced avatars of P2P exchanges and allow their users to carry out trades without a middleman, meaning they create a “trustless” environment where transactions take place using smart contracts. They are not controlled or co-ordinated by a single entity and there is no central server for transactions. Instead, they run on a distributed ledger such as blockchain where several users verify and authorize transactions. Hence, they are less susceptible to hacks as there is no single point of entry.
DEXs do not hold users’ funds and serve to match the buy and sell orders. These exchanges offer users a high degree of anonymity and are beyond any government control. That said, decentralized exchanges are difficult to use, especially by those who are less tech savvy. And they have very limited options for their users, meaning they do not provide facilities like stop loss, and lack trade volume due to less users.
A relatively new tech called cross-chain atomic swaps that uses hash time-locked contracts (HTLC), is being tested. When deployed, this is expected to make decentralized exchanges more efficient and accessible to the average user.
Some examples of decentralized exchanges are CryptoBridge, Waves and Stellarport, which support only the cryptocurrency Stellar Lumens for now. OmiseGo is developing a decentralized exchange on the Ethereum blockchain.
2. Crypto Brokers – They set a price for cryptocurrencies, which is usually the market price plus premium. Users can buy and sell cryptos at the price fixed by the broker. They are regulated and most of them have been in the business of currency trading for decades. Users can also use the contract-for-difference, or CFD, provided by brokers for speculative investment in cryptocurrrencies. Some examples of cryptocurrency brokers are eToro and Avatrade.
Cryptocurrency exchanges are frequently targeted by hackers who steal digital coins, which could sometimes result in the closure of the exchange.
The most famous and one of the first examples is the 2014 hack of the Tokyo-based Mt. Gox, when over $450 million worth of Bitcoins were stolen. Mt. Gox, which at the time was the world’s biggest bitcoin exchange, collapsed soon.
Unsurprisingly, regulators in different countries are closely watching cryptocurrency exchanges. Their main interest is in determining whether these venues comply with anti-money laundering and combating the financing of terrorism (AML/CFT) rules. They are also probing whether services offered by these exchanges are of a kind that treats cryptocurrencies as securities and hence, require a license to do so. Authorities are also on the look out for scams that may be promoted through these marketplaces.
In Asia, regulators in South Korea, Japan and China, which are the main markets for cryptocurrencies, have imposed strict rules on the working of crypto exchanges as the popularity of digital currencies surged. News of any action by regulators in these countries often cause sharp gyrations in cryptocurrency prices, especially those of main cryptos such as Bitcoin, Ethereum and Ripple.
Chinese regulators started their crackdown in 2017, as the growth of the crypto market in the country, risks from the high volatility in cryptocurrency prices and related fraud, raised concern. In September that year, the People’s Bank of China banned initial coin offerings and ordered shutdown of all domestic fiat-to-crypto trading platforms. That failed to deter the Chinese from participating in the crypto boom and they took to overseas platforms.
In January this year, the central bank banned domestic investor participation in overseas crypto platforms and also put strict restrictions on crypto trading over social media networks. Many big crypto exchanges in China re-located to Hong Kong and Japan following the clampdown.
Japan is apparently the first country to ask cryptocurrency exchanges to register with the securities watchdog. Making registration more necessary was a massive hack at the unregistered Coincheck exchange in January this year, in which $530 million worth of NEM coins were stolen, the biggest theft in cryptosphere thus far. The exchange was acquired by the Japanese online brokerage Monex Group in April.
Following the Coincheck incident, the Financial Services Agency began probing all exchanges, with some registered ones now under the scanner. The 16 registered crypto exchanges in Japan formed a self-regulatory body in March. Roughly the same number were waiting for approval. However, the recently strengthened norms prompted some exchanges to withdraw their request for registration. About a 100 firms are reportedly interested in entering the Japanese crypto market.
South Korea hosts several cryptocurrency exchanges that are largely unregulated. Prices of cryptocurrencies in the country tend to be much higher than elsewhere, say, over 40 percent, as buyers exceed those willing to sell. Such premium is called “Kimchi premium” in the local media, in an allusion to the famous Korean dish of spicy pickled cabbage. But higher prices have not deterred Koreans, both young and old, from taking to cryptos in a big way. And this interest prompted regulators to talk tough. They have been busy raiding crypto exchanges and banks that serve them, since the beginning of this year. The Financial Services Commission banned virtual or anonymous crypto trading accounts and made real name accounts mandatory for crypto trading. The government is also planning a licensing system for crypto exchanges.
In the U.S., the Securities and Exchange Commission keeps warning investors of the risks of investing in cryptocurrencies, and also alert them against possible scams. The regulator like its peers elsewhere, is worried about cryptocurrencies being used for money laundering and for funding terrorism activities. In March, the SEC suggested that crypto exchanges may have to register with it, similar to securities exchanges.
Other countries such as Australia, India and Singapore have also taken measures to regulate the cryptocurrency industry.
As regulators in Asia tighten the noose, some major crypto exchanges have announced plans to relocate to Europe, where the governments are welcoming fintech businesses to boost their economies.
The Hong Kong-based Bitfinex, which is the world’s fifth largest crypto exchange by 24-hour trading volume, is reportedly eyeing Switzerland. The exchange has been under the scanner this year after suspicions were raised regarding Tether, a cryptocurrency that has close links to the exchange. Tether claims that each of its coin is backed by a US dollar, something yet to be proved for lack of independent audit.
Another Hong Kong-based exchange Binance, the world’s largest cryptocurrency exchange by 24-hour trading volume, announced plans to open business in Malta as it fell out of favor with the Japanese financial regulator for failing to get a license to operate in the country.
In April, yet another crypto exchange from Hong Kong, OKEx, announced expansion of its operations to Malta.
As the cryptocurrency industry keeps growing, it is important that crypto exchanges embrace new measures to ensure faster, cheaper and more secure transactions to attract more users.
by Jyotsna V