The Flight to Quality: Compliance Will Be Key for Exchanges in the Age of Lowered Trust
The cryptocurrency industry has attracted intense regulatory scrutiny following the implosion of several multi-billion dollar projects in 2022
spacezerocom/Shutterstock modified by Blockworks
The cryptocurrency industry has attracted intense regulatory scrutiny following the implosion of several multi-billion dollar projects in 2022. Unsurprisingly, cryptocurrency exchanges have been the primary target for regulators, given their role as custodians and direct relations with retail investors.
In the United States, the Securities and Exchange Commission (SEC) has issued a Wells Notice to Coinbase, fined Kraken $30 million for staking-related offerings, and charged Bittrex for allegedly operating an unregistered securities exchange. Further, developments across the EU, Dubai, Hong Kong, and several other regulations suggest that the years of lax crypto regulation are firmly behind us.
Compliance for all cryptocurrency-related businesses will be key in this new era of lowered trust but it will be particularly important for exchanges. In this interview, Priscilla Adams, Group Director of Compliance at Bullish, provides an overview of the current regulatory landscape, the new normal of increased scrutiny, and how industry-leading exchange Bullish embraces compliance as part of its mission to drive mainstream adoption of digital assets.
The regulatory ball is rolling
Bullish’s Group Director of Compliance, Priscilla Adams, notes that regulators and international bodies have long recognized the need to mitigate crypto-specific risks associated with cross-border transactions and anonymity. For instance, solutions such as the virtual asset service providers (VASP) rules proposed by the Financial Action Task Force (FATF) in 2019 centered mainly on preventing the use of crypto as a backdoor for financial crimes like money laundering and sanctions evasion.
However, the FTX bankruptcy brought to the forefront the need for other regulatory provisions, specifically consumer and investor protection. The need for such safeguards was further reinforced after the Monetary Authority of Singapore (MAS), the country’s financial markets regulator, came under fire for loose rules allegedly contributing to state fund Temasek losing $275 million invested in the failed crypto exchange.
In the wake of the FTX collapse, regulators worldwide have responded swiftly to prevent retail and institutional investors from feeling the impact of a similar downturn in the crypto market. U.S. SEC Chairman Gary Gensler proposed requirements for custodial platforms to segregate funds, provide yearly disclosures and public audits, and ensure customer funds are accessible in case of bankruptcy.
Outside the United States, the European Union has approved its long-awaited Markets in Crypto-Assets (MiCA) regulation, with supervision and customer protection a recurring theme. Similarly, Dubai’s Virtual Asset Regulatory Authority (VARA) has established a new rulebook for crypto-related businesses with unique requirements for cryptocurrency exchanges and custodians.
Hong Kong is another region that has recently taken steps to establish definitive crypto regulations. A new licensing regime expected to go into force by mid-year would have substantial capital requirements for exchanges and restrict retail users to trade only large-cap assets.
Regardless of the approach taken by individual rule-making bodies, it’s clear that the regulatory ball is rolling. The need to add additional layers of safety to digital asset investing is firmly in sight, and regulators are catching up. However, cryptocurrency exchanges also have a significant role in implementing safeguards to protect clients.
An exchange’s responsibility
With a rapidly evolving industry and regulatory landscape, cryptocurrency exchanges bear the greatest responsibility in protecting users and maintaining strict compliance standards. The need for such proactive measures is even more critical as the window for regulatory arbitrage closes.
Instead of regulatory disparity, a baseline is gradually established with similar consumer protection measures in different countries. For instance, while national regulators may approach token taxonomy differently, the “Travel Rule” included under the FATF’s VASP rules has remained a prominent feature, especially for countries with licensing regimes in place.
As the industry matures, cryptocurrency exchanges are wise to lead the way even before regulations mandate practices in the emerging industry. Top-tier crypto exchange Bullish is an industry leader in embracing the latest compliance standards and adopting cutting-edge blockchain analytics tools to ensure a safer and more sustainable environment for investors.
Group Director of Compliance at Bullish, Priscilla Adams, believes that “If you as a digital service provider are serious about digital assets, you will be regulated, actively comply with regulations, and ensure you have technological solutions in place to protect the exchange from being exploited for financial crime.” She continues, “At Bullish, we can confidently state that we have screened every single digital asset before it enters our platform.”
Beyond screening new listings, Bullish is taking additional measures to position itself for an era where close regulatory scrutiny is the new normal. This proactive approach minimizes the risk of financial crimes through digital assets and preserves the integrity of the Bullish exchange.
The new normal of increased regulatory scrutiny
The FTX implosion ushered in a new era where cryptocurrency exchanges must either comply with regulations or risk losing customers to compliant platforms. In this new age, regulators broaden the scope of crypto risks beyond money laundering and terrorist financing.
Cryptocurrency exchanges become subject to compliance requirements previously only applied to the traditional financial (TradFi) industry. Among these requirements are consumer protection and market integrity risk arising from issues such as conflict of interests, segregation of duties, or segregation of client assets.
With further regulatory oversight, crypto exchanges maintain their financial crime compliance programs while expanding coverage of TradFi risk types. This trend is gradually becoming the new normal as regulators issue further guidance on these topics and the rules converge across different jurisdictions.
According to Bullish’s Priscilla Adams, this will also change the nature of crypto compliance teams. While the emphasis has traditionally been on building anti-money laundering and sanctions compliance teams, she notes that crypto firms will need to follow suit and double down on their investments into compliance teams to build expertise in areas such as market manipulation, insider trading, and regulatory compliance.
“Now that compliance is being defined more broadly,” Adams says, “compliance teams need to be prepared for more regulation, more jurisdictions requiring onshore licenses, more regulatory visits, and subsequent remediation programs.”
As a result, compliance teams may need to retrain or cross-train employees or hire additional staff to manage these new risks effectively. While this extra compliance work will be necessary in the future, crypto firms with the most robust controls and governance now stand to be the winners in what she defines as the ongoing “flight to quality” for investors.
Actions speak louder than words
At a time when trust is at an all-time low, regulators, industry players, and crypto firms all have an opportunity to help restore that trust together. Practically, this means that cryptocurrency exchanges must play by the rules and convincingly demonstrate how they are doing so. Or as Adams puts it: “Don’t only tell me what you are doing; show me what you are doing.”
And with that, she also takes herself and her exchange Bullish to the task. Crypto service providers must take truthful communication seriously; with clients, regulators, and counterparties.
One of Bullish’s essential tasks is to objectively assess the implementation of their measures, review them, and document any potential failures or risks that may arise. “We then determine whether any action is required and formally document our findings to be escalated to senior management.” This process, she says, “ensures that we can confidently identify and address any risks and make informed decisions on whether any corrective action is necessary.”
Adams believes that it is vital to be able to explain Bullish’s compliance program to anyone. So often, she sees crypto companies almost hiding behind complexity as a way to obscure the fact that they are not compliant. Her “sniff test” to determine if messaging is getting too complicated is whether she should feel comfortable explaining to her 80-year-old father why his funds would be safe.
Overall, she feels strongly that someone should not need extensive knowledge about cryptocurrency or finance to understand why their platform of choice is safe and credible. Simply knowing the basics – where a firm is regulated, what controls they have in place, and if there’s a culture of compliance driven from the top of the house – should be enough.
Technology: Not a get out of jail free card
Fortunately, the very nature of blockchain technology makes it ideal to support and enhance regulatory compliance. Many firms within the industry have needlessly encountered problems stemming from reverting to manual processes. Fully embracing the underlying technology of blockchain is essential for longevity and regulatory compliance.
Besides traditional compliance monitoring tools like money laundering transaction monitoring and trader surveillance, crypto service providers must rely on technology to address the risks of digital assets. These include proper geo-location tools for knowing a client’s actual location or proof of ownership over digital assets. In some cases, the technology to manage these risks is still evolving.
That said, Adams notes that “Although some crypto firms and exchanges fashion themselves as technology companies due to the industry’s history and reliance on technology, they are still subject to regulations and are not automatically exempt from them.” In other words, firms cannot claim immunity from the rules just because they believe they stand on higher technological ground.
She continues, “Now that regulation is evolving around the globe, we are seeing more instances of rules being applied to all firms regardless of technological origins or an alleged decentralized setup. Once you start touching financial services, regulations come into play.”
Adams believes there will be some variation in how regulations apply to firms due to differences in business models and technology. It cannot be a one-size-fits-all approach but a case-by-case evaluation of the firm’s activities and risk management procedures. For example, market-making activities and running an exchange may be permissible if a firm can demonstrate proper segregation of rules and assets.
The future
Compared to the centuries-old TradFi world, each party dealing with the cryptocurrency industry is relatively new to the space. Many crypto exchanges seem not to have a deep understanding of regulatory history to help them understand best practices and a roadmap forward.
And similarly, regulators are still wrapping their heads around how to best conceive of and deal with the digital asset industry. But this reality doesn’t need to lead to a negative outcome. In fact, this opens up the opportunity to bring both sides of the table together and have an open dialogue.
Adams believes that “It is counterproductive for crypto exchanges to solely rely on their technology as a defense mechanism, as this can erode trust and damage the industry’s reputation. Instead,” she says, “exchanges should demonstrate a willingness to work with regulators to help guide the conversation toward positive outcomes. Ideally, crypto exchanges should be given a voice at the table and have a two-way dialogue with regulators, making sure a wide range of stakeholders are included in the decision-making process.”
She is dedicated to furthering this cause with her work as Group Director of Compliance at Bullish. Although it will be a long road to rebuilding trust in the industry, she cannot think of a more worthwhile calling than helping restore integrity and being a small part of bringing the digital asset space into a bright future.
This content is sponsored by Bullish.
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