Cryptocurrency is an industry for which global regulation ranges from inconsistent to non-existent and as such, all participants face significant and diverse types of risk. Of all the potential risks, cryptocurrency exchanges are the primary source of concern for investors, users, and cryptocurrency advocates alike. For years, exchanges operated in the shadows, and everything from falling victim to malicious hacking to participating in fraud has occurred with alarming regularity. However, as the asset class has evolved, so have the exchanges, and many now employ a variety of ways to foster customer confidence and signal credibility.
While the cryptocurrency industry as a whole is unregulated in many countries, there are cases in which exchanges can comply with local regulators to operate and be regarded more like traditional financial institutions.
Gemini has worked with regulators in the United States to become a licensed exchange. According to its website: “We are a licensed digital asset exchange and custodian built for both individuals and institutions. We are a New York trust company regulated by the New York State Department of Financial Services (NYSDFS). Gemini is a fiduciary and subject to the capital reserve requirements, cybersecurity requirements, and banking compliance standards set forth by the NYSDFS and the New York Banking Law.”
Coinbase also has worked to satisfy customers in the United States by registering as a Money Services Business with the Financial Crimes Enforcement Network (FinCEN) government agency.
Security and Financial Auditing
Exchanges have been accused of creating markets and placing ghost orders to increase perceived trading volumes and collect more in trading fees. Other suspected activities include not holding enough fiat and/or cryptocurrency to pay their customers in the case of massive withdrawal requests. However, major players in the industry are now countering such accusations by working to combat price and trading volume manipulation.
It is now increasingly common for exchanges to voluntarily undergo financial and accounting audits, giving a third party the opportunity to examine the appropriateness and effectiveness of their financial practices. South Korean-based exchange UPbit recently went through an exchange audit in which it was found to be fully solvent, resolving questions surrounding the exchange and allegations of potentially illegal business practices, so and increasing its credibility in the industry.
Ernst & Young (EY), one of the Big Four accounting firms, recently announced a blockchain-based audit technology which can be used to audit a company’s transactions across multiple blockchains in order to reconcile and determine the validity of transactions as stated by exchanges and other blockchain-based businesses.
Exchange audits scrutinize not only financial transactions, but also security measures and underlying codebases. Cybersecurity platform Buglab is offering a pool of $2 million for penetration testers to audit cryptocurrency exchanges for security weaknesses. Other white hat hacking companies such as Hacken reward the public for discovering vulnerabilities in cryptocurrency businesses across the industry.
While LocalBitcoins provided great value as one of the first exchanges for users to buy and sell Bitcoin, its user experience was severely lacking in quality. Users had to navigate requesting a purchase, making a payment off-exchange, confirming the payment on-exchange, waiting for the payment to be confirmed by the other party, and confirming receipt of Bitcoin. This process represented an off-putting and often unmanageable barrier to entry for many beginner users.
Many exchanges have sought to lower barriers such as this by investing heavily in interfaces and exchange functions that are simple and intuitive for even the most technically inept of users. Shapeshift allows simple swapping of tokens with zero technical knowledge required. Meanwhile, exchanges such as Cobinhood provide robust charting and high level technical analysis tools for advanced users.
Trading Fees Nearing Zero
The fees required for transferring from fiat to cryptocurrency present another major impediment to bringing new customers onboard. High fees make purchasing small amounts of crypto economically impractical and have stranded many potential users on the sidelines.
The explosive growth of the industry has enabled exchanges to reduce their fees, and by doing so, open the market to millions of potential new users around the world. Coinbase offers the lowest potential fees for customers seeking to transfer from fiat to cryptocurrency. The exchange offers free deposits if done via ACH transfer, after which time users can transfer their fiat to Coinbase Pro (previously known as GDAX), which offers trading with fees starting at 0.30%.
For users who wish to trade in just cryptocurrency, the industry’s largest exchange to-date, Binance, offers trading fees of 0.1% for all trades, and less if trading fees are paid for in the exchange’s native BNB coin.
Even with these advancements, some blockchain purists remain concerned about the issue of centralization which affects almost all exchanges, and cite the need for decentralization throughout the industry. Over the past eight years, hacks of centralized exchanges have left many wondering if centralized exchanges will eventually be a thing of the past.
The hacking incidents and security concerns have precipitated the establishment of a number of decentralized exchanges. Waves and BitShares are two decentralized exchanges currently gaining market share by allowing users to exchange shares with no intermediary parties, thus reducing the risk of theft and fraud.
One of the industry’s leading exchanges, Binance, has announced plans for a decentralized exchange where any coin can be listed. As Binance CEO Changpeng Zhao noted, “We’ll have less control. More likely anybody can list any coin. That’s the philosophy of the decentralized exchange, it’s freedom of choice, freedom of investments.”
The Future of Exchanges
Exchanges are a vital component the cryptocurrency ecosystem as they provide the trading liquidity necessary to attract new market entrants and enable new markets to mature. This is particularly important now that there are hundreds of types of coins available. For exchanges to perform this role, however, they must be able to operate safely and affordably, and to gain and maintain the confidence of their customers. While this has been a serious and very public issue in the early years of cryptocurrency industry, advancements in the areas of regulatory compliance, user experience, security, and more, all point to a positive outlook for the position and growth of exchanges as in the future.