Marketplaces and exchanges have been around for centuries, but over the years trading has moved away from the outdoors to the indoors, to open outcry trading, and the onset of computers saw trading activity move to fully electronic systems. The rate at which crypto trading grew on the back of the then booming Initial Coin Offering (ICO) market has surpassed everyone’s expectations and, given the profitable nature of operating an exchange, resulted in a huge rush to the market by a number of cryptocurrency exchanges.

While launching a trading platform is a big technical challenge in itself, the bigger challenge is to ensure 24/7 reliability (something that traditional exchanges do not have to worry about given the trading halt on weekends) and durability as the market scales. Aside from technical challenges, there are also a number of legal issues to consider given the attraction towards the new asset class by users from across the world. To make things even more complicated, a number of crypto exchanges have funded their operations by launching their own token, a move which may backfire if regulation takes a firmer hold on the industry. For the most part, the focus has been on projects and teams that raised money through ICOs as a possible violation of securities laws. More recently, crypto exchanges have come under larger scrutiny and the SEC even took action against the decentralized token exchange, EtherDelta. What this case shows is that even though the decentralized nature of such exchanges makes it more difficult to shut down, it does mean that they can still be held liable for their actions.

Exchanges should be at the forefront of any regulatory change and should resist the temptation to circumvent regulation, but rather embrace it and challenge the rest of the industry to also do so.

Introduction

The current nature of cryptocurrency trading is very fragmented and, to a large degree, the industry has operated under self-regulatory principles. A number of vendors have established and pushed for broader regulatory adoption, all with the goal of achieving similar standards under which traditional financial trading activities are carried out. Proper regulation is something that institutional investors demand.

Cryptocurrency trading activity is very concentrated and, according to Coin360 data, the top 10 exchanges represented more than 60% of the total spot market volume in December 2018, and Binance alone accounted for over 10%. To evaluate the implications that potential regulatory changes could have on the industry, the rest of the report will focus on Binance’s operational model. As Binance is an exchange with such high monthly trading volume, its actions are likely to resonate across the industry as a whole.

Binance’s operational model and regulation

So, how would Binance’s model fit in a regulated environment? The BNB is the native token of the exchange and the temptation to replicate its success saw many competing exchanges launch their own token. The growth of BNB hasn’t yet been matched, and Binance’s market share continues to increase.

To put the performance of BNB into context, the coin, which is inferior in terms of technological design when compared side by side to both Bitcoin and Ethereum, has outperformed both since the beginning of last year. The token sale in mid-2017 saw the company raise $15mil and use the capital to create what is now the largest cryptocurrency exchange in terms of monthly volume, but not in terms of trading pairs.

According to Coin360 data, the average 24-hour volume of Binance for the last 30 days stands at around $812M. To achieve and, more importantly, maintain this volume Binance has been active in listing new projects. Because of the link with a regulated entity, one would expect both the listing as well as the KYC/AML process for crypto traders — both retail and professional accounts — to be much stricter and time-consuming relative to many of the other crypto exchanges. While the ethos of the Blockchain may be transparency, not every ICO is willing to open up its books for in-depth scrutiny to get listed on an exchange, especially if the source of wealth has a questionable origin. While Binance has 442 trading pairs on its exchange, it has rarely been applauded for being the strictest when it comes to verifying users’ information.

It might be the busiest exchange based on trading volume, but the product offering is far from the most advanced on the crypto market as it does not offer margin trading, lending, or dark pool trading. The main appeal in holding any BNB tokens comes from the perceived expectation that the value of the token will increase due to Binance’s special market operations (i.e. token burning).

The exchange has an ongoing commitment to decrease the total supply of its token in the market and to achieve this, 20% of profits are dedicated to buying back Binance Coin and then burning them. The concept is one many have compared to stock buybacks program. However, unlike the buybacks in traditional equity markets which improve earnings-per-share (EPS) by reducing the number of outstanding shares, there is little evidence to suggest that BNB purchases are, in fact, conducted on an open market. As such, to suggest that token holders have somehow benefited from this flow may be misleading at best. Moreover, to encourage the use of BNB coin for the reason that token holders will receive such benefits may mean that in the eyes of regulators, the token no longer follows utility principles but actually now falls under securities law. While the fragmented nature of the current crypto regulation across the world may mean that it is near impossible to enforce or monitor holders, especially since KYC is not a prerequisite for customers with less than 2BTC, a global push for regulation may put the exchange and its token holders in an awkward position. As it stands, this is, of course, a risky scenario as implementing world-wide regulation would not only take a long time but would also be incredibly difficult to enforce since some states will always look to gain advantage using the tax “safe-haven” model.

Despite the high volume and being in the public eye, certain aspects of running the group are non-traditional and questionable, to say the least. Although the exchange has been present in Malta for some time, very few are aware of the fact that it has moved jurisdictions five times. Originally starting in Hong Kong, followed by short transfers to Singapore, Taiwan, Japan, and the Cayman Islands. Being a world traveler is not against the law, but for a company that deals with crypto, and in such vast quantities, such regular travel arrangements may inadvertently raise questions about its operations. It is true, some countries (i.e. China) have clamped down on cryptocurrency exchanges and even the Chinese established Huobi, which was founded in 2013, was forced to stop Bitcoin withdrawals following a 2017 ban. The company now has offices in Hong Kong, Korea, Japan, and even the United States. In the summer of 2018, it became a publicly listed Hong Kong company.

Regulation is the biggest risk to the industry and a number of exchanges are less than prepared to deal with carrying out the changes that may be necessary in order to meet regulatory requirements. It is not just the costs relating to re-onboarding and re-screening users to comply with KYC/AML standard, but in some instances, there were reports of data and trade mismatch on various exchanges.

This is not to say that Binance suffers from such technical issues and given its solid financial position, it is safe to say that strengthening its compliance procedures would not have any critical impact on its underlying profitability. However, the success of BNB token and the cryptocurrency exchange has been such that it may have taken the impetus off the development of areas that will matter the most should regulation grip the industry. In fact, all it may take is for regulators to remind firms that trade crypto assets of their obligations when it comes to KYC/AML and trade reporting standards, for these firms to scale back their operations and overall use of such exchanges. Given its size, the Binance exchange may eventually attract such attention and, as alluded to earlier, while the actual enforcement of any regulatory measures may prove difficult, it may be enough to put off interest from institutional-type clients.

Conclusion

The cryptocurrency regulatory framework may differ from one jurisdiction to another, but it is more likely than not that crypto exchanges will gradually transform their operating practices to replicate those in traditional financial markets. Additional measures such as speed-bumps, which were popularised by Michael Lewis’s book “Flash Boys”, controls relating to market surveillance with live trade alerts, order book audit trails, and circuit breakers may become the norm. In addition to that, any internal market-making or trading desks will be prohibited, or at least segregated and a host of more complex products will be offered such as SWAPS, repos, margin crypto trading, and market structure that ensures limited slippage, especially when it comes to filling larger orders.

Whether or not Binance is in a position to present such an offering remains to be seen, and there are many other exchanges that may find it just as challenging, if not more. However, its current structure which offers rather limited visibility to an outside party past tendencies to seek an alternative jurisdiction and the use of BNB coin may make any attempts to realign with a more regulatory compliant stance rather challenging. All this, together with the fact that the market for the ICO is expected to only diminish further and that only a fraction of the ICOs that were launched between 2016-2018 era will survive, points to a much more challenging future.

Cryptocurrency trading, at least in its current form, is unlikely to survive long term, and as regulators across the world take on a more proactive stance, more exchanges will either be forced to close down or dramatically review their operational models. In this report, we have outlined some of the challenges that the leading cryptocurrency exchange may face in an effort to transition into a new environment. It may also be noted that brief mention was made of potential tools that market participants might soon begin to expect trading vendors to provide. The report focused on Binance, given its status as the cryptocurrency exchange with the highest volume, and while some of the challenges outlined above are Binance specific, other leading crypto exchanges may face similar issues in their efforts to shoulder the regulatory burden.

Thank you for reading,

The BeQuant’s Analytics team