Decentralized Exchanges: A Regulator’s Dilemma
Tags: Fintech, Crypto, Bitcoin, Regulation, Cryptocurrency

When Satoshi conceived of the Bitcoin blockchain in the aftermath of the Great Recession that erased 25% off the equities market in a single month, he envisioned a digital cash system enabled by a peer-to-peer network that would eventually displace fiat money in specific use-cases. However, at the start of its journey Bitcoin largely served black market vendors and other enterprising criminal concerns with higher risk appetites that were willing to experiment with this novel financing mechanism. As the crypto ecosystem continues to evolve, it has inevitably drawn the attention of law enforcement agencies looking to ensure compliance with existing regulations. The frenetic pace of blockchain development has led to many government entities contending with how to regulate this brave new world.

Wallet-to-wallet transaction activity occurs on the blockchain, out of the reach of regulatory bodies, making it difficult to monitor and nearly impossible to censor. Therefore, centralized exchanges responsible for the bulk of trading volume have become the preferred target of regulators aiming to impose a measure of control on the crypto markets. Their challenge lies in applying existing legislation in a firm enough fashion as to thwart money laundering and other illegal activity, yet relaxed enough to allow innovation to flourish.

Adding to the complexity is the emergence of decentralized exchanges on which trades can be executed directly on the blockchain, eliminating the need for a trusted third-party which acts as the custodian of customer funds.

Regulatory landscape for cryptocurrency exchanges

In its role as the world’s largest economy, the USA is often looked towards by smaller economies looking to formulate financial legislation. When the Securities and Exchange Commission issued a statement declaring that Ethereum should not be classified as a security, the ripple effects of the announcement were felt far beyond the SEC’s jurisdiction. The two major financial services and consumer protection laws that apply to traditional crypto exchanges in the US are:

- USA Patriot Act (2001)

- Bank Secrecy Act (1970)

The USA Patriot Act was introduced in the wake of the September 11 attacks as the federal government launched its war on terror. Initially aimed at curbing terrorist financing, the Title 3 of the Act was expanded to included such actions as bribing public officials and the smuggling or illegal export of controlled munitions amongst others. Exchanges are required to designate a compliance officer, conduct training and put protocols and controls in place to ensure compliance with the Act.

Based on the Bank Secrecy Act of 1970, the Patriot Act amends portions of this earlier piece of legislation in an effort to deal with the threat of money laundering in the modern era.

Passed by the US congress during the Nixon administration, the BSA requires financial institutions in the United States to assist the federal government in detecting and prevent money laundering. Enforcing compliance with the BSA falls to the Financial Crimes Enforcement Network (FinCEN.) In 2013, FinCEN issued interpretative guidelines on how to apply the Act to entities involved in the creating, distributing and exchanging of cryptocurrencies. The guidelines distinguish between 3 different classes of stakeholders in the virtual currency transmission ecosystem:

1) User

A “user” obtains cryptocurrencies for use on their own behalf. They do not fall under the category of a “money service business” (MSB) and therefore are not subject to the regulatory constraints of the Bank Secrecy Act.

2) Exchanger

An “exchanger” is a person involved in the business of exchanging one cryptocurrency for another or for fiat money.

3) Administrator

An “administrator” is responsible for issuing (putting into circulation) and redeeming (withdrawing from circulation) cryptocurrencies. Both administrator and exchangers are classified as MSBs and fall under FinCEN’s jurisdiction.

Can a DEX be an Exchanger per FinCEN guidelines?

According to the guidelines, a business fits the criteria of an exchanger if it (1) accepts and transmits a convertible virtual currency or (2) buys or sells convertible virtual currency for any reason. Since the guidelines were issued prior to decentralized exchanges being viable alternatives to their centralized counterparts, there is no established rule as to whether a DEX must register as a money transmission business. FinCEN and the courts are likely to consider whether DEX’s act as custodians of customer funds and if exchanges take fees for facilitating the transmission of cryptocurrencies.

By definition, a decentralized exchange facilitates on-chain execution of trades, allowing users to control their funds until such time that the exchange is finalized. As for engaging in profit-making activity by levying fees on traders, a distinction can be made between the different classes of DEX’s.

There are three categories of DEX’s:

On-chain orderbooks and settlements

Off-chain orderbooks with on-chain settlement

Smart contract-managed reserves

Exchanges that host off-chain orderbooks such as 0x relayers charge ‘maker’ and ‘taker’ fees and thus have a slight risk of being classified as money transmission businesses.

Can a DEX be an administrator per FinCEN guidelines?

Administrators as per the BSA are responsible for issuing and redeeming cryptocurrency. While certain DEX platforms such as IDEX, 0x and Bancor issue their own native token, these tokens are used to power a decentralized platform and cannot be withdrawn from circulation by their corresponding exchanges. It is unlikely that decentralized exchanges will be classified as administrator for the purpose of FinCEN compliance.

Singapore Leading The Charge

While regulators in the West struggle to keep pace with developments in the exchange ecosystem, the Monetary Authority of Singapore has recently proposed updated regulation that would ease the market entry for DEXs.

The de facto central bank in the Asian city-state published a paper updating its current single-tier “recognized market operators” (RMO) framework to reflect the emergence of blockchain-based decentralized trading platforms.

The new proposed framework creates a three-tiered structure with decentralized exchanges falling under Tier 3, granting them reduced capital requirements and a simplified set of requirements in relation to technology risk management and outsourcing.

Around the world, government agencies responsible for ensuring financial legality are grappling with questions as to how to address this novel financial technology. Thus far their preferred method of controlling crypto trading activity has been through enforcing existing financial legislation on centralized exchanges. However decentralized trading infrastructure is evolving into a robust alternative, further loosening the grip of regulators on the decentralized financial system.