Based on a “technological experiment” with Bitcoin (BTC) over a decade ago, the crypto asset industry has become a major driver of change in global financial markets. The exchange of cryptocurrencies began as a means to enable crypto enthusiasts to trade digital coins outside of the traditional financial system on a decentralized and largely autonomous basis.

Combined with government recognition and development of digital market infrastructures, acceptance of essential anti-money laundering practices, investments in security protection systems, and recognition of investor protection measures, these companies are likely to continue to expand and potentially merge or compete with each other on an even level with existing regulated marketplaces.

The success of these platforms in enabling the unregulated free flow of value across borders has unsurprisingly piqued the interest of governments and regulators. The initial skepticism was replaced by concerns about vulnerabilities related to money laundering, fraud and investor protection. As crypto exchanges have upgraded their systems to meet anti-money laundering and investor requirements, it is grudgingly recognized that these platforms brought much-needed modernization and democratization to a market that was widely viewed as remote and privileged.

Crypto exchanges offer participants from all walks of life 24/7 worldwide access to trading venues who can participate directly via online trading tools and graphics that in the past were almost exclusively available to a limited number of professional investors.

Overview of crypto regulation

Crypto assets have generally been on the outer fringes of the regulatory arena, but are increasingly under pressure to be included in the regulatory framework.

The first important step in this direction at the international level was the expansion of the AML standards announced in June 2019 for crypto-related companies by the Financial Action Task Force, the global standards body for combating financial crime.

Connected: Slow but steady: the FATF review underscores the struggle of crypto exchanges to meet AML standards

In the European Union, this was followed by the adoption of the 5th Anti-Money Laundering Directive (5AMLD), which brought the exchange of crypto assets and providers of custody wallets into the scope of the EU AML regime. As a result, in-scope crypto asset companies operating in the EU and the UK are now subject to all of the AML obligations that apply to most financial market participants, such as: B. the need to perform customer due diligence when adding a new customer. In addition, they must register with the relevant national competent authorities if they intend to carry out crypto-related transactions.

The general regulatory attitude

The general approach to regulatory treatment of crypto assets was more complicated. At EU-wide level, the previous position was to apply the existing legal framework to crypto assets that have the characteristics of regulated assets. Specific regulations such as the ban on selling crypto derivatives to retail investors are imposed, but more specific requirements are deemed necessary.

Exchanges trading digital assets are therefore subject to regulation if the assets traded fall within this regulatory area. To a large extent, this has meant understanding the application of the existing legal framework and applying it to relevant circumstances, using interpretative guidelines where appropriate.

As a result, two main categories of crypto assets that function similarly to regulated instruments and their respective service providers have been added to the scope of existing rules. These are digital assets that are similar to “financial instruments” (generally the capture of crypto-assets used as a means of raising funds and derivatives) but treated with existing rules for tokens that are To act as “electronic money”. This will capture crypto assets that are supposed to facilitate payments or some stable coins.

This means that crypto exchanges that trade digital securities such as DLT-based stocks, bonds, fund shares or derivatives – often referred to as security tokens – must be approved as regulated trading venues for business in the EU. This would also capture EU-based crypto exchanges that trade particularly popular instruments such as derivatives that reference Bitcoin (BTC) or other cryptocurrencies as underlying assets. This was complemented by jurisdictions that introduce tailor-made regulations for the crypto sector, e.g. For example, clarifying issues regarding the use of the underlying DLT technology (e.g. Luxembourg) or closing gaps in existing regulations (e.g. France).

Digital securities

In the securities space, important steps are being taken to develop a credible digital market infrastructure for the issuance, trading and settlement of digital securities. In particular, the UK financial regulator recently granted Archax Limited a MiFID license, which has become the UK’s first fully authorized digital securities trading venue

At the same time, established exchanges are building their own “digital versions”, such as the Stuttgart Digital Exchange in Germany and the SIX Digital Exchange in Switzerland. Despite these developments, the integration of digital solutions into existing market infrastructures remains a challenge, not least due to the restrictions that result from the existing rules for the requirements for the finality of settlement in the post-trading systems.

In order to unlock innovation opportunities in space, the European Commission recently published a proposal for a pilot regime for market infrastructures based on DLT, which would be used to create a tailor-made legal system for the application of DLT in post-trade services and DLT the creation digital securities settlement systems.

Regulation of crypto exchanges

Some of the largest crypto exchanges are seeking regulatory licenses around the world in order to be able to compete directly with incumbent financial institutions, adapt to user demand for more sophisticated services, and improve their own credibility in the marketplace.

For example, the US-based cryptocurrency exchange Coinbase received an e-money license from the UK’s FCA in March 2018 and from the Central Bank of Ireland in 2019, which enabled it to issue e-money and thus provide payment services. Crypto services. Kraken recently received a banking license from the state of Wyoming to create a special purpose custody institution (Kraken Financial) that it can use to provide deposit, custody and escrow services for digital assets.

In order to improve market integrity and investor confidence, the EU Commission presented a proposal on September 23 for the regulation of the markets for crypto assets (MiCA). The draft regulation covers crypto assets such as “asset-referenced tokens” (commonly referred to as “stablecoins”) and “utility tokens”.

According to the MiCA draft, crypto exchanges operating in the EU must receive official approval and are subject to strict regulatory and behavioral requirements. In addition, the draft regulation contains requirements for the admission of crypto asset instruments for trading, including the requirement to publish a white paper with specific content.

European Commission proposals have to go through a long legislative process before they become binding. However, the MiCA is likely to be a significant step in building credibility and structure in creating a viable crypto asset industry in the EU, identifying the conflicting legal framework for security-type crypto-type assets and non-security-type crypto-type assets. For many, the process of imposing regulatory requirements on pure crypto assets will be an atrocity, stifling innovation and creating barriers to entry for smaller fintech companies. However, this is the most likely approach to creating a long-term, viable market.

What it means for the industry

Large institutional players have a keen interest in entering the crypto-assets space. Some of the largest European institutions have extensive digital asset programs. For example, ING is currently working with industry participants on a digital custody and custody solution within the FCA sandbox that will provide institutional security for digital holdings and digital asset transfers. The US office of the currency validator recently gave US banks the all-clear to provide cryptocurrency management services to their customers. This development could bring crypto asset service providers (including exchanges) into direct competition with traditional players.

In the future, the innovation, democratization and expansion of access brought about by crypto exchanges, as well as improved recognition of their services by financial regulators, will be associated with the digitization of traditional securities and the expansion of the market infrastructure for digital trading. This is likely to create strong momentum for combinations and mergers between rapidly developing crypto exchanges and established institutions. We are currently at the forefront of advice on developments in space and we welcome the significant changes that undoubtedly lie ahead.

This article was co-authored by Martin Bartlam and Marina Troullinou.

The views, thoughts, and opinions expressed are the sole rights of the authors and do not necessarily reflect or represent the views and opinions of Cointelegraph.

Martin Bartlam is partner and head of FinTech at DLA Piper.

Marina Troullinou is an associate at DLA Piper.