Peer-to-Peer Crypto Exchanges Raise Regulatory Challenges

Keep up with the latest developments and legal issues in the telecommunications and emerging technology sectors, with exclusive access to a comprehensive collection of telecommunications law news,...

By Michaela Ross

The rise of peer-to-peer-operated cryptocurrency exchanges could complicate regulators’ ability to oversee the increasingly popular asset.

Peer-to-peer or decentralized exchanges, which are based on the the blockchain digital-ledger technology, allow users trading virtual currencies to trade directly with one another without a central operator, similar to music sharing. Most decentralized projects, such as Loopring or ones using 0x’s technology, are still in their infancy.

Central exchanges, which have been around for a few more years, have faced increased regulatory scrutiny worldwide in recent months as government officials cracked down on fraudulent crypto trading schemes. In the U.S., regulators could apply a wide range of regulations to the industry, including anti-money laundering rules in the Bank Secrecy Act and securities trading rules.

But the lack of a central operator in peer-to-peer exchanges could make them exempt from traditional financial industry laws, and could also make it tougher for regulators to probe trading activity, financial attorneys and former regulators told Bloomberg Law. The newfound regulatory spotlight also could drive more crypto traders to steer their business to decentralized exchanges.

“It’s an open question about whether decentralized exchanges will be treated as money services businesses and therefore required to meet Bank Secrecy Act and Anti-Money Laundering rules,” Ross Delston, an anti-money laundering expert witness and a former assistant general counsel to the Federal Deposit Insurance Corp., told Bloomberg Law in an email.

Cryptocurrency exchanges’ evolving relationship with regulators was illustrated April 17, when New York Attorney General Eric Schneiderman launched a probe into 13 of them, including Bittrex Inc. and Payward Inc., known as Kraken.

They are all centralized exchanges, with controlling personnel clearly identified.

“With the decentralized model, there’s no one person to go to to ask for information,” John Roth, chief compliance and ethics officer at Bittrex told Bloomberg Law. “It’s not a regulated exchange like we are, where officials can reach us to ask about suspicious customer transactions.”

Still, the emergence of decentralized exchanges could be a boon to consumers and regulators, industry advocates said. They offer an open, transparent trading model where a seller sells securities directly to a buyer at a determined price. Their funds aren’t held by a single company, thus making it less attractive for hackers, they said.

High-profile hacks into large global exchanges such as Mt. Gox and Bitfinex have cost users hundreds of millions of dollars. But users on decentralized exchanges hold their virtual currency funds and tap into a public, peer-to-peer software network only to trade.

“You can protect consumers with better technology, without relying on clumsy intermediaries that can run away with the money,” Peter Van Valkenburgh, research director at Coin Center, a blockchain advocacy group, told Bloomberg Law.

Absent Middleman

Classifying decentralized exchanges could be challenging for regulators. Without an intermediary that accepts and transmits the currencies, they may not be considered money service businesses that are subject to the Bank Secrecy Act, financial attorneys and former regulators said.

In contrast, centralized exchanges must be registered as money service business with the Financial Crimes Enforcement Network (FinCEN). This requires them to verify their customers’ identities and report suspicious activity, among other mandates.

A spokesperson from FinCEN did not immediately respond to a request for comment.

It is also unclear how the Securities and Exchange Commission would oversee decentralized exchanges trading virtual currencies that act like equities, Van Valkenburgh said.

The SEC requires intermediaries trading securities to register with the agency. But it could be argued that decentralized exchanges simply facilitate communications between buyers and sellers.

A spokesperson from the SEC did not immediately respond to a request for comment.

Decentralized exchanges trading products such as cryptocurrency futures or option contracts would likely fall under the Commodity and Futures Trading Commission’s oversight under the Commodity Exchange Act, Paul Architzel, former general counsel of the CFTC’s economic analysis division and partner at WilmerHale, told Bloomberg Law.

The law does not mandate that boards of trade, such as exchanges, be formal organizations, he said.

Regulators can tap into the blockchain technology underlying decentralized exchanges to mine data about the transactions continuously, instead of having to ask a centralized exchange for it, Van Valkenburgh said.

“This isn’t a threat to regulators, this is an opportunity,” he said.

Relief From Rules

U.S.-based centralized exchanges mostly say they’d welcome the increased regulation as the virtual currency market matures. But regulations they consider to be burdensome could drive some exchanges out of business or steer users to decentralized exchanges that have fewer compliance policies, industry executives said.

“I think regulators need to think about whether they want to have some control over the situation or they’re just going to force everything into decentralized exchanges eventually,” Kraken CEO and co-founder Jesse Powell told Bloomberg Law in a recent podcast episode of “Code & Conduit.”

Kraken doesn’t plan to comply with the New York attorney general’s information request, Powell has said.

To contact the reporter on this story: Michaela Ross in Washington at mross@bloomberglaw.com

To contact the editor responsible for this story: Roger Yu at ryu@bloomberglaw.com

Copyright © 2018 The Bureau of National Affairs, Inc. All Rights Reserved.

Request Tech & Telecom on Bloomberg Law