Investigations, regulation... What does the future hold for crypto exchanges?

‍👉 US exchanges soon to be stock market operators?

The complaints filed against Coinbase and Binance by the US financial watchdog (SEC) in early June have triggered shock among most exchange platforms.

Beyond details about each case - there is a potentially criminal component at Binance - the fact that the SEC considers most cryptos to be securities has a huge impact on the Exchanges model. The situation is simple: if they want to continue operating, US platforms are going to have to apply for the appropriate licences and move closer to the... traditional stock exchange model.

"Unlike in Europe, there is no dedicated status for companies providing services on digital assets in the US," points out Morgane Fournel-Reicher, a specialist in US banking and financial markets law for Kramer Levin.

📌 Across the Atlantic, the concept of crypto has no legal status.

"For years, there has been vagueness about the status that companies providing such services were required to obtain, and most only hold state money transmitter licences that mainly only relate to anti-money laundering and anti-terrorist financing obligations," she points out.

To comply, US platforms such as Coinbase and Kraken will therefore need to comply with obligations under the Securities Exchange Act of 1934, which regulates providers offering services in financial instruments on the secondary market.

The problem is that this involves a Copernican revolution for platforms that have never operated on the principle of a traditional stock exchange 🙃.

"This requires companies like Coinbase to structure themselves in a completely different way, including the separation of digital asset custody and registrar activities, and potentially even close access to retail investors!", says Morgane Fournel-Reicher.

"The Exchanges are now centralising all activities within a single structure", continues the lawyer.

The SEC is not the only player to call for the separation of the activities of exchange platforms. After the collapse of FTX, some voices in the web3 ecosystem had also stressed the need.

"Platforms should be used to buy and sell cryptos, not to hold them", said in November in The Big Whale Ledger CEO Pascal Gauthier.

As it stands, Coinbase doesn't see it that way and has decided to take its fight with the SEC to court, arguing that digital assets are not "financial securities".

This decision paves the way for several years of proceedings. "Probably between three and five years", blows a player operating on US soil.

👉 Why are Coinbase and Binance the only ones to be worried?

It is interesting to note that only Coinbase and Binance have - for now - been attacked (as well as Kraken, but only on its staking service). This could be explained by the fact that these platforms are the largest on the market and offer several hundred crypto currencies.

Coinbase adopted a very aggressive listing approach in 2021, just a few months after its IPO was authorised by... the SEC.

"Since 2021, Coinbase has gone from 130 to more than 400 cryptos available," explains Clara Medalie, director of research at Kaiko in New York. "Binance US accelerated at the end of 2021 from 120 cryptos to 300 in March 2023," she adds.

(Note: Bittrex filed for bankruptcy at the beginning of May 2023)

The other Exchanges such as Kraken, itBit (the Paxos platform) or Gemini, meanwhile, have been very cautious in their listing strategy, which could explain the SEC's relative benevolence towards them.

A sentiment corroborated by Jean-Baptiste Graftieux, CEO of Bitstamp, the world's seventh largest platform (read his interview).

"We only offer around 20 cryptos in the US, because we anticipated that some tokens might just be reclassified as financial securities," says the French boss of the Luxembourg-based company.

"To authorise the listing of a token, we follow a very strict process that contains around 400 questions and that we have supervised by independent players", he insists.

According to the teams at the Luxembourg platform, this stage is quite meticulous and the listing is not approved without being convinced that a crypto project is not at risk of being requalified as a financial security. So many precautions that must please the regulator.

The listing of cryptos by Exchanges has often been very opaque. Some have not hesitated to ask - under the table - for up to a million dollars to add tokens. It is not known whether this practice, which was very common between 2016 and 2018, still takes place today.

👉 Which cryptos officially qualify as financial securities?‍

Theoretically, only Bitcoin (BTC) is officially considered in the United States not to be a financial security. The first cryptocurrency is seen more as a commodity or raw material in the eyes of regulators.

For ether (ETH), it's more complicated: the second-largest market capitalisation was once considered by the SEC to be a kind of commodity, but the change in its consensus algorithm in September 2022, to Proof-of-Stake (read our feature), would have changed the regulator's perception. We should know more soon 👀.

According to the SEC's various grievances, around sixty tokens have officially been classified as unregistered financial securities to date.

Among the most capitalised are: Binance Coin (BNB), Ripple (XRP), Cardano (ADA), Solana (SOL), Polygon (MATIC), Binance USD (BUSD), Cosmos (ATOM), Internet Computer (ICP), Filecoin (FIL), Near (NEAR), Algorand (ALGO), The Sandbox (SAND), Decentraland (MANA), Axie Infinity (AXS), Chiliz (CHZ), Flow (FLOW), Nexo (NEXO).

"Even if the US exchange platforms were to become traditional stock exchanges, there are also doubts about the ability of the holders of crypto projects to legally register with the SEC in order to offer them to the Exchanges," warns Arnaud Touati, partner at Hashtag Avocats.

"Compliance costs are enormous, there are a lot of barriers that favour traditional finance", he laments.

👉 What consequences in Europe?

Thanks to MiCA regulation, which will be applied from mid-2024, platforms operating in Europe should not experience the same problems with the nature of digital assets.

"Financial instruments and crypto-assets are precisely defined and distinguished in Europe," explains William O'Rorke, partner for disruptive technology law firm ORWL Avocats.

As a result, PSAN registration is sufficient to offer the purchase/sale of cryptos, and most of them should not be requalified as financial securities in Europe.

There remains some uncertainty, however, for platforms wishing to offer derivatives such as futures. In particular, Binance has suspended access to futures for its European customers during 2022.

"Companies registered as PSANs (and tomorrow CASPs under MiCA) can only provide services on digital assets, but digital assets are a subsidiary qualification that cannot be used if the asset in question contains elements that allow it to be classified as a financial instrument," insists Morgane Fournel-Reicher.

In the United States, platforms have all been aware of this risk for several years. No individual user of Coinbase or Binance has access to futures contracts. This type of product is only offered to institutional investors on the Chicago Mercantile Exchange (CME).

👉 What framework for crypto derivatives in Europe?

This case has not yet been fully decided and is the subject of much discussion.

According to experts involved in several ongoing cases, the regulations are not appropriate, because they were designed for traditional financial contracts, but also because they were not designed for platforms aimed directly at retail customers.

At present, it seems fairly likely that Exchanges offering futures contracts in Europe will have to apply the rules relating to investment firms under the European MiFID 2 (Markets in Financial Instruments Directive).

According to our information, at least one platform operating in Europe is giving this very serious thought. This would enable it to broaden its scope of products available for trading, and in particular security tokens.

"Even if crypto Exchanges claim that they do not deal in traditional financial securities, as soon as they offer derivatives, they fall within the scope of financial regulation with standardised rules," blows a banking source.

A crypto platform wishing to list financial instruments would therefore have to apply for investment firm status operating a multilateral trading facility or organised trading facility (an unregulated market).

The conditions for obtaining this status are similar to those required for PSAN authorisation (guarantees in terms of governance and shareholding, equity and prudential capital, internal procedures for preventing conflicts of interest, internal controls in terms of LCB-FT, supervision of outsourcing, obtaining the regulator's approval of its market rules, etc.).

The conditions for obtaining this status are similar to those required for PSAN authorisation (guarantees in terms of governance and shareholding, equity and prudential capital, internal procedures for preventing conflicts of interest, internal controls in terms of LCB-FT, supervision of outsourcing, obtaining the regulator's approval of its market rules, etc.).).

The only difference, and it's a big one, is that the level of requirements is... much higher 😅. And certain points are likely to complicate the organisation of crypto platforms, as these markets must not be accessible to private individuals. Only intermediaries with regulated status are allowed on this kind of market.

"Unlike crypto companies, trading platforms are not in direct contact with their investors, but with companies subject to supervision by regulators, who are themselves in contact with retail investors," points out Morgane Fournel-Reicher of Kramer Levin. Quite a system!

Not to mention the fact that custody, registrar and clearing activities must be operated by separate companies, each subject to its own authorisation. However, in the case of crypto companies, these activities are concentrated within a single entity and under the same authorisation.