General Hurdles When Setting Up A Cryptocurrency Exchange

Data & Research / 20.06.2020

Cryptocurrency exchanges are intermediaries that stimulate the buying and selling of cryptocurrencies, usually in exchange for a fee. Exchanges function as a means to trade, speculate or convert existing value with other instruments like digital assets, and ultimately fiat currency. Exchanges form a huge part of the cryptocurrency economy, as they form a key component in the growth of the sector. Several exchanges have popped up since the advent of Bitcoin. One of the first was Mt. Gox, initially formed as a trading card exchange platform. The most famous exchanges today are Coinbase, Binance, Kraken, and the likes.

Operating a digital currency exchange today is quite a daunting task, as cryptocurrencies are still a nascent technology, undergoing immense global scrutiny. Exchanges function well in environments where the local legislation acts as a stimulant for innovation. For that reason, countries like Malta, Switzerland, and even the United States have seen a huge influx of blockchain-based start-ups. But due to its relatively new infrastructure, operating cryptocurrency exchanges bring in a whole new array of procedural and regulatory complexities.

Even though several problems are laid down, this article does not try to solve all the existing problems in one go, but aims to start a dialogue among the readers, so that a solution or compromise can be reached eventually.

Current Issues with Starting and Operating a cryptocurrency exchange

Regulation

Opening a Cryptocurrency exchange comes with all forms of operational risks. To start an exchange, one has to comply with the local jurisdictions. There have been numerous instances where exchanges were cracked down due to their inability to work hand in hand with the regulatory authorities. In the USA, exchanges can be formed in certain states, where the authorities allow them to function, provided they only stick to the guidelines provided. Delaware, New York, and California are home to half a dozen well-known cryptocurrency exchanges, as the regulatory authorities are satisfied with the exchanges’ ability to comply with the requests of the authorities.

In India however, banks or financial institutions regulated by the reserve bank were not allowed to have any relationships with cryptocurrency business, until early 2020. For that reason, peer-to-peer exchanges have found a market gap by connecting buyers directly to the sellers and removing the need for an arbitrating authority in between. They are thriving to ensure the public gets its share of the innovation.

Single point of failure

Exchanges act as custodians of data and value. They collect information of the users and store their cryptocurrencies to allow a seamless experience. But this also acts as a single point of failure. Any motivated entity with a determined attitude to bring down the exchange can do so by repeatedly targeting the single point. Mt. Gox, Cryptopia, Quadriga are just a few of the long list of exchanges that have faced closure or temporary setback due to outside interference.

Inability to handle flow

Exchanges are sometimes unable to keep their new account opening facilities, mostly due to a sudden influx of people. Because of this issue, many affluent traders could be temporarily halted from registering at their desired exchange. Late 2017 and early 2018 saw several exchanges face temporary closure due to a sudden increase in prospective customers. This issue has been noted numerous times by a lot of the major exchanges.

Jurisdictional Purview

Most regulatory frameworks usually assume the business operating within their borders to serve customers in their own jurisdiction. However, a cryptocurrency exchange usually serves customers from around the world. It is important to straighten out the complexities in running the exchange as most users of the exchange are citizens of another jurisdiction and do not fall under the purview of the particular country the exchange is registered in. This puts a question on the disclosure responsibilities of the exchange. Should it be allowed to ask for KYC documents from persons outside the particular jurisdiction, and if it should, should it be allowed to share the data with the local authorities and what can be done with the details in times of discrepancies.

Accountability

Audit of exchanges is really important as it has been noted that several exchanges such as Mt. Gox, Bitfinex, etc., have engaged in backend manipulation to cover up the faults of the administration, which ultimately ended up losing millions of dollars in customer funds. These activities mainly ended up compounding the inefficiencies due to the lack of audit procedures set in place by the regulatory authorities and the administration of the exchange.

Conclusion

It is obvious that the exchange ecosystem lacks several fundamental capabilities that can, and most probably, will hinder their long-term ecosystem growth. But that does not stop them from fulfilling the short-term demand. It can be seen that several exchanges such as LocalBitcoins, Bitfiniex, etc., have seen a historic rise in demand even though their internal structure remains far from functional.

Short term demand can be fulfilled, but if the exchanges wish to remain competitive and profitable in the long term, fulfilling the demand just won’t do. Regulation criteria have to be met, security structure updated, an internal and external audit conducted and interoperability softened to ensure sustained long-term growth prospects.

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Sudarshan M is a long time crypto-enthusiast. Pulled in by bitcoin early on, it did not take long for Sudarshan to divert all of his academic attention from business studies to blockchain by doing his Masters and eventually pursuing his PhD in the subject.