Digital Asset Exchanges: Registration Is the First Step in Regulatory Oversight

Before institutions invest more heavily in digital assets, they will require a much higher degree of regulatory certainty. Regulators are doing their part, and this means digital assets exchanges should expect that they will soon have to start proving the resiliency of their trading technology.

As digital assets emerge as a new investment class both for retail customers and established institutions, there is a clear need for regulatory clarity to protect investors.

Across Europe, forward-thinking financial regulators have recently issued edicts requiring crypto business operators to register with national authorities. “Crypto” is a broad term which encompasses both cryptocurrencies or e-money, and digital assets or security tokens.

In the UK, businesses undertaking crypto-asset activities (defined as activities involving cryptographically secured digital representations of value or contractual rights that can be transferred, stored or traded electronically) must be registered with the FCA by January 2021.

In Spain, a recently proposed amendment requires virtual currency service providers to register with the Bank of Spain. While the primary goal of these requirements is for crypto companies to comply with the EU’s fifth Anti Money-Laundering Directive (AMLD5), these firms will also need to establish much more transparent and rigorous governance frameworks than they have now.

The number of security token and digital asset exchanges is growing (one listing shows over 90 of them globally), yet to attract the interest of institutional investors, regulations still need to be ensconced to promote transparent and fair markets these investors demand and deserve.

Digital asset exchanges, therefore, are going to need to be prepared to go much further than previously required in their level of risk assessment – to meet additional regulatory obligations, such as capital requirements, orderly markets, potential market abuse detection, and transaction reporting – in order to attract institutional liquidity.

ESMA’s perception of risk

While institutional investors are showing increasing interest in crypto markets (almost 80% of investors from a Fidelity Digital Assets survey found something appealing about digital assets), they are exceedingly cautious about digital assets as an asset class. Their reasons include a lack of regulatory clarity, questionable valuation data, fragmented liquidity, and incapable technology. Regulators, however, are beginning to answer the call and have begun to make efforts over and above the auspices of AMLD5.

The US Crypto-Currency Act of 2020 aims to have crypto-securities answer to the Securities and Exchange Commission (SEC), Switzerland’s crypto-friendly market authority, FINMA, applies relevant provisions of financial market law regardless of the underlying technology, Hong Kong’s Securities and Futures Commission (SFC) recently announced guidance on custody requirements, portfolio valuation and risk management for digital assets, and in Abu Dhabi, market intermediaries such as broker-dealers, custodians, asset managers and digital asset exchanges need to be licensed by the Financial Services Regulatory Authority (FSRA).

In addition, new security token exchanges are increasingly seeking licenses to operate as Multilateral Trading Facilities (MTFs), Alternative Trading Systems (ATS's) or similar, with their national competent authority.

More generally, the European Commission has issued a consultation on a new digital finance strategy for the EU. ESMA, the EU’s securities markets authority, responded by noting the benefits of increased speed, efficiency, convenience and greater economies of scale. It did, however, also highlight risk areas including data security and operational incidents. These risks were laid out in detail in ESMA’s Advice Note on Initial Coin Offering and Crypto-Assets published in January 2019, which stated that:

“ESMA has identified risks that are specific to the underlying technology that might require new/enhanced requirements. In particular, ESMA believes that there should be a means to ensure that the protocol and smart contracts underpinning crypto-assets and crypto-asset activities meet minimum reliability and safety requirements.” [source: ESMA Advice, p.37]

 “Matching Engine-as-a-Service”

In order to stay ahead of competition, digital asset exchange operators now need to anticipate that they will have to prove the resiliency, capacity and auditability of their trading systems, to regulators in the very near future.

Take, for instance, establishing or maturing secondary markets. As the primary issuance digital asset market establishes itself, secondary markets for these same assets will become a necessity. The set-up of these two markets is vastly different due to the particular requirements of each.

Primary markets don’t need the same levels of latency and robustness of infrastructure (some can even be built using a spreadsheet). This is in no way robust enough for secondary markets, be they auction-driven or continuous trading. Digital asset operators of secondary markets need a matching engine that delivers, as well as an audit trail to prove to regulators and participants that orders are treated fairly and that trades are correctly executed.

In order to make sure an exchange is fit for regulated markets, it is best that the infrastructure is built from the foundation stemming from established and proven requirements in capital markets. Multi-asset class exchange infrastructure can deliver an exchange matching engine that is easy to integrate into new and existing ecosystems via APIs and accessible sandboxes.

This type of specialised infrastructure is crucial, as typical crypto off-the-shelf systems will not meet regulatory requirements, partly due to their inability to produce a clear audit trail (which is necessary to prove to regulators the running of a fair and orderly exchange).

A cloud-based “Matching Engine-as-a-Service” concept allows clients to easily scale depending on demand and available budget, thus avoiding the pitfalls of incumbent offerings, which can be expensive, time consuming, and difficult to integrate.

Proof of resilience

Before institutions invest more heavily in digital assets, they will require a much higher degree of regulatory certainty. Regulators are doing their part, and this means digital assets exchanges should expect that they will soon have to start proving the resiliency of their trading technology.

It goes without saying that the building of a robust market and provision of a better offering will thereby attract more liquidity and an increase of profits. The adoption of infrastructure built for regulated capital markets from the outset not only helps provide the assurance that regulators are looking for, but ultimately helps ambitious exchanges stay ahead of the competition.

Magnus Almqvist is Head of Exchange Development at Exberry

TabbFORUM is an open community that provides a platform for capital markets professionals to share their ideas and thought leadership with their peers. The views and opinions expressed are solely those of the author(s). They do not necessarily reflect the opinions of TABB Group, its analysts, TabbFORUM and its editors, or their employees, affiliates and partners.

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