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While cryptocurrency exchanges are the backbone of the decentralized economy, cryptocurrency exchange development extends beyond simply finding a great solution. You will be confronted with the process of navigating a plethora of existing global, regional, and local regulations.
With laws becoming strict and accountability difficult to expect from crypto end-users, regulatory compliance is now surely a cornerstone of any legal crypto exchange, regardless of the type (centralized/exchange, decentralized, custodial, etc.).
This blog will outline the necessary legal and regulatory requirements that must be addressed before establishing a crypto exchange, while also providing real-world examples, best practices, and actionable insights to help you build a compliant crypto business that is ready for the blockchain metaverse and future developments.
The first step, and the most important step, is figuring out how cryptocurrencies are classified and regulated in your target country. Some jurisdictions classify crypto as a digital asset (U.S.), others as commodities (Japan), and some even classify crypto as property (UK).
For instance, while the SEC governs crypto securities in the U.S., the CFTC distinguishes crypto assets like Bitcoin as a commodity. China, on the other hand, has a complete ban on crypto trading and mining, and this varied regulatory climate will affect the licensing process, tax implications, and your overall business plan.
Why does this matter?
A crypto exchange may incur heavy penalties, be shut down, or even face civil prosecution for failing to abide by its host country's classification framework.
Regulatory Licenses to Operate:
Depending on the needs will require, your new exchange will need to obtain several regulatory licenses for varied jurisdictions to operate as a cryptocurrency exchange.
Here are a few examples:
In Singapore, the Monetary Authority of Singapore may have an exchange register under the Payment Services Act. Furthermore, virtual asset firms in the U.A.E. must seek approval from the Virtual Assets Regulatory Authority (VARA).
Pro Tip:
Recommendations for beginning registration before implementing your exchange, as a regulatory license process can take 6–12 months, depending on management staff, information required, etc.
Role of KYC/AML Policies
Across the globe, regulators are requesting crypto exchanges to apply strict KYC and AML procedures in their operations, such as obtaining customer ID documentation, verifying sources of funds, and monitoring suspicious activity.
The 2023 Chainalysis report determined that money laundering associated with crypto totaled more than $20 billion in 2022. To address the amount of money laundering that occurs in the Virtual Asset sector, EU, Canadian, and United States jurisdictions implemented KYC as a requirement for crypto service providers.
Tools:
Many crypto exchanges utilize third-party tools (i.e., Chainalysis, Jumio, Onfido) to provide real-time identity verification and AML monitoring; this has become standard practice for the sector.
GDPR Considerations
If you're collecting data about users, particularly in the EU, your exchange will need to ensure compliance with GDPR (General Data Protection Regulation). Other jurisdictions will have similar legislation, including California's CCPA, India's Digital Personal Data Protection Act, and Brazil's LGPD.
To ensure GDPR compliance, you'll need to:
There are financial implications for not complying with GDPR; fines can be up to €20 million or 4% of your annual global revenue, whichever is greater.
Are the Tokens on Your Exchange Securities?
There is a lot of gray area in the classification of tokens around the world. The SEC has aggressively prosecuted exchanges for listing tokens determined to be unregistered securities (e.g., Ripple/XRP).
Exchanges should consider the Howey Test in the U.S. or similar approaches in the U.K., Singapore, Australia, and many other jurisdictions before listing any token.
Example:
In June 2023, Coinbase was forced to delist lots of tokens after the SEC referred to them as possible securities. Ignoring the securities laws could result in class action lawsuits, delisting, and the closure of an exchange.
Most regulators now require exchanges to report user activity for taxation purposes. For example, in the U.S., the IRS requires exchanges to issue a Form 1099 to the user. In the U.K., exchanges have to report cryptocurrency transactions to HMRC. In regard to taxation, India has a TDS (Tax Deducted at Source) law that requires a 1% tax on all cryptocurrencies being sent.
Countries differ in their tax treatment of cryptocurrency. Some like Germany, do not tax gains from cryptocurrency as long as it was held for more than a year. Others, like Australia, require real-time reporting of capital gains tax.
Tip:
You could integrate tax-reporting API's or dashboards so that users can comply with their local taxation laws.
International Data-Sharing for Crypto Transfers
As the Financial Action Task Force (FATF) rolled out the Travel Rule, which requires exchanges to share data on senders and receivers of crypto transactions over $1,000.
The Travel Rule applies to cross-border transfers, and with it requires the travel of personal data along with the transaction. FATF-compliant countries (the U.K., Switzerland, Japan, etc.) are enforcing Travel Rule compliance through national regulators.
For example, in 2023, South Korea required that all exchanges operating in the territory confirm to full Travel Rule compliance. This means that exchanges have to comply with the FATF Travel Rule and have impacted over 30 different platforms.
Legislation to Secure Platforms
Governments are increasingly focused on the cybersecurity posture of exchanges. A variety of legislation, such as the Digital Operational Resilience Act (DORA) in the EU, structures cybersecurity as risk management frameworks, including incident response capabilities and platform governance, as highlighted in DORA.
There are some key measures that jurisdictions are requiring exchanges to comply with, such as:
For example, in 2021, BitMart was hacked, losing over $200 million due to compromised hot wallets. The incident and the volume of funds lost resulted in renewed calls for changes to include mandatory insurance and consumer protection regulation in a number of markets.
Should You Follow The Crypto-Friendly Country?
Some exchanges chose to indulge in regulatory arbitrage by launching their brand in countries that are less regulated (e.g., Seychelles, Panama). While that may launch them quickly to market, it may also create a bleeding wound of distrust with users as well as future regulatory dilemmas when scaling into other jurisdictions internationally.
Preferred Strategy:
Start your exchange in crypto-friendly but compliant jurisdictions like:
All of these jurisdictions provide licensing, clear taxation, and an internationally recognized approach.
Changing the landscape for laws
The world of crypto regulation is changing and evolving weekly.
For example:
You will need a legal or compliance team, or partner with a firm like Elliptic, Coinfirm, or Koinly, to monitor the changes and be responsive fast enough in the crypto and regulatory space.
Tip:
Sign up for monitoring feeds from regulators, or sign up for a service like ComplyAdvantage to have alerts sent to your company when any updates happen.
An exchange is more than just a piece of technology; it is also legal foresight, operational transparency, and prudent stewardship of user funds. By commencing operations with compliance in mind, you protect yourself against legal risk and establish credibility in the eyes of users, partners, and investors.
Example: The seamless success of Binance came to an abrupt halt when it began facing legal issues in various jurisdictions for operating unregistered. The transparency, coupled with the regulatory oversight that Kraken and Gemini demonstrated, helped build trust with users.
Are you planning on Cryptocurrency exchange development ? Consider regulation as a core component, not an afterthought. Work with multifunctional, experienced legal advisors and blockchain consultants to build a compliant, trustworthy, secure, and scalable exchange.
Get in touch with us now, and we can work together to build your crypto exchange with confidence and credibility globally.
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