Crypto-exchanges are currently the most exciting area of the crypto-sphere. In the first article of our three-part series about crypto-exchanges we have therefore focused on their basic functionality and properties. In addition, we considered advantages and disadvantages of central and decentralized exchanges. Whether centralized or decentralized, crypto-exchanges are confronted with a multitude of problems and challenges.
That’s why in today’s article we are going to look at the difficult framework conditions under which Exchanges have to operate. The primary focus will be on financial and legal issues. But there are also grounds for hope. We will also show what possibilities there are for solving the problems of crypto-exchanges.
Challenges with Fiat Currencies and Crypto Exchanges
A major problem for crypto exchanges is the critical and negative attitude of governments and regulators towards their operations and crypto currencies in general. This rejection can take the form of restrictions or even a ban on the operation of crypto exchanges. In China, for example, the state banned the operation of exchanges and blocked access to foreign exchanges via ISP blocking.
The biggest problem for the ongoing operation of crypto currency exchanges, however, is low liquidity due to a lack of support from banks. Exchanges must have sufficient liquidity to settle trades in various currency pairs — and these can only offer flexible and filled bank accounts. Exchanges must have sufficient reserves when there are no more coins to sell. Only high liquidity can cushion fluctuations in supply and demand.
However, most banks are very conservative, risk-averse and have so far been reluctant to support the interesting and potentially lucrative crypto-exchange business. For example, Bitbay, one of the leading crypto-exchanges now established in Malta, stated that it had been forced to close its operations in Poland following the termination of a contract with a Polish bank.
Another problem, of course, is security. Every few weeks, another hack of a crypto-exchange makes headlines, causing fear and insecurity among traders. According to a report by Reuters, a total of around USD 4 billion has been stolen in recent years from wallets located at central exchanges. Such hacks of course damage the Exchange industry immensely — they prevent existing users from continuing to trade and prevent interested parties from becoming traders or users at all. As we already explained in the last article on the differences between centralized and decentralized exchanges, decentralized exchanges cannot be easily hacked, but they are all the more confronted with low liquidity.
Another problem that affects all crypto-exchanges equally is the general volatility of crypto currencies. As observed at the end of 2017 but also in the last few weeks, crypto currencies can regularly show rate fluctuations of 10% per day (!) or even more. This in turn places high demands on the liquidity of exchanges. Strong price fluctuations lead to large buying or selling peaks for traders, which are usually not offset by sufficient reserves of the Exchanges. It comes to “slippage” — trades may not be executed, traders themselves must pay higher surcharges so that Exchanges can cover the slippages.
Possible solutions for financial and legal issues
In view of these enormous challenges for crypto-exchanges, the question naturally arises as to how these can be met. Are there ways to address these challenges? Are there any countries where crypto exchanges are welcome? Are there countries where a legal framework has been put in place that provides crypto-exchanges with clarity and security? Countries where legislators and regulators are in principle open to blockchain technology, crypto currencies and crypto exchanges?
The answer, of course, is yes. In contrast to China’s position, some countries have adopted an open and even proactive approach to the settlement and establishment of blockchain companies and crypto exchanges. While this also applies to Switzerland and Liechtenstein, one country stands out in particular: only Malta has created the basis for official licensing of crypto exchanges by establishing its own license class. But there is much more that speaks for…
Malta as an attractive location for crypto-exchanges
The Blockchain island Malta is particularly interesting as a location for crypto-exchanges. The Maltese government has recognised the future potential of this still young industry, but especially of Exchanges, and is the first government in the world to have adopted a corresponding legal framework. The basis for this was created by three corresponding legal acts, including the Malta Digital Innovation Authority Act and the so-called Virtual Financial Assets Act (VFAA).
With the Malta Digital Innovation Authority Act, a separate regulatory and supervisory authority was created for the emerging area of virtual financial assets. The Virtual Financial Assets Act provides for the introduction of 4 different license classes, which differ in terms of the authorizations granted and the level of investment. The VFAA Class 4 is a license designed especially for Exchanges and in high demand.
In order to set the course, the Virtual Financial Assets Act (which we presented in detail) provides for a separate license class for Exchanges. Holders of such a license are granted permission to operate an exchange for virtual financial assets and to hold or control the money, VFAs or private cryptographic keys and custody or nomination services of customers only in connection with the operation and activities of that VFA exchange. Anyone wishing to acquire such a license must pay a one-time application fee of €25,000 for annual sales of up to €1,000,000, or an additional €2,500 for each additional €1,000,000 annual sales (up to €100,000,000).
They will also need a certified and registered VFA agent to support their application. In addition, of course, the strict guidelines of the MIFD must also be observed. In total, one should allow about 12 months for the entire process from the first consultation to the final licensing.