(Bloomberg Businessweek) — In the wild world of cryptocurrency exchanges, one strategy never seemed to pay off: embracing regulation.
Take Gemini, started by twins Cameron and Tyler Winklevoss. While it was plastering posters in New York subways a few years ago, declaring there was “Finally, a regulated place to buy, sell and store crypto,” an exchange called Binance—with no clear headquarters and a mysterious structure—quietly took the top spot among the world’s cryptocurrency exchanges.
Suddenly, touting adherence to the rulebook looks very smart. Although Binance Holdings Ltd. turns away American customers, it is now said to be facing probes from U.S. agencies. In late June, the financial watchdog in the U.K. told a Binance affiliate that it wasn’t authorized to carry out regulated activities in that country. The pressure on Binance raises the odds that several exchanges pledging to comply with tough U.S. regulations may soon find themselves operating with less competition in some of the world’s biggest economies. “We’re playing the long game,” says Cameron Winklevoss. “We’re trying to be the fastest tortoise in the race. The long game pays off over time.”
Warnings and lawsuits by U.S. authorities in recent years already had winnowed the list of platforms catering to U.S. consumers. There’s Coinbase, Kraken, Gemini, and Bittrex, among a few others. There’s also Binance.US, which says it’s separate from the global Binance platform and has licensed the name and some technology from Binance.
Coinbase Global Inc. published audited financials and beefed up its compliance operations as it listed shares in New York this year. Kraken got a regulated bank charter in Wyoming as it, too, prepares to go public. And Gemini’s parent, Gemini Trust Co., helped create the Virtual Commodity Association, which is supposed to root out bad behavior and prevent fraud and manipulation—reminiscent of the self-regulatory groups set up by Wall Street. As another Gemini poster put it: “Crypto needs rules.”
The idea is that if an exchange appeases U.S. authorities, it can probably operate just about anywhere and more easily lure institutional investors, such as hedge funds, family offices, and pension funds. But with each step a platform takes, it goes further toward emulating the staid financial world, where internal controls, industry groups, and regulators hold sway. “The Catch-22 is that the crypto system was set up to avoid big banks,” says John Griffin, a professor of finance at the University of Texas at Austin’s McCombs School of Business. But “rather than having this autonomous universe free of government regulation, we have crypto exchanges playing the role that traditional exchanges and governments play in traditional markets.”
There’s already a rich history of boom and bust in the relatively new world of crypto exchanges—and plenty of reason for traders to be worried about who they can trust with their assets. Mt. Gox is the most famous example. The Japan-based platform imploded in 2014 after losing the coins of thousands of customers. Quadriga CX abruptly shut in 2019, owing clients hundreds of millions of dollars in crypto. The three founders of Seychelles-incorporated BitMEX, once the biggest crypto derivatives exchange, were charged by U.S. prosecutors in 2020 with flouting banking laws intended to ensure that the platform isn’t used for illegal purposes while serving U.S. customers. All three have pleaded not guilty.
Binance Holdings vaulted from unknown to a powerhouse a few years ago and has sat high on global rankings ever since. This year, as the Biden administration settled in, probes emerged. The U.S. Department of Justice, the Internal Revenue Service, and the Commodity Futures Trading Commission are all said to be examining aspects of the business, according to Bloomberg News. The specifics of the inquiries are unknown, but they’ve included officials who look into whether companies have allowed money laundering. The company hasn’t been accused of any wrongdoing.
“As Binance.com continues to grow, we remain committed to working collaboratively with regulators around the world,” the company said in a statement provided by a spokesperson. “We take our legal obligations very seriously and we continue to invest in our compliance program.” The company said that includes building robust systems for catching money laundering and the hiring of former government officials to advise it on regulatory and compliance matters.
Binance remains the global venue to beat. Its daily spot trading volume is more than 100 times that of Gemini’s, according to CoinMarketCap, which is owned by Binance but generally is considered the leading source of crypto trading data. But even a midsize exchange can be worth billions. The Gemini exchange is worth $4.1 billion, according to estimates by the Bloomberg Billionaires Index. Coinbase sports a market value of more than $50 billion, making co-founders Brian Armstrong and Fred Ehrsam both billionaires. Kraken’s value is around $20 billion, based on secondary sales of its private shares. And Mike Novogratz, chief executive officer and founder of Galaxy Digital Holdings Ltd., which operates an over-the-counter trading desk, has a $3.6 billion stake in that company.
With new cryptocurrencies emerging daily, one of the biggest conundrums facing exchanges is deciding which ones to allow users to trade. Listings sometimes require technology upgrades and time to vet whether coins run afoul of laws, says Dave Ripley, the chief operating officer of Kraken. But restraint can leave an exchange’s risk-loving users on the sidelines when hot coins take off. For example, Coinbase started trading Dogecoin only in June, years after the token’s creation in 2013 and several weeks after its market value soared over $90 billion. The price has since tumbled.
One way U.S. exchanges can stay in regulators’ good graces is fairly easy: by simply not offering more-heavily regulated products such as derivatives contracts based on crypto. Venues also have to take care to avoid certain kinds of coins. Things can get particularly dicey if watchdogs decide a coin is really just a way to sell an investment in a business while sidestepping regulations. The question that arises constantly is, “Is this an unregistered security?” says Jason Urban, Galaxy Digital’s global co-head of trading. If it is, the coin could end being off-limits to U.S. investors. “There really isn’t a lot of clarity from the regulators, at least domestically.”
Going public ratchets up pressure on exchanges to ensure they’re vigilant, lest they be accused of failing to protect their shareholders from legal blowups. Coinbase added Stripe Inc.’s Melissa Strait as chief compliance officer months before it went public in April, then hired Faryar Shirzad from Goldman Sachs Group Inc. as its chief policy officer in May.
Regulatory compliance opens the way for institutional investors to use the trading platforms and their associated custody services, in which they hold digital assets for safekeeping. But the arrival of cost-conscious Wall Street investors invites other pressures. A growing chorus of analysts is predicting that as exchanges go mainstream, they won’t be able to maintain their hefty transaction fees.
That would be good for crypto traders but might weigh on firms like Coinbase, which generates most of its revenue from such charges. The exchange isn’t going to compete on fees, Chief Financial Officer Alesia Haas has said, arguing that in crypto, trading still isn’t commoditized the way it is in stocks. Crypto investors are navigating a confusing landscape, leaving plenty of opportunity for companies that can make trading seem simple and secure. “We’re trying to win on being the most trusted, the easiest to use, introducing our users to more and more crypto assets, offering more ways to transact,” Haas said at a Barclays Plc conference in May. “They’re choosing us for that experience. They’re not choosing us based on fees.”
The competitive landscape for crypto exchanges can shift quickly. Even if greater regulation helps established U.S. players take business from offshore operators, there’s an emerging challenge from so-called decentralized finance, or DeFi. This technology has allowed developers to set up coin exchanges that run entirely on computer code, where users trade assets with no middleman. After years of frustration over Washington’s pace in developing a regulatory regime, Gemini is moving out of a U.S.-centric model and expanding overseas. “One thing that is clear: The U.S. landscape is moving at a very slow pace,” says Cameron Winklevoss. “The U.S. will get there, but we can’t wait around for that.”