Will EDX Markets start A New Compliance Paradigm for Cryptocurrency Exchanges?
1、EDX Markets: an institutional-only cryptocurrency exchange
With a series of serial incidents involving Terra, 3AC, FTX, etc., the crazy growth momentum of the crypto market has been severely dealt with, and regulations are gradually tightening around the world. EDX Markets brought new hope and confidence to investors and traditional institutions at a time when the crypto ecosystem is facing the twin pressures of declining market share and regulatory onslaught, and thereby secured the backing of prominent financial heavyweights such as Citadel Securities, Fidelity Investments and Charles Schwab.
EDX Markets is the first virtual asset exchange designed to achieve security compliance through trusted intermediaries. EDX Markets aims to bring elements of traditional finance to the cryptocurrency sector, with a focus on compliance and the mitigation of conflicts of interest, and to provide access to the crypto market for major banks. It is based on the best practices of traditional finance and offers its clients unique advantages, including high liquidity, competitive pricing, and a non-custodial model designed to reduce conflicts of interest. It also borrows from the standard practices of traditional regulated financial markets and differs from the way cryptocurrency exchanges have operated before:
- Non-custodial Model
EDX Markets is a non-custodial exchange. Unlike traditional cryptocurrency exchanges, it does not control customers’ crypto assets directly. Instead, it delegates the control and security of customers’ funds to a third party bank and specialist custodial service providers. Normally cryptocurrency exchanges held custody of customer funds and tokens themselves, which carried potential risks. For example, FTX once lent out billions of dollars worth of customer assets to fund risky bets by its affiliate trading firm, Alameda Research. And SEC also filed charges against Binance for allegedly stashing billions of dollars of its clients’ assets in accounts controlled by its founders. These incidents have raised concerns about the security and compliance of cryptocurrency exchanges.
- Serving institutional clients majorly
EDX Markets primarily serves institutional clients. Using an API -based trade access approach, rather than a traditional front-end user interface, it provides institutional clients with a secure trading platform for executing cryptocurrency and fiat trades, with external settlement and custody. With respect to retail investors, EDX Markets does not service them directly. Instead, retail investors submit buy and sell orders through retail brokers, which route those orders to EDX Markets and execute the orders on the exchange.
In this way, trading actually takes place on the exchange, while retail investors operate via the retail broker. This kind of trading mode can effectively reduce regulation risks to some extent. Exchanges can indirectly strengthen its compliance by cooperating with brokers with a higher degree of compliance. This is similar to the operation of the traditional stock market, where investors submit orders through brokers such as Fidelity Investments or Charles Schwab, rather than directly trading on exchanges.
- Focusing on pure trading business and eliminating internal market making
EDX Markets abandons some of the in-house market-making tools commonly used by mainstream cryptocurrency exchanges in order to avoid allegations of market manipulation. Its core objective is to completely separate trading from market-making and custody in order to ensure it exists as a purely trading platform in order to minimize conflicts of interest and prevent misuse of assets. This follows the SEC’s filing of 13 charges in early June against Binance, the world’s largest cryptocurrency exchange, including one related to a “conflict of interest” alleging that its companies “artificially inflated trading volumes on their platforms and manipulated trades”. The Financial Times also reported in mid-June that Crypto.com had a proprietary trading and in-house market-making team, and privately prohibited its employees from disclosing it to the public. SEC Chairman Gary Gensler, who abhorred the model of crypto exchanges that combine trading, market-making, and custodianship, pointed out that “these platforms that call themselves exchanges mix multiple functions, and in traditional finance, we would not see the New York Stock Exchange operating as a market maker and hedge fund.”
- Prudent listing style to avoid legal issues
Unlike other mainstream cryptocurrency exchanges, EDX Markets only offers investors access to four cryptocurrencies: bitcoin (BTC), ethereum (ETH), litecoin (LTC), and bitcoin cash (BCH), tokens that make up 67% of the overall cryptocurrency market capitalization. This limited list of cryptocurrencies may be intentional, which avoids it coming into head-on conflict with the U.S. regulators and is part of its compliance strategy.
Previously, the SEC filed lawsuits against several mainstream cryptocurrency exchanges, arguing that the tokens they list are considered securities. In the future, as the definitions of securities and cryptocurrencies are interpreted more clearly, and as the cryptocurrency market and regulatory environment change, EDX Markets may add more trading pairs and further expand its service offerings, but it will be based on the bottom line of “compliance”.
Regarding EDX Markets, David Schwed, COO of Halborn Security said, “EDX Markets has built the infrastructure that Wall Street banks need to enter the space. As countless B2B startups have discovered, it pays to be a trusted supplier to the big boys. They’re building plumbing, middleware, and technology to provide these services, and it’s the right move right now. Whoever enters this space and wants to build on regulated endpoints is going to need this type of technology.”
The launch of EDX Markets highlights the resilience and tenacity of the crypto industry, despite the growing regulatory challenges. It seeks to explore a viable compliance path for cryptocurrency exchanges to meet regulatory requirements. Here’s an in-depth look at how EDX Markets designed its compliance path from a legal perspective.
2、An Analysis of EDX Markets Compliance Pathway
As an American company, EDX Markets only provides trading services in the United States, so this article focuses on the legal risks of EDX Markets in the United States. Due to the lack of specific legislation at the federal level in the United States, the regulation of crypto assets has to be established gradually through a large number of enforcement activities, so it shows the characteristics of “legislation by law-enforcement”. In addition, due to the highly complex traditional U.S. financial regulatory system and the lack of clear judgment standards for the legal nature of crypto assets, the compliance of cryptocurrency industry needs to consider the regulatory requirements of federal and different state regulators. Finally, certain “financial innovations” in the crypto industry that are different from traditional financial practices also make them conflict with existing regulatory regimes, giving rise to prominent compliance issues under the existing regulatory framework.
Among them, cryptocurrency exchanges, as the product of the combination of traditional finance and crypto elements, face more complex compliance challenges. EDX Markets explored compliance in the following three aspects:
Securities&Futures Trading Regulation
With the background that many cryptocurrencies are classified as securities, and several leading cryptocurrency exchanges have been cited by the SEC for conducting business as securities exchange, broker and clearing house without registering, EDX Markets adopted a cautious business model. On the one hand, EDX Markets only listed crypto assets that are unlikely to be recognized as securities; on the other hand, EDX Markets has returned to its positioning as an exchange, i.e., it is only engaged in the trading business. The following is further analyzed:
1）The trading assets are limited to non-security crypto assets: EDX Markets only accepts tokens that will not be recognized as securities according to its trading rules and currently only has four cryptocurrencies live: Bitcoin (BTC), Ethereum (ETH), Litecoin (LTC), and Bitcoin Cash (BCH). As for such cryptocurrencies, Gary Gensler, the current chairman of SEC, said in a public speech before taking office that they did not constitute securities, which became the basis for the cryptocurrency industry to believe that such cryptocurrencies were not securities. However, this view was not endorsed by the regulatory authorities.
In April, when SEC Chairman Gary Gensler was asked by a House committee whether ETH was a security, he declined to provide an answer. Moreover, as ETH’s consensus mechanism completes the transition from proof-of-work (PoW) to proof-of-stake (PoS), the likelihood of ETH being considered a security has increased further. In a lawsuit brought by the state of New York against KuCoin, a crypto exchange registered in the Seychelles, Attorney General Letitia James accused KuCoin of selling unregistered securities, including ETH. The move raises further concerns that ETH may be considered as a security in the future, but it is also less likely to be considered a security as such a designation would be ruinous for many U.S. investors and also the SEC would not have the resources to follow through with such a designation. Although unlikely, if ETH is considered a security, EDX Markets will need to remove ETH under its published trading rules, or register with the SEC as a national securities exchange or an Alternative Trading System (“ATS”).
2）Transactions are limited to spot transactions. Although it is unlikely that such cryptocurrencies will be deemed to be securities, according to the CFTC, Bitcoin and other virtual currencies constitute commodities. According to a statement by the CFTC, its oversight of virtual currencies covers derivative trading, fraud and manipulation involving interstate commerce. According to the answers of CFTC on its official website, intermediaries engaging in derivatives business are required to register as required. Previously, crypto exchanges such as Binance and Bitfinex were sued by CFTC for engaging in relevant derivatives business without registration. However, in accordance with the trading rules of EDX Markets, EDX Markets only engages in spot transactions, so it is not subject to the above-mentioned risk of engaging in relevant derivative intermediary business without registration.
3) Operations Restricted to Transactions: In the U.S. Securities markets, exchanges, brokers, clearing houses, custodians are typically separate legal entities and are required to be registered and regulated separately by the SEC in order to avoid potential conflicts of interest. Although EDX Markets does not trade in securities, it uses this best practice as a reference. Specifically, first, like stock exchanges such as Nasdaq, EDX Markets does not deal directly with retail investors, but receives their trade orders through a third-party broker-dealer. Second, EDX Markets does not provide custody services itself. Instead, it’s Anchorage Digital, one of the first crypto asset institutions with the National Trust Bank Charter from the OCC to provide custody services. Finally, unlike existing crypto exchanges that settle via a central depository, under its trading rules, EDX Markets currently adopts a bilateral clearing model, with itself acting as the Clearing Agent, calculating the clearing obligations between the parties and notifying each of its members and authorized custodians. Accordingly, settlements will be made in accordance with the legal agreement between the member and its authorized custodian, without any recourse to EDX Markets. In addition, EDX Markets’ user agreement also specifies the rights, obligations and responsibilities between EDX Markets and its members, including the settlement obligations of the members and the scope of the exchange’s exemptions from liability, which makes EDX Markets more risk-isolated than other crypto exchanges with all-in-one functionality. In summary, EDX Markets has adopted business arrangements that are in line with the compliance practices of traditional exchanges, and the legal risks are relatively controllable.
AML Compliance and Sanctions Compliance
In accordance with the applicable regulations of the Bank Secrecy Law (“BSA”) and the applicable guidance of the Financial Crimes Enforcement Network (“FinCEN”), crypto exchanges belong to Money Services Business (“MSB”) under the Bank Secrecy Law (“BSA”) and shall be registered. According to the search result on MSB Registration, the registration of EDX Markets LLC, the legal entity behind EDX Markets, was completed on 14 October 2022, and that of EDX Clearing LLC, which is set to provide cryptocurrency clearing services by the end of this year, was completed on 3 March 2023. In addition to this, as an MSB, EDX Markets has obligations to make suspicious activity reports and establish a written anti-money laundering program. If it violates these obligations, it may be subject to prosecution by FinCEN. Previously, cryptocurrency exchange Bittrex was accused of violating many of its obligations under the Bank Secrecy Act (BSA), including failing to develop, set up, and maintain an effective anti-money laundering program and failing to file suspicious activity reports. Bittrex ultimately pleaded guilty to the charges and agreed to pay a total of $29,280,829.20 in penalties.
Currently, EDX Markets claims to have a compliance program that reflects industry best practices to prevent exchanges from being used for financial crimes in the document “EDX Markets Compliance Due Diligence Overview” available on its website. Specifically, EDX Markets conducts annual and ad hoc due diligence on its members’ AML compliance and sanctions compliance programs. According to its published trading rules, EDX Markets has set up an Anti-Money Laundering Compliance Program and a Sanctions Compliance Program, and has set up obligations for its members to regularly check for anomalies or abuses in user accounts and other obligations for members to regularly check for unusual or abusive behavior in user accounts. In general, EDX Markets’ legal risks in this regard are relatively manageable.
Data protection and network security
Data Protection: In EDX Markets’ User Agreement, the members authorize the exchange to use the data provided by members to the exchange within certain limits. In addition, members make representations and warranties that they have full rights to the data and that the provision of the data will not infringe on the rights of any third party or violate relevant laws. Thus, EDX Markets reduces the risks associated with data protection, at least as far as the internal relationship between the exchange and members is concerned.
Network Security: EDX Markets members are connected to the Exchange via the xNET network. According to EDX xNET’s technical documentation, xNET has taken certain technical measures to address unauthorized access and potential network attacks, including measures such as Access Control Lists (ACLs), Network Address Translation (NAT), Intrusion Detection System (IDS), and other measures. These include measures such as Access Control Lists (ACLs), Network Address Translation (NAT), and Intrusion Detection Systems (IDS). Further, EDX Markets also states in the User Agreement that it does not make any warranty in respect of any system, software and other facilities provided to the members. Therefore, as far as the relationship between EDX Markets and its members is concerned, its network security risks are relatively manageable.
However, it should be noted that the legal recognition of cryptocurrencies is constantly changing even in a more mature legal environment like the United States. Therefore, it will take time to see if EDX Markets can always fulfill its commitment to compliance.
3、New Paradigm for Crypto Exchange Compliance Transformation
In summary, we believe that cryptocurrency exchanges need to focus on the following areas when making its compliance transition:
Registration before issuance
How cryptocurrencies on exchanges are characterized determines what laws cryptocurrency trading platforms should comply with. The SEC is currently defining some of the tokens issued through ICOs as securities, mainly through the Howell test, in the hopes of bringing them under the regulation of securities laws. This means that if a cryptocurrency exchange wants to operate legally, it should first make sure that the cryptocurrencies traded on its platform are not recognized as securities by the SEC, otherwise it will face charges of issuing unregistered securities. However, only the United States has made such a ruling so far, with countries such as Singapore and Australia treating tokens as mere assets rather than securities. These countries are paying closely attention to crypto assets but do not intervene in the issuance process. In addition, although the SEC does not currently characterize cryptocurrencies such as BTC or ETH as securities, it does not mean that they will not in the future. Therefore, crypto exchanges should be cautious about the cryptocurrencies they trade and keep a close eye on how countries characterize them.
Preventing Conflicts of Interest
One of the charges Binance faced from the SEC was a “conflict of interest” in that it transferred client funds to Merit Peak Limited, a separate company controlled by its founder, mixing client funds with company funds. Therefore, if cryptocurrency exchanges are to operate in a compliant manner, it is essential to control conflicts of interest. Currently, EDX Markets separates trading from custodianship and market making in order to prevent conflicts of interest. Complying with the “conflict of interest” rules ensures that the exchange does not take sides when processing trades and orders, ensures the fairness and transparency of the trading platform, and protects the interests of investors and the healthy development of the market.
Registered as a stock exchange
Regulators may also seek to bring various crypto exchanges that avoid regulation by broadening the definition of exchange. The SEC, for example, has sought to bring crypto exchanges under its regulation by expanding its definition of exchange to include not only actual orders on a stock exchange, but also conditional orders and non-firm indication of willingness to buy or sell. Therefore, crypto exchanges should follow the most updated legal opinions and register as stock exchanges.
Complying with securities laws
If cryptocurrency exchanges are under the regulation of the securities law, they should ensure that the disclosure of information is true, accurate and complete, and that it can not manipulate the market, make false statements or engage in insider trading.
Keeping a close eye on potentially changing laws
Currently, regulators among different countries have not reached a uniform conclusion on the nature of cryptocurrencies. Even countries with more mature experience (e.g., the U.S.) are constantly changing their views on cryptocurrencies. Cryptocurrency exchanges should keep a close eye on possible changes in the law if they want to meet legal compliance requirements. Besides, one crypto platform may be regulated among different jurisdictions depending on its place of registration, place of operation, or even the nationality of its developers. Sometimes regulators do not regulate cryptocurrency exchanges out of concern for the development of the crypto industry, but may instead come from the competition between regulators for the administrative authority on crypto industry.
