Where to set up a Cryptocurrency Exchange – Part 1: The Fundamentals

Flag Theory Weekly Letter – Wednesday, August 15th, 2018

What is the best jurisdiction to incorporate my cryptocurrency exchange?

This has been one of the most common questions we have received from entrepreneurs and companies that are planning to launch an exchange and this is why we start a new article series in which during the next two weeks we will discuss some of the most important aspects to take into account when deciding where to incorporate and we will review some of the most suitable jurisdictions.

Returning to the above question, there is no ‘one-size-fits-all’ solution and there is no such thing as the best country.

It is true that there are more crypto-friendly jurisdictions to operate in, but there is a multitude of factors to consider with the most important being the regulatory environment and the exchange business model to determine what regulations/licenses you will be subject to and the requirements to obtain them.

In this first chapter of “Where to set up a cryptocurrency exchange” article series, we summarize some of the most relevant factors you should consider when deciding what is the most suitable jurisdiction for your crypto exchange platform.

Cryptocurrency Exchange Regulations

The first thing to determine is if you plan to launch a regulated or unregulated exchange. There is a bit of uncertainty globally around what would be regulated and what not regulated – but there is a clear difference between fiat-crypto and crypto-crypto type exchanges. Some people might argue that crypto-crypto is unregulated, but other governments think otherwise.

Very few jurisdictions have established specific regulations for crypto exchanges. Currently, most regulated exchanges run with Electronic Money Institution licenses. We’ll discuss this later.

Certain jurisdictions such as Gibraltar, Malta, Thailand, Estonia, Philippines or Japan, among others, have passed laws that specifically cover crypto wallets, crypto to fiat or crypto to crypto exchange activities.

Obtaining a cryptocurrency exchange license in one of the above-mentioned jurisdictions provides a higher degree of regulatory certainty and adds legitimacy and confidence with users, in addition to potentially give access to more and better banking options.

However, to obtain a license you must fulfill certain requirements. From a solid and comprehensive business background of the promoters, physical presence in the jurisdiction, capital requirements, insurance, protocols, and procedures when holding clients’ crypto assets, qualified compliance personnel, appropriate security protocols and systems, and data protection procedures, among many others.

Although many of these requirements should be fulfilled by any ‘self-regulated’ exchange, especially when we speak about security and KYC/AML, the truth is that the whole process has a burden and a considerable cost that many projects simply don’t have the resources for.

For instance, we have seen well-known exchanges operating in Europe withdraw their license applications in Japan, stating that they cannot meet regulatory requirements.

You can choose to operate in a jurisdiction where the crypto exchange activity is not regulated. You can launch your exchange without having to obtain a license, it is possible.

However, there will be certain restrictions on the services that you can offer and you will have to comply with the KYC/AML and current data protection regulations.

In any case, if you are planning to launch an unregulated exchange you should prepare for the inevitable. The regulatory wave has begun and it is expected that during the next 1-2 years exchanges will be fully regulated in most jurisdictions. You might want to be ready for that day.

Supporting Fiat Currency

As we have said, there are a number of exchanges that are run as Electronic Money Institutions in the USA and especially in Europe, where authorized EMIs can use their license across the whole continent without requiring additional licenses or operational/physical setups.

E-money licenses do not usually cover crypto exchange specific activities but they can authorize the exchange to hold customer funds in its bank accounts, that is, provide fiat wallets and allow deposits and withdrawals in fiat currency.

Obtaining this type of license not only allows supporting fiat currency but also can give confidence to your customers, some degree of regulatory certainty, and access to solid options in terms of banking, which in turn allows for better service to your users.

Passing the licensing process, meeting stringent requirements, having to follow AML/KYC regulations and being under the scrutiny of the regulator can considerably reduce banks perceived risk with crypto businesses. Banks are more comfortable working with regulated entities.

However, obtaining an E-money or other financial services license in Europe and the US may simply not be feasible to some startups due to their cost, requirements and time to obtain the license (which may take between 6 months and 1 year).

Some projects choose to go for an offshore financial services license whose cost is significantly lower and the requirements are more lenient. Such licenses include FX, Money Broker, or Payment processing licenses, depending on the exchange model.

The main issue is going offshore lies in the available banking options. Some offshore banks are not ideal for transactional, or day to day operations, accounts.

If deposits and withdrawals take time to complete and the costs of such transfers are high this can become a barrier to consumer acquisition. One possible solution is to work with an external payment processor to overcome it and provide a better customer experience.

We have also seen exchanges offering fiat deposits, withdrawals and wallets without any type of license or authorization for it. They usually suffer regular interruptions – mainly because bank accounts get closed. It is not a feasible long-term option because, in addition to poor service and a business operational headache, it can lead to legal issues.

Utility or Security Token?

Regardless of whether you incorporate your exchange in a jurisdiction where the activity is regulated or not, or accept deposits and withdrawals in fiat currency, if your platform allows for security tokens trading – you will be subject to the relevant capital markets regulations.

That is if you are running a Securities Token Exchange or there is any regulated financial product listed on your platform you will need permission and/or licensing from the relevant Securities and Exchange Commission.

Depending on your exchange model and the jurisdiction where you operate, you will need to seek different types of permission/licenses.

For instance, in the US you will need permission from the SEC to operate as an Alternative Trading System (ATS) or if operating in the EU, as a Multilateral trading facility. At the moment there are only a handful of licensed brokerage platforms dealing exclusively with security tokens.

Another thing to consider is whether you want to list “anonymous” coins in your exchange. Some countries where crypto exchanges are regulated do not allow listing coins such as Monero or Dash, other jurisdictions have restrictions on the cryptocurrencies that can be used as trading pairs.

Compliance

If you run an exchange you will have to comply with anti-money laundering (AML) and counter financing of terrorism (CFT) rules. KYC/AML & CTF requirements vary between jurisdictions and may influence your decision to opt for one jurisdiction over another.

Many jurisdictions have issued statements specifying that exchanges are obliged to perform KYC/AML checks in accordance with established regulations. Other jurisdictions have not ruled on this.

However, normally, even if your activity is not explicitly subject to such rules you will want to comply with them.

You will have to identify your client and perform the appropriate customer due to diligence and AML procedures, plus you may have to report suspicious transactions in accordance with established protocols and criteria. You will be required to keep the transaction records and comply with the retention periods according to the regulations, in addition to hiring the appropriately qualified compliance personnel, among other requirements.

There is a great risk of not doing so. If it is demonstrated that your exchange has been used for money laundering or terrorist financing, you may face serious legal issues.

Banking

Obtaining banking is another hurdle you must overcome. Most ‘onshore’ banks located in highly reputable jurisdictions are hesitant to take crypto-centric clients including exchanges, and those who do so only do it if there is a significant potential commercial relationship and they will still most likely require a costly risk assessment.

Being regulated will definitely open you up to more and higher quality options for both your business transactions and to hold clients’ funds in order to provide better services.

Your banking needs play an important role when choosing the jurisdiction for establishing your exchange operations. You will also need to consider whether you will need merchant processing services to accept deposits via credit card or other payment processing services for deposits & withdrawals or other alternative payment methods.

At Flag Theory, we consistently help crypto businesses, including exchanges, open bank and merchant accounts for both regulated and unregulated companies.

Taxation and fees

Tax obligations can have a considerable impact on the profitability of your cryptocurrency exchange.

In addition to corporate taxes, you should consider the associated fiscal costs in establishing a physical presence in a given jurisdiction such as personal income or social security taxes, the costs associated with maintaining a license or specific taxation of your economic activity. For instance, Thailand imposes 0.002% tax on the total trading volume.

Certain tax obligations can also have a considerable impact not only at an economic level but also at an operational level, such as having to withhold tax on your users crypto gains or applying V.A.T.

Target Market

The target market is also an important factor when designing the corporate structure and determining the jurisdiction where to establish your exchange, especially if you plan to launch a regulated exchange. Where your clients are located is something that you should keep in mind, for instance, your setup will not be the same if you are targeting the EU or you want to focus on Asian markets.

The Bottom Line

The jurisdiction(s) in which you set up your cryptocurrency exchange can have a considerable impact in the long-term.

If you decide to launch an unregulated exchange, adhere to the best practices and prepare your business to meet requirements when licenses are available. There is a clear trend of increasing and more rigorous regulatory supervision.

If you are looking for more regulatory certainty and have sufficient capital and resources to do so, set up your exchange in one of the jurisdictions where there is a legal framework and the regulatory conditions are favorable.

Over the next few days, we will review and compare various jurisdictions where you can potentially establish a cryptocurrency exchange, its advantages, disadvantages and important aspects to consider.

We will start with some of the most suitable Asia-Pacific region’s jurisdictions in our next article.

If you are planning to set up an exchange we can help you set up a sound corporate structure choosing the most advantageous jurisdictions, obtain licensing and bank accounts, as well as assisting in compliance matters. Contact us, it will be our pleasure to assist you.

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