When crypto exchanges act like banks, regulators may treat them as such

Governments that are still debating how to regulate cryptocurrency exchanges should note that digital funds don't just pass through these entities — those funds are held there in digital wallets, often shifted around within the exchange until they need to be spent.

Someone who deposits a number of banknotes into a bank account doesn’t expect the banknotes to be kept in a special envelope and then moved to another envelope the moment the bank is asked to make a transaction from the account. But things work differently in the world of cryptocurrencies.

At a cryptocurrency exchange, when someone who buys some cryptocurrency, the exchange put this into a digital wallet. When the wallet owners make a transfer to another customer of the same exchange, this is done by making a transfer from their digital wallet to that of the recipient.

At least, that is often the assumption.

A group of researchers from the University of Cambridge in the U.K. looked into this and found that exchanges aren’t very transparent about their methods, but that in fact most handle such internal transactions “off-chain”: they merely write down the transaction in a digital notebook.

There is of course nothing inherently wrong with this approach; after all, this is exactly how regular banks have worked for centuries. But there are a number of important implications.

One of them is that it makes it a lot harder to track stolen or fraudulently obtained cryptocurrencies, something the same researchers had recently pointed out is actually quite easy in many currencies, including bitcoin, when all transactions happen on the blockchain itself.

Another implication is that it is possible for exchanges engaging in off-chain transactions to hold only a small percentage of the deposited cryptocurrencies and use the rest for investments. Again, this is exactly how banks have worked for centuries, but the volatility of cryptocurrencies — where a 25% drop in value overnight is not unheard of — makes them a far more likely target for digital bank runs.

The researchers thus make a number of recommendations to the U.K. and EU governments, the most important of which is that exchanges that offer such off-chain transactions should be regulated according to the EU’s 2009 E-Money Directive.

This directive requires that those offering electronic payment systems maintain enough assets to be able to pay creditors. Though the directive was written before the rise of cryptocurrencies, the researchers conclude that its text applies just as well to cryptocurrency exchanges.

Other recommendations in the paper, which was presented at a conference in Austria this week, include that governments compel exchanges to make clear to their customers how transactions and assets are handled, and that they forbid regulated exchanges from dealing with unregulated ones.