Compliance in Focus

Building Surveillance and Compliance for Digital Assets

Stefan Hendrickx, Ancoa

By Joe Schifano, Global Head of Regulatory Affairs, Eventus

Legacy financial regulations assume the existence of intermediaries and asset classes well-defined in legal code. The emergence and growth of digital assets has forced regulators, the traditional financial sector, and the crypto community to discuss new paradigms.

The absence of designated intermediaries pose challenges for regulation, compliance, and financial stability. Traditional financial institutions offered another layer of reassurance at times of market stress and the removal of intermediaries from the global regulatory chain is vexing policymakers around the globe. The good news is that digital asset exchanges and venues increasingly realize regulation is inevitable and those that have embraced its role are reaping early benefits.

Digital asset exchanges and venues are not only exposed to reputational risk, but the diversity of investors attracted to crypto asset markets presents an unparalleled compliance challenge and the uncertainty is pervasive. However, the release of President Biden’s “Executive Order on Ensuring Responsible Development of Digital Assets” has been generally received as a sign that government officials want to foster the balance between innovation, regulatory frameworks and competitiveness.

With a framework for U.S. policy discussion now in place, digital asset market participants must consider the status of their surveillance and compliance programs now, noting that policy discussion does not preclude enforcement. In fact, the Executive Order provides relevant guidance by saying that crypto exchanges should “be subject to and in compliance with regulatory and supervisory standards that govern traditional market infrastructures and financial firms… same business, same risks, same rules.”

Blockchain technology is also spreading to other asset classes, including the bond  market, with faster on-chain settlement and automated payments. This application of the technology will require a reassessment of compliance and surveillance protocols beyond the trading of digital assets as blockchain technology advances.

So how does a new digital asset venue build a surveillance and compliance program to mitigate these new risks? Here is a brief summary of the key steps to get started, but remember: There is no one-size-fits-all solution.

Know the space—and yourself

Any regulatory plan should align with the overall mission of the company and take into account the markets it trades within as well as exposures to different jurisdictions.

These basic questions can have profound effects on your operating structure, workflows, toolsets and more, so clearly defined North Stars are a must. Start with first principles by a straightforward assessment of your risk.

While there may not be a universal path to the crypto markets, subject matter expertise is one crucial prerequisite for all aspirants. Professionals who built their careers in traditional markets are actively  sought after for their expertise and experience with regulatory frameworks.

Much of the assessment will depend on the technology used and the tools deployed to surveil and monitor the process. Build your compliance program and continually monitor guidance from advisors and regulators.

Building a robust network of connectivity

Firms need to have access to an ecosystem that offers multiple avenues to liquidity while accounting for the unique characteristics that define crypto markets. Similar to traditional markets, building a diverse liquidity pool with redundancy and strong uptime leads to better execution and institutional investor interest. Onboarding also stands to benefit by attracting quality liquidity that is screened using optimal and tailored processes. That also extends to bringing on new clients, a process that can be done easily and quickly while holistically managing risk.

And while many aspects of this process are similar—navigating fragmentation, assessing providers’ approaches to compliance and risk, integration with back-office systems—the fact that crypto markets are still developing adds complexity.

Understanding your liquidity partner, their approach to know-your-customer (KYC) and anti-money laundering (AML) and where they are domiciled are some of the key questions that need to be addressed. Crypto is structured around communities—joining and participating in those communities is a good way to build and understand where risk is most prevalent. Any solution should also offer scalability to support a potentially unlimited number of transactions and it should also draw everything together in a holistic view in real-time.

Capture risk across compliance verticals

While the regulatory landscape for digital assets is not as mature as traditional finance, regulators are apt to view your venue through a traditional lens, because that’s what they understand best. Accordingly, there are several best practices to keep in mind.

Trade surveillance and market risk tools are essential for digital asset exchanges, and their ability to monitor activity in real time is especially important due to the unique nature of the crypto markets. These 24/7/365 venues must also decide how their compliance desk will be staffed, with options ranging from round-the-clock monitoring to periodic reviews.

In addition, trade surveillance for crypto poses unique data challenges, such as the need to deal with far more decimal places than in traditional markets and a lack of standards in data integration and symbology.

What differentiates crypto markets from traditional markets is that compliance programs must be structured to monitor risk across all verticals. As crypto markets evolve and digital asset exchanges offer new products such as ETFs or derivatives, venues and exchanges will require solutions that surveille trading, operations, compliance and risk management across multiple asset classes. It is also vital to have access to experienced surveillance experts to help bridge lessons of the past with technology of the future.

Pulling it all together 

Increased regulation and surveillance are only a matter of time, so it is important to future-proof against a fluid regulatory landscape. Confronted with myriad challenges, how digital asset exchanges move ahead and participate in a sector that some regard as a defining moment in financial markets, will influence policymakers and their attitude toward regulation. Despite well-documented reservations, the evidence says that crypto trading is a rapidly evolving asset class and is here to stay.

After more than a decade of regulatory ambiguity, policymakers are beginning to close the loopholes. Be ready for the future.

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