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Exchanges

Fast footwork: Binance has danced around regulations — and even moved itself — to run its exchange the way it wants

Quick Take

  • Binance has become adept at moving to where regulations are most favorable, from greater China to Japan to Malta
  • The exchange giant, though, often complies with regulations regarding money laundering and customer information
  • Still, a loophole allows moving upwards of $10,000 — two bitcoin at a time — through the exchange anonymously and a grand forthcoming plan to decentralize could further expand that loophole

The Block recently looked deeply into the strategy at Binance, the world’s leading crypto exchange. Here, contributor Amy Castor explores some of the thorny questions surrounding Binance and how it does business.  

Since launching in 2017, Binance has found favor with high-frequency traders, made hundreds of millions in profits, and seen astonishing growth under its charismatic leader Changpeng Zhao — known simply as CZ. But despite becoming the world’s largest crypto exchange, questions have emerged about Binance’s approach to regulations, particular with respect to securities and banking rules.

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For even as Binance appears to be making money hand over fist, it does so in the face of American and European laws. An unregulated exchange, Binance has a lax know-your-customer (KYC) policy. It allows customers to deposit or withdraw up to 2 bitcoin (roughly $11,200, at current value) per day without a full identity check. It also lists its own token, BNB or Binance Coin. There have been suggestions BNB resembles a security, though CZ and the company disagree. Binance also allows trading in dozen of other initial-coin-offering tokens that have the characteristics of securities.

Often on the move

As a way of sidestepping regulatory oversight, Binance has adopted a nomadic strategy. Since China banned bitcoin exchanges in September 2017, the exchange has been continually on the move in search of smaller “crypto friendly” jurisdictions to host its offices and servers.

“Any country that can attract Binance to open a branch in their location will receive a handsome tax income revenue,” Binance wrote in a Medium post in May 2018.

Ahead of the China ban, Binance moved its infrastructure to Japan, but soon found itself unwelcome there as well. Japan’s Financial Services Agency sent Binance a warning in March 2018. The regulator was perturbed Binance was not checking the identity of its users and threatened criminal charges if Binance continued to operate in the country without a license.

Binance then headed to the Mediterranean nation state Malta. “Now we have our IPs registered in [the British Virgin Islands] and other locations,” CZ told a reporter last month. “So we are registered in multiple locations and we have people in multiple locations. That way we will never be affected by one regulatory body.”

One step removed from the banks

As a crypto-only platform, Binance has no direct links to banks — and it wants to keep it that way. “The more you deal with fiat, the more [authorities] can control you,” CZ told Tech in Asia last year. “The bank will freeze your bank account. They can make the wire transfer slow.”

While that may be true, traders still need a way to onboard into the crypto world. So as part of its ambitious expansion efforts, Binance is working on setting up a series of separate, unaffiliated fiat-to-crypto platforms in Malta, Singapore, Bermuda, and other locations around the globe. Recently, Binance launched a fiat-to-crypto exchange in Uganda. Even there, Binance sought to stay away from the banks and partnered with an undisclosed mobile payments provider.

In the meantime, though, Binance’s lack of support for fiat means the exchange does big business in tether — a stablecoin pegged 1:1 to the US dollar. Currently, Binance has more than 500 million tether on its exchange, making it the largest holder of tether behind the project itself

One could argue that Binance is putting itself at risk by having such a large stake in tether. Bitfinex, the crypto exchange that issues tether, has yet to release a third-party audit showing that tether is fully backed. If authorities were to freeze Bitfinex’s bank accounts, tether could wind up losing value — a risk that became all too real recently. Binance is actively looking to expand its stable of stablecoins.

Know-your-customer concerns

Crypto exchanges doing business in the U.S. are required to register with FinCEN, the part of U.S. Department of the Treasury set up to combat financial crimes. They also have to comply with anti-money-laundering (AML) obligations, which require knowing who their customers are and filing suspicious-activity reports when potential money laundering is discovered.

FinCEN regulates money services businesses on a federal level. In 2011, FinCEN issued an update covering crypto and two years later followed that up with a Guidance Letter clarifying that all the existing regulations governing MSBs apply to crypto businesses as well.

Several crypto-only exchanges in the U.S. have already fallen in line with those laws. HBUS (the U.S. arm of Singapore-based exchange Huobi) and Poloniex are both FinCEN registered. And recently, Shapeshift, a non-custodial exchange that has long been a bastion of anonymity, also implemented KYC.

Binance is different in that it operates outside of the U.S., but still relies on the U.S. for much of its business. A month after its mid-2017 launch, Binance revealed that nearly half of its customers came from the U.S. and China. (The platform began restricting Chinese IPs after the China ban.)

“There are always tricky questions about the ability to enforce that law, but generally speaking, if company without a money transmitter license is permitting persons in the U.S. to transmit money, that company is going to be in violation,” Jared Paul Marx, a partner at law firm Harris, Wiltshire & Grannis LLP said.

The problem with lax KYC policies is they create a loophole for money laundering, tax evasion, and other criminal activities. In September 2018, blockchain forensic and analytic service BlockTrace traced some of the roughly 6,000 bitcoin stolen from Japanese crypto exchange Zaif. After being broken down into addresses containing amounts of 1.99 bitcoin  — just a shade under Binance’s 2 bitcoin KYC limit —  some of those funds found their way onto the exchange.

A spokesperson from Binance would not comment specifically on Zaif, but said that Binance takes KYC seriously and locks funds if there is reasonable evidence of suspicious activity. “Victims do need to file a support ticket and provide a police report and we will work directly with law enforcement to handle the recovery of funds,” the spokesperson said.

Binance recently froze accounts that received more than 93,000 ether from two wallets linked to the troubled Russian exchange WEX (formerly BTC-e). And last month, Binance partnered with crypto compliance and investigation software provider Chainanalysis to implement a global KYC solution. Whether Binance will bring KYC to all  of its customers, though, remains to be seen. 

In the beginning

By some accounts, the founder of Binance is a wealthy man, even though he dresses modestly in black hoodies and doesn’t own flashy cars. In February 2018, Forbes estimated CZ’s crypto wealth at $1.1 billion to $2 billion, mainly due to his large stake of BNB coins. (More on that later.)

Born in China, CZ moved to Canada when he was 12. He attended high school in Vancouver and university in Montreal. After graduating, he sharpened his trading software skills at a firm in Tokyo. In 2001, he landed at job at Bloomberg in New York City, where he spent four years developing software solutions for futures trading. In 2005, he and two partners launched Fusion Systems, a Shanghai-based company focused on building high-frequency trading systems for brokers.

CZ’s foray into bitcoin can be traced back to September 2013. His friend Ron Cao, an institutional investor told him about opportunities in the crypto space. (Cao was later an angel investor in Binance.) Cao had just backed BTC China, now BTCC) one of the largest crypto exchanges in China at the time. Another friend, Bobby Lee, the CEO of BTCC, also encouraged CZ to invest in bitcoin.

Soon after, while researching bitcoin and attending conferences at the end of 2013, CZ stumbled into bitcoin investor Roger Ver — now, also a Binance backer) — in Tokyo. The meeting led him to join Blockchain.info, a crypto wallet and blockchain explorer project. CZ also held the position of CTO at crypto exchange OKCoin for a short stint, before leaving amid controversy.

Finally, in early 2015, CZ joined a few friends in starting BijieTech, a company that was building exchange platforms as a cloud solutions for other exchanges. A system they built from scratch would later become the basis for the Binance trading engine.  

Binance coin is born

In mid 2017, the crypto markets were afire. At a potluck dinner in mid-June 2017, CZ heard more about the ease of raising money via an ICO. Not one to shy away from opportunity, in a matter of days, he and his team threw together a white paper that spelled out the basic ideas for a business.

Nine days later, at the height of the ICO bubble, Binance launched its own ICO. The project raised $15 million after selling half of its 200 million supply of BNB tokens. The founding team kept 80 million of the tokens (40% of the total) while another 20 million went to angel investors. A month later, the exchange was up and running.

But soon after Binance’s token fundraise, China’s central bank banned all ICOs in the country. It required that any company that raised money in an ICO return the money to investors. CZ claims he did his best to try and return the funds, but since BNB had already gone up substantially in value,  nobody took him up on the offer. “The government forced the projects and the exchanges, but they couldn’t force the individuals,” he told Epicenter in May 2018.

Worth $0.11 in July 2017, the price of BNB soared to $24 six months later. As with nearly all tokens, BNB is down substantially in 2018 and is worth around $9 today. Every quarter Binance uses 20 percent of the profits from its business to buy back and burn BNB coins- i.e. destroy them. The plan is to continue buying them back over time until the entire supply is reduced by half. This mechanism is akin to corporate stock buybacks where reducing the number of shares increases the value of each. Mathematically, for every BNB token Binance burns, the remaining ones have a slightly higher claim to the profit distribution.

For instance, if 10 percent of the supply of BNB is burned, the value of that 10 percent is spread proportionally to the people still holding the remaining 90 percent of the coins. The mechanic of the burn acts like a regular “dividend” for token holders and is one reason why some people insist BNB is a security. It’s worth reiterating, though, CZ disagrees.

Currently, BNB lives on the Ethereum blockchain as an ERC-20-standard token. CZ told Epicenter that some of his friends advised him not to do an ICO because Binance was not a blockchain-based project. “I kind of ignored that,” he said. “I said, look, you have a digital blockchain token that people can trust. And if it has an association with [an ERC-20] project and your project as well — and this token will rise in value — I think that model will work,” he said.

Meanwhile, Binance has given the token a slew of utility. Traders can use BNB to pay for trading fees on the exchange — they currently get a 25 percent discount if they do. BNB can also be used to buy other tokens on the platform including certain ICOs listed through Binance’s Launchpad program.

Eventually, the plan is for BNB to play a central role in a decentralized exchange that Binance hopes to launch in coming months. Binance Chain, as the platform is called, will exist as a public blockchain for the transfer and trading of digital assets.

More security tokens

Earlier this year, U.S. Security and Exchange Commission chairman Jay Clayton stated that in his view, while bitcoin and cryptocurrencies are commodities, nearly all ICO tokens are securities. As of this writing, Binance lists roughly 158 coins on its platform. Similar to BNB, many of those resemble securities, but lack the disclosure requirements and investor protections found on regulated stock exchanges.  

In an Unchained podcast in September 2018, CZ told the interviewer that if a project wants Binance to lists its coin, they first need to get a letter from a lawyer stating they are not a security. At least one lawyer was appalled by the statement. “Who is signing these things?,” tweeted Preston Byrne, an English lawyer. “Most lawyers I know won’t provide these legal assurances.”

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While Binance claims to scrutinize the tokens it lists on its main trading platform, the forthcoming Binance Chain will allow users to trade nearly any coin they want. “That’s the philosophy of the decentralized exchange, it’s freedom of choice, freedom of investments,” he told Bloomberg in March 2018. “But with freedom there will be people who are scammers. That’s not something we can control.”

U.S. and European regulators may not be on board with such freedoms. In March 2018, the SEC issued a clear warning that crypto exchanges listing securities need to follow the same laws as other exchanges — they need to register through the SEC as a national securities exchange, an alternative trading system, or a broker-dealer. Binance has thus far done none of those.

More recently, the SEC followed up on that warning when it brought charges against the founder of Denver-based EtherDelta for operating an unregistered exchange. This was the first enforcement action against an allegedly illegal crypto exchange — and an indication of what may lay ahead for exchanges that continue to flout the rules. Still, CZ seems unfazed. He claims he is not targeting the U.S. “We are doing promotions everywhere else; other than the U.S.,” he told Unchained. “Most people have this mindset you have to stay in one place and work one government. Why can’t you go to a place and work with a government you choose?”

Amy Castor is an independent journalist and a frequent contributor to Bitcoin Magazine. She began her career by starting a company that created content for high tech companies. She eventually got fascinated by the crypto industry and started writing for Forbes and CoinDesk.