South Korea has long been considered one of the world’s most innovative and dynamic digital economies. The home of Samsung and LG, South Korea led the world in diffusing ubiquitous fiber-based broadband in the early 2000s, provided the benchmark for uptake of online gaming, and its K-pop audio and video phenomenon defined an entire new entertainment genre.

South Korea has also been at the forefront of the burgeoning new world of cryptocurrencies. As of August 2021, over 300 companies were estimated to be operating in the Korean cryptocurrency space, including 79 identified as cryptocurrency exchanges. On August 3, these exchanges accounted for 9.4 percent of global transaction volume.

Exchanges: The weakest link

Cryptocurrency exchanges are the “weak link” in the cryptocurrency ecosystem, in large part because most individuals using wallets managed by the exchanges do not actually hold crypto assets. Rather, they own a promise to pay the balance in a given currency (similar to bank deposits). Most high-profile losses associated with cryptocurrencies have thus occurred when lax information security has led to theft from an exchange and, hence, inability to meet account holders’ claims.

Consequently, there have long been calls for prudential regulation of cryptocurrency exchanges in a similar manner to that of conventional banks. Japan began cautiously down this path in 2017, requiring exchanges to register with its prime minister. However, this proved of little use in 2018 when a theft occurred at the Coincheck exchange.

The problem is: Due to the different technologies used, the risks with crypto exchanges are not necessarily the same as those that conventional banks and securities face. Hence, conventional regulators and their tools are not best placed to identify the presence of a problem, take the necessary action to thwart it, or devise remedies when risks crystallize.

Self-regulation: The first recourse

In an embryonic market like cryptocurrency exchanges, industry self-regulation might be an optimal first option. Those aware of the intricacies are best placed to draw up codes of conduct and form alliances of exchanges adhering to specific codes. “Good” alliances are best placed to monitor the ethical behavior of their members and use refusal to admit or ejection from the group as checks against less-ethical traders.

As consumers will prefer better codes or alliances over poorer ones, competition will lead the best codes to not just survive but prevail, as the worst ones fail from lack of customers. These arrangements prevailed in the governance of embryonic share markets at their outset and subsequently amongst banks. They have also been evident in the crypto space, with the Japanese Virtual Currency Exchange Association, the Korea Blockchain Association formed in 2018 by cryptocurrency exchanges, and CryptoUK.

Enter governments

Nonetheless, in March 2021 the South Korean government began establishing a more formal regulatory environment for cryptocurrency exchanges under the Act on Reporting and Using Specified Financial Transaction Information. In this respect, it is ahead of the United States, the European Union, and many other countries in establishing government oversight of the sector.

The new legislation covers all Virtual Asset Service Providers, including all exchanges, custodians, asset managers, and wallet-service providers, which must register with the Korea Financial Intelligence Unit. In addition, they must be certified by The Korea-Information Security Management System, ensure their customers have real-name bank accounts, and ensure their CEOs and board members have not been convicted of a crime. Moreover, cryptocurrency exchanges are required to partner with domestic banks, establish real-name bank accounts for their customers, and provide proof of adequate levels of deposit insurance to cover potential losses from hacks.

By requiring exchanges to partner with banks, South Korean regulatory and law enforcement agencies will have access to crypto transaction data for their various investigative purposes. This is purported to ensure anti–money laundering activities are enabled and that evasion is countered.

However, as the implementation deadline of September 24 nears, the legislation’s full ramifications are becoming evident. Of all the cryptocurrency exchanges in the country, only the “big four” (Bithumb, Upbit, Korbit, and Coinone) hold partnerships with local banks suitable for the real-name account trading provisions. Understandably, banks have been reluctant to provide these services to what they perceive as their competitors. Only around 20 exchanges are expected to meet the requirements by the due date. A mass shutdown of exchanges is anticipated, along with the disappearance of a significant number of the so-called “kimchi coins” they manage.

A ‘fix that fails’?

Ironically, the new regulatory regime may precipitate a run on small, vulnerable exchanges — a “regulatory fix that fails,” so to speak — if the exchanges have more claims than they are able to satisfy. There is much the US can learn about a potential future regulatory regime from observing South Korea’s as September 24 comes to pass.

Bronwym Howell is a nonresident senior fellow at the American Enterprise Institute.

This article was first published by the American Enterprise Institute.