Factors Keeping Centralized Crypto Exchanges Secure & Compliant

Centralized cryptocurrency exchanges (CEXs) are gateways to the digital ecosystem. They're the on- and off-ramps that help people buy, sell, and trade cryptocurrencies, as well as offering custodial solutions for those that don’t want self-custody crypto. Even in a world where decentralized exchanges are prevalent, centralized exchanges offer hardened security protocols against hackers and a more robust trading environment that many institutional and retail traders prefer.

That doesn't mean centralized exchanges are immune to security breaches. Over the past year there have been a number of regional CEX's that have been hacked.

These hacks serve as lessons learned for the industry as a whole and help to further security and compliance measures against future hacks. As Binance Head of Regional Markets Vishal Sacheendran explains, "At the end of the day, a hack on one of our own people within the industry is a hack on the entire industry. Everyone takes a hit, not just the users but also the regulators and the critics of crypto. It's an opportunity for us to come together, rebuild trust, and show that we are capable of helping each other. This year alone, Binance has helped recover over $80 million in stolen funds, and we’ve helped prevent billions in fraud. It’s all about collaboration and education, because as an industry, we grow stronger when we work together.” 

That centralized role of these exchanges means a stringent set of security and compliance protocols. However, the red tape is a selling point for newcomers and institutions. It's a sign that everything is above board and correct, and there are certain investor protections in place for centralized exchanges that offer custodial solutions. Here are the main factors that contribute to the security and compliance of centralized exchanges.

KYC, AML, and Constant Oversight

These principles go against the classic ideals of the blockchain, but they're old-world banking practices brought into the new world. Know Your Customer and Anti Money Laundering compliance are just two ways that the institution is required to take all your personal information. 

The anonymity of Web3 is simply too hard for the old world to accept. Robust KYC and AML procedures will capture government-issued ID, proof of address, and more. This allows the platforms to vet their users and, perhaps more importantly, comply with various nations' tax demands and requests for personal information.  

Constant transaction oversight is the next step, and it is important to look for patterns that could suggest money laundering or other financial crimes. The exchange bears significant responsibility for transactions and so must stay one step ahead of the criminals with pattern recognition and AI-driven analysis of transactions. There are reporting requirements with the local tax authorities, as well.

Of course, this is the antithesis of the new breed of Web3 decentralized exchanges where you can sign up with just a crypto wallet address and nothing more. These often exist with licensing outside the established financial framework. This is what it takes to achieve full compliance and keep the likes of the Financial Action Task Force at bay.

Constant Proof of Funds

Exchanges constantly have to prove their liquidity, which is not a bad thing. A Proof of Assets (PoA) protocol allows the exchange to demonstrate its solvency at all times and ensure its funds and trades are properly backed at all times. Binance is the largest centralized crypto exchange and provides an updated proof of reserve report for each of the coins on their exchange. 

To maintain their licenses and secure their walls, centralized exchanges run a constant stream of security assessments, internal and outside audits, and penetration testing. Any centralized exchange with access to thousands of wallets will become a target for hackers at some point, and that's guaranteed. The exchange needs to be prepared for the worst to protect access to its players, their data, and their funds.

Centralized exchanges often fall back on another traditional banking favorite to boost security, too, with Multi-Factor Authentication. Again, Web3 was meant to resign this kind of ID check to the Stone Age, but it's still a popular tactic in heavily regulated markets and industries. 

The CEXs are also championing Multisig Wallets, which add further layers of security to your transactions as they require multiple private keys. It's not foolproof, but this method could be a way to combat the big hacks that are a blight on the industry and show the way to the less regulated markets.

Traditional Banking Practices and Standards

Essentially, a CEX does most of the same things as a DEX for the end user; it's on the organizational side where things get much more complex. The level of certification, compliance, and record-keeping mean centralized exchanges are a world apart. 

They are essential. The user-friendly nature of a centralized exchange, together with the level of regulations, is proving a powerful draw for institutional investors and new investors. Both appreciate the ease, simplicity, and perceived safety of doing business with a centralized exchange backed by a proper set of regulations. Centralized exchanges can also deal with fiat currency, which is essential for new investors.

Everything from employee certification and training to bank-grade SSL protection and collaboration with regulatory bodies worldwide has to be on point. The segregation of duties has to be spot on; the business structure has to be clean, and the processes beyond reproach.

A centralized exchange is held to many of the same standards as an old-world financial institution, and many potential customers like that familiarity that breeds trust.

Conclusion

The world still wants and needs highly regulated, centralized exchanges with the faint whiff of traditional banking. That familiarity with the processes makes customers and institutions flock to centralized exchanges, while they may not trust the new generation of DEXs so readily. So, there's a lot of paperwork, compliance, and plain higher standards with a CEX, but it’s those very things that give confidence to the new crypto investors that want peace of mind when they invest, trade and sell. 

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This post was authored by an external contributor and does not represent Benzinga's opinions and has not been edited for content. This content is for informational purposes only and not intended to be investing advice.