The concept of a bitcoin exchange is not new. There is however a noticeable absence of a reliable, efficient and cheap exchange for conversion. The recent bitcoin price volatility has contributed to a frenzy of mainstream press attention, steering the discussion away from the merits of the payment system, and toward the question of whether there is in fact a bubble and whether bitcoin will cease to exist.

Bitcoin supporters tend to agree that more stability against the dollar would spur wider adoption, but that can only be achieved if there are reliable wholesalers to provide liquidity and price discovery. This role would normally be filled by exchanges and market makers, but the current bitcoin exchanges have so far been unable to operate reliably enough to attract established liquidity providers.

The short history of bitcoin exchanges is marked by a pattern of consistent disruption, often caused by technology problems or issues managing client funds. Examples include Bitcoinica, a player that went down after two hacker intrusions involving coin theft, and Bitfloor, a one-man-show that ended when the bank unilaterally closed the company’s account. Mt. Gox is the leading exchange today and is notorious for its inability to handle spikes in trading volumes.

In the race currently underway to create digital currency exchanges, VCs and new startups alike are placing more attention on regulatory compliance than technology and operations. Until March 18th, digital currency businesses were operating in a near-complete regulatory void.

FinCEN (Financial Crimes Enforcement Network) has said that “exchangers of virtual currencies” are money transmitters. Businesses that exchange bitcoin for dollars - and vice versa - are therefore strongly encouraged to follow regulations that apply to this specific subcategory of money service businesses. Generally, this means companies should register as money transmitters with each US state in which they have customers.

The state of Ohio, for example, currently supervises 63 registered money transmitters. Among them, we find Western Union, MoneyGram, PayPal, Xoom, etc... The common element is that these businesses act as intermediaries between a sender and a receiver of cash. The term transmitter makes perfect logical sense when a business facilitates a payment between two parties.

Whether they be forex or digital-to-dollar, exchange transactions are not payments. No value is transferred (transmitted) between any two parties. The business model of exchanges consists in creating a marketplace where persons with complementary needs are anonymously matched. This is fundamentally different from an internet payment system.

The digital currency ecosystem is still developing, and therefore service providers often integrate vertically. For instance, bitcoin exchanges today maintain customer account balances, much like a brokerage. Businesses and customers are in a one-to-one relationship, unlike the three-way relationship occasioned by a payment via money transmitter.

Sifting through the lists of other US states’ registered money transmitters, we don’t find businesses whose model resembles that of an exchange or a brokerage. Why then the money transmitter categorization? We can only speculate.

When technology races ahead, legislation lags behind. This is a normal phenomenon, but it is a real problem for innovators who face a legal void. Anything related to money is highly sensitive, and as such regulators tried to fill the void around digital currency as quickly as possible, and the result is stopgap regulation.

Sending bitcoin is practically free and requires no intermediaries. This new internet technology may eventually make money transmitters obsolete. PayPal recognized this fact and said the company is “looking at bitcoin closely”, presumably to find a profitable way to integrate bitcoin into their system. Perhaps the individuals at FinCEN who assigned money transmitter status to exchanges simply attributed bitcoin’s properties to any company dealing in bitcoin.

Further evidence of confusion arose in June when California’s Department of Financial Institutions issued a cease and desist warning to the Bitcoin Foundation. The Foundation is a non-profit registered in Washington, DC. The only financial transactions it is involved in are donations and membership fees coming directly from supporters. Yet, California urged the Foundation to stop “conducting the business of money transmission” without a license.

It is hard for the casual observer not to take these early legal skirmishes at face value and then wonder: can regulators possibly be that ill-informed? The reality, however, is more subtle. Marco Santori, the New York attorney who recently joined the Foundation to head the Regulatory Affairs Committee, explains that California regulators are acting politically: the preemptive purpose of the letter is to engage the Foundation in a dialogue. By doing so, California hopes to gain information while safeguarding against future blame for standing by idly while digital currency grew out-of-control.

Another theory is that FinCEN understood the nuances between the various business models clearly, but settled on money transmitter because registering with 48 states is a long and expensive process. The guidance, in effect, slows progress down. Whether government intends to adequately regulate or kill bitcoin, buying time seems like a savvy tactical manoeuver.

Currency markets are intrinsically global, and if bitcoin is the currency of the internet then global is even more fitting for bitcoin. There is little sense in deferring to the states to individually regulate an industry that is global. What the industry needs is uniform regulation that matches the sophistication of potential fraud. Financial regulation’s other purpose is to prevent crimes like money laundering and funding terrorists. What the public needs is strict rules at the federal level.

Money transmitter registration aims to protect consumers from dishonest or incompetent remittance processors. But acquiring the 48 licenses does little to protect consumers from reckless risk-taking by their digital currency brokers. Nor does it ensure fairness in the marketplace. Digital currency trading already presents these risks today. As the market grows, the need to protect small investors from price manipulation by large players, or simply from firms going bust, will become more evident.

Digital currency markets are conceptually so similar to forex and commodities markets that their regulation will eventually fall under the same jurisdiction. A public statement in May 2013 by Bart Chilton, commissioner at the CFTC (Commodity Futures Trading Commission), that bitcoin “is for sure something we need to explore”, lends credence to this view. Chilton told the Financial Times that his agency, which also supervises retail forex trading, was “seriously examining” the issue.

There is an arms race to create digital currency exchanges. Many of the new startups in this space waste precious time and resources trying to build their system from the ground up. The necessary back-end technology already exists, and replicating it is an expensive, complicated endeavour.

Even more wasteful is the choice to invest a year and a million dollars applying for 48 money transmitter licenses. The key to operating an exchange successfully is to have a strong relationship with the banks that act as custodians of customer cash funds.

As David Landsman from the National Money Transmitters Association will attest, a money transmitter license does not help: once banks know that a business is a money transmitter, they typically reject account applications. Once a relationship with a bank is established, the business no longer needs the license because banks are exempt.

Most likely is the prospect of a shift toward regulations under agencies such as the CFTC, which would make the lax money transmitter supervision mandated by FinCEN irrelevant. When this shift occurs, only companies with experience of securities compliance will survive.

This guest post was co-authored by Ken Abe and Shawn Sloves from Atlas ATS. Ken is a software developer and co-founder of Atlas ATS, a digital currency exchange based in New York City. Shawn is a partner at Atlas ATS. He is also the CEO and Co-founder of Fundamental Interactions. Previously, Shawn was a Co-founder and Head of Product & Strategy at Mantara Inc.