What Are Nested Exchanges and Why Should You Avoid Them?
What is nesting?
Nesting occurs when a financial service provider creates an account with another financial institution to use their services. The account holder then acts as a bridge, offering services to their customers via the nested account. This happens for many reasons. For example, a bank in one country would provide its banking services and ecosystem to a bank operating in a different country, known as correspondent banking.
Imagine a customer who wants to transfer money to a bank account in Australia. Their bank might not be able to do this, but they could use a correspondent bank to transfer the funds for them. The customer's bank would process the transfer request through its nested account with the correspondent bank. The correspondent bank must take care and conduct due diligence on the bank they work with. The correspondent bank essentially serves customers they don't know, so they need to trust the nested account holder.
What is a nested cryptocurrency exchange?
A nested cryptocurrency exchange works in a fairly simple way. An entity or person creates an account with a regulated exchange. They then use this account to offer trading services to third parties through their nested account. These nested exchanges are sometimes known as instant exchanges and often have multiple accounts across different exchanges.
Some may ask for identifying documents, but others might require little to no identification at all. This makes them a popular choice with scammers, fraudsters, and ransomers. Some nested exchanges even allowed for the purchasing and selling of crypto in person with cash.
What's the danger of nesting?
When it comes to traditional finance, one of the biggest problems is the risk of money laundering. As the correspondent bank only deals directly with the underlying respondent bank, they cannot be sure exactly who they are dealing with. This is why nesting requires enhanced due diligence checks on the underlying bank. Individuals or whole countries may be blacklisted and have sanctions placed on them. If an underlying bank doesn't abide by these, the respondent bank may end up supporting illegal activities, such as avoiding sanctions or money laundering.
As the cryptocurrency industry is still developing robust regulations, it's easier for nested exchanges to operate under the radar. A nested exchange could open an account with a large crypto exchange without them easily knowing.
What are the dangers of nested cryptocurrency exchange?
When you use a nested cryptocurrency exchange, it doesn't just hurt centralized exchanges. You and your funds are also in danger for several reasons:
1. Your deposits have fewer guarantees on their safety than with a regulated exchange.
2. You might be supporting illegal activities that fund crime and terrorism.
3. Regulatory authorities may shut down the exchange, causing you to lose your crypto or other funds.
4. You could face legal repercussions from law enforcement if you knowingly work with an exchange that is involved with illicit activity.
The best way to avoid these is not to use nested crypto exchanges. Spotting them can be tricky as it's not always obvious. Follow our tips later on for the best chance to protect yourself.
What's the difference between a nested exchange and a decentralized exchange?
At first, a nested exchange and a decentralized exchange look similar. Decentralized exchanges require no KYC, and nested exchanges can have lax KYC processes or none at all. However, the way they deal with transactions is different. A decentralized exchange will connect buyers directly to sellers or even use liquidity pools. The exchange will never take custody of the traded cryptocurrency. Instead, smart contracts handle the process. However, a nested exchange will take direct custody of your crypto and use the services of another exchange.
The Suex nested exchange incident
Let's take a look at a real-world example. On 21 September 2021, the Office of Foreign Assets Control (OFAC) sanctioned the Suex cryptocurrency exchange incorporated in the Czech Republic and operating out of Russia. Suex OTC provided a nested cryptocurrency exchange service using Binance and other large exchanges to serve its customers. Suex offered little to no KYC and even provided in-person cash exchanges for crypto.
According to Chainalysis research, Suex helped launder a large number of funds from ransomware attacks and hacks. Binance proactively deactivated several accounts associated with Suex, and the OFAC blacklisted almost 30 different Bitcoin, Tether, and Ethereum wallets. Binance’s offboarding also included Chatex, a cryptobank with reported ties to Suex. Chatex has since then faced related sanctions from the OFAC. Anyone having dealt with Suex is now at legal risk, and they have taken down their website since the OFAC decision.
How to spot a nested exchange?
Nested exchanges typically won't make the fact they are a nested exchange obvious. The following points are a good start in spotting a nested exchange and keeping you and your funds safe:
1. They don't require KYC or AML checks or have minimal requirements. Signing up for an exchange almost instantly without any limits is a good warning.
2. The UI doesn't clearly show where trading takes place.
3. There is no clear statement that the exchange is facilitating trades. A legitimate exchange will state trading takes place directly through its platform and not a nested account.
4. The exchange aggregates different rates you can choose from. This means that the exchange is using nested accounts with multiple exchanges.
5. If you suspect that you have used a nested exchange, try following your crypto's trail on the blockchain with a blockchain explorer. You may find that it has come from a wallet associated with another exchange.