Why Are Regulators So Cautious About Crypto Derivatives?

For little over a decade, cryptocurrencies have largely escaped regulatory scrutiny, but things are changing.

This July, the UK’s Financial Conduct Authority (FCA) published two vitally important documents detailing its final guidance on if and how government ought to regulate crypto assets, as well as its preliminary stance on crypto derivatives.

In short, it reads that regulation is in order whenever crypto assets have the characteristic of ‘securities’ — i.e. tokens that constitute equity, debt, or are integral to a collective investment scheme. However, exchange tokens, such as Bitcoin, continue to fall outside of the UK’s regulatory parameters.

In the FCA’s initial proposal to ban the sale of crypto-derivates to retail investors though, there are wider considerations at play.

The 2008 Financial Crisis

The FCA’s cautious stance towards crypto derivatives, and in particular its explicit focus on retail investors, can best be understood against the backdrop of the 2008 Financial Crisis — arguably the worst economic disaster since the Great Depression of 1929.

While initially linked to falling housing prices and banks selling too many mortgages, it soon became clear that the actual problem — causing the crisis to escalate beyond the housing sector — had to do with the widespread practice of selling mortgage-backed securities and other unregulated derivatives.

What had effectively happened was that banks had chopped up mortgages and resold them in bundles of higher-yielding and seemingly safe derivatives, but whose underlying assets were hard to price accurately. These high yielding and in some cases triple-A-rated securities became extremely popular and drove near-insatiable demand for more and more mortgages. So when housing prices fell in 2006, triggering defaults, risks were quick to spread into mutual funds, pension funds, and corporations who owned these opaque products.

It is worth noting that it was during this time — shortly after US investment bank Lehman Brothers filed for bankruptcy — that Bitcoin was born.

In response to the crisis, following The Pittsburgh Summit in 2009, the G20 released a communique in which it reflected and resolved to make an end to an ‘era of irresponsibility’, rein in the ‘excesses that led to the crisis’, and drastically reform ‘over-the-counter derivatives markets’.

Ten years later though, derivatives remain attractive as they provide a way to lock in prices and to hedge against unfavorable market conditions. We can see this expressed in the crypto industry where the market for crypto derivativesis heating up.

But their complexity in some cases remains a concern for regulators. And, when built on top of cryptocurrencies which themselves have proved to be volatile and follow a valuation logic that differs from what may apply to conventional asset classes, there is some perhaps legitimate concern on how some of these assets should be regulated and who should be permitted to buy them.

This historical backdrop, as well as the complexity of derivatives, explains the overall caution. It also clarifies why the FCA is inclined to limit crypto derivatives trading to professional investors, who by definition should be better informed of the risks of such investments.

A Call for Collaboration

The regulator’s position is not an enviable one. Its conundrum is that on the one hand it is tasked with providing adequate protection mechanisms, in particular for less-informed market participants, while on the other hand, it needs to ensure that the business environment is conducive to growth — and if there is anything to be said about the crypto industry, it is that with respect to finance, technology, and business, it is consistently cutting at the edge of innovation.

Far from shunning the regulator, it is our view — as a next-generation crypto exchange — that constructive collaboration is necessary if we want the industry to move forward and really start to add value to the mainstream economy. Such collaboration also entails crypto exchanges joining the regulator in learning from the past and applying best practices.

Just as in conventional financial markets, there is a place for derivatives and the undeniable benefits they bring. But the deployment of crypto derivatives should be coupled with:

• responsible advertisement;
• a concerted effort to educate potential investors;
• in-built mechanisms to guarantee timely liquidation;
• transparency and accountability; and
• market integrity.

The elegance of cryptocurrency lies in the fact that it was born from a drive to decentralize the economy, distribute power, and foster financial inclusion. Now, as the market matures and expands to include institutional investors, the challenge is to retain that openness and inclusivity.

This is what it means when we say, that with AAX, we’ve built an institutional-grade platform, for everyone.

About the author

Avina Lobo oversees legal and compliance at AAX.

Originally published at https://blog.aax.com on September 3, 2019.