JFSA Virtual Currency Study Group #7: Derivatives & Margin Transactions
The Japan financial regulator, the Financial Services Agency (FSA), held their seventh virtual currency study group on Friday, October 19, focused on regulations concerning derivatives transaction with virtual currency underliers, and margin transactions in virtual currency.
Derivatives Transactions
Current state
Currently, nearly half of virtual currency exchange operators offer virtual currency margin transactions. This is a form of virtual currency derivative trading, and it is also assumed that a new type of derivative transaction will be developed in the future.
According to the data of the Japan Virtual Currency Exchange Association, in fiscal year 2017 (ending March 2018), virtual currency derivative transactions account for about 80% of the total domestic virtual currency transactions.
Due to the inadequacies on the dealer systems and uncertainty around the scope of the service, a considerable number of customer complaints have been received by the FSA.
Currently, virtual currency derivative transactions are not subject to financial regulation because virtual currencies are not included in the underlying assets of derivative transactions prescribed by the Financial Instruments and Exchange Act in Japan.
Necessity of financial regulation
In discussing previously the necessity of financial regulation, the following viewpoints were regarded as important.
- Whether individual actions using virtual currency have the function of finance (accommodation of money, etc.)
- Whether the introduction of financial regulation is expected based on the social significance including the future potential of virtual currency and the existence of risk such as promotion of speculation in the case of having a financial function
Derivatives transactions are contracted in advance for trading of underlying assets at a certain price in the future for various purposes such as avoidance and reduction of price fluctuation risk, and generally, it is thought that they have a function to convert cash flow according to the will of the transacting parties.
For this reason, in the Financial Instruments and Exchange Law, a framework has been developed that allows derivative transactions to be subject to financial regulation regardless of the underlying asset. Based on these considerations, it seems appropriate to think that virtual currency derivative transactions also have financial functions.
Note: Under the current Financial Instruments and Exchange Law, derivative transactions that refer to financial instruments (securities, deposits, currencies, etc.) and indicators (price, interest rate and weather observations, etc.) are subject to business regulation. It is also possible for cabinet orders to decide what it is deemed necessary to secure the protection of investors for derivative transactions related to such assets and to subject them to business regulation.
If it is assumed that regulations are required, what kind of regulation is appropriate? Instead of banning virtual currency derivative transactions, it is also possible to establish certain regulations based on the current virtual currency function and risk, and to protect users and ensure appropriate transactions.
Contents of regulation
Rules based on similarity with OTC derivatives transactions
- When introducing regulations on virtual currency derivative transactions,, the following regulations are imposed on persons who conduct currency-related OTC derivative trading (Type 1 financial instruments business dealers) under the Financial Instruments and Exchange Act. It is considered necessary to apply at least the same regulations to those who carry out virtual currency derivative transactions in view of their functions and similarity of transaction contents.
- Minimum capital and net asset regulation
- Obligation to improve business management system
- Advertisement / recruitment regulation
- Delivery of written documents, etc. before contract signing
- Request for explanation
- Separate management obligation of customer vs. proprietary assets
- Restrictions on upper limit of margin magnification and loss cut - As for the upper limit of the margin ratio, it is thought that an appropriate level should be set according to the price fluctuation, which is currently large for virtual currencies.
Note: At present, domestically, some vendors set the margin ratio of virtual currency derivatives trading to 25 times (i.e., the same as FX margin trading), but according to the draft self-regulation rule of the Japan Virtual Currency Exchange Association , the maximum amount of margin shall be stipulated as four times.
Rules based on the specific characteristics of virtual currencies
- By using virtual currency as the underlying asset, the virtual currency derivative transaction can be impacted, for example, by the customer’s insufficient knowledge of the characteristics of the virtual currency, handling of a problematic virtual currency (eligibility as a underlier target).
- For this reason, it virtual currency derivatives dealers should be subject to similar regulation as required by the virtual currency exchange trader.
- Furthermore, if it is considered that the risk of (for example) excessive speculation is bigger than the social significance of virtual currency derivative transactions, and individuals exposed to such risk have insufficient knowledge about capital and virtual currency, further measures should be taken to prevent them from transacting.
- Measures to restrict transactions of persons who are deemed inappropriate to conduct transactions such as insufficient resources
- Setting of transaction start criteria (minimum margin etc.)
- Thorough awareness of customers
Margin Transactions
Current state
Currently, virtual currency margin transactions are provided at multiple virtual currency exchange operators. Although conducting trading and exchange of virtual currencies as a business is subject to regulation by the fund settlement law, there is no financial regulation for the virtual currency margin transaction itself.
Necessity and contents of regulation
Virtual currency margin transactions are virtual currency derivative transactions in that they carry out leveraged transactions on the original funds (deposits). Although there is a difference between virtual currency margin transactions and notional principal transactions, the transactions perform the same function and incur the same risk.
When virtual currency margin transactions are deemed to have functions and risks similar to those of virtual currency derivative transactions, they may be covered by regulations similar to those of virtual currency derivative transactions.
Appropriate transition measures
At the time of introducing the regulation to the virtual currency exchange industry (April 1, 2017), it was deemed that confusion and disadvantage may be caused to the customers by not allowing operations until the completion of the examination of registration etc. for those exchange operators who were doing business before the enforcement of the law. Based on that, the following transitional measures were established with reference to other financial regulations:
- At the time of the enforcement of law, those who have been conducting newly regulated work can perform the work without registration for six months after the enforcement (and had to file their exchange application by September 30, 2017)
- When applying for registration within the period, if the period has elapsed, the same treatment as above shall be dealt with until the registration, the refusal disposition, or the discontinuation of operations for that application is received.
It was pointed out that the registration review was not completed in time, and that the exchange operators proactively advertised and rapidly expanded their business, and at that time, many customers asked what a “deemed dealer” is (i.e. an exchange operator with a pending exchange application who is allowed to continue operating), a clear indication that they did not understand the regulatory regime.
Based on the lessons learned, to introduce business regulations related to virtual currency derivative transactions in the future, the transitional measures need to apply to all companies, such as the following:
- Do not add business transactions or virtual currency
- Do not acquire new customers or do not advertise or solicit for the purpose of acquiring new customers
- Indicate on the company websites that formal registration has not been received, or when there is a refusal of registration, state that the business will be shut down
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