Posted on Monday December 2, 2019
Thomas Hulme, Cryptoasset and Blockchain solicitor at Mackrell.
In January, the Financial Conduct Authority (FCA) put forward a proposal that would see a ban on crypto derivatives for retail investors, including options, futures, contracts for difference (CFDs) and exchange-traded notes with underlying (unregulated) cryptoassets.
The proposed rules were to be introduced to “address harm to retail consumers” from the sale of derivatives and exchange-traded notes (ETNs) and was originally intended to be reported on following consultation that ended on 3 October.
The FCA estimated that the potential benefit to retail consumers from banning these products would be in the range of £75 million to £234.3 million a year.
It believes that crypto derivatives were ill-suited to retail consumers who cannot reliably assess the value and risks of derivatives or ETNs.
What is a crypto derivative?
Derivatives are financial securities based on or tied to another base asset. Their value and behaviour are derived from the base asset or assets.
They are typically created via a contractual agreement between at least two parties, centred on the assets in question, and priced according to fluctuations in the price of the base asset.
Crypto derivatives tend to be sold on an unregulated basis, so they would not typically fall under the FCA’s remit, but there is a significant standardised derivatives market on exchanges.
Where the crypto market enters this sphere is that several prominent names have begun selling derivatives where the base asset is a cryptoasset, such as Bitcoin.
Cryptoassets are seen as distinctly risky ventures, but the idea of crypto derivatives is that it allows people with risk-management experience to enter the sphere and potentially reap larger profits from the volatility of the markets, while also lowering the risk factor for the market as a whole by supporting and stabilising it.
Why are they less suited to retail consumers?
In its initial report, the FCA said that crypto derivatives were unsuitable for retail consumers i.e. regular, non-professional investors, because of the:
- inherent nature of the underlying assets, which have no reliable basis for valuation;
- the prevalence of market abuse and financial crime in the secondary market for cryptoassets, such as cyber theft;
- extreme volatility in cryptoasset prices movements; and
- inadequate understanding by retail consumers of cryptoassets and the lack of a clear investment need for investment products referencing them.
In its approach, the FCA hoped to prevent inexperienced investors from losing out on a market that was complex and ever-changing.
It believes that “retail consumers might suffer harm from sudden and unexpected losses if they invest in these products.”
What did the ban propose?
The ban proposed that the sale, marketing and distribution of all crypto derivatives and ETNs that reference unregulated transferable cryptoassets by firms acting in, or from, the UK.
The FCA said that the move to regulate the derivatives market for cryptoassets would fulfil its commitment to the UK Cryptoasset Taskforce Final Report.
At the time, Christopher Woolard, Executive Director of Strategy & Competition at the FCA, said that the regulator would “act when we see poor products being sold to retail consumers.”
He described crypto derivatives as “complex contracts built on top of complex assets.”
He added: “Most consumers cannot reliably value derivatives based on unregulated cryptoassets. Prices are extremely volatile and as we have seen globally, financial crime in cryptoasset markets can lead to sudden and unexpected losses. It is therefore clear to us that these derivatives and exchange-traded notes are unsuitable investments for retail consumers.”
Where is the ban now?
The report of an impending crypto derivative ban by the FCA was met with great controversy, with several cryptoasset stakeholders in the UK condemning the restriction.
In fact, the World Federation of Exchanges (WFE) declared that a ban on crypto derivatives “wasn’t a good idea”. While many others have said that the ban would do little more than force digital innovation out of the UK and into other jurisdictions with a less well-regulated financial marketplace.
Many hoped that the Government would interject and keep the market open, but it has said it is powerless and cannot to interfere with any decision by the Financial Conduct Authority (FCA) regarding the fate of crypto derivatives.
John Glen, Economic Secretary to the Treasury told stakeholders on 21 October that the FCA was an independent body and had “made a commitment to consult on the prohibition”.
He added that “the final decision on this consultation is a matter for the Financial Conduct Authority (FCA), which is operationally independent from government.”
Although the consultation ended on 3 October 2019, the FCA is yet to publish its findings or recommendations, which has left many unsure of where to turn next.
Whilst many hope the ban will not go ahead, many fear that the FCA will feel that it has a greater responsibility to protect consumers.
The WFE has been leading the way in suggesting alternatives to an outright ban. They are calling on the FCA to adopt a “nuanced approach” instead of a ban, which would considerably affect its members who trade in crypto derivatives.
It has said that the FCA needs to find a way of balancing the need for investor protection, while not seriously harming the UK’s crypto market.
Next steps for investors
As the FCA is yet to provide further clarity on its earlier proposals many investors are now left in limbo.
Globally, financial regulators are taking a much more critical view of cryptoassets and we have already seen discussions of outright bans in India, South Korea and China.
In the US, the Financial Crimes Enforcement Network has also indicated that it feels greater regulation after accusing the crypto-market of being a conduit for illegal activities.
It is introducing new regulations such as know your customer (KYC) and anti-money laundering (AML) and the Bank Secrecy Act, which are designed to ensure crypto markets operate within the law.
This is certainly an area that merits closer inspection and will require stakeholders to have legal advice at hand to ensure they are operating inside the complex regulatory regime.