In October 2020, the UK Financial Conduct Authority (‘FCA’) imposed a ban on the selling of cryptocurrency-related derivatives (‘crypto derivatives’) to retail investors. The FCA implemented this ban after concluding that cryptocurrency as a reference asset in any derivatives product is opaque, complex, and unreliable. In Europe, the European Securities and Markets Authority (‘ESMA’) has taken a similar view regarding crypto-derivatives and imposed a temporary ban on that ground that crypto-derivatives are extremely volatile, and expose consumers to harmful, speculative, and risky trading. While regulators in different jurisdictions have begun strictly scrutinizing crypto-derivatives and other forms of risky crypto-assets to protect investors, the US Commodity Futures Trading Commission (‘CFTC’) continues to regulate these products in an old-fashioned manner by invoking the “self-certification” method. Self-certification of crypto-derivatives contracts requires the listing exchange to verify the contracts are not readily susceptible to manipulation, amongst other requirements. However, given the CFTC’s lack of jurisdiction in the cryptocurrency spot market, it cannot be reasonably demonstrated that trading in the underlying is, or is not, manipulated. As a result, retail investors trading crypto derivatives risk substantial losses.
In my recent paper, I present three arguments: first, crypto-derivatives in the present US regulatory context are a risky and unreliable investment product; second, under the current regulatory framework, the CFTC does not have any visibility into the cryptocurrency spot market and emerging derivatives exchanges, and therefore, there is no effective method available to the CFTC to ensure that the underlying derivatives contracts are not manipulated; and third, in terms of taking regulatory measures, imposing restrictions on crypto-derivatives trading can bring temporary relief in protecting investors’ interests. Nonetheless, in order to provide transparency and regulatory clarity, the cryptocurrency industry is in need of a long-term solution: enacting federal cryptocurrency regulation with a single regulatory agency, mandatory licensing requirements for cryptocurrency spot markets and derivatives exchanges, and a centralized digital trading platform for entities that are involved in trading cryptocurrency-referenced assets. Without centralized cryptocurrency regulation in the US, market manipulation in cryptocurrency spot markets and derivatives exchanges will continue to undermine market integrity and investor confidence.
Analyzing the risks of a crypto derivative
A crypto derivative is a financial contract that derives its value from the underlying asset, i.e., cryptocurrency. In the US, the crypto-derivatives market started in 2014 when TeraExchange—a bitcoin-derivatives exchange—upon approval from the CFTC, self-certified a bitcoin swap contract that allowed investors to trade dollar-dominated bitcoin currency swaps. Following the CFTC’s classification of bitcoin as a commodity, the Chicago Mercantile Exchange (‘CME’) and the Chicago Board Options Exchange (‘CBOE’) launched cash-settled bitcoin futures contracts in December of 2017. In 2019, the Intercontinental Exchange (‘ICE’) introduced physically-settled bitcoin futures and bitcoin options. Subsequent to the CFTC’s classification of Ethereum as a commodity, Eris Exchange introduced an Ethereum futures contract in 2020.
The current volume in the crypto derivatives market is $153.34 billion, while the market cap for all cryptocurrencies is more than $2 trillion. There are over 40 crypto-derivatives exchanges and more than 400 cryptocurrency exchanges. As the market grows, unregulated cryptocurrency exchanges and third-party brokerage firms offering cryptocurrency-referenced assets are also emerging, increasing the risk of spot market manipulation, fraudulent activities, and cyber hacks. Further, cryptocurrencies are extremely volatile, highly speculative, and prone to sudden price drops. Bitcoin’s most recent price drop wiped out $300 billion from the cryptocurrency market. New data indicates that further price shocks are likely.
Image Source: Forbes
In the context of volatility, uncertainty, and price dislocation, the reliability and viability of cryptocurrency as a reference asset is questionable. Likewise, any product that contains cryptocurrency as an underlying asset runs the same risks as cryptocurrency. Crypto-derivative products do not follow any standardized pricing and settlement mechanism, which limits retail investors’ capacity to understand the terms of the product. Moreover, many cryptocurrency spot markets operate in an unregulated or loosely regulated space. In the absence of any specific regulation, the operation of these spot markets obstructs regulators’ visibility into the spot market. Therefore, market abuse, price manipulation, and security breaches in the cryptocurrency market are rampant and directly threaten investors’ interests. Further, investors have a significant lack of understanding regarding the complex nature of cryptocurrency-based derivative products. A studyshows that liquidations of bitcoin futures are higher among retail traders who respond frantically to any sudden price drop in cryptocurrency. In April 2021, as a response to bitcoin’s sudden price drop, the bitcoin futures market saw $10 billion worth of liquidations—the highest since the market emerged in 2014. Liquidation events occur when traders cannot fulfil margin requirements and get sold out of their position; they often exacerbate price movements.
Responses to crypto-derivatives’ risks in different jurisdictions
The underlying risks in crypto derivatives were addressed by the EU and the UK. In the EU, the derivatives markets are regulated by ESMA. In 2018, ESMA first expressed its concerns regarding the EU’s crypto-derivatives market through a Call for Evidence Report. In the report, ESMA alleged that crypto-derivative products are speculative, volatile, and likely to expose retail investors to pecuniary losses. Therefore, the report concluded that these products should be subject to strict regulatory scrutiny. After collecting comments and opinions from market participants, ESMA invoked Art. 40 of MiFIR to adopt a prohibition on the marketing, distribution, and sale of cryptoderivatives to retail investors, stating that “[t]he pricing, trading terms, and settlement of such products is not standardized, impairing retail investors’ ability to understand the terms of product.”
Similarly, in the UK, the FCA imposed an outright ban on cryptoderivatives, alleging that cryptoderivatives, as investment products, are ill-suited to retail investors given that there is no reliable method of assessing their value and market risks. Further, cryptocurrency’s opacity and complexity, and its susceptibility to market volatility, limit retail investors’ ability to make an informed decision on crypto derivatives. Allowing crypto derivatives to grow in the retail market might promote a perception that cryptocurrency is a suitable investment product.
In contrast to the EU and UK’s regulations, the CFTC permits trading of crypto derivatives through “self-certification” under §7(a)(2) of the Commodity Exchange Act (‘CEA’). Under the “self-certification” process, designated contract markets (‘DCMs’) can list a derivative product within 24 hours of certifying to the CFTC that the product complies with the CEA and CFTC regulations. The self-certification process has been questionable since its inception in 2000, especially with regard to listing complex derivatives products. Allowing self-certification of complicated exchange-traded derivatives products creates opacity and unpredictability. Further, “self-certification” requires the DCMs to demonstrate that the underlying contract is not susceptible to market manipulation. However, in the absence of any specific regulation on cryptocurrency and the CFTC’s lack of oversight of the spot market, it is borderline impossible for a DCM to show that the contract is resistant to fraud and price manipulation.
For cryptocurrency, the CFTC has adopted “heightened review,” mandating that DCMs enter into direct or indirect information-sharing agreements with spot market exchanges. In the CFTC’s view, “heightened review” allows the Commission to access market data and detect illicit activities. However, the spot markets are unregulated and many crypto exchanges are based outside the US. Without brining cryptocurrency exchanges under a regulatory framework, it is unlikely that “heightened review” will prove to be adequate in curbing the risk of manipulation in the cryptocurrency market. The limited number of CFTC fraud and manipulation enforcement actions in the crypto market supports this point
In the absence of regulation and visibility into the spot market, cryptocurrency as an underlying asset in a futures contract is unreliable and poses a threat to market participants who are invest in it, especially retail traders. Unlike the CFTC, the SEC has raised concerns regarding investors’ risk in the wake of fraud and market manipulation in the cryptocurrency spot market. The SEC’s view became evident when it rejected a bitcoin exchange-traded product, alleging that the cryptocurrency spot market is not resistant to market manipulation and does not provide adequate investor protection as required by §6(b)(f) of the Exchange Act. Although trading exchange-traded products on national securities exchanges might provide some additional protection, these platforms are not designed to prevent the fraudulent and manipulative acts and practices connected with cryptocurrency spot market.
What can be done?
To establish a robust regulatory framework for crypto derivatives, it is paramount that proper interventions are in place to detect manipulation and fraudulent practices in the cryptocurrency spot market. In order to do so, the regulators must establish visibility and transparency in the spot market.
The UK Model
The US, following the UK (and possibly the EU in the future), could impose an outright ban on the trading of crypto derivatives. Crypto derivatives pose a unique threat to retail investors due to their high leverage and extreme price volatility. The failure of the CFTC to have any oversight mechanism on the cryptocurrency spot market prevents the Commission from exercising its mandate to protect investors from fraud and abusive market practices. Therefore, unless the CFTC establishes a meaningful supervisory mechanism to oversee the cryptocurrency spot market, a ban is likely to act as a warning to investors not to invest in such risky products.
However, a ban comes with its own costs. First, a complete ban may hinder financial innovation. Second, existing cryptocurrency exchanges would be affected by the ban. Third, a ban could prompt crypto firms to migrate to other jurisdictions, underground activities, or black markets. And fourth, a ban is not a complete solution as the market is expanding with new innovative products, such as Facebook’s Diem (formerly known as ‘Libra’), non-fungible and semi-fungible tokens , and DeFi (decentralized finance) products.
In the UK, the FCA has established a registration regime for the entities involved with cryptocurrency exchange businesses that have a presence or market product in the UK, or provide services to UK residents. The UK government is also consulting with various stakeholders and market participants to design an effective regulatory approach that addresses the risk of cryptocurrency and related digital assets, as well as enables safe innovation.
The EU Model
In September 2020, the European Commission adopted a legislative proposal, ‘Regulation on Markets in Crypto-assets (‘MiCA’),’ as part of its ‘Digital Finance Package.’ The regulation aims to establish a coherent and harmonious regulatory regime for cryptocurrency related assets and decentralized finance across the EU and replace existing national frameworks on crypto assets. With a broad scope, MiCA intends to (1) bring crypto-referenced tokens, e-money tokens, stablecoins and any other crypto-assets under a single EU regulatory framework; (2) develop a “market abuse regime” to prevent insider trading and market manipulation; and (3) mandate that crypto assets service providers implement surveillance and enforcement mechanisms to comply with the market abuse provisions. In addition to MiCA, ESMA will continue to regulate financial instruments that come within the purview of its regulatory periphery.
The Japanese and Swiss Models
Japan’s Financial Services Agency (‘FSA’) has accelerated their efforts to regulate cryptocurrency exchanges and trading platforms after a series of high-profile cyber hacks. Japan’s current framework comprising the Payment Services Act (‘PSA’) and the Financial Instruments and Exchange Act (‘FIEA’) is based on the principle of protecting market integrity and investors’ interests. The regulations require cryptocurrency exchanges and entities providing cryptocurrency-related services, including crypto-derivatives trading platforms, to comply with the strict requirements of mandatory registration, implementation of cyber-security tools and anti-money laundering/countering financing of terrorism compliance.
Recently, the Swiss Financial Market Supervisory Authority (‘FINMA’) approved a new digital stock exchange—SIX Digital Exchange (‘SDX’)—a distributed ledger technology-operated single platform that allows investors to trade, settle and store digital tokens via regulated entities. FINMA anticipates that a single platform can potentially balance innovation with market integrity.
Developments in the US
Heightened cryptocurrency regulation is gaining traction in the US. Recently, SEC chairman Gary Gensler remarked that to save the cryptocurrency industry, it’s important that the industry gain the trust of investors. In order to achieve this trust, it is vital that these exchanges are regulated, especially though mandatory registration.
The need for comprehensive regulation in the US is based on five observations. First, current regulation regarding cryptocurrencies is sporadic and divided among different regulatory agencies, thereby creating a potential avenue for regulatory arbitrage. For instance, while the SEC’s jurisdiction includes initial coin offerings, this does not necessarily place all digital tokens under the SEC’s regulatory perimeter. Similarly, the CFTC has concluded that several virtual currencies, such as bitcoin, Litecoin, and Ethereum, are commodities. While the CFTC’s approach in setting out the scope appears to be on a case-by-case basis, a large number of new cryptocurrencies that trade on cryptocurrency exchanges remain unregulated.
Second, the multiplicity of regulations among several federal agencies creates confusion among market participants.
Third, the novelty involved with cryptocurrencies and the platforms that issue them requires a uniform and separate regulatory approach than what is currently applicable. Until recently, regulators have been keen to include cryptocurrency and cryptocurrency-related assets in the traditional financial system. Nonetheless, cryptocurrencies are unique, complex and pose novel threats to the market. Further, opacity and fragmentation in cryptocurrency regulation increases the prevalence of scams and fraudulent activities. Cryptocurrency exchanges also pose novel threats like custody risk and security breaches.
Fourth, in the absence of regulatory clarity, fraud and manipulation will eventually drive investors away from the market, thereby decreasing the level of trust and limiting the sector’s growth potential. Many exchanges are willing to work within the purview of regulation in the hopes of gaining market confidence and investors’ trust.
And fifth, if business entities and financial services companies start accepting cryptocurrencies and other forms of digital currencies, such as stablecoins, as a means of payment, this could have a substantial impact on the Federal Reserve’s (Fed) monetary policy.
The centralized nature of a cryptocurrency regulation
The US should introduce a centralized regulatory structure for cryptocurrency exchanges and trading platforms that is based on information, equal access, and investor confidence. My paper argues that the fundamental features of a new cryptocurrency regulatory regime should be: (1) a federal cryptocurrency agency established by an Act of Congress; (2) mandatory federal licensing requirements for cryptocurrency exchanges and service providers, including custodians; and (3) a centralized cryptocurrency trading platform with specific entry regulations for the participants.
A federal cryptocurrency agency having exclusive jurisdiction over cryptocurrencies can avoid the problem of multiple and fragmented regulatory regimes while exercising direct oversight over the cryptocurrency spot markets (both exchanges and over-the-counter) and protecting investors’ interest. The establishment of a separate federal regulator to protect consumers’ interests is not unknown; for example, the establishment of the Consumer Financial Protection Bureau in response to the financial crisis of 2008. As the paper argues, the “crypto-regulator should combine existing regulators’ mandates, jurisdictions, responsibilities, and enforcement authorities”, and by doing so, be capable of “overcome[ing] the current regulatory overlap and ambiguity.”
To build market trust and surveillance mechanisms, the new regulator should establish a licensing regime for entities that provide cryptocurrency-related services or operate trading platforms. A mandatory licensing regime for cryptocurrency companies will facilitate the development of a centralized oversight mechanism under a single regulatory authority and ensure that industry participants comply with the US laws, including anti-money laundering/countering financing of terrorism, anti-manipulation, anti-fraud, consumer disclosure, and prudential (licensing and minimum-capitalization) requirements. Thus, any cryptocurrency exchanges and over-the-counter marketplaces that are engaged in purchasing, selling, and trading cryptocurrencies and cryptocurrency-referenced assets must register with the new regulator.
The new regulation should also establish a centralized digital cryptocurrency trading platform accessible to investors via licensed exchanges, over-the-counter marketplaces and other cryptoassets service providers. A digital system that keeps records of all cryptocurrency-based offerings and products is conducive to establishing a transparent system based on information-symmetry and equal access. The listing and recording of cryptocurrency-related transactions will curb fraudulent and suspicious activities and market manipulation. Direct visibility into the trading platform will also enable the regulator to take actions against wrongdoers and restore investors’ confidence.
The US Congress should follow the lead of the UK and the EU and pass federal cryptocurrency legislation. Such legislation should be functional and technology-neutral so that it is ready to tackle future challenges. Such legislation would further the public interest by providing a uniform regulatory approach, minimizing the risks in the cryptocurrency spot market, reducing the likelihood of market failure, strengthening US financial markets, and recognizing the unique features of cryptocurrency.
Recent comments from SEC chairman Gary Gensler and Federal Reserve Chairman Jerome Powell show that top regulators are becoming increasingly concerned with cryptocurrencies’ risks. If US financial regulators want to regulate these novel assets, bringing cryptocurrencies under a centralized regulatory framework should be the first step.
Sangita Gazi is a Research Fellow and PhD candidate at the Asian Institute of International Financial Law, University of Hong Kong.
This post is adapted from her recent paper published in the Cambridge Law Review, “Reimagining a Centralised Cryptocurrency Regulation in the US: Looking through the Lens of Crypto-Derivatives.”
 CFTC v Coinflip Inc  CFTC Docket No. 15-29.
 As of 4:30PM, 15 September 2021.
 For an in-depth analysis on the impact of self-certification of bitcoin futures, see Lee Reiners, ‘Bitcoin Futures: Self-certification to System Risk’  23 North Carolina Bank Institute 61.