The U.K.’s decision this month to limit retail access to financial derivatives linked to cryptocurrencies caught the eye of legal experts in the U.S. and is fueling debate about whether Washington could follow the move in London, especially if Democrat Joe Biden wins the presidency.
Robert Hockett, a professor at Cornell Law School, may be an outlier in the debate, but he says the Financial Conduct Authority’s ban on retail investors’ trading derivatives based on cryptocurrencies such as bitcoin and ether could be emulated in the U.S. The FCA oversees financial regulation in the U.K.
Hockett told CQ Roll Call the restrictions could be a first step in preventing another financial crisis.
Derivatives can greatly increase the payout or loss when an asset’s value rises or falls. In the U.S., it’s legal for retail investors to trade futures and options on cryptocurrencies, allowing them to bet on more long-term trends or gain more leverage than buying the currencies directly.
The U.K. regulator justified the ban, which takes effect next year, by saying that cryptocurrencies are difficult to price, volatile and vulnerable to fraud. It is allowing larger and more sophisticated investors to keep trading them.
Hockett said the ban represents the U.K.’s first “foray” into clamping down on digital currencies, even if it covers a small part of the cryptocurrency market.
The ban signals to the industry that regulators aren’t going to “sit back and watch you guys set everything on fire again,” Hockett said. “We’re watching and we’re going to start introducing limits now, like requiring you to have fire extinguishers and limiting the amount of flammable material you can have lying around when you’re playing with matches.”
Protection has a price
Others working in cryptocurrencies said limiting retail investor access to the derivatives may be a fair approach, but they disagreed with Hockett on its significance.
Ariel Zetlin-Jones, an economics professor at Carnegie Mellon University, said he didn’t believe cryptocurrency markets would reach a size that could threaten financial stability without significant involvement of banks, which would have to comply with existing regulations.
Regulators have good reason to think about investor protection when it comes to derivatives linked to cryptocurrencies, he said in an interview, but he noted that those protections come at a cost.
“These derivatives markets are extremely complex. Although the cryptocurrency exchanges that create them market them as easy to understand for retail investors, I think they’re anything but,” he said. But they do make cryptocurrencies more liquid or easier to trade, which makes for fairer prices for the underlying assets.
Zetlin-Jones said he didn’t think the U.S. would follow the U.K.’s lead and ban the products because futures and options based on digital currencies are already available through regulated exchanges and trading platforms.
Richard Levin, chairman of the financial technology and regulation practice at Polsinelli PC, said retail use of cryptocurrency derivatives is so small that the U.K. ban is unlikely to have much of an impact.
For the most part, institutional investors, such as investment companies or hedge funds, and not retail investors, are trading derivatives. The FCA is protecting the least sophisticated investors from new, complex products they may not understand, he said.
“It’s not going to stifle innovation,” he told CQ Roll Call. “It’s just a reasonable reaction to concerns about a sophisticated product being offered to people that do not have the sophistication to trade the product.”
Levin said he didn’t think further regulation of cryptocurrency derivatives is likely in the U.S. because the Securities and Exchange Commission and Commodity Futures Trading Commission already limit retail investors’ access to swaps, which must be offered by regulated exchanges and trading platforms.
Those dismissals miss the point, Hockett argued. There’s “growing concern” that crypto could become “the next realm of shadow banking,” he said.
The term, coined by economist Paul McCulley in 2007, refers to nonbank companies that provide services similar to those of a commercial bank outside the usual regulations. The idea came to prominence during the last financial crisis, in part because of the role shadow banking played in the recession.
At the time, the shadow banking system that McCulley described was largely involved in products like derivatives and complex securitized assets, as well as others. Although much of that activity was addressed by the 2010 Dodd Frank Act, there’s now a concern that that behavior may show up in other places, including cryptocurrency, Hockett said.
Hockett compared the market to mortgage-backed securities, a derivative product that bundled residential mortgages and contributed to the 2008 crash. Right now, cryptocurrency markets match the popularity of mortgage-backed securities in 1999 or 2000 — a “bit player” but growing rapidly, he said.
“If the pace is the same, then it would seem to me that within three to four years we’re going to be looking at possible systemic danger,” Hockett said. “It might end up happening faster than that because in some ways, crypto seems to be spreading faster than [mortgage-backed securities].”
Disclosure is key
Thomas Chippas, CEO of ErisX, called the U.K. ban unfair. He said it holds cryptocurrency products to a different standard from other complex investment vehicles. ErisX offers bitcoin futures, although the company is unlikely to be directly impacted by the ban because its U.K. customers are institutional investors, Chippas said in an interview.
“I think disclosure is always a much better approach than outright banning,” Chippas told CQ Roll Call, adding that there’s ample data available about cryptocurrencies underlying the derivatives — and in some ways it’s more extensive than the information available about other commodities.
“Everyone knows how many bitcoin are going to be produced. Everyone knows the frequency they’re being produced. Everybody knows the incentives of the miners and the network. All the data is there,” he said. “You can’t tell me how many ounces of gold are going to come out of the earth.”
Moreover, investors have no lack of complex financial products they can already access, such as leveraged exchange traded funds. The same approach, which relies on disclosure, should be used for investment products tied to bitcoin and other cryptocurrencies, Chippas said.
If anything, the U.K.’s ban highlights what U.S. regulators, particularly the CFTC under the leadership of Chairman Heath Tarbert, are getting right, Chippas said.
The narrative has changed from a few years ago when the cryptocurrency complaint was that regulators had made it too onerous to get approval for new products, he said.
“We fast-forward to now. And it turns out if you just put your head down and put your back into it and you can do it,” he said. “Actually, the regulators have improved things along the way.”