Dangerous Derivatives: Amateur hour is over for bitcoin derivatives

February 14, 2021

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3 min read

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What's going on here?

The Financial Conduct Authority (FCA), the UK financial regulator, has banned the sale and promotion of derivatives of cryptocurrencies, including bitcoin, to amateur investors.

What does this mean?

A derivative is a financial instrument whose value is derived from the value of an underlying asset. In other words, its price changes as the asset’s value changes. Almost any tradable asset can be used as the basis for a derivative; stocks, bonds, commodities, currencies and indices are all commonly used. Examples of derivatives include futures, swaps and options. Therefore, one could buy a futures contract on the price of crude oil. This would allow one party to buy crude oil at a set price from the other at any point within a set time period.

There is a huge market for derivatives of all types, partly owing to their function as a hedge. This means they are used to mitigate the risk of an investment, turning potentially massive losses if the market moves in the wrong direction, to minor losses or even marginal returns. For a small fee, a party can purchase a futures contract which would “lock-in” their sale price. Therefore, if the market moved in the other direction, the price at which the party can sell is unaffected.

The FCA has recently banned the sale of derivatives of cryptocurrencies to amateur investors. This took effect on Wednesday 6 January and is the latest in a wave of increased cryptocurrency regulation globally. One of the reasons for the prohibition is a University of Cambridge report claiming several large crypto exchanges (online platforms where cryptocurrencies and their derivatives are traded) are operating without the necessary licences. For example, the owners of BitMex, an exchange in America, were indicted late last year for operating without a licence.

What's the big picture effect?

The end of 2020 was hailed as the coming of age of cryptocurrencies, particularly bitcoin. Its price skyrocketed, more than doubling in the final two months of the year. Unlike its previous peak, in 2017, serious institutional investors are buying in, forcing its price to peak in the first week of the new year at over $40,000. There is a belief that bitcoin could keep growing; a former Goldman Sachs hedge fund manager said he thought bitcoin could break $1m, even JP Morgan’s more conservative assessment of its real value being around $146,000 had speculators salivating. With this interest came a greater volume of trading in derivatives. Around one fifth of all money exchanged on crypto markets in 2019 was in derivatives and the market grew further throughout 2020.

Cryptocurrencies have long been a target for greater regulation, as they have been linked with criminal behaviour, in particular money laundering, due to the anonymity they offer. This, regulators believe, makes the market unstable and puts amateur investors, who do not understand the market well, at a significant disadvantage and therefore at risk of significant losses. One of the reasons for the instability is cryptocurrencies’ novelty. They have not had time to reach their true value, having only been traded for a decade or so. This means investors have little sense of what the underlying asset is worth.

One danger of derivatives trading is that investors often leverage themselves in order to make a trade. When an investor leverages themselves, they borrow money in order to purchase an asset, potentially increasing the returns on their investment. They earn the same amount from a trade but provide less capital, so the percentage return is increased. Some exchanges allow investors to borrow 15 times the value of the trade. This allows for enormous gains to be made if successful. The flip side is that if the markets move against the trade, the losses can be even bigger and could bankrupt investors who did not fully understand the risk they were taking.

The overall impact of the new regulation has been debated. The UK market for cryptocurrency is fairly small, so the regulation is unlikely to drastically affect the prices that cryptos trade at. Many exchanges which UK investors use are based overseas and thus can avoid the regulation. The danger to bitcoin is the UK could be just the first jurisdiction to regulate. If the US introduced similar regulation, the market could take a significant hit.

The regulation only affects retail investors, so professional investors will still be able to trade in derivatives. This too lessens the impact of the legislation. Overall, it is likely to be judged a correct move, as it protects those with less capital and less expertise, without affecting the drivers of the markets.

Report written by Joshua White

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