Explosion of Dangerous Crypto Derivatives Is Sparking Clampdown


The quadrupling of Bitcoin, the world’s largest cryptocurrency by market capitalization, to nearly $12,000 this year has spawned an array of structured derivative products linked to the price of digital assets. This phenomenon has ignited concern among regulators who argue that derivatives products should not be based on a wildly volatile, speculative currency. It doesn’t help that derivatives helped spur the 2008 global financial crisis. Now, UK regulators are moving to ban crypto derivatives trading as U.S. regulators also eye new ways to rein in the industry, as outlined by The Wall Street Journal.

Bitcoin Resurgence Gives Way to New Products

Bitcoin, which saw its price rise to an all-time-high near $20,000 in December 2017, has been on a winning streak in 2019 after a drawn out “crypto winter” that followed its bubble burst. As of Tuesday afternoon, Bitcoin sold for $12,300 per coin versus $3,700 at the start of the year. The performance of Bitcoin has far outpacing the growth of other cryptocurrencies despite them having also staged their own comebacks. 

Crypto’s resurgence, with Bitcoin at the helm, has led to a rising popularity of Bitcoin structured products. Derivatives are often harder to understand and more difficult to trade, which can result in major losses when things take a sharp turn, such as when the housing crisis caused a crash in such products that were tied to mortgages. 

GSR, a firm led by former Goldman Sachs commodities traders, has released several Bitcoin derivatives since March, including variance swaps, which pay buyers if Bitcoin’s volatility increases, as well as binary options, with pay either nothing or a fixed amount depending on whether Bitcoin trades above or below a predetermined price. 

The Bitcoin derivatives use complex formulas determining how much they pay out, similar to that seen by derivatives tied to stocks, commodities and mortgages. While the market for these Bitcoin derivatives is still relatively small, and the firms that sell them indicate that their products are not targeted at mom and pop investors, some market vets are calling out a warning for investors. 

“We would not fathom pushing this to anyone who would not be fully versed in the risk or in the nature of the underlying asset,” said Gerald Mr. Banks, managing partner at Greenwich, Conn.-based Cipher Technologies, which sells crypto derivatives. Banks, who helped develop Merrill Lynch’s structured-products business in the 1990s and early 2000s, now manages money for wealthy families and individuals.   

UK and US Regulators Threaten Bitcoin Structured Products

That said, some are unconvinced that it’s a good idea to use Bitcoin, a currency traded on an unregulated exchange and known for its massive swings, as a building block for complex financial instruments, per the WSJ. 

The UK’s Financial Conduct Authority (FCA) has proposed banning the sale of derivatives and exchange traded notes (ETNs) per ZDNet. 

“The FCA considers these products are ill-suited to retail consumers who cannot reliably assess the value and risks of derivatives or ETNs that reference certain cryptoassets (crypto-derivatives),” wrote regulators. 

“We are closely following how cryptocurrency is being traded, including in its derivative forms that would be subject to our regulatory jurisdiction,” said Commodity Futures Trading Commission enforcement director James McDonald. 

Craig McCann, a former Securities and Exchange Commission economist and the current head of the Securities Litigation & Consulting Group, echoed the downbeat sentiment. He notes that, “there are all kinds of problems associated with any structured product tied to bitcoin,” adding, “it doesn’t belong in anybody’s portfolio.” 

Looking Ahead

This all comes as law makers in Washington and around the world are moving to regulate the red hot industry, which has been marked by headlines citing market manipulation, fraud, and other scandals, per another WSJ report. 

The IRS is slated to update its 2014 guidance on cryptocurrencies in the coming weeks, amid a bipartisan push to resolve some of the unresolved legal issues surrounding the nascent industry. Meanwhile, the Financial Action Task Force, a multi-government effort, is expected to adopt new stricter guidelines for dealing with Bitcoin and other digital assets. 

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