In response to the recent intensive domestic regulatory policies, many exchanges have made business adjustments to cryptocurrency derivatives. Huobi Exchange does not open contracts and leverage services for new users in China; BitMart Exchange announced that it will suspend contract trading services for all Chinese users; Matcha Exchange restricts margin trading and futures for new users in Mainland China, Hong Kong, Macau and Taiwan And other services; BiKi Exchange announced that it will stop providing contracts, OTC, leverage and other services to users in mainland China. In addition, some regulatory agencies and financial institutions also impose restrictions on cryptocurrency derivatives. In January of this year, the British Financial Conduct Authority (FCA) prohibited institutions from selling cryptocurrency-related derivatives, including delivery contracts, perpetual contracts, and options, to ordinary investors. In June, Futu Securities decided to restrict the provision of services related to CME cryptocurrency futures contracts. Combined with a series of recent events surrounding cryptocurrency derivatives, this article focuses on the supervision of cryptocurrency derivatives and its impact.
Introduction to cryptocurrency derivatives
Financial derivatives is a general term for a special category of financial instruments bought and sold, and its value depends on changes in the value of the underlying financial assets. There are many types of underlying financial assets, such as stocks, interest rates, exchange rates, commodities, indexes, etc. According to different product forms, financial derivatives can be divided into futures contracts, forward contracts, swap contracts and option contracts. The main functions of financial derivatives include hedging and hedging, price discovery, raising capital utilization, and speculation. In recent years, the financial derivatives market has developed rapidly. According to a survey report released by the American Futures Industry Association (FIA), in 2020, the trading volume of exchanges in the Asia-Pacific region increased by 39% year-on-year, and the trading volume of North American exchanges increased by 25% year-on-year. At the same time, more than 60% of the interviewees expect that the trading volume of the global financial derivatives market will continue to grow in 2021.
There are futures contracts, option contracts and other products similar to mainstream financial derivatives in the cryptocurrency market, and innovative derivatives such as perpetual contracts have been developed on this basis. Perpetual contracts fit well with the characteristics and needs of investors in the cryptocurrency market and have achieved great success. “Cryptocurrency Market Derivatives Sorting” (Wanxiang Blockchain Research Report, 2020 Issue 61) gives a detailed introduction to the main cryptocurrency derivatives. Among them, the development of perpetual contracts has rapidly become the current mainstream derivatives, option contracts are still in their infancy due to liquidity reasons, leveraged tokens continue to innovate but trading platforms are limited, and leveraged trading has gradually been replaced by other derivatives.
Leverage is a distinctive feature of financial derivatives. Investors generally only need to deposit a certain percentage of deposit or margin when trading, which can control more investment with less capital cost, thereby increasing the return of investment. However, the leverage of financial derivatives also means a high degree of risk. In theory, if all investors can do a good job of risk management when using financial derivatives, then there will be no large-scale losses in the financial derivatives market. However, many investors use financial derivatives out of speculation, and they will not consciously strictly abide by the risk management rules. At this time, if the market trend does not match the expectations of these investors, financial derivatives will not only fail to achieve asset preservation and prevent risks, but will magnify investors’ losses, such as the collapse of the British Barings Bank and the loss of Japan’s Daiwa Bank. Therefore, it is very important to supervise financial derivatives.
Let’s look at cryptocurrency derivatives in detail. Since the launch of Bitcoin and other cryptocurrency derivatives, there have been many large-scale liquidation in the market. This is because cryptocurrency does not have a recognized valuation basis, and the manipulation and fraud in the cryptocurrency market, coupled with exchanges providing investors with highly leveraged derivatives, all causes the volatility of cryptocurrency derivatives Much larger than mainstream financial derivatives. More importantly, most investors in cryptocurrency derivatives lack professional investment knowledge and experience. They do not fully understand cryptocurrency derivatives, and their participation in transactions is not for legitimate needs such as hedging and value preservation, but as a gamble. Therefore, compared with mainstream financial derivatives, cryptocurrency derivatives require strict supervision.
Current status of cryptocurrency derivatives regulation
Regulatory agencies in different countries have different attitudes towards cryptocurrency derivatives, but take corresponding regulatory measures based on specific national conditions and existing regulatory frameworks. The U.S. has a relatively clear regulatory logic for cryptocurrency derivatives. Many countries will refer to the United States’ practices. The following uses the United States as an example to introduce the current regulatory status of cryptocurrency derivatives.
The United States adopts a multi-head regulatory model for cryptocurrencies. The main regulatory agencies include the Securities and Exchange Commission (SEC), the Commodity Futures Trading Commission (CFTC), the Office of the Comptroller of the Currency (OCC) and the Financial Crime Enforcement Network Agency (FinCEN). Among them, the cryptocurrency derivatives market is mainly regulated by the CFTC. The main function of the CFTC is to supervise the operation of the futures and options market, to protect investors from fraud, market manipulation and improper operations related to commodity and financial futures and options, and to ensure the openness and competitiveness of futures and markets. And financial reliability.
If an organization wants to provide cryptocurrency derivatives services in the United States, it must first obtain relevant regulatory licenses, mainly the designated contract market license (DCM) and the derivatives clearing organization license (DCO). After obtaining the license, the institution can carry out services related to the custody, trading and clearing of cryptocurrency derivatives.
For cryptocurrency derivatives trading platforms that follow the compliance route, they need to do a good job in compliance with the regulatory framework, and then accept the supervision of the CFTC. Compliant cryptocurrency derivatives trading platforms have developed rapidly, and their business has continued to expand, from the initial Bitcoin futures to other cryptocurrencies such as Ethereum. At present, the main cryptocurrency derivatives trading platforms are CME and Bakkt, and other platforms that follow the compliance route, such as ErisX and LedgerX, have also obtained DCM and DCO licenses.
For non-compliant cryptocurrency derivatives platforms, US regulators have significantly increased their crackdown on cryptocurrency derivatives platforms. In October 2020, the U.S. Department of Justice and the CFTC filed a lawsuit against BitMEX, a well-known cryptocurrency derivatives exchange. The CFTC requested the termination of BitMEX’s derivatives business in the United States and requested BitMEX to compensate customers. In March 2021, the CFTC investigated whether Binance provides cryptocurrency derivatives services to U.S. citizens.
Other countries generally hold a very cautious attitude towards cryptocurrency derivatives. The Monetary Authority of Singapore (MAS) believes that crypto asset derivatives are not suitable for most ordinary investors. Therefore, MAS takes prudential measures to supervise crypto asset derivatives, strictly supervise compliant crypto asset derivatives exchanges, and will not extend the scope of supervision beyond compliant exchanges to prevent ordinary investors from underestimating cryptocurrency. The risk of asset derivatives.
The impact of regulation
First, ordinary investors. The development speed of the cryptocurrency market is far beyond people’s expectations. Before regulators took notice of this field, there were already a large number of ordinary investors participating in transactions in it. In order to attract more users and traffic, most exchanges set almost no restrictions on user registration and KYC processes, resulting in the participation of cryptocurrency derivatives investors far lower than mainstream financial derivatives. After strict supervision of cryptocurrency derivatives, compliant crypto asset derivatives exchanges will have higher access conditions, and the number of ordinary investors will be significantly reduced. If ordinary investors want to continue to participate in the cryptocurrency derivatives market, they can only switch to non-compliant exchanges or leave the derivatives market.
Second, institutional investors. Institutional investors have a large amount of funds and pay more attention to the safety of funds. They participate in cryptocurrency derivatives transactions more for hedging and maintaining value, using a combination of spot and derivatives trading to reduce risk exposure. After strict supervision of cryptocurrency derivatives, more institutional investors will be willing to participate, which means that the cryptocurrency derivatives market has a lot of room for development. At the same time, institutional investors have rich experience in the derivatives market, which can promote the innovation and growth of the cryptocurrency derivatives market.
Third, compliant exchanges. A compliant exchange must first fully comply with regulatory requirements. Generally speaking, there are relatively high barriers to participation in compliant transactions. For example, the contract size of Bitcoin futures initially launched by CME is 5 BTC, which exceeds the amount of funds of many ordinary investors and prevents them from buying on compliant exchanges. And trading cryptocurrency derivatives. However, the number and trading volume of institutional investors in compliant exchanges may increase significantly, which is a great benefit for compliant exchanges. At the same time, some compliant exchanges are also trying to lower the barriers to participation. For example, CME launched a micro bitcoin futures contract.
Fourth, non-compliant exchanges. Non-compliant exchanges are subject to relatively minor regulatory constraints. Compared with compliant exchanges, non-compliant exchanges can provide more types of cryptocurrency derivatives with higher leverage. The profits of non-compliant exchanges are very dependent on the derivatives market. They certainly do not want to shut down the derivatives market, because it means losing users and trading volume. The degree of their response to regulatory policies depends on the team members.
Fifth, regulatory agencies. The attitudes of global regulators towards cryptocurrency derivatives are not exactly the same, and they have not adopted coordinated measures in the field of cryptocurrency derivatives. When an influential regulatory agency strictly supervises cryptocurrency derivatives, regulatory agencies in other countries may feel pressure to act and introduce corresponding measures. Of course, the supervision of cryptocurrency derivatives by various national regulatory agencies will not be exactly the same, and ordinary investors and non-compliant exchanges will gather in “regulatory depressions” with more relaxed supervision.
Thinking and summarizing
At present, the cryptocurrency derivatives market is still in a relatively early stage, and the lack of supervision is the main reason for the frequent chaos in the cryptocurrency derivatives market. Strict supervision of cryptocurrency derivatives may have an impact on trading volume in the short term, but in the long term it is beneficial to the healthy development of the entire market. Supervision is a condition for prosperity. Only a clear supervision system and orderly supervision and management can provide a guarantee for a virtuous market cycle, attract more investors and funds to enter, and further promote the stability and development of the derivatives market.
The price of cryptocurrencies fluctuates greatly, and the use of derivatives will further amplify the volatility. Coupled with the irrational use of excessive leverage by many cryptocurrency market participants, they are prone to large losses. Therefore, cryptocurrency derivatives are not suitable for ordinary investors without professional knowledge and experience to participate. The regulatory policies formulated and introduced by regulatory agencies are also out of consideration for protecting investors.
As a financial instrument of cryptocurrency, cryptocurrency derivatives have the attributes of cryptocurrency and are very difficult to supervise. Cryptocurrency has a natural cross-border nature, and the regulatory policies of a certain country or region cannot achieve practical results. Investors can move to other exchanges to continue participating in the cryptocurrency derivatives market. Therefore, the supervision of cryptocurrency derivatives requires the joint efforts of various regulatory agencies.