Explosion of Risky Crypto Derivatives Is Sparking Clampdown

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Explosion of Risky Crypto Derivatives Is Sparking Clampdown

The quadrupling of Bitcoin, the world’s biggest cryptocurrency by market capitalization, to almost $12,000 this year has produced a slew of structured derivative instruments tied to digital asset prices. Regulators are concerned about this issue, arguing that derivatives products should not be based on a highly fluctuating, speculative currency. It doesn’t help that derivatives had a role in causing the 2008 global financial crisis. Now, UK officials are considering a ban on crypto futures trading, while US regulators are looking for new measures to rein in the sector, according to The Wall Street Journal.

Bitcoin Resurgence Gives Way to New Products

Bitcoin, which reached an all-time high around $20,000 in December 2017, has been on a winning run in 2019 after a protracted “crypto winter” that followed the bust of its boom. Bitcoin was selling for $12,300 per coin on Tuesday afternoon, up from $3,700 at the start of the year. Despite the fact that other cryptocurrencies have staged comebacks, Bitcoin’s performance has far outpaced theirs.

The comeback of cryptocurrency, driven by Bitcoin, has resulted in an increase in the popularity of Bitcoin structured products. Derivatives are frequently more difficult to comprehend and trade, which may result in significant losses when things go wrong, like when the housing crisis precipitated a meltdown in such instruments related to mortgages.

Since March, GSR, a firm led by former Goldman Sachs commodities traders, has released a number of Bitcoin derivatives, including variance swaps, which pay buyers if Bitcoin’s volatility rises, and binary options, which pay either nothing or a fixed amount depending on whether Bitcoin trades above or below a predetermined price.

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Bitcoin derivatives, like derivatives connected to equities, commodities, and mortgages, employ complicated algorithms to determine how much they pay out. While the market for Bitcoin derivatives is currently very tiny, and the businesses that offer them say that their products are not aimed at small-time investors, some market veterans are issuing a caution to investors.

“We would not consider recommending this to somebody who is unfamiliar with the risk or the nature of the underlying asset,” said Gerald Mr. Banks, managing partner of Greenwich, Conn.-based Cipher Technologies, which sells crypto derivatives. Banks that helped Merrill Lynch expand its structured-products business in the 1990s and early 2000s now manage money for rich families and individuals.

UK and US Regulators Threaten Bitcoin Structured Products

However, others are skeptical of using Bitcoin, a currency traded on an uncontrolled market and notorious for its enormous fluctuations, as a building block for complicated financial products, according to the WSJ.

According to ZDNet, the UK’s Financial Conduct Authority (FCA) has suggested a ban on the selling of derivatives and exchange traded notes (ETNs).

“The FCA believes these products are unsuitable for retail customers who are unable to accurately evaluate the value and risks of derivatives or ETNs that reference specific cryptoassets (crypto-derivatives),” regulators stated.

“We are actively monitoring how bitcoin is traded, especially in derivative forms that would be subject to our regulatory authority,” said James McDonald, enforcement director at the Commodity Futures Trading Commission.

Craig McCann, a former SEC economist and current chairman of the Securities Litigation & Consulting Group, shared the pessimistic outlook. “There are all sorts of difficulties involved with any structured product related to bitcoin,” he says, adding that “it doesn’t belong in anyone’s portfolio.”

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Looking Ahead

This comes as lawmakers in Washington and throughout the globe work to regulate the hotly debated business, which has been characterized by headlines alleging market manipulation, fraud, and other scandals, according to a separate WSJ story.

The IRS is expected to amend its 2014 guidelines on cryptocurrencies in the coming weeks, as part of a bipartisan effort to address some of the industry’s unsolved legal difficulties. Meanwhile, the Financial Action Task Force, a multi-government organization, is likely to issue new, stronger recommendations for dealing with Bitcoin and other digital assets.

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