How Regulators Should Approach The Bitcoin Derivatives Market

We already know of bitcoin's complicated relationship with governments and regulatory agencies the world over. But bitcoin's relationship with the US Commodity Futures Trading Commission (CFTC), the agency responsible for regulating the futures and options markets, is particularly ill-defined.

Bitcoin is in a Catch-22-style bind. As long as the price remains volatile it will remain dangerous for merchants to accept the cryptocurrency, barring adoption on a massive scale. Derivatives might be a useful risk management tool to hedge against volatility. But regulatory ambivalence leaves entrepreneurs timid or unwilling to invest in the infrastructure for these transactions.

While derivatives have the ring of abstruse tools, they could make or break the bitcoin ecosystem.

Despite this uncertainty, the bitcoin derivatives markets are drawing attention. Seed-stage incubator Seedcoin allotted 500 bitcoins to BTC.sx, a derivatives trading platform, in early July. Last year, SecondMarket awarded a leveraged FOREX trading platform, Coinsetter, $500,000 in venture capital.

In a Mercatus Center working paper, scholars say that based on current regulations, many bitcoin derivatives should be exempted from CFTC regulation. They also recommend that policymakers use a “bottom-up” approach to the new technology.

It's no secret that bitcoin is volatile. In theory, the volatility will decrease as the network reaches a larger capacity.

But for now, a dive in price could impact the future of a company that wants to transact in it, making vending in bitcoin a prohibitively risky move.

That is where derivatives come in. The contractual tool “derives” its value from an underlying asset – in this case bitcoin. The value of the underlying asset can fluctuate, but the contract locks it in at an agreed-upon price for a period of time.

There is a lot of uncertainty. It is beneficial for merchants to lock in a long term price, so that they can still operate and plan in the face of possible fluctuations. Traditionally, this has been a useful tool for agriculture, oil, and other markets where the prices of underlying commodities were subject to volatility. BTC.sx chief operating officer George Samman said:

There are a number of types of derivatives: options, forwards, futures, and swaps. CoinDesk correspondent Daniel Cawrey previously touched on the various types of derivatives.

As long as the network is composed of a small number of actors, many institutional players are hesitant to move into the bitcoin market until hedging instruments develop.

Houman Shadab, professor at New York Law School and author of the Mercatus paper told CoinDesk: “The development of bitcoin derivatives means that people are taking bitcoin seriously and want to make it easier to use.”

Right now, regulatory focus is fixed on bitcoin's use in money laundering and illicit purchases. But when the markets for advanced financial instruments expand, the arm of the government will likely follow.

In mid-April, the Mercatus Center, a market-oriented think tank, released a working paper titled Bitcoin Financial Regulation: Securities, Derivatives, Prediction Markets, & Gambling that describes the government's role in these transactions.

According to the authors – Jerry Brito, Houman B. Shadab, and Andrea Castillo – as bitcoin evolves and the infrastructure develops for bitcoin trade, new financial instruments will pop up to deal with risk. Securities, derivatives, prediction markets and gambling will assume greater significance in the bitcoin ecosystem.

The paper is a draft and is subject to change. The scholars' recommendations is summarized as follows:

"Following the approach to virtual currencies taken by FinCEN, we argue that other financial regulators should consider exempting or excluding certain financial transactions denominated in bitcoin from the full scope of their regulations, much like private securities offerings and forward contracts are treated.

We also suggest that to the extent that regulation and enforcement becomes more costly than its benefits, policymakers should consider and pursue strategies consistent with that new reality, such as efforts to encourage resilience and adaptation."

Many bitcoin derivatives resemble forwards, which are not regulated by the CFTC. Forwards are not subject to regulations outlined in the Commodities Exchange Act (CEA) for a couple of reasons. Forwards contracts are generally tied to a physical commodity, unlike futures which are settled in cash. Since bitcoins have a cap and inherent value it resembles a physical commodity. Bitcoins are also easily transferable.

CFTC regulations are reserved for speculative markets.

Bitcoin derivatives should be treated like any other commodity derivative, Shadab told CoinDesk. "The CFTC should exempt from the full scope of its regulation derivatives that ultimately transfer bitcoins between users, for the same reasons physically settled commodity derivatives are not regulated as heavily as futures."

"The CFTC should help to foster a liquid and robust market for bitcoin derivatives so investors and users can decrease their exposure to price risk," he added.

Other opinions

A CFTC spokesman declined to comment because the agency "has not taken any actions with regard to bitcoin". But last year, the former chairman Bart Chilton said the agency was "seriously considering" regulation.

Some think clarity is the number one priority. Early this year Sen. Tom Carper (D-DE) asked the CFTC to clarify its position to "remove the cloud of uncertainty". Harvard Review reported on the general attraction to regulation amongst bitcoin entrepreneurs, simply because it helps to dispel the paralyzing uncertainty.

Undoubtedly, bitcoin would benefit from clarification from the CFTC.

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