What will the future hold for regulation of cryptocurrency derivatives? Whereas the Commodity Futures Trading Commission hasn’t yet released explicit regulatory guidance, it has left clues that indicate what the regulation of Bitcoin and other cryptocurrency derivatives could look like. After all, increased acceptance and usage of cryptocurrency indicate a clear need to hedge the risk of volatility. At Latham & Watkins, we’ve examined how the current U.S. derivatives regulatory regime of the CFTC may apply to Bitcoin and other cryptocurrencies. Here are some points investors, start-ups, payment processors and financial institutions should keep in mind.
The CFTC is watching Bitcoin like a hawk but has not formalized any regulatory position on Bitcoin and Bitcoin derivatives — yet. The CFTC, which has kept a watchful eye on Bitcoin since it was created in 2008, took active steps this year toward clarifying its regulatory role. Last fall the agency held an open meeting on Bitcoin derivatives just as the first swap execution facility was launching the first Bitcoin derivative. Since then, CFTC chair Timothy Massad and commissioner Mark Wetjen have both made public statements that indicate Bitcoin will fall under their organization’s purview. Nonetheless, the CFTC has yet to formalize any regulatory position on cryptocurrency derivatives products — an essential next step as market demand for Bitcoin continues to grow.
Greater U.S. activity in Bitcoin derivatives is forcing the CFTC to react. Massad and Wetjen have indicated in public statements that cryptocurrencies such as Bitcoin likely fall under the Commodity Exchange Act’s definition of “commodity.” In practical terms, this means that the CFTC retains enforcement authority over a Bitcoin transaction regardless of whether it is a derivatives transaction. Last year the regulatory group approved the trading of a Bitcoin nondeliverable forward on TeraExchange, a derivatives exchange based in Summit, New Jersey. The North American Derivatives Exchange now offers a Bitcoin option contract referencing TeraExchange’s proprietary index. New York–based SolidX Partners offers institutional investors total return swaps on Bitcoin. And LedgerX in New York has applied for registration as a swap execution facility and a derivatives clearing organization, hoping to become the first Bitcoin options exchange.
Additionally, the CFTC has enforcement and regulatory authority over specific retail commodity transactions, which would include certain Bitcoin contracts, making them subject to the same rules as futures contracts. As a result, the CFTC retains broad enforcement authority over Bitcoin and other cryptocurrencies. Bitcoin spot contracts, however, will likely remain largely unregulated unless a unique reason arises in the foreign exchange or commodity cash markets. Another question still up in the air is whether the CFTC will regulate Bitcoin derivatives in the off-exchange and off-facility markets. The answer depends on whether the CFTC will decide to regulate cryptocurrency derivatives in a similar fashion as it does foreign exchange transactions, or if they will be regulated like other commodities, such as precious metals. Alternatively, an entirely new regulatory regime could be applied.
Everyone’s talking about the blockchain. The derivatives industry is no exception. The applications that could be based on the blockchain, including Bitcoin and many other cryptocurrencies, could revolutionize the derivatives industry. Much of the existing technology in the over-the-counter derivatives market and the futures market is rickety at best and has failed to keep pace with the demands of the industry. The blockchain protocol could provide functionality (currently unavailable) and be a game changer.
Industry participants (including banks) foresee leveraging the programmable blockchain protocol to develop smart contracts in which complex payment obligations, collateral and other terms would be programmed into the contract without the need for intermediaries. This type of contract could eliminate the need for a futures exchange or at least call into question its intermediary role while inserting a low-cost transparent platform we know as the blockchain protocol. Yet despite the strong potential, regulation could always get in the way.
What does this all mean? In short, the CFTC is on track to assert its regulatory authority over cryptocurrencies like Bitcoin. The process will require applying the general principles of ensuring against market manipulation, reducing systemic risk and providing consumer protection against the safeguards that the protocol itself embeds on the open ledger. The road ahead will likely be challenging for the CFTC, although if it can align public goals with the benefits we hope this technology will bring — including a safer, more efficient and more cost-effective market — everyone stands to win.
Vivian Maese is a partner in the corporate department and financial institutions industry group, and Yvette Valdez is a senior associate in the derivatives practice group and financial institutions industry group, both at law firm Latham & Watkins in New York.
Get more on regulation and on trading and technology .
