The Commodity Futures Trading Commission (CFTC) recently issued a Staff Advisory notice (the Staff Advisory) to exchanges and clearing organizations which are interested in listing and trading virtual currency derivatives (sometimes referred to as cryptocurrency derivatives). The intention of the Staff Advisory is to provide regulatory clarity for market participants seeking to innovate in compliance with CFTC regulations.
Virtual currency derivatives are a growing market which regulators in Canada are paying close attention to. The Quebec securities regulatory authority, the Autorité des marches financiers (AMF), published a reminder on May 24, 2018 that anyone wishing to create or market a derivative linked to a cryptocurrency or another innovative underlying is subject to the Derivatives Act (Quebec) (QDA) including derivatives qualification, derivatives dealer and derivatives advisor registration and derivatives reporting requirements. The Investment Industry Regulatory Organization of Canada (IIROC) also recently issued a Notice setting higher dealer margin requirements for cryptocurrency futures contracts.
Virtual currency derivatives are being monitored by international regulators as well. In April, 2018 the United Kingdom Financial Conduct Authority issued a statement on cryptocurrency derivatives (see our blog post on the subject). The US Department of Justice also recently launched a criminal investigation into Bitcoin price manipulation in concert with the CFTC. The CFTC also applauded “Operation Cryptosweep”, a coordinated set of enforcement actions by the North American Securities Administrators Association against fraudulent virtual currency investment products.
The Staff Advisory is important because it will affect how virtual currency derivatives are listed and traded. Derivatives are ways in which financial market participants can hedge their risks. The presence of derivatives thus impacts how attractive it is for investors to trade the underlying virtual currency assets. The Staff Advisory is also important because it affects how likely exchanges are to carry virtual currency derivatives in future. There are five areas covered by the Staff Advisory: Enhanced Market Surveillance, Coordination with the CFTC Surveillance Group, Large Trader Reporting, Outreach to Market Participants, and Risk Management for Derivative Clearing Organizations (DCOs).
Market Surveillance & Reporting
The CFTC Staff Advisory requires virtual currency derivatives listed on a designated contracts market or swap execution facility or exchanged by a DCO to be covered by an appropriate oversight program. This is meant to detect and prevent manipulation, price distortion, and disruptions to the settlement process. An oversight program must have visibility into the spot market for the underlying asset to be effective.
The Staff Advisory recommends oversight bodies have an information sharing arrangement with the underlying virtual currency exchange which provides the right to access trade data on the spot markets including “information relating to the identity of the trader, prices, volumes, times, and quotes.” DCOs are also required by CFTC regulations to monitor all trading of derivatives on their electronic platforms in real time to identity anomalies.
The Staff Advisory indicates the CFTC believes “a heightened level” of monitoring is warranted to virtual currency derivatives. This includes the know your customer (KYC) and anti-money laundering (AML) standards which are required of financial institutions. This means that market participants in the spot markets can expect heightened surveillance by CFTC-regulated entities in future.
CFTC Regulations also require certain large volume trading firms to file daily reports with the Commission identifying positions above specific reporting thresholds defined in CFTC regulation 15.03(b). The Staff Advisory recommends setting a large trader reporting threshold for virtual currency derivative contracts at 5 bitcoin, or the equivalent amount in another virtual currency. Having this information will be useful to exchanges by enabling them to better target their surveillance of the underlying spot markets.
Information Sharing and Coordination for Risk Management
The Staff Advisory expects DCOs to fully cooperate with the CFTC in its monitoring of virtual currency derivatives markets. This includes regularly discussing issues with CFTC staff and providing data related to the settlements process so the CFTC can conduct its own monitoring of the markets. For example, the Staff Advisory notes that before the launch of Bitcoin futures there were extensive discussions to make the CFTC comfortable that the products were not vulnerable to manipulation. The Staff Advisory also suggests DCOs consult with industry stakeholders on the listing, terms, and risks associated with virtual currency derivative contracts in order to promote market confidence in the novel area of virtual currency derivatives.
The Staff Advisory is also meant to aid market participants in the design of risk management programs for virtual currency products. The Staff Advisory notes the CFTC may request information on the proposed initial margin requirements of any potential virtual currency derivative to assess initial risks as well as the ability of margin requirements to cover future risk exposures. If necessary, the CFTC can require a DCO to change margin requirements. The CFTC may also request information on DCOs governance processes for approving new virtual currency derivative contracts and adherence to these policies.
The regulatory system for virtual currency derivatives continues to evolve with the market. The CFTC Staff Advisory indicates regulators have concerns with market manipulation in virtual currency derivatives. The heightened surveillance standard proposed will also have a likely knock-on effect in the spot markets for virtual currencies, where participants can expect greater scrutiny as well.