UK regulator proposes ban on crypto-derivatives for retail consumers
Derivative contracts can allow individuals to benefit from changes in the value of cryptoassets like Bitcoin without having to buy them directly. The UK Financial Conduct Authority now plans to block these crypto-derivatives from being sold to retail consumers. Firms offering crypto-derivatives as retail products will likely have to stop doing so next year.
What has the FCA proposed?
In a consultation paper, the FCA has suggested banning the sale, marketing and distribution to retail consumers of crypto-derivatives. These are derivatives and exchange traded notes that reference unregulated transferable cryptoassets. The ban would apply to firms acting in, or from, the UK.
Why has the FCA done this?
In the UK Cryptoasset Taskforce report last year, the FCA promised that it would consult on prohibiting the sale of certain cryptoasset derivatives to retail consumers.
In its latest paper, the FCA explains that crypto-derivatives are “ill-suited” to retail investors who cannot reliably assess the value and risks of derivatives or ETNs that reference cryptoassets.
In the FCA’s view, consumers need protection because cryptoassets have “no reliable basis for valuation”, their value is extremely volatile, and retail consumers lack adequate understanding of the investment. Other risks highlighted in the FCA paper are financial crime, market abuse, and opaque costs and charges.
What types of cryptoasset are caught?
The FCA has previously talked about three types of cryptoasset: security tokens, exchange tokens and utility tokens. The retail ban is targeted at derivatives referencing exchange tokens.
These tokens – like Bitcoin and Litecoin – are not issued or backed by any central authority and are used as a means of exchange or for investment purposes. Generally buying and selling this type of cryptoasset is not a regulated activity in the UK.
However, as the FCA has said for some time, creating products deriving from cryptoassets is likely to be a regulated activity. The FCA has seen a small derivatives market develop as the UK cryptoasset market has grown.
Some new definitions
In the draft rules, instead of referring to exchange tokens, the FCA has used the term “unregulated transferable cryptoassets”.
For something to be caught by this definition, it must:
- be a digital representation of value or contractual rights,
- be cryptographically secured,
- use distributed ledger technology,
- be tradeable on cryptoasset platforms, and
- not be e-money or another regulated investment like a security.
“Cryptoasset derivatives” are then defined to include derivatives where the underlying includes an unregulated transferable cryptoasset or an index relating to such a cryptoasset. Derivatives referencing, for example, security tokens would not be caught by the ban (but they would be regulated as securities).
What is a derivative?
Derivatives are contracts which derive their value from something else. They include:
- futures (where you agree to buy/sell an asset at a set price at a point in the future),
- options (where you have the right to buy/sell an asset at a set price at a point in the future), and
- contracts for difference (where you agree to exchange the difference in price of an underlying between set dates).
According to the FCA, CFDs are the most common type of crypto-derivative seen on the market today. The FCA has already restricted the sale of CFDs to retail consumers, including setting a 2:1 leverage limit on contracts that reference cryptocurrencies. This limit would no longer be needed if the ban takes effect.
What is an exchange traded note?
ETNs are financial products that are structured to provide returns in line with the performance of a specific asset or index. The FCA has only identified a limited number of ETNs available today that track cryptoassets.
What happens next?
The FCA seeks feedback on its proposals until 3 October 2019 and then expects to publish its final rules in early 2020.
The FCA says there will be an “appropriate implementation period” to help firms transition away from providing crypto-derivatives to retail clients. Existing contracts would be allowed to run off so that firms are not expected to close clients’ positions immediately.
Later this summer the FCA will also finalise its broader guidance on how cryptoassets are regulated.