Digital Asset Derivatives: Regulatory Landscape

Different countries approach the regulation of digital derivatives in different ways. In the UK, the UK Financial Conduct Authority prohibited the sales of these derivatives to retail clients in October 2020 because they are too volatile, and retail investors may not understand the risks associated with such derivatives. 

Europe takes a similar approach. The European Securities and Markets Authority (ESMA) was also looking into restricting trading with digital asset derivatives because of their high volatility, the possibility for price manipulation, and the lack of investors' understanding of the product complexity. 

In the US, the approach to digital derivatives is different, and they are treated within the existing legal framework. If any derivatives do not fit in the existing legal framework, they are prohibited, even though some market participants insist that this is a reason why these derivatives may move to other, less regulated markets. 

US Regulation on Digital Asset Derivatives

According to the Commodity Futures Trading Commission (CFTC), digital currencies such as Bitcoin, Ethereum, and others are considered commodities. Therefore, all derivatives on such digital currencies such as futures, options, and so on are regulated by the CFTC. The regulator admits that the regulatory norms were created before the emergence of digital assets and their derivatives, and that is why there are many gaps in the regulation. This is why a regulatory framework should be created that can monitor all of the activities with these assets adequately. 

Another regulator, the US Securities and Exchange Commission (SEC) has oversight of digital assets that are considered securities and, thus, their derivatives. The SEC claims that not only tokens and their derivatives will be regulated, but also the way they are sold or resold (secondary markets). 

So, if the SEC considers all crypto assets as commodities, then the derivatives will be regulated by the CFTC. However, if the SEC considers all crypto assets securities, the SEC is responsible for the regulation of their derivatives.

Internal Revenue Service (IRS) and Revenue Reporting

Even though the IRS has not created any rules for digital asset derivatives, the Internal Revenue Code has some. Taxpayers will report gains and losses on positions in some futures and options (e.g., those of Bitcoin) on an annual mark-to-market basis as if the assets were sold on the last day of the year. 

The IRS recognizes digital currency as property; taxpayers do not pay any taxes on it until it is sold or exchanged. However, when derivatives come into question, the rules may be different in regard to some of them. 

For example, if a person trades Bitcoin futures, then these positions may be subject to mark-to-market reporting. 

Details to Be Considered

Many details will be considered by regulators to integrate digital asset derivatives into the existing regulatory framework. The following things will be considered and addressed to cover all of the regulatory aspects of this type of derivative.

Forks in the Blockchain

A fork is an event that results in the evolution of two separate chains. Forks impact the product structure and value and, thus, derivative users must understand how to process these fork events.

Valuation Time

The market of digital assets operates non-stop, 24/7. How, then, will the valuation be performed? What point will be taken for the valuation needs and, more importantly, which exchanges will be considered? These reference data sources should be determined for accurate asset valuation.

Transaction Fees

Transaction fees range from 0.25% to 0.75% for derivatives. If assessed incorrectly, these fees may impact the benefits of trading derivatives. When there are a lot of transactions, fees rise and impact the required collateral. 

Settlement Standards

Market participants can choose the method of settlement, and they can choose deliverable or non-deliverable products as a settlement. However, there is no standard method for derivatives settlement.

Margin Requirements

It is necessary to establish initial and daily variation margins because the volatility of digital asset derivatives is very high. Also, some measures may be needed to offset the volatility and liquidity issues.

Capital Requirements

Industry standards should be developed for the capital requirements concerning digital assets and their derivatives. What is the risk weight of a bank’s holdings in digital assets and whether it shall differ for holdings in Bitcoin, Ethereum, and other coins? Should capital requirements for stablecoins be lower than those for non-pegged cryptocurrencies? Measures are needed to create a reserve to absorb losses in the event of a default. Risk profiles should be established to develop an appropriate capital framework. 

Future Developments

Institutional users are demanding more exposure to digital asset derivatives; thus, the market complexity will grow, and the market will mature. Over time, more viable decentralized solutions will be built. They will reduce costs, speed up transactions, and provide a more reliable infrastructure overall. Therefore, sooner or later, operational, regulatory, and tax requirements will be determined and the underlying legal framework will be created.