Durham University law student Jamie Campbell looks at the potential dangers of crypto derivatives
Since the release of Bitcoin on 9 January 2009, the cryptocurrency market has steadily grown to be valued at over £1.5 trillion. While the median holding of investors in 2021 is relatively low at only £300, cryptocurrency investors, traders and enthusiasts have been able to speculate and increase their returns by utilising risky cryptocurrency derivatives. For those that don’t know, a derivative is a “contract between two or more parties whose value is based on an agreed-upon underlying financial asset”.
The first kinds of derivatives for cryptocurrency were rudimentary and conducted on a small scale. For example, early marketplaces allowed traders to employ arbitrage to buy digital currency with spot and then sell futures contracts where a premium was present. This allowed traders to effectively hedge against volatility and secure a price for their Bitcoin. Typically, this kind of service is provided by the traditional banking systems. However, as cryptocurrency is supposedly ‘decentralised’, online exchanges and marketplaces were able to set up these systems themselves, allowing would-be investors to jump right in to trade complex financial instruments.
In 2016, the derivative platform BitMex invented the Bitcoin perpetual swap/future, a new kind of instrument without the expiry date and price deviations from the underlying assets associated with futures contracts. In 2017, CME group launched the first Bitcoin futures contract. Eventually, prime brokers such as CMC Markets Connect, Advanced Markets and B2Broker have launched crypto CFD (contract for differences) offerings. Since 2017, much has changed in the crypto derivative space. In short, during the bull run of 2017 and then with the proceeding bear market, trading in crypto derivatives increased significantly as profits could be made even when prices tumbled. This trend of the derivatives market exceeding the spot markets has continued with derivatives trading exceeding spot trading when prices fall.
An introduction to Binance
More recently, Binance, one of the leading exchanges in the crypto realm, has recently come under fire from regulators around the globe for a plethora of issues. Primarily, regulators and commentators have cited Binance’s promotion of perpetual crypto futures to retail investors unqualified and ignorant of the risks involved. For context, Binance’s influence in both the spot (money paid in cash) and derivatives markets remains unparalleled, even after the regulatory barrage it has faced. In terms of trade volume and open interest, it consistently places as the number one exchange globally. This fact is attributed to its high trust score and the sheer number of coins and pairs it makes available to consumers. In the Financial Conduct Authority (FCA)’s Cryptoasset Consumer Research paper 2020, Binance was found to be the second most used exchange by UK consumers. I have personally used Binance and will likely keep doing so, but as I will explain, there is a ‘correct’ and ‘incorrect’ way to use an exchange’s services, and customers should know the risks involved in doing so.
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FCA regulation on cryptocurrency and Binance crackdown
There is no doubt that Binance offers its consumers a wide array of features and choices for investing and trading in the world of crypto. For the most part, its consumers are generally satisfied and happy with the services it provides — as is shown by its dominance in the market. Notwithstanding this, in October 2020, the FCA banned the sale of crypto derivatives to UK retail customers. During Binance’s application process under regulation 57 of the 2017 Money Laundering Regulations to become a registered cryptoasset business — with plans on launching a UK based cryptoasset exchange under the trading name Binance.UK. — the FCA discovered that Binance was offering customers crypto derivative products on the Binance.com website. Additionally, these products were easily accessible with no barrier to entry for UK based consumers.
In response to this, in June 2021, the FCA issued a supervisory notice on Binance Markets Limited, ordering it to stop all regulated activities in Britain as well as other strict requirements. This is said to be “one of the most significant moves any global regulator has made against Binance“. Consequently, this prompted Barclays, Clear Junction, Santander, NatWest and HSBC to stop allowing payments to Binance. The impact this had on the crypto markets was so great that Binance rivals felt a boost to the number of users on their platforms.
In other jurisdictions, Binance has also faced regulatory push-back. For example, in April, BaFin (Germany’s financial regulator) issued a warning to Binance that they risk being fined for offering stock tokens (securities-tracking digital tokens) as they failed to provide the necessary prospectuses as is required under EU securities law. Proceeding this, in July, the Italian Consob (Italian Securities and Exchange Commission) issued a warning against Binance offering of stock tokens and other derivatives products. A day after the Consob’s notice, Binance announced it would suspend its services related to the exchange of stock tokens. However, unlike with stock tokens, Binance has not removed derivatives trading on its platform, and UK customers can still access crypto derivatives through the Binance.com website.
Although Binance users in the UK can still trade on Binance, this may change with the end of the FCA’s Temporary Registration Regime (TRR) for cryptoasset businesses. The TRR aims to allow currently operating cryptoasset firms to continue operations while under a process of assessment by the FCA. The purpose being the prevention of money laundering, counter-terrorist financing, and to ensure consumer protection. The deadline for the TRR is on 31 March 2022. As such, any firms not registered may cease to be allowed to remain in operation with its end. Although a Binance spokesperson has stated: “We take a collaborative approach in working with regulators and we take our compliance obligations very seriously. We are actively keeping abreast of changing policies, rules and laws in this new space.” They have so far not commented on whether the company will register under the FCA’s requirements.
You may be wondering why crypto derivatives need regulating at all. For this article, I want people to be aware of the risks to mitigate potential losses; consumer protection is chiefly necessary. In the UK, CFDs are among the most common derivatives used by investors and speculators to trade underlying securities. These typically involve leverage, and so incur the risk of margin calls. Resultingly, with the increased risk to consumers, the FCA has imposed permanent restrictions on selling CFDs and CFD-like options to retail consumers. Some key restrictions include limiting leverage (to 30x) and providing a standardised risk warning, whereby firms are required to inform customers of how many of their retail clients make a loss. These restrictions are in place for good reasons; primarily because CFD firms have aggressively marketed their products to the public, which are not ‘appropriate for them’. This is exemplified by FCA research that revealed that 82% of CFD customers lose money. Unlike traditional CFDs, with perpetual crypto futures, regulation is hardly enforced and ignored. For example, using as much as 125x leverage, one customer found herself down more than $250,000 as she attempted to keep her positions from being liquidated in a truly devasting story. Although more experienced investors may laugh or feel no pity at her apparent ignorance, it is a case study that genuinely exemplifies the current problems in the space.
What is clear is that regulators globally are having a hard time enforcing any action in the cryptosphere. So Binance is likely here to stay, and even if it disappears, customers will continue to find a way to gamble away their life savings. One thing is for sure, regulatory pressure is mounting, and as time progresses, the crypto world and the real world will become more intertwined.
A lesson to be learnt
Typically, the complexity of these products is not understood by retail traders. Moreover, even if they know the risks, they likely do not know how to properly utilise derivatives as part of a proper trading strategy, as would a financial professional (usually for risk management). Instead, they are just gambling on market movements. Worse even is when ‘investors’ are gambling away their life savings, utilising lines of credit and short-term loans. I have personally lost money trading forex, indices, and crypto-based derivatives, although a controlled amount and advocate extensively against this type of behaviour — as tempting as it is.
My advice, to those resolute on trying their hand at using crypto derivatives is to only gamble away what you are prepared to lose and understand that you will most likely lose most, if not all, your money. The odds will forever be stacked against you. So instead, if you are interested in crypto and want to support your favourite projects, purchase the underlying assets themselves and then move them off exchanges onto your own wallet. This way, you will have control of the assets and will not be subject to the risk of margin calls and liquidation. This way, when we next see gains in the crypto markets, you may celebrate without the devastation of losing everything and having to re-mortgage your home.
Jamie Campbell is a final year law student at Durham University.
This Journal is in no way intended to amount to financial and/or investment advice.