The Regulation of Financial Product Innovation Typified by Bitcoin-Based Derivative Contracts
Bitcoin and blockchain epitomize, respectively, financial “product” and financial “process” innovation. However, the new innovative trend does not stop with Bitcoin and blockchain themselves: Bitcoin now represents an asset that offers the basis for the further development of financial “product” innovation through derivative contracts. The presence in the American financial markets of several types of Bitcoin-based derivative contracts, such as Bitcoin non-deliverable forwards, Bitcoin options, Bitcoin futures, and Bitcoin binary options is a clear signal of the new trend.
It is notorious that one factor that has favored the creation and development of a market for Bitcoin-based derivative contracts is the attempt by the US-regulated derivative markets to attract the investment interests of institutional investors. So far, this category of sophisticated traders has been hesitant about being exposed to Bitcoin through foreign unregulated trading venues. Although Bitcoin-based derivative contracts offer the opportunity to get exposure to the underlying asset through regulated designated contract markets (DCMs) and swap execution facilities (SEFs), they do not completely shield investors from some typical risks inherent in Bitcoin. Thus, there could be room for regulators to step in and support Bitcoin derivative markets in mitigating those risks.
In my recent article, “The Regulation of Financial Product Innovation Typified by Bitcoin-Based Derivative Contracts,” I offer an overall analysis of the CFTC’s regulatory approach towards financial “product” innovation typified by Bitcoin-based derivative contracts. The research starts in with an analysis of retail commodity transactions involving virtual currencies, as these transactions are subject to the same regulation as futures contracts. Then, I analyze the different types of Bitcoin-based derivative contracts that DCMs and SEFs have created to attract both institutional investors (Bitcoin futures and Bitcoin swaps, for example), and retail investors (such as Bitcoin binary options). In my conclusions, I point out that the CFTC could improve the accuracy of the Bitcoin spot market by exercising—through a direct regulation of crypto-based derivative contracts—a de facto regulatory power over foreign unregulated trading venues. Indeed, trading venues may be strongly incentivized—by the return they may receive in terms of reputational gain—to be selected by an U.S.-regulated derivative market (a DCM or SEF) as a source for the determination of the reference price of Bitcoin. The CFTC could leverage these incentives by requiring that such regulated markets select those trading venues that meet certain listing and trading standards as their source for the determination of the reference price.
Another issue that has not yet received a coherent response from the derivative markets is the handling of hard forks. Some markets have adopted policy frameworks to manage the occurrence of these events, but those frameworks do not ensure predictability, and in essence state that the market will have pure discretion in handling the fork. The CFTC should conduct thorough empirical and legal analyses of the consequences of hard forks for investors holding positions in Bitcoin-based derivative contracts, and then decide on whether a regulatory response is needed to preserve investors’ rights.
Scholars have expressed doubts about whether Bitcoin will keep its role as a major crypto-asset. Should Bitcoin’s position decline in favor of other virtual currencies, the overall regulatory framework for Bitcoin-based derivative contracts that is being created by the CFTC—and that legal scholars may help to shape—will nonetheless remain a useful model for the regulation of the evolving area of crypto-based derivative contracts.
Giovanni Patti, New York University School of Law