From buy buy to bye-bye for crypto derivatives in the UK

Fresh from the Financial Conduct Authority on Wednesday: a proposal to ban the sale, marketing and distribution of derivatives and exchange traded notes linked to "cryptoassets" for retail consumers.

The rationale for the ban is the following (our emphasis):

We believe that retail consumers can’t reliably assess the value and risks of derivatives (contracts for difference, futures and options) and exchange traded notes (ETNs) that reference certain cryptoassets. This is due to the:
  • inherent nature of the underlying assets, which have no reliable basis for valuation

  • prevalence of market abuse and financial crime (including cyberthefts from cryptoasset platforms) in the secondary market for cryptoassets

  • extreme volatility in cryptoasset prices movements

  • inadequate understanding by retail consumers of cryptoassets and the lack of a clear investment need for investment products referencing them

We think these issues will cause retail consumers harm from sudden and unexpected losses if they invest in these products. We estimate a ban could reduce harm by £75m to £234.3m a year for retail investors.

That estimate (£309.3m) is no doubt an approximation based on some FCA knowledge of how much retail investors have lost (in what they feel is unfair circumstances) to date.

But the ban isn't a forgone conclusion just yet. The FCA is offering a consultation period during which time crypto derivative firms will be able to make their case as to why the ban should not be pursued.

Thus far, the list of who might be affected runs as follows:

  • firms issuing or creating products referencing cryptoassets

  • firms distributing products referencing cryptoassets, including brokers and investment platforms, and financial advisers

  • firms marketing products referencing cryptoassets

  • operators of trading venues and platforms

  • retail consumers and consumer organisations

Associated documents confirm this includes entities offering CFD-type exposures: the number-one way in which UK punters have been getting exposure to crypto assets the past few years.

As the FCA notes on that matter:

In terms of the scale of the UK market, CFDs are the main derivative product that reference cryptoassets. Based on figures obtained from firms, between August to October 2017, there was c £3.4bn in retail client trading volume, representing 0.7% of total retail CFD trading volumes. This fell to £77m in the same three months in 2018. The decline in trading volumes is partly linked to the introduction of ESMA’s temporary intervention measures restricting leverage to 2:1 from 1 August 2018, as well as a significant decline in the price of cryptoassets during this period.

As for the justifications for the ban -- dig deeper into the docs and you'll discover the most amazing anecdote.

A key criterion for scrupulous derivative investing is some broad consensus on how these derivatives are valued. But as the FCA discovered in its inquiry, it is "impossible to reliably value the derivatives contracts or ETNs linked to them".

Broadly, they note, there is a lack of reliable valuation models, which contrasts with other high-risk assets where at least some sort of credible valuation can be resorted to.

To test the seriousness of this valuation issue, the FCA referred to bitcoin valuations by two different analysts using the same pricing model. As they note, these two analysts arrived at bitcoin valuations with a 400x difference.

As they noted about the discrepancy:

Even if the supply of one such exchange token is genuinely limited, the supply of others is potentially infinite and they are substitutable, implying that the value of any single such currency will fall to zero over time.

Total utter madness, in other words.

From our perspective, the ban doesn't necessarily go far enough. If one takes the concept of a derivative in its purest sense, the ban should also be applicable to wallet services and exchange services that issue their own crypto-linked liabilities to punters instead of offering fully key-controlled ownership of the underlying.

If you're going to invest in the supposedly positive "be your own bank" features of crypto, you should "be your own bank" and not hypocritically use third-party intermediaries for your exposure.

Related links:
FCA proposes ban on sale of crypto-derivatives to retail consumers - FCA
Kaminska vs eToro and others at the UK Treasury Select Committee into digital currencies - Parliament
Puff the tragic cryptowagon smokes out the Mumsnet demographic
- FT Alphaville
“Cryptoassets” are crashing again. Is it time to start calling them cryptoliabilities instead? - FT Alphaville
European regulators extend CFD restrictions until May
- FT
IG Index fights claim it encouraged ‘risky’ trades - FT
London remains wary of jumping on crypto bandwagon
- FT

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