Almost all U.S. financial regulators have taken an official stance regarding Bitcoin and other virtual currencies.
The Treasury Deparment's Financial Crimes Enforcement Network (FinCEN) stated that companies sending or exchanging "convertible virtual currencies" like Bitcoin would be subject to anti-money laundering and related regulations. The Securities and Exchange Commission successfully argued in a suit that a Bitcoin-denominated investment scheme to invest in bitcoins was under its jurisdiction. By contrast, Federal Reserve Chair Janet Yellen said the U.S. central bank has no jurisdiction over Bitcoin. Even the Internal Revenue Service has weighed in, and categorized Bitcoin as property for tax purposes.
The one major financial regulator that has yet to make an official move on Bitcoin is the Commodity Futures Trading Commission (CFTC). But that hasn't stopped market participants. Already, there are several venues to trade Bitcoin derivatives.
But it's only a matter of time until the CFTC proposes new rules applicable to Bitcoin, brings enforcement actions, or at least issues some guidance.
So as the CFTC goes about regulating Bitcoin, here are some observations it should keep in mind.
First, Bitcoin should be categorized either as an "exempt commodity," like gold and other precious metals, or as an "excluded commodity," like currencies and other financial interests. The case for the fomer is that bitcoins are limited in number and capable of being physically delivered (at least in a digital sense). The case for the latter is that bitcoins are a currency substitute, at least in some contexts, and are also a broader financial interest due to the underlying Bitcoin block chain enabling far more than payments transactions. Alternatively, it may be better for the CFTC to harmonize its approach with FinCEN (and the People's Bank of China, for that matter) by defining a new category of "virtual commodity" that includes cryptocurrencies like Bitcoin.
Second, parties that trade Bitcoin derivatives probably intend for physical delivery and not a cash settlement for the value of the trade. For example, the Bitcoin options being offered on Derivabit are structured to result in physical delivery of bitcoins. The Derivabit Guide states that the “underlying [Bitcoin] is fully available if the call option holder chooses to exercise the option."
The same applies to MPEx, a Bitcoin securities and futures exchange. For example, the settlement terms for MPEx’s X.Eur contract contemplates physical delivery, “intend[ing] to market make an Euro based Bitcoin future with physical delivery for the foreseeable future."
The intent to settle Bitcoin physically is important. Physical settlement is one of the most important characteristics that determines whether a derivatives contract will be regulated. For example, while the CFTC regulates futures, it has no jurisdiction over forwards, which are contracts to physically trade commodities in the future at a price agreed to now. As the court in CFTC v. Erskine explained:
The purpose of [the] “cash forward” exception [to CFTC regulation] is to permit those parties who contemplate physical transfer of the commodity to set up contracts that . . . reduce the risk of price fluctuations, without subjecting the parties to burdensome regulations. These contracts are not subject to the CFTC regulations because those regulations are intended to govern only speculative markets; they are not meant to cover contracts wherein the commodity in question has an “inherent value” to the transacting parties.
This reasoning applies to Bitcoin derivatives. First, unlike agricultural commodities, bitcoins are easily transferable between parties. Indeed, a primary feature of bitcoins is that easier to transfer them than their cash-equivalent. And due to Bitcoin's price fluctuations, parties are likley attempting to reduce the risk associated with its volatility. Finally, unlike derivatives contracts themselves, as a means of payment and of potentially transferring property titles and performing other financial services, bitcoins have inherent value.
Similarly, options that entail physical delivery are exempt from CFTC regulation, but only if they are traded between entities that include financially sophisticated parties and commercial users, and don't involve fraud and manipulation.
Thus, the digital nature of bitcoins, along with their near costless transferability, suggest that derivatives transactions involving bitcoin intend for physical settlement. Accordingly, they should probably not be treated as fully regulated futures contracts.
For more on how the CFTC and other regulators should approach Bitcoin regulation, see my co-authored article, Bitcoin Financial Regulation: Securities, Derivatives, Prediction Markets, & Gambling, with Jerry Brito and Andrea Castillo.