Lawbitrage

Making Sense of Bitcoin Derivatives Regulation

Bitcoin price volatility isn't what it used to be. Compared to its meteoric rise and fall in 2013, recent months' fluctuations around $600 seem tame.

But despite the fact that Bitcoin has become boring--at least for speculators--widespread adoption of the cryptocurrency will not happen unless merchants and others can shield themselves from its volatility.

And companies are stepping up to meet that need.

A recent entry is Coinapult’s Locks, a service that allows customers to lock in the price of their bitcoins to an existing currency like dollars or Euros, and even gold. The Bitcoin Mercantile Exchange is another relative newcomer, and reportedly went live last week (on July 28, 2014).

Companies hedging fluctuations in currency prices is nothing new, of course. Firms that operate internationally routinely use derivatives contracts to reduce risk. Coca-Cola, for example, uses forwards and options to hedge currency price risk from selling in Europe and Japan.

So as companies increasingly offer derivatives to hedge Bitcoin price risk, an open question is how Bitcoin derivatives will be regulated. It's an open question because the Commodity Futures Trading Commission (CFTC) has yet to take any public action regarding Bitcoin derivatives even though they fall directly under the CFTC's jurisdiction.

Nonetheless, the CFTC's existing regulatory framework is clear enough to make sense of how Bitcoin derivatives are likely to be regulated. In broad terms, CFTC regulation has three components most relevant to the Bitcoin economy: futures regulation, the distinction between futures and forwards, and swaps regulation.

Futures

Futures contracts, whereby one party agrees to deliver an underlying asset or its cash-equivalent at a later time at a pre-specified price, fall squarely within the CFTC's jurisdiction. They're standarized with respect to all terms except for price and are required by law to trade on regulated futures exchanges.

Virtually any type of economic good or measurable quantity--from crops to prices to the weather--can be the basis of a futures contract. This is due to the Commodity Exchange Act's extremely broad definition of "commodity." When it comes to Bitcoin, the only question right now is whether the CFTC will categorize bitcoins as "excluded commodities" like currencies or other financial interests, or as "exempt commodities" like gold and other precious metals.  

Futures Versus Forwards

In contrast to futures are forward contracts. Forward contracts also lock in a price for an underlying commodity at the inception of the contract. But unlike futures, forwards are not  standardized, do not trade on exchanges, and physically deliver the underlying commodity. In the words of the CFTC, the “primary purpose of a forward contract is to transfer ownership of the commodity and not to transfer solely its price risk” as is the case with futures.

Importantly, forward contracts are not regulated by the CFTC.

While it may be obvious whether a particular contract is a future or a forward, when the CFTC or courts distinguish between the two, the most important factor tends to be whether the contract was intended to physically deliver a commodity (and hence is a forward) or whether it was meant to enable parties to speculate on the price of the commodity (and hence is a future). A contract is also more likely to be considered a forward if it is not fungible and not traded on a venue that functions as an exchange (by, for example, taking on counterparty risk and enabling parties to enter into offsetting contracts).

Whether a contract is a regulated Bitcoin futures or an unregulated Bitcoin forward in principle should be no different that futures and forward in other types of commodities. If the agreement is highly standardized and traded without the intent or ability of the parties to physically deliver Bitcoins, it may be deemed a futures agreement. Contracts that contemplate physically delivering bitcoins or that are nonfungible are likely to be considered forward and fall outside of CFTC regulation.

Importantly, the fact that bitcoins are digital assets and cannot be "physically" delivered in the traditional sense does not matter: the CFTC recognizes that intangible assets (which may include bitcoins) may be the subject of a forward contract so long as "ownership of the commodity can be conveyed in some manner and the commodity can be consumed.” Bitcoin ownership can certainly be conveyed and, if bitcoins are deemed by the CFTC to be intangible, spending or trading them likely qualifies as being "consumed."

Swaps

Swap agreements are another common way for companies to hedge price risk. In a swap, two parties agree to exchange cash or other another commodity based on the price of an underlying asset or event. Ford Motor Credit, for example, uses cross-currency swaps to reduce its exposure to exchange rate changes arising from international debt financing.

Due to reforms ushered in by the Dodd-Frank Act, swaps are subject to a fair amount of CFTC regulation. Swaps must be cleared and traded on regulated central counterparties and multi-dealer trading platforms. Dealers and major users of swaps are also subject to capital, disclosure, and a host of other regulations. Swaps that are not subject to mandatory clearing are still subject to margin requirements, which may be fairly onerous once they are finalized.

Users of Bitcoin swaps may be able to escape the full scope of swaps regulation, however. Merchants that use Bitcoin swaps to hedge price risk would like qualify for the commercial end-user exemption from mandatory swaps clearing. In addition, to the extent a Bitcoin derivatives contract is structured and recognized by the CFTC as a contract involving a nonfinancial commodity intended for physical delivery, it will be deemed a forward contract and by definition excluded from any aspect of swaps regulation.

Finally, there is also the possibility that the Treasury Department may ultimately end up exempting physically settled Bitcoin swaps from the clearing mandate for the same reasons it did so for certain physically settled foreign exchange swaps; namely, because they are short-dated and don't pose a systemic risk. 

Options are another type of derivative that may help to reduce Bitcoin volatility. They are basically regulated like swaps. 

While it is certainly possible that the CFTC will create a unique regulatory framework specifically for virtual currencies like Bitcoin, it is more likely that its existing framework for futures and swaps regulation already provides a basis for understanding how Bitcoin derivatives will be eventually regulated.

For a deeper analysis of Bitcoin financial regulation, see my co-authored article here.

How the CFTC Should Approach Bitcoin Regulation

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.

 

Dodd-Frank Unlikely to Reach Foreign Shores

The Dodd-Frank Act does not apply extraterritorially, to activities outside the United States, unless those activities meet a threshold level of significance to the U.S. Under Section 722(d), for example, swaps regulation does not apply outside the U.S. except to activities that "have a direct and significant connection with activities in, or effect on, commerce of the United States."

Depending on how broadly regulators or courts interpret "direct and significant," a wide range of overseas transactions could be subject to Dodd-Frank. That could include, for example, requiring a European swaps dealer to abide by Dodd-Frank reporting, capital, margin, and business conduct standards if it enters into a swap with a U.S. institution. The problems with such an approach include subjecting non-U.S. institutions to duplicative or inconsistent regulation, and that doing so may make non-U.S. dealers reluctant to transact with U.S.-regulated institutions in the first place.

U.S. lawmakers recently took a significant step away from such a broad approach, however, by seeking to clarify and limit the extraterritoriality of Dodd-Frank swaps provisions in a bill, the Swap Jurisdiction Certainty Act.

With respect to extraterritoriality, the proposed bill would permit non-U.S. swaps dealers registered with the Commodities Futures Trading Commission (CFTC) to only comply with Dodd-Frank requirements with respect to their swaps with U.S. institutions, hence exempting them from complying with U.S. rules for their swaps with non-U.S. institutions. And even with respect to their swaps entered into with U.S. institutions, the bill would exempt registered non-U.S. swaps dealers from Dodd-Frank's capital requirements so long as their home country's regulations are comparable and the country is a Basel signatory.

Although the bill is in its early stages, it seems to reflect a growing acceptance of limiting Dodd-Frank's extraterritoriality as seen, for example, in recent remarks by CFTC Chairman Gary Gensler and in a number of comment letters on behalf of financial institutions to regulators. Importantly, the "mutual recognition" approach adopted by the bill (which allows complying with comparable non-U.S. regulation to substitute for complying with Dodd-Frank) will likely promote healthy regulatory competition.

More Cost-Benefit Analysis is Coming to Financial Regulation

Last week saw introduction of the Financial Regulatory Responsibility Act (FRRA) of 2011 by Senator Richard Shelby (R-AL). Based on its summary, the new bill would mandate greater and more consistent use of economic analysis in financial regulation, require a reexamination of existing regulations and new ones every five years, and prohibit regulators from finalizing rules for which the costs exceed the benefits. The bill would also create a new Chief Economist Council to coordinate the cost-benefit analyses of financial regulators. 

The FRRA comes amid a growing wave of attention by policymakers on the use of cost-benefit analysis in the regulatory process. On the very same day the FRRA was introduced, a bipartisan group of lawmakers also proposed the Regulatory Accountability Act of 2011, which would require even more extensive use cost-benefit analysis throughout the entire spectrum of federal rulemaking. The FRRA is in part a response to examinations earlier this year of each financial regulator's use of cost-benefit analysis.* Senator Shelby and other lawmakers viewed the results of these examinations as demonstrating that cost-benefit analysis in financial regulation left much to be desired for lacking depth and consistency and failing to focus on broad costs such as on employment and economic growth. The growing importance of cost-benefit analysis was also highlighted earlier this year when the DC Court of Appeals overturned the Securities and Exchange Commission's Dodd-Frank shareholder proxy access rules due to the court's opinion that the agency's cost-benefit analysis was faulty.

Throughout 2011, a focus on the burdens of regulation and the need to maintain flexibility in light of economic analysis and changing circumstances have been a hallmark of the Obama Administration's approach to regulation. Two executive orders (from January and July) highlight the principles of this approach, which also requires a retroactive cost-benefit assessment of existing regulation as seen in the FRRA.

It is too early to tell whether the FRRA will have widespread support by Congressional lawmakers. However, given that it embeds into law the Obama Administration's principles of regulatory analysis, and a bipartisan group of legislators introduced a different law on the same day that would even more forcefully enshrine cost-benefit analysis into the entire regulatory system, it is very likely that some piece of legislation will soon be able to obtain enough votes and require far more extensive cost-benefit analysis in financial regulation.

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*The examinations for each agency were undertaken by their respective offices of inspector general and the reports are located at the following links for each agency: the Commodity Futures Trading Commission, the Federal Deposit Insurance Corporation, the Federal Reserve Board, the Office of the Comptroller of the Currency and Treasury Department, and the Securities and Exchange Commission.