Lawbitrage

Emerging Bitcoin Derivatives Offer Choice to Merchants and Institutional Investors

Products being developed for large, sophisticated players is usually a sign of a maturing market. And the Bitcoin market is no different.

Until recently, derivatives based on Bitcoin, such as those offered by ICBIT and BTC Oracle, were suited only for small, individual traders. But recent months have witnessed the development of two types of derivatives contracts that are suitable for institutional investors and large merchants.

Derivatives are contracts whose value changes based on the value of some underlying security, currency, commodity, or price index. Derivatives can be used to hedge risk, speculate, or take an investment position in the underlying asset or price index.

Derivatives come in a wide variety of forms, such as stock options and S&P futures. But the new institutional-grade Bitcoin derivatives take forms that are less common.

The first Bitcoin derivative for sophisticated parties to come to market was the TeraExchange (Tera) Bitcoin forward. The Tera contract works in the following way: First, on the initial trade date, the buyer and seller enter into a contract for a certain amount expressed in U.S. dollars. The minimum contract size is $1,000. Then, on the contract's settlement date, the buyer pays the seller in cash if the price of Bitcoin in U.S. dollars has increased since the trade date. The amount the buyer has to pay the seller is based on the size of the contract and how much the price of Bitcoin has appreciated since the trade date. On the other hand, if the value of Bitcoin decreases after the initial trade date, the seller makes the cash payment to the buyer. 

The Tera Bitcoin forward is traded on a platform regulated by the Commodity Futures Trading Commission (CFTC) and known as a swap execution facility. The platform provides prices and matches up parties, but does not clear the trade or otherwise assume any risk related to the parties not paying each other. The Bitcoin swap is uncleared, meaning that the buyer and seller assume the risk that the trade will not properly settle. But as is typical with swap agreements, the Bitcoin forward requires collateral to be posted when the trade is entered, and for parties to make adjustments based on the market value of Bitcoin. Using collateral reduces counterparty risk. 

The first Tera Bitcoin derivatives trade was executed on October 9, 2014, between digitalBTC and another party. digitalBTC is a publicly listed Australian a company that provides Bitcoin mining, trading, and liquidity-provision services. digitalBTC seems to have entered the forward to gain exposure to Bitcoin as opposed to hedging its Bitcoin price risk that arises from holding bitcoins due to its business activities.

A second type of Bitcoin derivative is under development by SolidX partners. According to its press release, the SolidX agreement will take the form of a total return swap, which is a relatively common type of derivative instrument that emerged in the late 1980s. A total return swap enables a buyer to get investment exposure to an underlying asset--including its gains and losses--without having to actually own the asset or necessarily even pay any money upfront.

A total return swap is structured the following way: the buyer pays the seller a set rate in exchange for receiving payments that reflect the gains, if any, from owning an underlying asset. If the underlying asset produces a gain from interest income or market appreciation, the total return swap buyer gets paid that amount. If the underlying asset suffers a loss, the the buyer must pay the swap seller the amount of the loss (in addition to the set rate).

The SolidX Bitcoin total return swap will give its buyer the same gains and losses it would have as if it purchased bitcoins outright (minus the fixed rate it pays to SolidX). Because bitcoins qualify as a type of "commodity" under the Commodity Exchange Act, the SolidX swap will be regulated by the CFTC.

The following diagram shows some basic structural differences between the Tera and the SolidX bitcoin swaps.

Both instruments permit parties to effectively invest in bitcoins without actually owning any. The benefit of doing so is that it allows merchants and financial institutions to gain exposure to Bitcoin without having to deal with anti-money laundering issues and other regulatory concerns that could arise from directly holding bitcoins. 

There are some important differences between the Bitcoin forward and the swap, however. Only the Tera Bitcoin forward offers parties the ability to "short" the Bitcoin market and gain from a Bitcoin price decline. Merchants, investors, and others that hold bitcoins can benefit from Tera's forward giving them the ability to hedge their Bitcoin price exposure.

Another major difference is the source of counterparty risk. With a Tera Bitcoin forward, the other party to the trade will be the source of counterparty risk. With the SolidX Bitcoin swap, SolidX itself will be the source of the counterparty risk. The ability of SolidX to make good on its end of the bargain will depend on how well it translates Bitcoin price gains into an income stream for the buyer. 

Gaining exposure to Bitoin may have different accounting and cash-management consequences with each instrument as well. The Tera Bitcoin forward only triggers the primary payment obligation on the settlement date. By contrast, the SolidX swap may require a more frequent exchange of cash flows. As a result, the SolidX product would have a more direct impact on earnings and liquidity. On the other hand, the buyer of the SolidX swap may not have to post collateral or any cash upfront, which may make the instrument more attractive than an equivalent Tera Bitcoin forward.

Ultimately, differences between the Tera Bitcoin forward and the SolidX Bitcoin swap will depend on the particularities of the terms of the trade and counterparties involved. 

With the advent of these two products, and likely many more on the way, the Bitcoin economy will attract a wider range of commercial and financial market participants.

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.

 

It's the Comparability, Stupid: What Really Matters for Overseas Derivatives Regulation

As financial market regulators seek to coordinate their post-financial crisis reforms, a contentious question is to what extent one nation's regulations apply to companies in other countries. The general principle under the Dodd-Frank Act is that U.S. derivatives (swaps) regulation only applies to transactions that have a significant connection or effect on the U.S.

Much of the debate surrounding the Commodity Futures Trading Commission's (CFTC) regulation of cross-border swaps transactions has centered around which firms are subject to U.S. regulation either because they fall under the definition of a "U.S. person" or because they engage in transactions with U.S. firms. The key worries underlying these debates are subjecting foreign firms to onerous and duplicative U.S. regulation, and whether doing so will undermine the ability of U.S. firms to do business internationally.

But there's a good possibility that the content of U.S. regulation and concerns about who is ensnared by U.S. regulation will eventually become irrelevant to overseas firms.

This is because CFTC regulations do not apply to foreign firms if the CFTC determines that the foreign country's regulations are comparable to its own. On December 20, 2013, the CFTC determined that the swaps regulations of six non-U.S. jurisdictions (Australia, Canada, the European Union, Hong Kong, Japan, and Switzerland) were comparable. This means that firms in those six jurisdictions that would otherwise be subject to U.S. law because of their trades with U.S. firms are now exempt. 

The only thing preventing non-U.S. firms in those six jurisdictions from never having to worry about compliance with U.S. regulation is that the CFTC limited its comparability assessments to only a portion of its derivatives regime. As the law firm Sullivan and Cromwell observed, "[i]t is notable that the CFTC has not made any comparability determinations with respect to the CFTC’s mandatory clearing...trade-execution requirements...[and] margining for uncleared swaps."

The reason that the CFTC's failure to make comparability determinations in those areas is notable is because doing so would likely result in the vast majority of non-U.S. firms not being required to comply with the core requirements of U.S. derivatives regulation; namely, mandatory clearing and trade-execution for all swaps transactions, and lots of collateral for any exempted (uncleared) swaps. 

The possibility that the CFTC will ultimately make comparability assessments in the areas it has not done so is a good one. Right now, the CFTC's approach is piecemeal and fails to comport with the approach widely agreed upon by international financial regulators, including the Securities and Exchange Commission.

Over time, market participants will likely convince regulators to remove duplicative regulations among otherwise equivalent regulatory regimes. When that happens, the more important issue will be what derivatives regimes are considered comparable to those that are already recognized as a comparable to one another, and not the specific rules of any regime or the risk of being subject to a foreign jurisdiction's regulations.

In Contrast to CFTC, SEC Cross-Border Derivatives Proposal Takes an Outcome-Based Approach

Today, the Securities and Exchange Commission (SEC) announced that it will be proposing new rules relating to how U.S. regulation under Title VII of the Dodd-Frank Act will apply to cross-border derivatives transactions.

In so doing, a significant difference seems to have emerged between how the SEC and the the Commodity Futures Trading Commission (CFTC) will go about regulating cross-border derivatives.

A major component of the SEC's and CFTC's rules is to allow certain foreign firms that trade swaps in the U.S. to be exempt from the agencies' respective regulations. The basic reason being that foreign firms may already be subject to comparable regulation in their home country such that compliance with U.S. rules would be unnecessary to protect U.S. participants or markets.

In other words, the SEC and CFTC will permit foreign firms to substitute compliance with their home country's regulation for their own.

Importantly, the SEC's analysis of foreign regulation will focus on "regulatory outcomes" as opposed actual rules and requirements. As the press release describing the SEC's proposed cross-border rules explains:

Under substituted compliance, a foreign market participant would be permitted to comply with the requirements imposed by its own home country, so long as those requirements achieve regulatory outcomes comparable with the regulatory outcomes of the relevant provisions of Title VII....the Commission would take a holistic approach... rather than basing the ultimate determination on a rule-by-rule comparison.

The SEC should be applauded for focusing on comparable regulatory outcomes instead of comparable rules and requirements. It means the SEC understands that there is more than one way to protect investors and markets. An outcome-based approach will permit foreign jurisdictions to experiment with different approaches to regulation without necessarily undermining their domestic participants' access to U.S. markets. Focusing on outcomes will also help prevent foreign firms from being subject to duplicative regulation and keep U.S. capital markets competitive.

Indeed, in a 2009 article published in the NYU Journal of International Law and Politics, Jerry Ellig and I called for an outcome-based approach towards substituted compliance with securities regulation. Using very similar language, we argued that

the SEC should permit substituted compliance with a foreign regulatory regime so long as that regime achieves investor-protection outcomes similar to the investor protection outcomes achieved by the SEC....Compliance with a regime having comparable regulatory outcomes would thereby serve as a substitute for standard registration and oversight by the SEC.

Notably, however, the SEC's outcome-based approach towards substituted compliance seems very different than the approach taken by the CFTC, which focuses more on rules and requirements in making a foreign regime comparability assessment. Instead of focusing on regulatory outcomes, the CFTC will focus on the following aspects of a foreign regime in determining whether the regime is comparable:

the scope and objectives of the regulatory requirement(s), the comprehensiveness of such requirements, the comprehensiveness of the foreign regulator’s supervisory compliance program; and the foreign regulator’s authority to support and enforce its oversight of the non-U.S. swap dealer or non-U.S. major swap participant.

There thus seems to be a fundamental difference in how the SEC and CFTC will go about determining whether a foreign regulatory regime is comparable to their own. Although differences between the two approaches may matter little in practice, the differences could ultimately impact which foreign jurisdictions are considered comparable to the U.S. and lead to regulatory arbitrage.