Regulators are tightening their grip on cryptocurrency trading venues. Following a year-long consultation, the UK’s FCA recently announced a new policy banning the offering of derivative products that track cryptocurrency assets to UK-based retail investors and traders. Charles Kerrigan, attorney and global head of fintech at global law firm CMS, spoke with Ian Taylor, chair of industry trade organization Crypto UK, about the ban. 

Kerrigan explained that the FCA’s focus is two-pronged: activities and investments. The first bucket, activities, represents marketing and selling, while the second bucket, investments, represents just that in products such as derivatives and exchange-traded notes (ETNs) as well as stocks and bonds. 

The regulator is responsible for ensuring an orderly market and authorization for market participants. The FCA is worried about consumer protection, as they must be sure customers are treated fairly and protected. This means investors should not be in a position where they could be exposed to unreasonable losses, and that is the place that this regulation is coming from. 

(4:16) “So the ban on derivatives and ETNs in relation to crypto comes from I think fairly clearly consumer protection motivated by the regulator,” Kerrigan said, adding: “It’s worth just noting at this stage that we are broadly consistent with the regulators in the US in this respect,. And the FCA isn’t saying that it’s got a problem with crypto. Its report form earlier this year around summer was pretty positive.” 

The regulator, however, would get blamed if cryptocurrency derivatives blew up in consumers’ faces. Kerrigan stated that it’s a fast-moving market in the best of times and he believes the FCA is just concerned about the potential exposure that customers have in this area. 

Nearly all of the responses that the FCA received, or 97% of dozens upon dozens, were against a complete ban. There were suggestions that regulators look to other areas such as CFDs, where they treat leverage differently and there isn’t a complete ban for retail.  

Kerrigan explained that financial services is generally a conservative industry and there is a degree of support for the ban, adding that people in that market probably weren’t among the respondents. 

Fintech would be more open-minded for crypto, as these people are in the market and they believe these are valuable products that they can use in a trading strategy. There is surely a degree of disappointment that people wouldn’t be able to access those trading products and strategies that they’ve been using. Providers, meanwhile, are going to be losing business because they won’t be able to provide these products to customers in the future as they’ve been doing. 

Within crypto, Kerrigan believes there is an institutional element to the market that is less focused on derivatives and more focused on adoption for digital assets and cryptocurrencies. 

(8:31) “The key from that perspective is not to have this blow up before we’ve got to full adoption, to try and make this a broad market that has more users rather than a narrow market that focuses on those sophisticated users that want to use these products,” he said. 

Kerrigan believes the FCA’s decision comes down to leverage. He explains that it is in some ways ironic, because when the regulator looks at derivatives in the general markets, it’s a relatively boring market with CFOs managing their interest rates and foreign exchange currency exposure. For them, derivatives are a tool to manage down risk of volatility. He describes a “parallel world” in which feedback from the regulator is almost the polar opposite of what you would expect them to say in the conventional market. 

(10:50) “The numbers that we see tell the story of that, that the support for crypto derivatives is particularly underpinned by leverage. So you can use derivatives to achieve two aims: you can hedge away your risk/reduce your risk or you can magnify your risk by using leverage. And the role of derivatives in all markets, this isn’t just crypto, is that they allow larger trades to be made and therefore the potential for larger losses. And I think that is what the regulator is concerned about,” said Kerrigan. 

He pointed to large corporates with deep balance sheets moving into crypto, noting that they are just buying the asset and treating it as risk enough without taking leveraged positions. He pointed to incremental change, saying the regulator has identified what it thinks is a risk because of the value of derivatives and does not necessarily have a problem with derivatives themselves. That exposure reflected in the value and volume of the numbers is what is concerning them. 

As adoption continues, it may be two steps forward, one step back for the industry, followed by another couple of steps forward. So this doesn’t in any way change his view of where the market is going.