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Crypto derivatives have been enjoying widespread popularity among investors, especially institutional clients. In July 2023, their trading volume on centralized exchanges surged 13% to $3.12 trillion compared to the previous month, meaning derivatives account for 69% of total cryptocurrency volumes, which also includes spot market trades.
Yet, despite the growth of crypto derivatives and their potential to onboard institutional investors, regulatory complexities have introduced numerous challenges for market players.
Regulatory landscape for crypto derivatives
While traditional derivatives are regulated in most jurisdictions, many nations lack the appropriate legislation for their digital asset variants. Regulatory uncertainty has been heavily cited as one of the critical barriers to mainstream crypto adoption. A common approach for regulators is to categorize cryptocurrencies and derivative products based on existing legal and regulatory frameworks.
The UK Law Commission views digital assets within the existing concept of property. Simultaneously, the statutory body believes smart contracts operate similarly to traditional contracts, with the potential for English law to support their use without reform.
Similarly, US regulators have sought to apply the standing derivative rules to crypto derivatives. Still, those that fall out of the scope of the existing framework are prohibited, including those traded on foreign exchanges or located in jurisdictions with lax regulatory laws. As a result of the latter, the Commodity Futures Trading Commission imposed a $1.25 million fine on Kraken for illegally offering margined retail commodity transactions in digital assets to US customers as an unregistered futures commission merchant.
Unlike the UK and the US, the European Union has taken a different approach to crypto regulation. In May 2023, the EU became one of the first to introduce a comprehensive regulatory framework for digital assets after adopting new rules under the Markets in Crypto Assets (MiCA) bill. MiCA aims to advance innovation in the sector within the EU by seeking market stability and improving investor confidence via various safeguards.
On the other hand, China is continuing to clamp down on digital assets altogether, as shown by the September 2021 decision by the People’s Bank of China to make all crypto transactions illegal. With a blanket ban on all activities, cryptocurrency derivatives are not viable financial products for the nation’s investors.
Regulatory challenges remain at the center of attention
As laws differ significantly by jurisdiction, regulatory compliance is often a key challenge for market players trying to navigate the crypto derivatives landscape. Simultaneously, the novelty of blockchain technology has led to further issues for both industry participants and regulators.
For example, the existing platform regulatory framework assumes a centralized network where a company has complete control and rights over all content and activities. However, most blockchains are decentralized, with protocols deployed on them facilitating networked content distribution with little to no control over what a consumer sees.
As recent regulatory responses seek to protect end-users through more centralized control over content, a radically different approach is needed in this field to achieve desired policy outcomes. It could be achieved by imposing rules on protocols to regulate on-chain activities or requiring a certain minimum functionality to remain centralized with a control authority under the regulator’s supervision.
Existing regulatory rules make it impossible—or at least undesirable—to create and enforce intellectual property rights while using public, permissionless blockchain networks for records. Until further statutory rules recognize a legal title to digital assets, the adoption of decentralized platforms for such instruments will remain restricted. Such issues are primarily due to incompatibilities between blockchain-based legal rights and legal areas that need to be addressed case-by-case.
Regarding crypto derivatives, the decentralized nature of blockchain technology can become problematic when it comes to the valuation of the underlying assets. Unlike in the case of securities, there is no single, dominant exchange to value them. While this makes consensus on valuation more challenging to reach, risks of market manipulation and a lack of liquidity could negatively impact prices on exchanges, presenting new issues for industry players. Unexpected disruption events, such as hard forks, cyber attacks, and times of extreme volatility, can also pose additional dangers in this field.
New hope for the sector
Recent market developments can potentially alleviate or even tackle current regulatory and legal challenges. The International Swaps and Derivatives Association (ISDA) has published the documentation outlining a new standard for digital asset derivatives. With a standardized approach and contractual framework for the ISDA Master Agreement, greater efficiency can be achieved, and parties can assess their contractual risks and obligations with better conditions.
In the UK, English law remains dynamic, flexible, and resilient when accommodating digital assets. To date, United Kingdom-based courts have handed down several judgments in blockchain and crypto-related disputes. Because English law recognizes digital assets as property, it gives rise to remedies for property owners, including the right to obtain injunctions.
However, there are a few areas where English law must evolve to fit the unique characteristics of the crypto market, for which the Law Commission has published new recommendations for reforms and developments in June 2023.
Besides the ones listed above, multiple jurisdictions have introduced pro-crypto policies focused on attracting crypto organizations with regulatory clarity and a friendly environment that facilitates innovation and growth. The UK’s upcoming regulation and Dubai’s VARA framework are excellent examples in this field.
A positive outlook for the future of crypto regulation
The regulation of blockchain technology and cryptocurrencies is already complex for regulators and market players. Yet, the growing popularity of digital asset derivatives makes the task even more complicated to achieve.
That said, recent regulatory developments, such as the ISDA’s new standard for crypto derivatives, the proposed evolution of English law, and the UK’s and Dubai’s cryptocurrency-friendly approaches, provide a positive outlook for the industry’s future regulation. Jurisdictional consistency and the equivalent treatment of centralized and decentralized digital asset providers should remain essential to upcoming regulatory frameworks.
