UK Regulator Proposes Ban on Crypto-Derivatives for Retail Clients
On 3 July 3 2019, the UK Financial Conduct Authority (FCA) issued a consultation paper (CP19/22) on prohibiting the sale, marketing and distribution to retail clients of investment products that reference unregulated cryptoassets that allow transferability (i.e., can be widely exchanged on cryptoasset platforms or other forums). The prohibition will cover firms acting in, or from, the UK.
The investment products within the scope of the prohibition are contracts for difference (CFDs), futures and options and exchange traded notes (ETNs), which the FCA believes pose similar risks to derivatives on tokens. "Referencing" includes derivatives that use an index or benchmark price for tokens within the contract, as well as those using a single price from a cryptoasset trading platform. The derivatives and ETNs within the scope of the ban are referred to by the FCA as "crypto-derivatives".
The FCA cites these reasons for the proposed ban:
Valuation and price formation: The FCA has found that firms manufacturing, and consumers seeking to invest in, crypto-derivatives are unable to value reliably the underlying cryptoassets. This, therefore, makes it impossible to reliably value the derivatives contracts or ETNs linked to them. Therefore, consumers cannot make informed decisions about the value of their investment and face significant risk of harm as they cannot accurately assess their risk of loss, or possible rate of return.
Risks from financial crime, market abuse and operational issues: In the FCA's view, the integrity and confidence in the cryptoasset market also affects retail clients holding crypto-derivatives. This is because their products' value is directly affected by any sudden devaluation or price dislocation in exchange or utility token prices. Market immaturity (including cryptoasset platforms' systems and controls), lack of transparency and absence of comprehensive market oversight in underlying cryptoasset markets means there are significant risks from financial crime (including cyber-attacks), market abuse and operational risks.
Extreme volatility: Extreme volatility and price dislocation in an underlying asset affect the scale and speed of client losses from a derivative (e.g., if consumers are unable to quickly close a long, open position in falling markets). The FCA's CFD analysis has shown that the frequency of trading increases with leverage and volatility and amplifies aggregate losses due to trading costs. Volatility is also exacerbated by market abuse, especially in the forms of pump-and-dump schemes which drive up and then crash prices.
UK consumers' understanding of crypto-derivatives: Limited understanding among UK consumers of the underlying cryptoasset market, as well as the complex nature of derivatives, can further exacerbate the above risks and make crypto-derivatives unsuitable for retail consumers.
The ban will also include products sold, distributed or marketed in or from the UK to retail clients. This includes banning sales to UK retail clients by other firms within the EEA, including where retail clients seek products via reverse solicitation. It would also prevent UK brokers or platforms marketing and distributing products available in other jurisdictions to UK retail clients. However, retail clients could still seek products from a third-country firm via reverse solicitation.
The ban will not cover:
- Tokens that are unregulated but are not widely transferable. This would exclude, for example, tokens used on a private network where they can only be redeemed with the issuer and cannot be exchanged between third parties via platforms.
- Derivatives that reference e-money tokens.
- Derivatives that reference security tokens.
- Investment funds, given that UCITS and non-UCITS retail schemes are not currently permitted to invest directly or indirectly in cryptoassets. However, qualified investor schemes and unauthorised alternative investment funds (AIFs) such as hedge funds could invest in derivatives referencing unregulated tokens, as they are subject to rules that restrict promotion to certified high net worth or sophisticated retail clients. The FCA views the combination of existing restrictions on the promotion of unauthorised AIFs, the diversification of risk in a pooled fund structure and existing regulatory obligations on AIF managers all as sufficient to protect the limited subset of retail clients who can access them.
- Wholesale investors, as the inherent risks of valuation, financial crime, market abuse and volatility affecting crypto-derivatives could pose similar harm. However, the FCA does not extend an intervention to professional clients or eligible counterparties.
The consultation is open until 3 October.
© Arnold & Porter Kaye Scholer LLP 2019 All Rights Reserved. This Advisory is intended to be a general summary of the law and does not constitute legal advice. You should consult with counsel to determine applicable legal requirements in a specific fact situation.