UK ban on crypto derivatives may fail to protect investors

The Financial Conduct Authority (FCA), which regulates financial services in the UK, issued a ban this week on the sale of cryptocurrency derivatives and crypto exchange-traded notes (ETNs) to retail investors.

While this may not seem particularly significant for the crypto asset market as a whole (UK retail investors have little appetite for cryptocurrency derivatives and the market has barely reacted), the signal behind this news is worth paying attention to.

The message is a public statement: “We don’t like crypto assets.”

If you think I’m exaggerating, take a look at the first sentence of this policy statement: “There is growing evidence that crypto-assets are causing consumer and market harm.” (There is no such sentence. It’s annoying for a financial regulator to make such a bold statement without any evidence.)

There is nothing wrong with the news itself; not everyone likes crypto assets. However, the job of financial regulators is to protect consumers, not to pass judgment on new asset classes. The document accompanying the ban reads like the personal opinions of some senior officials, exceeding the mission and authority of the regulator.

Ironically, crypto assets were created to circumvent this kind of unreasonable centralized control.

Is the threshold too high?

The second shocking news is that the FCA believes that retail investors cannot understand this new class of assets.

The FCA's reasoning is that this is all for the benefit of retail investors. It leads investors to believe that this move will prevent losses of £19 million to £101 million each year. This is an insult to the intelligence of retail investors because no matter what method is used to calculate, the final number will be very biased and difficult to be convincing. I am curious about how much retail investors lose on the National Lottery each year.

We analyze the five main reasons for issuing the ban based on the FCA announcement.

1) The first is "the inherent nature of the underlying assets, i.e., there is no reliable basis for valuation". Seriously, what asset out there has a reliable basis for valuation? OK, that's a stretch. But the idea that market prices reflect reasonable valuations was proven wrong a few months ago.

Additionally, crypto assets are a new type of asset. They don’t lend themselves to traditional valuation methods, but that doesn’t mean they don’t have any value drivers. There is a lot of work going on to better understand and communicate these factors.

2) Second, “market abuse and financial crime (e.g., cyber theft) are rife in secondary markets.” You may recall that at the end of September, leaked FinCEN documents revealed that the U.S. Treasury Department labeled the United States a “high-risk jurisdiction” due to its relatively high incidence of financial crime, but not related to cryptocurrency derivatives.

3) "Extreme price volatility of crypto assets" is also an unreasonable excuse. Although crypto assets are more volatile, Bitcoin's volatility has been declining over the years and is lower than some equity derivatives. However, the FCA will not prohibit UK retail investors from buying or selling Tesla equity derivatives.

4) Throughout the statement, the FCA frequently refers to “retail investors’ lack of understanding of crypto assets”. This is completely insulting. How do they know that investors lack understanding? This assumes that retail investors are incapable of doing their own research and understanding the material. I’m sure many retail investors understand crypto assets better than the FCA does.

In addition, according to the results of the FCA consumer survey released in July this year, "the vast majority of crypto asset owners understand the product, are aware of the lack of regulatory protection, and understand the risks of price volatility." The FCA's research shows that retail investors have done their homework. It seems unreasonable for regulators to think that they have not done enough homework, especially when no reason is given.

5) Finally, and the point I want to make the most is that there is “insufficient legitimate investment demand for crypto assets from retail investors.” Is it the FCA’s job to determine market demand? Does the market really need more equity exchange-traded funds (ETFs)? Many well-known investors with good reputations believe that crypto assets do meet investors’ needs to hedge against inflation and financial turmoil.

The real reason

The ban also includes ETNs, which reinforces the idea that the reason behind this is less about lack of disclosure or regulation and more about curbing interest in new assets. This has a bigger impact than the derivatives ban because ETNs are the entry point for retail investors into the crypto market. This is even more confusing because ETNs are much less risky than derivatives.

However, the risk profile is not important. The FCA acknowledges that ETNs will have a detailed prospectus, but it believes that the prospectus does not allow retail investors to reliably evaluate crypto ETNs.

The FCA also acknowledged that ETNs are traded on regulated exchanges. However, “retail investors are still unable to reliably predict the price impact of issues in the underlying cryptoasset markets.” (Are stock markets more predictable?) You guessed it, the FCA meant that investors “cannot reliably value ETNs.”

In addition, ETNs have no leverage. But this is not important. What matters is whether investors can correctly value the assets.

Scope of the ban

You might wonder why the ban was not extended to crypto assets themselves, when it is clear that the problem lies with crypto assets, and not their derivatives.

The consumer survey mentioned above shows the same result. The survey shows that 83% of UK holders do not buy cryptocurrencies through UK-based exchanges. Perhaps the FCA realizes that an outright ban is futile? Perhaps the companies that provide funding to the FCA (members of the UK financial services industry) have also put some pressure on the FCA to save this potential high-yield source?

However, in banning derivatives, the FCA has failed in one of its main duties. Making it difficult for retail investors to hedge their positions, and/or pushing them to less regulated offshore trading platforms, doesn’t sound like it’s protecting them. Excluding relatively safe crypto ETNs from the available cryptocurrency instruments means retail investors are left with their own custodial investments, which may be less secure.

The ban also hurts the cryptocurrency industry. Derivatives are an important part of efficient markets. They allow people to express different opinions, help price discovery, and provide downside protection to promote liquidity. Institutional investors who dominate the market can still buy cryptocurrency derivatives, so the direct impact may be small. However, such measures will increase unfairness and concentrate the opportunity to gain benefits in the hands of the rich. Markets should not only benefit institutions.

Please note that the ban targets sophisticated investors and high net worth individuals, as they could potentially lose more. The FCA has decided that these experienced and/or financially strong individuals are not entitled to use their own funds to invest in cryptocurrency derivatives and ETNs, and assume the corresponding financial risks.

Advancing research

Currently, it is very difficult to value crypto assets. There are many theories, but no one knows how to do it. This is a new market with completely different drivers and the underlying technology produces completely different data sets. Analysts across the industry are digging into these data sets.

That’s why we’ve started publishing a series of reports and hosting webinars analyzing the fundamentals of crypto assets. Our goal is to provide a deeper understanding of how to evaluate crypto assets. This is the beauty of the cryptocurrency industry: the opportunity to “discover” uncharted territory in asset research, lay the foundation for deeper exploration, and expand the scope of financial analysis.

As the theory advances, valuation models will emerge in the future. Moreover, cryptocurrency investors can gain additional insights from more granular data than investors in traditional assets. Crypto assets will be more transparent and provide richer information than stocks. One day, we will look back and be surprised to find that we put too much trust in the information provided by the issuing company, audited by the service provider, and sold on platforms with opaque fees. Since Graham and Dodd published the security analysis framework in 1934, its investment valuation model has been used to this day. The emergence of crypto assets and their special data sets may have a huge impact on this model.

Ultimately, the real problem is not that investors cannot reasonably value crypto assets, but that the FCA lacks foresight. (Coindesk)