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Cryptocurrency derivatives enjoy widespread popularity among investors, especially institutional clients. In July 2023, trading volume on centralized exchanges reached $3.12 trillion, a 13% increase from the previous month. This means that derivatives account for 69% of total cryptocurrency trading volume, including spot market trading.
However, despite the growth of cryptocurrency derivatives and the potential for institutional investor participation, regulatory complexity has created numerous challenges for market participants.
Regulatory environment for cryptocurrency derivatives
While traditional derivatives are regulated in most jurisdictions, many countries lack adequate laws for digital asset variants. Regulatory uncertainty has been widely cited as one of the significant barriers to mainstream cryptocurrency adoption. The common approach of regulators is to classify cryptocurrencies and derivatives based on existing legal and regulatory frameworks.
The UK Law Commission views digital assets within the traditional concept of property. At the same time, the statutory body believes that smart contracts operate similarly to traditional contracts and that UK law is likely to support the use of smart contracts without reform.
Likewise, U.S. regulators have been trying to apply perpetual derivatives rules to cryptocurrency derivatives. However, anything outside the existing framework is prohibited, including trading on foreign exchanges or located in jurisdictions with lax regulatory laws. As a result of the latter, the Commodity Futures Trading Commission fined Kraken $1.25 million for illegally offering margin retail commodity trading in digital assets to U.S. customers as an unregistered futures commission seller. .
Unlike the UK or the US, the European Union has taken a different approach to cryptocurrency regulation. In May 2023, the EU became one of the first countries to introduce a comprehensive regulatory framework for digital assets after adopting new rules under the Markets in Cryptocurrency Assets (MiCA) Act. MiCA aims to promote innovation in the sector within the EU by promoting market stability and improving investor confidence through a range of safeguards.
Meanwhile, China is cracking down on digital assets across the board, with the People’s Bank of China deciding to outlaw all cryptocurrency trading in September 2021. Cryptocurrency derivatives, which impose a blanket ban on all activities, are not a viable financial product for state investors.
Regulatory issues remain at the center of attention.
Because laws vary greatly across jurisdictions, regulatory compliance is often a major challenge for market participants trying to navigate the cryptocurrency derivatives landscape. At the same time, the novelty of blockchain technology has created more challenges for both industry participants and regulators.
For example, existing platform regulatory frameworks assume a centralized network where companies have complete control and rights over all content and activity. However, most blockchains are decentralized, with protocols deployed to facilitate network content distribution with little or no control over what consumers see.
As recent regulatory responses seek to protect end users through more centralized control over content, a fundamentally different approach is needed in this area to achieve the desired policy outcomes. This can be achieved by imposing rules on the protocol to regulate on-chain activity or by requiring certain minimum features to maintain centralization of governance under the supervision of a regulator.
Existing regulatory rules make it impossible, or at least undesirable, to create and enforce intellectual property rights while using public permissionless blockchain networks for recording. Until additional legislation recognizes legal ownership of digital assets, decentralized platforms’ adoption of such tools will continue to be limited. These issues arise primarily due to incompatibilities between blockchain-based legal rights and legal areas that must be resolved on a case-by-case basis.
When it comes to cryptocurrency derivatives, the decentralized nature of blockchain technology can be problematic when it comes to valuing the underlying asset. Unlike securities, there is no single, dominant exchange that values them. While this makes consensus on valuation more difficult, the risk of market manipulation and lack of liquidity can negatively impact exchange prices, presenting new challenges for industry participants. Unexpected disruptions, such as hard forks, cyberattacks, and periods of extreme volatility, can also pose additional risks to this sector.
New hope for the industry
Recent market developments could potentially alleviate or even resolve current regulatory and legal challenges. The International Swaps and Derivatives Association (ISDA) has published a document outlining new standards for digital asset derivatives. A standardized approach and contractual framework for ISDA framework agreements can increase efficiency and enable parties to assess contractual risks and obligations on better terms.
In the UK, UK law remains dynamic, flexible and resilient when it comes to embracing digital assets. To date, UK courts have issued several rulings on blockchain and cryptocurrency-related disputes. Because UK law recognizes digital assets as property, it provides remedies to property owners, including the right to obtain an injunction.
However, there are several areas where UK law needs to evolve to suit the unique characteristics of the cryptocurrency market, and the Law Commission published new recommendations for reform and development in June 2023.
In addition to those listed above, several jurisdictions have introduced cryptocurrency-friendly policies focused on attracting cryptocurrency organizations with regulatory clarity and a friendly environment that fosters innovation and growth. The UK’s forthcoming regulations and Dubai’s VARA framework are excellent examples in this area.
Positive outlook for the future of cryptocurrency regulation
Regulation of blockchain technology and cryptocurrencies is already complex for regulators and market participants. However, as digital asset derivatives grow in popularity, the task has become more complex to accomplish.
That said, recent regulatory developments such as ISDA’s new standards for cryptocurrency derivatives, proposed developments in UK law, and cryptocurrency-friendly approaches in the UK and Dubai provide a positive outlook for future regulation of the industry. Jurisdictional consistency and equal treatment for centralized and decentralized digital asset providers are essential to the future regulatory framework.