The future of cryptocurrency futures regulation

Add the chairman of the largest electronic brokerage firm in the U.S. to the list of Cassandras warning us of the perils posed by the trading of cryptocurrencies.

In a remarkable open letter in The Wall Street Journal addressed to J. Christopher Giancarlo, the Chairman of the Commodity Futures Trading Commission, Thomas Peterffy, Chairman of Interactive Brokers, reacted adversely to a proposal by the Chicago Mercantile Exchange to allow Bitcoin and other cryptocurrency derivatives to be cleared in the same clearing organization as other products. The reason? According to Peterffy:

“Cryptocurrencies do not have a mature, regulated and tested market. The products and their markets have existed for fewer than 10 years and bear little if any relationship to any economic circumstance or reality in the real world.” (“Dangers of Clearing Bitcoin and Cryptocurrency Derivatives in Same Clearing Organization as Other Products,” The Wall Street Journal, Nov. 15, 2017, p.B5)

The risk is so great that “a catastrophe in the cryptocurrency market that destabilizes a clearing organization will destabilize the real economy,” Peterffy said. His solution is for the CFTC to require that any clearing organization that wishes to clear cryptocurrencies or their derivatives do so in a wholly separate clearing system which is isolated from the systems for other products.

While the potential for catastrophe may be a bit exaggerated, the solution shouldn’t be easily dismissed. It’s not as if the CFTC has ignored problems projected by trading in cryptocurrencies. Actually, the agency has for years been trying strike a balance between making the public aware of the dangers they pose and not seeming too heavy handed in doing so.

The CFTC’s reach is quite broad. The agency’s regulatory powers extend to exchange actions and the review and approval of futures contracts, and it has the power to issue any rule it finds necessary to accomplish the mission of the Commodity Exchange Act, to foster open, transparent and financially sound markets [7 U.S.C. § 12(a)(5)]. Before it approves a contract for trading, the CFTC must determine that it is in the public interest by assessing whether its use for price discovery and hedging serve a genuine economic purpose [7 U.S.C. § 19(a)(2)]. The CFTC also uses its power to prevent fraud and market manipulation to assert jurisdiction over commodity trading in spot markets.

The CFTC took the occasion of a settlement with an unregistered swap execution facility to declare that Bitcoin and other virtual currencies are commodities and subject to regulation as such [In the Matter of Coinflip, Inc. d/b/a Derivabit and Francisco Riordan, CFTC Docket No. 15-29 (Sept. 17, 2015)]. Only recently, the CFTC circulated a “Primer” on virtual currencies to educate the industry and investing public on their nature and, perhaps most important, the risks they pose [“A CFTC Primer on Virtual Currencies” (Oct. 17, 2017)].

To date, market commentators, like the CFTC, have focused on a number of valid concerns about cryptocurrencies: They’re a bubble. They pose security risks. They’re a ready vehicle for fraud and money laundering. Peterffy’s point is different: That cryptocurrencies will, in the end, damage clearing and trading firms that deal in the currencies, and even those that don’t, and the exchanges.

It’s a point well taken. Consider this: Futures margin rates range from 2% to 8%. The more aggressive trading firms set their rates at the lower end of the range to attract business. When losses exceed the amount margined, the broker must cover them first and then try to collect from the client.

This year, the price of Bitcoin has been up by as much as 1000% and that of Ethereum more than 2000%. Those prices might rise. But no one should be surprised if they collapse by 50% or more. Unlike, say, an agricultural commodity or an equity index, cryptocurrencies have no real economic function, and there is often no apparent or fundamental reason for their price movements.

That’s why, according to Peterffy, trading and clearing firms, especially those which don’t have much money to lose, will collapse along with the price of cryptocurrencies – and take firms which don’t even trade in the currencies with them, and maybe the exchanges as well.

That’s where the CFTC comes in. So far, its attempts at gentle persuasion don’t appear to have been terribly effective. The CFTC has far more authority than it has used. Maybe it’s time for the CFTC to set aside its reluctance to put a thumb on the scale and recognize that it’s in the public interest to be proactive and adopt Peterffy’s suggestion or even place limitations on liability for cryptocurrency futures. Will that happen? Place your bets.