Opinion: The prospect of a regulatory framework brings hope for crypto derivatives.

Disclaimer: The author’s views and opinions expressed in this article are solely their own and do not represent the views and opinions of crypto.news’ editorial team.

Investors, especially institutional clients, have embraced crypto derivatives, leading to a significant increase in trading volume on centralized exchanges. In July 2023, the trading volume of crypto derivatives surged by 13% to reach $3.12 trillion compared to the previous month. This means that derivatives now account for 69% of the total cryptocurrency volumes, which also includes spot market trades.

However, despite the growing popularity of crypto derivatives and their potential to attract institutional investors, regulatory complexities have posed numerous challenges for market players.

The regulatory landscape for crypto derivatives varies across jurisdictions. While traditional derivatives are regulated in most countries, many nations lack appropriate legislation for digital asset derivatives. This regulatory uncertainty has been identified as a major barrier to mainstream adoption of cryptocurrencies. Regulators commonly categorize cryptocurrencies and derivative products based on existing legal and regulatory frameworks.

In the UK, digital assets are viewed within the existing concept of property by the Law Commission. Additionally, smart contracts are considered to operate similarly to traditional contracts, with English law supporting their use without the need for reform.

Similarly, US regulators have attempted to apply existing derivative rules to crypto derivatives. However, derivatives that fall outside the existing framework, including those traded on foreign exchanges or in jurisdictions with lax regulatory laws, are prohibited. As a result, 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.

In contrast, 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 through the Markets in Crypto Assets (MiCA) bill. MiCA aims to promote innovation in the sector within the EU by ensuring market stability and enhancing investor confidence through various safeguards.

On the other hand, China has continued its crackdown on digital assets, as evidenced by the People’s Bank of China’s decision in September 2021 to make all crypto transactions illegal. With a blanket ban on all activities, cryptocurrency derivatives are not viable financial products for Chinese investors.

Regulatory challenges remain a focal point of attention. Due to significant differences in laws across jurisdictions, market players often face challenges in achieving regulatory compliance in the crypto derivatives landscape. Moreover, the novelty of blockchain technology has introduced additional issues for both industry participants and regulators.

For example, the existing regulatory framework for platforms assumes a centralized network where a company has full control and rights over all content and activities. However, most blockchains are decentralized, and protocols deployed on them facilitate networked content distribution with limited control over what consumers see.

Recent regulatory responses have aimed to protect end-users through more centralized control over content. However, a different approach is required to achieve desired policy outcomes in this field. This could involve imposing rules on protocols to regulate on-chain activities or requiring a certain level of centralization with a control authority supervised by regulators.

Existing regulatory rules make it challenging, if not undesirable, to establish and enforce intellectual property rights while using public, permissionless blockchain networks for records. Until statutory rules recognize legal ownership of digital assets, the adoption of decentralized platforms for such instruments will remain limited. These issues arise from the incompatibilities between blockchain-based legal rights and existing legal frameworks, which need to be addressed on a case-by-case basis.

The decentralized nature of blockchain technology poses challenges for valuing underlying assets in crypto derivatives. Unlike securities, there is no dominant exchange to provide a single valuation. This lack of consensus on valuation increases the difficulty of reaching agreement, while also introducing risks of market manipulation and liquidity issues that can negatively affect prices on exchanges. Unexpected events such as hard forks, cyber attacks, and extreme volatility also pose additional risks in this field.

Recent market developments offer hope for addressing current regulatory and legal challenges. The International Swaps and Derivatives Association (ISDA) has published documentation outlining a new standard for digital asset derivatives. This standardized approach and contractual framework under the ISDA Master Agreement can enhance efficiency and allow parties to assess their contractual risks and obligations under better conditions.

In the UK, English law remains adaptable and resilient in accommodating digital assets. English courts have already issued several judgments in blockchain and crypto-related disputes. Recognizing digital assets as property under English law provides property owners with remedies, including the right to obtain injunctions.

However, there are areas where English law needs to evolve to align with the unique characteristics of the crypto market. The Law Commission has published new recommendations for reforms and developments in June 2023 to address these issues.

In addition to the above examples, multiple jurisdictions have implemented pro-crypto policies aimed at attracting crypto organizations by providing regulatory clarity and a supportive environment for innovation and growth. The upcoming regulation in the UK and Dubai’s VARA framework are notable examples in this regard.

Despite the complexity of regulating blockchain technology and cryptocurrencies, recent regulatory developments, such as the ISDA’s new standard for crypto derivatives, proposed changes to English law, and the cryptocurrency-friendly approaches of the UK and Dubai, offer a positive outlook for the future regulation of the industry. Consistency across jurisdictions and equal treatment of centralized and decentralized digital asset providers should remain key considerations in upcoming regulatory frameworks.