In this opinion piece, the authors explain the importance of a recent CFTC approval of a cryptocurrency derivatives platform and its potential impact on the market.
In what was a bustling month in crypto-land, one among the more important industry events may are lost within the news flow.
We’re talking about LedgerX, a startup whose board members include, among others, Mark Wetjen, a former Commodity Futures Trading Commission (CFTC) commissioner, and its successful registration as a derivatives clearing organization (DCO) with the CFTC – the first U.S. derivatives regulator.
While the primary registration of a DCO meaning to offer cryptocurrency-linked derivatives is critical in and of itself, the approval was granted alongside a letter providing LedgerX exemptive relief from a number of the onerous requirements that (justifiably) apply to DCOs.
This article discusses those details, also as what impact the registration may need more broadly.
1. Clearing derivatives: an summary
First, let’s clear up clearing.
“Clearing” a contract (or “swap”) as against a security, means a transaction, which can be entered into bilaterally or an exchange or other trading platform, is then legally transferred to a central counterparty (a CCP, or within the CFTC’s nomenclature, a DCO).
This is as compared to an uncleared swap, which remains bilateral between the customer and seller (which means they continue to be exposed to every other’s credit risk). during a cleared swap, the CCP acts as a central counterparty for every buyer and seller, and effectively “guarantees” performance (to the extent it’s the resources to try to to so).
CCPs are beneficial because, among other things, they ameliorate default risk and permit participants to offset transactions entered into with multiple counterparties. But if there’s one thing that Satoshi taught us, it’s that centralization carries its own systemic risks – that’s why CCPs are subject to significant regulatory requirements and oversight.
It’s worth pausing at now to notice that earlier in July, LedgerX also registered as a swap execution facility (SEF). this is often a separate regulatory designation. An SEF may be a trading platform through which users can view indicative pricing and quotations, and trade and transact in derivative products.
Unlike a CCP, an SEF doesn’t stand between buyer and seller. SEFs were introduced following the financial crisis and therefore the major U.S. legislative efforts that followed (the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act and its related regulations).
The purpose of SEFs include providing greater transparency in pricing, business conduct, execution and reporting of derivative products. Currently LedgerX is one among two SEFs offerings cryptocurrency-linked products, the opposite being TeraExchange.
To round out this tour , it’s worth mentioning that some existing cryptocurrency exchanges do offer margin trading (which may be a sort of derivative). However those exchanges have generally relied on an exemption from being regulated with the CFTC as an SEF that allows margin trading goodbye because it leads to the “actual delivery” of bitcoins within 28 days (rather than deferred delivery, or a claim against an account with bitcoins).
2. What about securities and therefore the SEC?
In the U.S., the regulation of swaps and securities is overseen by separate regulators, respectively, the CFTC and therefore the Securities and Exchange Commission (SEC).
The SEC’s recent determination that DAO tokens were securities doesn’t by itself impact LedgerX or the CFTC’s regulation of swaps. It does, however, mention that some cryptocurrency exchanges that traded DAO tokens should are registered as national securities exchanges or received an appropriate exemption.
To clarify, what the SEC is talking about here is securities exchanges, not necessarily exchanges or trading platforms on which trades in commodities or swaps are executed (which the CFTC regulates). For the instant , the sole proposed crypto-derivatives relate to bitcoin, then the SEC’s wider role in regulating some security related elements of the derivatives market (like security-based swaps) has yet to be addressed.
3. How LedgerX compares to other DCOs and SEFs
While the CFTC’s order approved LedgerX’s registration as a DCO, such a designation comes with significant regulatory requirements and oversight.
That a part of the equation was addressed during a CFTC letter issued at an equivalent time. The letter outlined the exemptive relief being granted to LedgerX from a number of those regulations. The relief included regulations concerning financial resources and related requirements of risk management, participant eligibility and management of funds.
LedgerX managed to avoid many of those requirements due to two primary differences between it and other established DCOs.
First, it’s employing a fully collateralized clearing model (buyer and seller must provide the complete amount of their potential future obligations up front) numerous of the regulations, which are aimed toward protecting the CCP against defaults from its participants, are addressed by the very fact that 100% of the collateral is already in situ .
Second, LedgerX will only initially clear trades from LedgerX’s own SEF, meaning it already has vetted the relevant participants.
In addition, the initial product being offered looks to be an easy bitcoin swap and therefore the CFTC has already determined bitcoin may be a commodity. Given these factors, the CFTC granted the above relief to LedgerX. However, as LedgerX expands both its client and merchandise base, it’ll likely need to engage with the broader array of CFTC regulations applicable to DCOs.
4. What does this mean for cryptocurrencies?
This registration represents alittle but significant breakthrough for bitcoin, and cryptocurrency more generally, as an asset class.
Although LedgerX’s initial launch are going to be relatively limited, it signifies a growing interest from institutional investors who are keen to realize exposure to cryptocurrency risk.
For example, given the relative lack of regulated bitcoin-based investment vehicles, the LedgerX DCO now provides another possible avenue for such investors.
Secondly, the SEC’s order rejecting the Winklevoss Bitcoin ETF in March mentioned, in pertinent part, that there was an absence of a big regulated derivatives marketplace for bitcoin which contributed to the SEC’s determination that there wasn’t sufficient transparency in bitcoin markets.
That decision is currently under review, and therefore the LedgerX DCO approval may impact that analysis.
Third, the LedgerX approval and relief is that the latest during a number of CFTC actions and initiatives with cryptocurrencies and blockchain. The regulator, and its current chairman Christopher Giancarlo, seem particularly focused on fintech and cryptocurrency-related issues, like the establishment of LabCFTC.
The CFTC appears to developing into a very forward-looking regulator within the cryptocurrency space.
The order stated that LedgerX must have a cryptocurrency audit performed by an independent certified public accountant. No further detail is given on this requirement, and it comes at a time when the Financial Accounting Standards Board is considering best practices for cryptocurrency accounting.
Lastly, the order didn’t mandate any particular cryptocurrency storage method (such as cold storage). this is often perhaps unsurprising, given the evolving nature of the technology and industry.
While certain cryptocurrency derivatives exist already in jurisdictions round the world (Bitcoin Cash futures anyone?), LedgerX’s registration as a DCO represents an interesting development the U.S.
As interest in cryptocurrencies continues to grow, “crypto-derivatives” may begin to seek out an area alongside other skilled elements of the crypto economy, like payments and securities tokens.