Following consultation, the FCA has published final rules on banning the sale of cryptoasset derivatives to retail consumers. The FCA has highlighted a number of consumer harms that retail customers are facing in the current cryptoasset derivatives market. It is the FCA’s view that retail consumers cannot reliably assess the value and risks of derivatives and ETNs that reference certain cryptoassets. This is due to the:
- Nature of the underlying asset, which has no inherent value and so differs from other assets that have no physical uses, promise future cash flow or are legally accepted as money.
- Presence of market abuse and financial crime (plus cybertheft from cryptoassets platforms) in cryptoassets markets.
- Extreme volatility in cryptoassets prices.
- Inadequate understanding of cryptoassets by retail consumers and the lack of a clear investment need for the investment products referencing them.
It should be noted that under current regulations, while most cryptoassets themselves are not regulated, derivatives relating to cryptoassets are caught by MiFID and as such are regulated by the FCA.
The intrinsic value of cryptoassets
Many respondents to the consultation argued that cryptoassets do have an intrinsic value, highlighting the fact that some companies such as Starbucks and Microsoft accept Bitcoin as payment using the Bakkt service. Many cryptoassets are easily exchangeable into fiat currencies on exchanges and that due to the supply and demand characteristics of the tokens they could also act as a store of value in the way that gold is.
The FCA did not agree with these arguments, and in response highlighted that while some companies do accept cryptoassets as payment, the goods and services are priced in fiat currency and then converted to the relevant price in tokens at the time of sale, so the underlying medium of exchange is still the fiat currency. The FCA also highlights the fact that price volatility is a significant hindering factor in the use of cryptoassets as a medium of exchange, it is the FCA’s view that the value of cryptoassets are too influenced by market sentiment and speculative behaviour, resulting in volatility that is far too high for widespread use as a medium of exchange. The FCA does recognise that cryptoassets have the potential to act as a store of value, but once again cite that high volatility of current tokens such as Bitcoin and Ethereum are prohibitive at this time.
The FCA does make a point to say that they have seen evidence through the FCA Sandbox initiative that the use of cryptoassets can be beneficial to consumers in the context of payment, and reaffirm their commitment to developing the cryptoassets and cryptoassets payments industry in the UK.
Valuation of cryptoassets
One major reason behind the FCA’s decision to introduce this ban is the fact that it is difficult for retail consumers to properly value the cryptoassets that underpin the relevant derivatives. The lack of a consistent valuation method means that the risk of unexpected losses for retail customers is high, something the FCA sees as consumer harm and not in line with a transparent market. The FCA has previously conducted a detailed analysis of the issues surrounding valuing cryptoassets for retail customers and reached the following conclusions:
- There is a large degree of price dislocation between exchanges, the FCA examined 5 BTI verified exchanges over 4 years and found significant price dislocation across the whole period.
- A high amount of correlation across cryptoassets prices in general, which in the FCA’s view is indicative of the prices being driven by speculation rather than factors specific to each token examined, with the correlation increasing from 2016-2019.
- The FCA was also able to find a strong correlation between cryptoassets prices and news/search data, indicating significant speculative behaviour.
Many of the responses that the FCA received suggested that there were reliable valuation methods and that instead of an outright ban, these derivatives should be treated like other high-risk assets when sold to retail consumers.
As part of this consultation, the FCA reviewed a wide array of valuation methods, and while some may be reliable, there is a significant divergence between the methods and a large number of subjective assumptions made that vary from method to method. The FCA determined that the methods examined could produce extremely wide variations in the value of certain tokens.
Market abuse and financial crime
When looking at the financial crime risks, the FCA recognises that the introduction of the 5th AML Directive (5AMLD) is helping to reduce the financial crime levels in the cryptoassets sector, but that investor losses due to fraud and misappropriation in the sector have increased more than fivefold from 2018 to 2019. The FCA highlight that the impact of this fraud and misappropriation on price is significant, citing a 5% fall in the price of Bitcoin following the Binance hack that saw US$40m stolen. These price fluctuations, in the FCA’s view, increase the risk of holding derivatives relating to cryptoassets.
Cryptoasset derivatives serve no legitimate investment need
Many responses to the initial consultation highlighted legitimate uses of crypto derivatives in the current market, such as hedging existing positions, bypassing custody issues, liquidity and accessing leverage.
In the FCA’s response, they highlight two issues with these interests. Firstly, the use of hedging is not common amongst retail consumers, the FCA found that for most retail consumers their investment behaviour was far more speculative and closer to gambling than these legitimate behaviours. Secondly, many of these legitimate interests are outweighed by the inability to price the underlying assets and the extreme price volatility of those assets.
Cryptoasset ETNs
The FCA did consider excluding ETNs tracking cryptoassets indices from its ban since they benefit from certain protections, such as being traded on a regulated exchange, having no leverage, being sold with a prospectus and having lower fees. However, while the FCA recognised that these are all correct, the ETNs still suffer from the same fundamental issue as the other derivatives caught by the ban, that the underlying assets cannot be reliably valued. This is supported by data which shows that, for retail customers, a similar proportion lose money on cryptoassets ETNs as lose money on cryptoassets CFDs.
When and to what will the ban apply
The ban will come into force on 6 January 2021 but will not apply to the following tokens:
- Security tokens – as these are already considered specified investments and regulated by the FCA as a financial instrument;
- Tokens that are not widely transferrable – such as private network tokens or tokens only redeemable from the issuer;
- E-money tokens;
- Commodities where ownership is recorded on the blockchain (crypto commodities); and,
- Currencies issued or guaranteed by a central bank or public authority, commonly known as central bank digital currencies (CBDC)
Outside of these five exceptions, all derivatives based upon cryptoassets and ETNs will be subject to the ban.
