Why the FCA Ban on crypto-derivatives is good news for crypto investors

Matthew Dixon, founder and chief executive of Evai.io talks about the recent action taken by the FCA to ban Crypto-derivatives

The FCA’s upcoming Crypto-derivatives ban is a welcome intervention and will most certainly help protect retail investors from substantial losses.

Not only are such derivatives poorly understood by most retail investors, but even professional investors would also do well to steer clear of these derivatives that can be so easily abused due to pricing anomalies and manipulation.

Let us be clear, the FCA is NOT banning cryptocurrencies – It is banning crypto-derivatives.

What Is a Derivative?

Essentially, derivatives are contracts that derive value from the performance of an underlying asset. One example is found in a contract for difference, or CFD.

CFDs are a variant of derivative originally developed in the early 1990s in London as a type of equity swap that was traded on margin.

Virtually anything can be traded as a CFD.

You can buy an ‘Apple Inc’ share traded on the NASDAQ for $113.16 today, and your investment would fluctuate directly depending on the price variation of Apple shares.

Alternatively, you could buy an Apple CFD, for example, at 20% of the total Apple share price. So, for 20% of the share price (20% x 113.16 approx = $22.63), you have exposure to the same fluctuation in the Apple share price. Therefore, if the price of an Apple share appreciated by 20% up to $135.79, this increase would equate to a $22.63 profit for an Apple shareholder. But for an Apple CFD holder who only invested in one Apple CFD @ $22.63, the profit of $22.63 would equate to a 100% gain. Consequently, a $113.16 investment into Apple CFDs would double to $226.32 if Apple shares appreciated by 20%.

This is fine when the market is going up, but with the same price move in the opposite direction a CFD holder would suffer a 100% loss of investment for a mere 20% fall in Apple share price. Even worse, if the price fell by more than 20%, an investor could not only lose the whole investment but actually be left owing money. So losses are not necessarily limited to the amount initially invested.

Too Big to Fail

Even big financial institutions can fail when trading derivatives. Derivatives exacerbated the 2008 world financial crisis when collateralised debt obligations (CDOs) were packaged as derivatives and traded between financial institutions. When the underlying mortgages defaulted, the effect was multiplied many times over for the ultimate derivative holders, and the whole world financial system was brought to the brink of collapse. That day of reckoning was at least delayed by the introduction of negative interest rates and QE (money printing) to keep institutions afloat via bailouts and stimulate the economy.

Clearly, derivatives are a dangerous instrument – even in professional hands. Another facet of the crisis was perhaps a failure of regulation at the time. Rating agencies were wrongly rating these CDOs as triple-A-rated securities when they clearly were not of that investment grade. The regulators did nothing to deal with this fundamental issue.

If we look to identify the root causes of the 2008 crisis, we can conclude that mortgages in themselves are not a bad thing when proper risk assessment is carried out on borrowers and adequate security taken. However, if there are discrepancies in the risk assessment of borrowers, then mortgages are more likely not to be repaid. A mortgage lender may well be able to manage a certain level of defaults by relying on reserves and insurances. But when debt is packaged within a derivative, then the problem is multiplied, and losses can spiral out of control.

When considering the ban on crypto-derivatives, we need to first consider the underlying securities – in this case cryptocurrencies and secondly the operation of derivatives within this asset class.

Cryptocurrencies are a relatively new asset class, currently comprising over 7,000 cryptos, according to Coinmarketcap, with a market capitalisation of around $350 billion, and concentration in just a handful of the top cryptos. Many Cryptocurrencies have legitimate, valuable, and viable business uses – and many do not. Hence a reliable ratings system is required in order to help identify real value.

This is where EVAI comes in.

Evai itself is a cryptocurrency whose use-case is assessing and rating other cryptocurrencies using an unbiased, reliable ratings methodology developed as an extension of research undertaken by Professor Andros Gregoriou of the University of Brighton.

Valuable and useful cryptocurrencies can be identified, but it needs to be remembered that this is a new emerging asset class. As such, trading issues occur due to a lack of liquidity and hence valuation anomalies. Such anomalies can be exploited and particularly when the underlying cryptos are leveraged so that the problems are multiplied (like in the 2008 financial crisis).

To conclude, we agree wholeheartedly in the FCA statements as stated below:

“The FCA considers these products to be ill-suited for retail consumers due to the harm they pose. These products cannot be reliably valued by retail consumers because of the:

• inherent nature of the underlying assets, which means they have no reliable basis for valuation
• prevalence of market abuse and financial crime in the secondary market (e.g., cyber theft)
• extreme volatility in cryptoasset price movements
• inadequate understanding of cryptoassets by retail consumers
• lack of legitimate investment need for retail consumers to invest in these products”

Though, we would add – “do not throw the baby out with the bathwater.”

Some cryptocurrency assets are legitimate and should form part of a balanced portfolio after thorough rating analysis, as evidenced by the growth in institutional, professional, and retail investors holding cryptocurrencies. We feel sure that the FCA would agree with this, and we agree with the ban on crypto-derivatives and its potential to aid crypto investors in the long run.