Bitcoin: Jury is still out on derivatives

By:
Farah Khalique
Published on:

Bitcoin is riding high after a recent European Court of Justice ruling that users in Europe are not liable to pay value-added tax when trading the cryptocurrency. But regulators worldwide are divided on whether it is a commodity or a currency and are still probing the advent of bitcoin derivatives as exchanges flourish to satisfy traders' demand for a wider range of products.

Bitcoin is a virtual, decentralized currency that can be transacted without the need for middlemen – that is, banks. Last week, the European Court of Justice (ECJ) ruled that bitcoin is indeed a currency and so should be exempt from value-added tax (VAT), meaning that people in European Union (EU) states can buy it without paying tax. The case came to the ECJ from a Swedish national, David Hedqvist, who wanted to launch a bitcoin exchange and asked Swedish tax authorities whether converting bitcoin into Swedish krona would incur VAT. He was informed that it would but, undeterred, he appealed against the decision. The case reached the ECJ, the highest court in the EU.

The ECJ found in his favour, a decision welcomed by bitcoin exchanges. Daniel Scott, co-founder or The CoinCorner Bitcoin Exchange, says: "It's a great thing from our perspective. We have been through this with the UK [which ruled that it would not tax bitcoin trades]; now the EU has done the same thing. It means we can keep operating and we don't have to change anything or [incur] extra costs."

Currency or commodity?

In the US, though, regulators classified the bitcoin as a commodity in an official ruling last month against an unregistered bitcoin options trading platform, Derivabit. It was found to have illegally offered to connect buyers and sellers of bitcoin option contracts, without having been properly registered either as a swap execution facility (SEF) or a designated contract market.

The US Commodity Futures Trading Commission's director of enforcement, Aitan Goelman, said in a statement: "While there is a lot of excitement surrounding bitcoin and other virtual currencies, innovation does not excuse those acting in this space from following the same rules applicable to all participants in the commodity derivatives markets."

Also in September, though, the CFTC temporarily approved bitcoin options platform LedgerX to operate as a SEF, although it has not yet launched. LedgerX is now seeking a derivatives clearing organization licence to operate as a fully functioning exchange and clearing house; it has recently hired ex-CFTC commissioner Mark Wetjen to its board. A CFTC-regulated derivatives exchange is paramount to attracting institutional investors that are bound by US compliance laws.

Moreover, a derivatives market might add stability to the bitcoin market, which is susceptible to high levels of volatility. These can be triggered by anything from a bad story in the press to a market sell-off of risky assets.

Futures, forwards and options

Cryptocurrency derivatives trading platforms are catching on elsewhere, though, with Seychelles-registered BitMEX offering a 100X bitcoin/US dollar futures contract (XBT24H), which is its most popular product.

London-based Crypto Facilities, founded by two former bankers, now offers bitcoin forwards, with maturities of one, two, three and four weeks. This enables traders to hedge their existing bitcoin risk or simply take a punt in the hope of making a quick buck on the price of the cryptocurrency rising or falling.

Further reading
Bitcoin: special focus

Singapore-based Coinut enables users to trade binary options or European vanilla options; according to Coinut, 60% of bitcoin owners need risk-hedging tools to protect against a falling bitcoin price. This year, the Coindesk Bitcoin Price Index has fallen from a high of $427.24 to as low as $177.28, although it has rallied in the last month.

Boston-based Alt-Options even launched a competition that gives anyone the chance to learn how to trade bitcoin derivatives, without risking their own money.

The need to hedge the risk of volatility will grow as better-known institutions begin to use cryptocurrencies as a form of payment and, says law firm Latham & Watkins' Financial Institutions Industry Group, the growth of a derivatives market is a "natural result of the nascent cryptocurrency market".

But the CFTC is still wary, having asserted its authority last month with Derivabit. International law firm Sidley Austin LLP believes that the CFTC's decision to treat virtual currencies as commodities has "significant regulatory implications" for those who trade bitcoin derivatives, such as futures, forwards, swaps or options. Any collective investment vehicle that invests in these derivatives will be classified as a "commodity pool" under US law, meaning they are subject to registration with the CFTC.

Coming up in the November issue:














Getting to grips with the blockchain

Banks have suddenly cottoned on to the power of the blockchain technology beneath Bitcoin. Inside their own treasuries and innovation labs, and increasingly in collaboration, banks are testing uses for rebranded distributed ledgers to replace their costly, proprietary systems. 

Enthusiasts see banks creating a new fabric for payments transfer and financial markets, an internet of money. 

Doubters sense it’s all hype. 

Big challenges remain, but markets from private equity and syndicated loans to corporate bonds and derivatives may go on private blockchains within months.