Ban of crypto asset derivatives and CFDs?

It seems that the South African regulators are considering putting a stop to the trade of derivative instruments which reference crypto assets (like bitcoin and ethereum) as the underlying reference asset.

At least this is the view adopted by the Intergovernmental Fintech Working Group (IFWG) in its latest position paper on the regulation of crypto assets in South Africa, published on 11 June 2021 (Position Paper).

In the Position Paper, the IFWG has proposed a ban on crypto asset service providers (CASPs) selling derivative products, such as contracts for difference (CFDs), where crypto assets are the underlying reference asset.

The IFWG's latest recommendation follows on from its previous position paper (published in April 2020) where the IFWG considered the use of crypto assets in derivative products as well as the Financial Sector Conduct Authority's (FSCA) draft declaration (published on 20 November 2020) which set out the proposed regulatory framework for crypto assets.

This is our previous article on the FSCA's draft declaration.

Derivative instruments and CFDs

Derivative instruments are regulated under the Financial Markets Act, 19 of 2012 (FMA).

The definition of "derivative instruments" includes any financial instrument or contract that creates rights and obligations and whose value depends on or is derived from the value of one of more underlying asset.

The definition of a derivative instrument in the FMA is silent as to the type of underlying reference asset which may be used. The IFWG have highlighted that theoretically it is possible to create a crypto derivative (including a crypto CFD).

The position of the IFWG

The IFWG has clarified its position by stating categorically in its Position Paper that it is currently not in support of the use of crypto assets as underlying assets in derivative instruments. Some of the reasons noted by the FSCA for its concerns include:

• the challenges around valuing crypto assets;
• the extreme price volatility in the crypto market;
• the propensity for these instruments to be used to facilitate market abuse and financial crime;
• the inadequate understanding of crypto assets by retail customers; and
• a lack of what the IFWG described as a "truly legitimate investment need for retail consumers to invest in these products."

The IFWG also reiterated its stance that crypto asset marketing material is often extremely biased and only highlights the potential upside of crypto assets, without making consumers aware of the potential downside associated with investing in these types of assets. Risks are particularly prevalent in respect of crypto derivatives which operate in a volatile trading environment with leverage and margins that do not mirror the traditional market trends.

The stance taken by the IFWG is similar to that taken by the Financial Conduct Authority (FCA) in the United Kingdom. The FCA has already banned the sale of derivatives and exchange traded notes that reference certain types of crypto assets to retail consumers specifically. Some of the FCA's reasons supporting the imposition of a ban are the same as those cited by the IFWG.

Going forward with crypto asset derivatives

Before the ban is imposed, the IFWG has recommended that the FSCA and National Treasury conduct an in-depth analysis into the merits of requiring institutions that issue over-the-counter derivative instruments with crypto assets as the underlying reference asset to be licensed by the FSCA.

This recommendation however is subject to any further developments under the Conduct of Financial Institutions Bill and the review of the FMA.

Conclusion

Whilst CASPs await the outcome of this regulatory analysis and a possible change in policy position, any platforms which offer or seek to offer derivative instruments referencing crypto assets should be mindful that this business might become unlawful in the future.

Bridget King is recognised as one of the top 5 ranked FinTech lawyers in South Africa. Ranked in Band 2 in Chambers FinTech 2022.