As reported earlier by The New York Times (NYT) and Bitcoin Magazine, Intercontinental Exchange (ICE), parent company of the New York Stock Exchange (NYSE), is developing an online trading platform that would allow large investors to trade bitcoin directly. As news about the ICE platform continues to develop, Bitcoin Magazine spoke with lawyers Ben Sauter and Dave McGill of Kobre & Kim, a New York City law firm which specializes in disputes and investigations, to examine the regulatory issues surrounding the launch of such a platform, including swap contracts and the implications the ICE platform might have on cryptocurrency trading in the future.

Sauter and McGill are also participating lawyers in the Digital Currency & Ledger Defense Coalition (DCLDC), a coalition of lawyers and academics whose collaborated effort focuses on understanding the regulatory and legal issues surrounding cryptocurrencies and blockchain technology to protect individual constitutional rights and civil liberties in connection with regulatory and law enforcement scrutiny.

For a large financial institution such as ICE or Goldman Sachs, figuring out how to develop a cryptocurrency trading platform is a potentially complicated analysis that begins with the question of whether or not a cryptocurrency is a security. If a cryptocurrency is deemed a security by the Howey test, “there are a lot more regulatory requirements,” according to McGill.

While many people agree, including Peter Van Valkenburgh, director of research at the Coin Center, that the Howey test can act as the ultimate clarifier of which cryptocurrency is a security and which is not; the distinction is also important for another reason. Ultimately, the Howey test gives guidance on which regulatory agency polices which cryptocurrency. At this point, securities fall under the U.S. Securities and Exchange Commission’s (SEC) jurisdiction. Non-security cryptocurrencies — or commodities until proven otherwise — are in the realm of the Commodity Futures Trading Commission (CFTC). While this is obvious to anyone who can remember each agency’s full name, the distinction is also important because each agency has taken a different approach to policing cryptocurrency.

The SEC has gone after what McGill called “low-hanging fruit.” These are the “pump-and-dump” ICOs that are scams or otherwise illegitimate in their offerings to investors. And, at least with ICOs, both agencies appeared to be on the same page in January 2018. More recently, the SEC has created a fake ICO. The token, aptly named HoweyCoin, is being used as a way to demonstrate potential signs of fraud in ICOs to cryptocurrency investors.

Outside of the SEC’s scam scrubbing, Sauter and McGill have also seen regulator behavior that is not exactly encouraging for private sector participants:

“The Commodity Futures Trading Commission (CFTC) and Securities Exchange Commission (SEC) say they want to have an active dialogue with industry participants to understand the latest trends and developments. Unfortunately, we see a lot of regulators initiating those conversations with industry players by way of subpoena. Whenever you receive a subpoena from a regulator, you have to be concerned that it could be a lead-in to an enforcement action. This dynamic doesn’t exactly promote a free and healthy exchange of ideas,” said McGill.

CFTC: The Prevailing Bitcoin Regulator?

In late April, SEC Chairman Clayton said bitcoin is not a security. According to both McGill and Sauter, because bitcoin will not likely be classified as a security, larger financial institutions like CME, CBOE, Goldman Sachs and now ICE are able to move forward with giving their clients exposure.

Not being a security also means that the CFTC is the federal agency that most often acts as a watchdog over bitcoin transactions. But it is also not the only one. The Department of Justice (DOJ) has become involved in some bitcoin futures trading in pursuit of acts of perjury and obstruction of justice.

Even if it is the prevailing regulator, how the CFTC will handle bad actors and fraud in bitcoin transactions is still up for debate. In the last year, there have been more aggressive actions such as CFTC v. McDonnell (CabbageTech) and, outside of cryptocurrencies, the CFTC’s prerogative to cut down on fraud and market manipulation (Monex). This could be evidence that there will likely be a crackdown on certain types of short-term trading behavior.

“An underlying concern of the CFTC is that there are a number of people who can fairly easily impact prices with their trading. It makes it very difficult to regulate markets,” said Sauter, “but innovation is happening in futures and derivatives markets.”

Speaking toward how Bitcoin law will develop in the U.S., Sauter stated that industry cases which reach the court of appeals will be the ones that will ultimately shape U.S. regulation by either correcting case decision errors or clarifying and interpreting the law itself.

Contract Swaps Aren’t New or Unregulated

If reports that ICE is considering using a model of trading bitcoin with swap contracts, this type of trading would remain under the regulatory realm of the CFTC. Furthermore, it would also decrease transaction speed.

Swaps are a type of derivative contract where two parties trade based on a notional principal amount. Generally, one of these amounts is fixed while the other is variable, commonly based on an interest rate, floating currency exchange rate or index price. Swaps do not normally trade on exchanges but instead are over-the-counter contracts between different organizations. Sauter and McGill suggested that ICE would likely use an interest rate swap, though they are most likely still figuring out what they will pin bitcoin prices to.

“Using the swap mechanism allows ICE to position themselves squarely under CFTC regulations, but getting that regulatory certainty looks like it will come at the cost of speed,” said McGill. “One of the ideas behind bitcoin and other digital currencies that made them so attractive as a concept was the idea that market participants could securely transact with one another almost instantly, without the need for intermediaries. But, if you have to create a swap product with a one-day settlement period to get regulatory clarity, then you lose a lot of what made digital currencies attractive in the first place.”

“Bitcoin swaps aren’t entirely novel, either,” pointed out Sauter.

TeraExchange began offering Bitcoin-based swaps in 2014. And, since launching its derivatives swap option in October 2017 after CFTC approval, LedgerX is reported to have increased their trading volume sevenfold.

Sauter stated that one reason why regulators have not moved more quickly to establish clear law around Bitcoin is that there still remains debate and uncertainty about regulators, the CFTC in particular, to police the markets.

“One way regulators and institutional players are dealing with this is to move trading to regulated derivatives markets, be it swaps, futures or options,” said Sauter. “When that happens, the CFTC has a much more direct line of access to the markets and market participants. That’s part of the reason why we’re seeing such innovation happening in the derivatives markets.”

Another reason Sauter proposes for the interest in Bitcoin derivatives is that they are a much easier route by which big financial institution players can get involved. “Institutional investors often have strict requirements concerning the types of markets and products they can trade, and they tend to like the idea of trading in markets that they know are being policed and that offer remedies in the event problems arise.”

How Decentralized Proprietary Trading Could Be Affected

The implications of the rise in bitcoin-based swap contracts also means that the instantaneous transaction, so highly placed in the early value of bitcoin, might be a thing of the past for more mainstream investors to gain less-risky exposure. However, as McGill pointed out,  “A lot of that early speed and eliminating transaction fees comes at the cost of added risk.”

It can be assumed that any cryptocurrency trader that is familiar with Mt. Gox is well aware of the risks associated with trading on unregulated cryptocurrency exchanges. Still, for some, the risks are worth it.

“Some of this will just be decided by the market,” said Sauter. “Plenty of investors are weighing the risk of maybe not getting their money back when they need to unwind a trade. Traders who don’t want to deal with this will opt-into these trading platforms run by accredited institutional investors.”

“There’s clearly more risk in operating on less regulated and decentralized exchanges,” said McGill. “There may well be more lucrative opportunities as well, but there are all sorts of risks — including insider fraud — that a lot of traders want to avoid.”

By this estimation, bitcoin futures have brought the attention of regulators and that will inevitably alter the current space, whether making it more regulated or diversified remains to be seen.

“CME bitcoin futures acted as the canary in the coal mine. From a regulatory perspective, it will be interesting to see if some of the fast-and-loose trading techniques that were being deployed on the nascent cryptocurrency exchanges carry over to the more mature and tightly regulated markets operated by CME and ICE,” said McGill. “Certainly, you’re going to get more players in the mix, and that alone will probably translate into more enforcement activity by CME and government regulators.”

Weighing the risks of unregulated and decentralized exchanges draws back to the fundamental conflict that has been revolving around the cryptocurrency space since the Bitcoin white paper was first issued.

Will bitcoin remain truly decentralized or will the desire to hedge against risk lead the majority of traders to accredited and regulated institutions? For many who are invested in bitcoin, not just for profit, but also ideological reasons, the answer appears obvious. Yet whether these Bitcoiners are early adopters of a movement or no more than fringe factions will be decided by the market. It would appear that less regulated and decentralized exchanges still need to develop strategies to match the greater security legacy financial institutions are championing to bring to cryptocurrency.

“From a regulatory point of view, the idea of decentralized exchanges pose some interesting jurisdictional questions,” said McGill. “Ultimately, U.S. regulators tend to be less concerned about physical location and more focused on whether the activity interacts with and impacts U.S. commerce. I don’t think the notion of decentralizing an exchange will translate to immunity from regulators, but it has the potential to create a lot of headaches for regulators.”

Another factor in ICE and other legacy institutions hopping into bitcoin trading is an increase in the space’s technological innovation brought by increased competition.

“Now you’re going to have the most sophisticated trading companies in the world trading in these products at an algorithmic level, which will substantially increase the volume of trading activity,” said McGill.

“You’re going to get more players in the mix and probably many of those will have less regulatory experience and perhaps as a result more enforcement cases,” said Sauter.

On New Competition and Shorting

Though the involvement for big U.S.-based financial players will certainly affect the market, established cryptocurrency exchanges are optimistic about the future.

Tendai Musakwa, director of marketing at the Hong Kong–based cryptocurrency exchange, BTCC, believes that exchanges like BTCC “will remain the go-to cryptocurrency market for retail clients for the foreseeable future.”

“We specifically designed our USD exchange to be accessible, drawing on our seven years’ experience operating the longest-running bitcoin exchange to create an effortless crypto trading experience. “

Musakwa also pointed out that many legacy financial exchanges will have “high barriers of entry and inaccessible or confusing user interfaces.” Citing “real-person 24/7 customer support and deposit options such as credit cards,” he believes that cryptocurrency exchanges will continue to create value that institutional exchanges are unable to offer. “In addition, legacy fiat exchanges are geographically bound, while exchanges like BTCC offer customers worldwide easy access to BTC/USD trading.”

Added to this, Sauter attested that there are still many more regulatory hurdles for institutional exchanges — many of which have not yet been created. For instance, “even if an exchange is authorized, investment companies and broker dealers and issuers of ICOs must become accredited before they can move forward.”

The ICE has also indicated that plans for such a platform could dissolve at anytime based on the unregulated changes in cryptocurrency market. Another institutional player, CEO of Nasdaq Adena Friedman told CNBC that Nasdaq would be open for bitcoin trading when “people are ready for a more regulated market.”

“It’s going to be a more balanced marketplace going forward,” stated McGill. “It would be a shame that, in the process, a lot of what has drawn people into cryptocurrency could be lost in the shuffle due to new regulation.”