Three Easy Pieces
A little bit of theory, a splash of derivatives, and some bankruptcy as garnish. Oh my.
Brogan Law provides top-quality legal services to individuals and entities with questions related to cryptocurrency. Cryptocurrency law is still new, and our clients recognize the value of a nimble and energetic law firm that shares their startup mentality. To help our clients maintain a strong strategic posture, this newsletter discusses topics in law that are relevant to the cryptocurrency industry. While this letter touches on legal issues, nothing here is legal advice. For any inquiries email info@broganlaw.xyz
This week, I want to highlight a few points that I think deserve attention. Buckle up for a rollicking thrill-ride through the annals of derivative and bankruptcy law.
I Did an Interview
First, George Leonardo interviewed me for his newsletter Cap Hill Crypto. It was a very interesting discussion and I think there is much worth considering in there, so I highly recommend you go check it out here.
I make a number of points in this interview that I have often harped on in this newsletter, namely ways that the proposed crypto legislation could be improved.
Not to be a wet blanket, but legislation is a serious pursuit. Basically, my thesis on this is that, while good legislation is better than good rulemaking, bad legislation is worse than nothing at all. Where goals could reasonably be accomplished through rulemaking alone, I would strongly consider taking a beat before pursuing a legislative agenda.
Here is my reasoning. Good rulemaking will tend to be sticky, whereas bad rulemaking will be overturned. But legislation, good or bad, will persist. It takes immense activation energy to pass new legislation, and (besides litigation) there is no other mechanism for overcoming old, failed, law.
The main risk that advocates for legislation point to in rulemaking is that some future regime could overturn it. That’s true. That’s how it works. But think through actual outcomes here.
If the SEC were to promulgate a successful “safe harbor” exemptive regime that allowed projects to make disclosures and move forward with crypto-fundraising, Americans, probably millions of Americans, would buy the resulting assets. From that posture, it would be extremely difficult for a hypothetical regime to enter in 2028 and unwind the safe harbor. Doing so would effectively be vaporizing billions of dollars of value held by American retail customers. That is possible legally, but politically difficult.
But if something goes wrong in market structure legislation, if, for example, the 4(a)(8) “crowdfunding regime” is too limiting to gain adoption, forcing yet more issuers underground or offshore, there is no fix. Maybe the lobby can convince Congress to include a fix in a future reconciliation bill, but it will be an uphill battle.
This isn’t to say I oppose this legislation, I think on net GENIUS is almost certainly good for my clients and the broader cryptocurrency ecosystem, but I do think that the community should take seriously the risk that the legislation poses. Something is not always better than nothing.
My vision of effective crypto legislation would not be over 200 pages long, it would be two pages, and empower a prudential body to implement common-sense regulation on the crypto industry, subject to certain restrictions and guardrails. It is incredibly difficult to draft inflexible, prescriptive legislation, and actually achieve goals with it. Flexibility and discretion are dangerous but necessary for effective governance.
Veronica Wrote About Perps
Second, Veronica wrote on Wednesday about the development of a new, legal, perpetual futures (“perps” in crypto contexts) market. I know that most of you have seen this already, but I think its one of the best pieces of reporting we’ve done here, and if you haven’t checked it out already I recommend you drop everything now and do.
Personally, I’ve found the perpetual futures market baffling in recent weeks. This product has been so popular on unregulated markets, that I assumed it was impossible to offer any other way. So I was surprised to see regulated entities begin offering them.
I wasn’t sure how similar these regulated perps would be to their unregulated predecessors or what legal basis they had, so this week I decided to figure it out.
The upside is that there is a plausible argument that designated contract markets (DCMs) like Bitnomial and Coinbase Derivatives Exchange should be allowed to offer these contracts as “futures” to retail customers. And, practically, they will likely be superficially similar to unregulated perp markets. They will have key drawbacks however, which might ultimately limit their adoption.
Perpetual Derivatives Markets
Perpetual futures were first proposed by the Nobel Prize winning financial economist Robert Shiller in “Measuring Asset Values for Cash Settlement in Derivative Markets: Hedonic Repeated Measures Indices and Perpetual Futures.” His goal was to enable price discovery in illiquid markets by providing exposure to indefinite cash flows. The implied net present value of the asset generated by trading on the perpetual contract could then be used to cash settle ordinary derivative contracts where physical delivery could be impractical.
This, it turns out, is not the principal function of contemporary cryptocurrency perpetual futures. Instead, the modality was developed as an on-chain method of trading with high leverage. Participants post collateral, choose leverage amounts, and make direction bets. These are facilitated through automatic matching of bids and asks in a digital order book, producing pairs. Traders can then sell and exit their position at any time, again through automatic matching, contingent on the availability of liquidity. Generally, this liquidity is available through market makers (though not necessarily in times of high stress).
As in Shiller, and unlike traditional futures markets, which operate on fixed durations, these perps are open indefinitely. However this creates a pricing problem. In traditional derivatives markets, market price is maintained through in-kind settlement. At some point, the contract will close and a trader, in theory, might have to take actual delivery of the underlying asset. In reality this never happens, and contracts can cash settle. However, because perps never close, market dynamics could unmoor their price from underlying spot markets. To remedy this, perps operate with a funding rate, cash payments that are routed between long and short positions depending on the movement of the underlying spot price of the asset, subject to a low clamp.
Incidentally, perps are subject to automatic liquidation during price action. Trades purchased at any given liquidity have fixed liquidation thresholds automatically close the contract and claim the collateral to manage risk. This doesn’t automatically close the winning side of trades, instead making any marginal payments out of an insurance fund or else “auto-deleveraging” trades that win too much.
Market Adoption
This has proven to be an entirely workable model for crypto trading both through centralized exchanges like Binance, and through decentralized platforms like dYdX. But you can see that its main function is that it is convenient, can provide significant leverage, and can be managed mostly automatically. This has led to the modality becoming wildly successful for crypto trading, reaching $58.5 trillion in trading volume in 2024 at top CEXs alone.
This vast area for speculating on crypto assets has, nonetheless, been largely illegal in the United States. Platforms that offered the product like Binance, Kraken, and Deridex were the subject of enforcement by the CFTC. Inconvenient though it is, enforcement should not be chalked to simple political persecution. The truth is, without registration, this product would be illegal under any regime. The Commodities Exchange Act, which governs derivatives, is quite broad, reverberating, in the words of former Chair Rostin Benham “throughout financial markets around the world.” Discussing Mango Markets in 2022, current Acting CFTC Chair Caroline Pham said “perpetual futures’ can constitute swaps. A swap is a swap, even by any other name.”
So, when Veronica reports that Acting Chair Pham believes that perps are legal, the effect of “legalization” is not to liberalize the treatment of the popular, unregistered perps that have proliferated over the last decade, but to create a new market of regulated perps on registered exchanges. And, as much as the CFTC might want to characterize this decision as a principled application of laws, there is no fundamental legal difference between an event contract that already lists on DCMs, and a perpetual future — they are both swaps.
Registration Options
Without getting too far into the weeds of CFTC oversight, here is the actual core issue for Bitnomial, Coinbase, and any other perpetual futures. They are DCMs, which is a CFTC designation that allows retail trading. Generally, swaps must trade on either a DCM or a swap execution facility (SEF), but SEFs are only available to eligible contract participants (ECPs), which for individuals requires $10,000,000 in discretionary investments, profoundly limiting availability. Swaps can trade on DCMs, but are subject to numerous limitations and checks that limit the practicality of such contracts.
Event contract platforms list prediction markets, without requiring compliance to these swap limitations, under no-action relief granted by the CFTC. On April 22, 2021, the CFTC granted Kalshi (and its clearing house, LedgerX) “No-Action Relief from Commission Regulations 38.8(b), 38.10, 38.951 (In Part), and 39.20(b)(2), and Parts 43 and 45, for Binary Options Traded On or Pursuant to the Rules of KalshiEX LLC and Cleared by LedgerX, LLC.”
However, this approach is not available to perpetual futures. The entire purpose of perpetual swaps is to permit convenient, leveraged trades on crypto assets price action. The reasoning that propelled Kalshi would probably not pertain here. So instead, Bitnomial has taken a different tack.
While the self-certified Bitnomial market Bitcoin US Dollar Centi Perpetual Futures Contract would likely satisfy the criteria of a swap, Bitnomial has certified it as a future instead, relying on a “quarter-century” expiry, because §1a(47)(B)(i) of the CEA states that “The term ‘swap’ does not include any contract of sale of a commodity for future delivery.”
And it is true, according to the Bitnomial rulebook, if a participant is holding the perp at its expiry in 2050, they can participate in “final physical settlement.”
Through this convenient sleight of hand, Bitnomial was able to find sufficient comfort to offer these contracts, with some key differences from the traditional, unregulated markets. For one, instead of automatic liquidation, these contracts will rely on a slightly more forgiving margin call mechanism. This is probably good at the margin for traders, but the flip side is that it will make risk management at extreme leverage prohibitively difficult. Currently, the Bitnomial Clearinghouse has a minimum margin rate of 15%, meaning that the maximum leverage that can trade through Bitnomial perps is 6.66x. This is tiny compared to leverage available elsewhere, up to 500x on BTCC.
Reasonable minds could argue that there are good reasons to cap leverage at less than 500x, but there is little doubt that 6.66x will be limiting for some traders and may decrease the popularity of regulated markets as long as unregulated options are available.
And this is the real question about the new, legal markets. You can see why players like Bitnomial and Coinbase might want to enter this market. Even if they can only take 1bp of fee, $60 trillion transaction volume nets $6 billion. At the more common 2-5 bps, we are talking silly revenue generation. But if the regulated versions of crypto markets will always be slightly ersatz, watered down versions of their decentralized predecessors, will they be attractive to size?
The CFTC has taken a liberal view of regulation. At the Piper Sandler conference that Veronica referenced, Acting Chair Pham delivered this message:
We are open to ideas, open to changes that will help the processes of price discovery and risk management. But, please, engage the CFTC early in the development of novel and innovative products and market operations. Too often, the CFTC is brought into the conversation long after crucial decisions have been made and resources expended, only to face regulatory obstacles that could have been avoided. Self-certification should be the end of a dialogue with the CFTC, not the beginning. Come talk to us. Get a preliminary view before you commit to a particular course of action. We are here not as an opponent or enemy, but as a sounding-board, someone who can help identify how innovations can be made consistent with our regulations or point to open questions that need to be answered.
It should be applauded for this approach. In law we have two categories of wrongs, malum in se and malum prohibitum. The first category is fundamental wrongs, generally direct violations of the rights of others. Violence, theft. This is the fundamental basis of law as a tool for interpersonal morality. The second category is thornier. We attempt to use the law to accomplish policy goals, and each regulation represents an inherent tradeoff between on one hand diminished liberty and on the other, achievement of some goal.
These products don’t fit within malum in se, so the burden should be on the regulator to articulate a reason why they should be banned. With perps, there isn’t one, so the CFTC is making them legal. Kudos.
I Made a Mistake
Finally, last week, I talked about issues that some practitioners have taken with the bankruptcy provisions of the GENIUS Act. Well, a reader (spoiler: it was George Leonardo of beginning-of-this-newsletter fame) pointed out to me that the version of the text I referenced last week was actually different from the then-current ANS version of the bill, and thus also different from the eventual final version that was passed by the Senate last Tuesday.
If you recall, I mentioned the issue that claims of the stablecoin holders may receive priority above professional fees, making administration of a debtor’s estate impractical.
Well, they’ve changed the language, and it is still broken. Here is the current:
Observe that the language has changed from guaranteeing first priority in all cases to now guaranteeing first priority for payment stablecoin holders only when they are first “not able to redeem all outstanding payment stablecoin claims from required payment stablecoin reserves.”
This may seem like quite a good savings clause at first glance, but as it turns out, it really doesn’t help that much. The risk that these reserves are most sensitive to is that the value of their constituent collateral will move against them because of sudden changes in the Treasury market, and this will leave them temporarily undercollateralized, leading to a run. In this scenario, of course, the payment stablecoin reserves would not be able to fully satisfy the payment stablecoin holders’ claims, and we would once again be in the mess I described last week.
Of course, there are other bankruptcy scenarios, and this language does help with those. But still, this is another reminder that a system that was more like deposit banking, wherein full collateralization was not required and instead deposit insurance protected the system against runs, would be more robust.
Until next week.
Brogan Law is a registered law firm in New York. Its address and contact information can be found at https://broganlaw.xyz/
Brogan Law provides this information as a service to clients and other friends for educational purposes only. It should not be construed or relied on as legal advice or to create a lawyer-client relationship. Readers should not act upon this information without seeking advice from professional advisors.
In perpetual futures, if there is automatic liquidation, wouldn't that exacerbate volatility in times of high market stress? Or, are their price limits/circuit breakers that would stop the market in the case of extreme volatility?