Cyprus Securities and Exchange Commission guidance on derivatives based on virtual currencies

Following the decision by the European Securities and Markets Authority (ESMA) to bring contracts for difference (CFDs) on virtual currencies within the scope of its product intervention measures, the Cyprus Securities and Exchange Commission (CySEC) has announced that it considers such CFDs to be financial instruments falling within the scope of the Investment Services and Activities and Regulated Markets Law of 2017, and has issued a circular, C268 dated 15 May 2018, setting out its guidance on derivatives based on virtual currencies.

As indicated in CySEC’s announcement dated 15 November 2017, issuing and trading in virtual currencies is not subject to regulation by CySEC unless the virtual currency concerned has characteristics that fall within the existing regulatory framework. However, virtual currencies may constitute an underlying variable in other derivative contracts including CFDs, options and futures.

Part III of the First Appendix of the Investment Services Law, which defines the financial instruments falling within the scope of the law, includes the following:

  • (4): “[…] any other derivative contracts relating to securities […] which may be settled physically or in cash”;
  • (9): “financial contracts for differences”;
  • (10): “[…] any other derivative contracts relating to assets […] not otherwise mentioned in this Section, which have the characteristics of other derivative financial instruments”.

Therefore, depending on the specific characteristics of the product, providing investment services in relation to derivatives based on virtual currencies will require specific authorisation by CySEC.

Cyprus investment firms conducting regulated activities in derivatives, including CFDs, based on virtual currencies must be authorised and must comply with the applicable national legislation, with EU regulations, with Guidelines and Recommendations issued by the European Securities and Markets Authority and the European Banking Authority which are adopted by CySEC, and with the Q&As, Opinions and other Convergence Tools published by ESMA.

Like other regulatory bodies, CySEC considers that the risks associated with derivatives based on virtual currencies are high. It therefore advises investment firms it regulates that they should approach the provision of such services with caution, and that compliance with all of their legal obligations will be closely monitored, including their obligations to:

  • act honestly, fairly and professionally, in accordance with the best interests of their clients;
  • provide fair, clear and straightforward information to their clients;
  • provide appropriate guidance on and warnings of the risks associated with investments in the instruments concerned;
  • have adequate product governance arrangements;
  • execute orders on terms most favourable to the client; and
  • maintain adequate capital.

To that end, they should thoroughly consider their obligations under the Investment Services Law when designing, creating and distributing derivatives based on virtual currencies, and inform their clients in advance of any investment:

  • of the risks associated with these products in a specific risk warning;
  • that such products are complex, extremely risky, and usually highly speculative;
  • that they entail a high risk of losing all the invested capital;
  • that virtual currencies are subject to extreme price volatility, which may result in significant losses being incurred in a short period of time;
  • that they are not appropriate for all investors, and that customers should engage in trading in relation to such products only if they have the requisite knowledge of the product and are able to bear the loss of their entire investment. Customers must be fully aware of and understand the specific characteristics and risks of the products concerned;
  • of the fees and costs entailed, particularly any roll-over fees.

Firms which provide investment services in relation to over-the-counter derivatives based on virtual currencies must ensure that the reference prices used in relation to the underlying asset are gathered from reputable, publicly available sources. Firms should perform a thorough evaluation before selecting their pricing sources and keep them under constant review, in order to ensure compliance with the best execution requirements.

Regulated investment firms must also include the risks associated with their activities relating to derivatives based on virtual currencies when calculating their capital adequacy ratios and modify their risk mitigation strategies appropriately. They should consider the potential impact of their activity in derivatives based on virtual currencies on their wider operations, and adequately address the risks associated with these activities in the context of their Internal Capital Adequacy Assessment Process.

Taking into account the extreme volatility of virtual currencies, regulated investment firms which undertake investment activities in relation over-the-counter derivatives based on virtual currencies will be expected to maintain an adequate additional capital buffer of common equity tier 1 capital in order to enhance their resilience.

In addition to these requirements, regulated investment firms must also observe ESMA’s product intervention measures relating to contracts for difference and binary options, specifically the prescribed leverage limits (1:2), the margin close out rule, negative balance protection, the restriction on incentives and the requirement to provide a firm-specific risk warning. They must also observe the requirements of ESMA’s Questions and Answers Relating to the provision of CFDs and other speculative products to retail investors under MiFID.

Regulated investment firms wishing to provide investment services in relation to derivatives based on virtual currencies should submit the appropriate application to CySEC. Firms which have already submitted an application under the category of “other service” under article 5(5) of the Investment Services Law may reclaim the application fee if the application has not been processed.

If you have any questions about this matter or require any clarification please contact our funds advisory team or your usual contact at Elias Neocleous & Co LLC.

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