Response to the CFTC Request for Input on Ethereum Blockchain

The Commodity Futures Trading Commission released a request for input to improve its understanding of the Ethereum blockchain. As a service provider in the derivatives field, Chatham is particularly intrigued with the opportunities presented by blockchain, especially smart contracts and crypto-derivatives. Among other initiatives, Chatham has been involved in the International Swap and Derivatives Association’s Common Domain Model (ISDA CDM) initiatives. Chatham is committed to being prepared to advise and support our clients as these technological developments move from the realm of the most technologically advanced to more mundane, every day uses. For these reasons, Chatham responded to the Commission’s request for information regarding crypto-asset mechanics and markets.

Blockchain and Distributed Ledger Technology: Purpose and Functionality

The development of blockchain and distributed ledger technology (DLT) that undergirds Ethereum and Bitcoin reflect a desire to reshape some of the norms, such as centralization and data ownership, that had been unquestionably accepted by most internet users. 

Users have only recently started questioning the efficacy of a system that grants ownership of data pertaining to them to third parties. Centralization of the internet, as it concerns where users’ digital information is held, used, and monetized by companies who have shown themselves to be poor stewards of the data they have amassed with little oversight or control given to the users themselves, have made it such that a few large companies hold the data of many. 

Blockchain was created counter to those norms. It is decentralized, with data replicated across several unrelated nodes, allowing users to maintain control over their data through encryption keys. 

Smart contracts reflect a similar desire to reshape legal processes by establishing a process that removes any question of whether the parties will perform. These self-executing smart contracts seek to create a system that makes trust irrelevant. 

As stated by Dr. Gavin Woods in “Ethereum: A Secure Decentralised Generalised Transaction Ledger”, one of the key goals of the development of Ethereum was to “facilitate transactions between consenting individuals who would otherwise have no means to trust one another. This may be due to geographical separation, interfacing difficulty, or perhaps the incompatibility, incompetence, unwillingness, expense, uncertainty, inconvenience, or corruption of existing legal systems.” 

The technology seeks to create one truth—one that cannot be corrupted or changed by bad actors, a system that cannot be manipulated or controlled by any outsized presence. While Bitcoin functions as a store of value, Ethereum is a technology that leverages many of the core features of DLT (fully transparent, anonymous, time-stamped, unanimous, immutable, secure, and programmable) and pairs it with smart contracts to allow for parties to enter into legal agreements with full confidence they can anticipate the possible outcomes regardless of their counterparties and the systems in which they exist. 

As demonstrated at the Barclays DerivHack in September 2018, Chatham feels Ethereum is a prime platform on which to deploy the ISDA CDM. In Chatham’s proposed solution, which won Best Solution Architecture in the U.S., the ISDA CDM use cases (setting up counterparty data, a new trade event, lifecycle events, etc.) were deployed on Ethereum. Chatham’s team selected this approach because Ethereum is a public platform, which would allow market participants equal access to the model and its benefits. Chatham sees the ISDA CDM as a leading use case for capital markets to benefit from the functionalities and capabilities of the Ethereum Network.

Derivative Contracts on Ether: Markets, Oversight and Regulation

As an active participant in derivative markets, Chatham is especially interested in thinking through how the Commission can provide oversight to derivative contracts on Ether. Prior to creating regulation and oversight mechanisms, Chatham encourages the Commission to first further refine their definitions of the categories of derivative contracts.

Definition of Derivatives Contracts 

There are many ways to define derivative contracts on Ether. One useful way to think about derivative contracts is to break them into the following categories: futures, OTC swaps, or options on the USD/ETH exchange rate; futures or OTC derivatives stored on a blockchain using a system like ISDA CDM, but mechanically executed off-chain; futures or OTC derivatives stored on a blockchain using a system like the ISDA CDM and executed through a smart contract; futures or OTC derivatives stored on a blockchain using a system like the ISDA CDM and executed through a smart contract; and futures or OTC derivatives on the implied interest rate from proof of stake (PoS) deposits. 

As far as futures, OTC swaps or options on the USD/ETH exchange rate are concerned, within that category are deliverable and non-deliverable USD/ETH futures and OTC derivatives traded either on- or off-chain. For non-deliverable USD/ETH futures and OTC derivatives traded off-chain, Chatham believes that those crypto-derivatives could be treated like any other futures contract. There are several ways to approach deliverable USD/ETH futures and OTC derivatives traded off-chain. One such example is that the exchange could create a contract where the seller deposits the Ether and the buyer of the contract at delivery gains the right to withdraw the Ether.

The Commission could audit this contract as well as monitor its usage. For deliverable USD/ETH futures and OTC derivatives traded on chain that are executed through a smart contract, there are a lot of potential issues to address including security, KYC, and the need for an oracle. 

Ether Cash Market 

In terms of the Ether cash market, it is not clear from the Commission whether this exchange supports ETH/USD only. Chatham believes that such a definition could also feasibly include the ETH token or ERC-20 tokens. Additionally, Chatham believes that bespoke insurance-like contracts on ERC-721 tokens could similarly fit within that definition. 

Effects of Introducing Derivative Contracts on Ether

Introducing derivative contracts, such as futures, on Ether may lead to several interesting impacts on a PoS consensus model.  

In general, PoS incentivizes market participants to hold long positions due to economic rewards. Due to the decrease in availability of tradeable Ether, the market experiences upward pressure on its price.  However, the introduction of derivatives contracts typically adds downward pressure on price as there is now a way for market participants to short Ether. Under these market conditions, those who hold Ether must make a more complicated decision regarding how the value of Ether will be affected by derivatives and speculation. 

As an example, these competing market forces are demonstrated through the interest rate parity effect that will occur during the initial phase of the upcoming Casper FFG protocol. A participant in Casper will be an Ether stakeholder who locks their Ether to act as a validator. As compensation, the stakeholder gains an established rate of return during the duration of the deposit.  

Alternatively, the Ether holder could exchange Ether to USD (or another currency) and deposit the USD into an interest-bearing instrument for the same time period as the previous example. Derivatives futures contracts on the ETH/USD exchange rate could be used to lock in a rate of return on the Ether. 

In summary, participants would know: 

S: spot exchange rate 

F: future exchange rate 

DF_USD: USD discount factor (interest rate) 

DF_ETH: ETH discount factor (interest rate) 

 

If the USD interest rate is high enough, holders of Ether may prefer to lock in gains using USD interest and futures instead of participating in the PoS mechanism.  

S = DF_USD/DF_ETH*F 

Interest Rate Parity for ETH/USD exchange flowchat

Interest Rate Parity for ETH/USD exchange
 

If the situation is modified to assume liquid markets, interest rate parity would relate the four quantities. Deviations from interest rate parity could lead holders of Ether to not participate in the PoS mechanism.

Conclusion

Chatham appreciates the opportunity to comment on the Commission’s “Request for Input on Crypto-asset Mechanics and Markets” and looks forward to continuing to engage in the surrounding legal and regulatory debates that will ensue as this technology continues to be developed and crypto-derivative markets emerge. It is Chatham’s desire to advocate on behalf of end users and buyside participants during this market evolution. Read Chatham’s full response to the Commission’s request for input. 

 


Disclosures

Chatham Hedging Advisors, LLC (CHA) is a subsidiary of Chatham Financial Corp. and provides hedge advisory, accounting and execution services related to swap transactions in the United States. CHA is registered with the Commodity Futures Trading Commission (CFTC) as a commodity trading advisor and is a member of the National Futures Association (NFA); however, neither the CFTC nor the NFA have passed upon the merits of participating in any advisory services offered by CHA. For further information, please visit https://www.chathamfinancial.com/legal-notices/.

Transactions in over-the-counter derivatives (or “swaps”) have significant risks, including, but not limited to, substantial risk of loss. You should consult your own business, legal, tax and accounting advisers with respect to proposed swap transaction and you should refrain from entering into any swap transaction unless you have fully understood the terms and risks of the transaction, including the extent of your potential risk of loss. This material has been prepared by a sales or trading employee or agent of Chatham Hedging Advisors and could be deemed a solicitation for entering into a derivatives transaction. This material is not a research report prepared by Chatham Hedging Advisors. If you are not an experienced user of the derivatives markets, capable of making independent trading decisions, then you should not rely solely on this communication in making trading decisions. All rights reserved. 19-0066

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