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Arca's Lawyer Warns Against Crypto Derivatives

By Linas Kmieliauskas
Arca's Lawyer Warns Against Crypto Derivatives 101
Source: iStock/XtockImages

Crypto derivatives, that offer "synthetic exposure" to traditional financial instruments, are inappropriate for retail investors, Philip Liu, co-founder and chief legal officer of Arca, a Los Angeles-based crypto investment management firm, warned.

Recently, crypto projects have been announced that allow an investor to "get exposure" to a stock or a basket of stocks (such as the S&P 500) without actually owning the stock or an ETF (exchange-traded fund) that owns the basket of stocks.

In a blog post, Liu argued that financial derivatives are "complex, intertwined financial instruments that can wipe out a fortune with a misstep or miscalculation by a person or someone else outside of the person’s control."

"Financial derivatives have been called "time bombs" and "financial weapons of mass destruction" by Warren Buffett," Liu added. He classified crypto derivatives as "exotic". It is different from the vanilla-style derivatives that follow commonly-established rules such as exchange-traded options. According to Liu, exotic derivatives is "everything else" and which may include bespoke features.

"Some have argued that crypto derivatives deliver market and product access that is not currently available. I kindly disagree. Exotic derivatives are only right for really sophisticated investors (hedge fund managers, large institutions like banks and insurance companies) and even these sophisticated investors get it wrong sometimes leading to disastrous consequences," co-founder said.

According to him, such derivatives are unsuitable for the average investor due to, among other things, the counterparty risk, which "probably can't" be evaluated by a retail investor. Also, he's discussing the valuation and leverage risks and risks associated with various events such as mergers, regulation, bankruptcy, and various market disruption events.

"How does one account for such events? If these questions can’t be answered, the derivatives contract has serious gaps which may result in large losses," Liu stressed, adding that one should not forget that derivative instruments are also the most fee-intensive.

"Some have argued that derivatives are appropriate for non-U.S. retail investors because they are not prohibited for retail investors in every jurisdiction. I disagree. It’s my opinion that the complexity of these products makes them appropriate for only the most financially-able and sophisticated investors and counterparties. Everyone else should stay far away from them," Liu concluded.

As reported last week, decentralized financial contracts platform UMA launched the USStocks token that represents synthetic ownership of an index of the 500 largest exchange-listed US stocks. Meanwhile, there are other projects, such as Currency.com, DX.Exchange, and Synthetix, that offer exposure to stocks, commodities, ETFs. Synthetix also plans to launch indices and derivatives trading "soon." All these products are not available in the U.S.

However, Arca itself is working on the Arca UST Coin, a stablecoin project, which is currently under review with the U.S. Securities and Exchange Commission. With the coin, the company aims to tokenize US Treasury Bonds using the Arca Digital Securities Platform and pay interest to owners of the coin quarterly.

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