SULLIVAN & CROMWELL LLP
May 29, 2018
Recent Virtual Currency Actions by the
CFTC and State Regulators
CFTC Staff Issues Advisory for Exchanges and Clearinghouses
Listing Virtual Currency Derivatives and Announces Agreement for
Information Sharing with State Securities Regulators amid “Operation
Cryptosweep”
SUMMARY
On May 21, 2018, the staff of two divisions of the Commodity Futures Trading Commission (the “CFTC”)
published a staff advisory (the “Advisory”) that provides guidance for CFTC-registered exchanges and
clearinghouses when listing virtual currency derivative products.
The following key areas are highlighted
in the Advisory as requiring particular attention by entities that list, trade and clear a virtual currency
derivatives contract:
1
enhanced market surveillance;
close coordination with CFTC staff;
large trader reporting;
outreach to a broad range of stakeholders prior to listing;
Derivatives Clearing Organization (“DCO”) risk management and governance; and
the possibility of a staff notice to exchanges identifying concerns regarding new products,
including potential public release of the notice and sharing with other regulators.
On the same date, the CFTC, in a joint press release with the North American Securities Administrators
Association (the “NASAA”), announced that it had signed a Memorandum of Understanding Regarding
the Treatment of Non-Public Information Shared Between State Securities Administrators and the CFTC
(the “Agreement”) to establish a closer working relationship between the CFTC and individual state
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The Agreement sets out a framework for the sharing of
confidential information to assist participants in enforcing the Commodity Exchange Act (the “CEA”).
securities agencies (the “Joint Release”).
2
The signing of the Agreement coincides with the NASAA’s announcement of a coordinated international
crackdown on fraudulent Initial Coin Offerings (“ICOs”) and virtual currency-related investment products,
dubbed “Operation Cryptosweep.” To date, Operation Cryptosweep has generated nearly 70
investigations and 35 pending or completed enforcement actions in both the United States and Canada.
CFTC ADVISORY ON VIRTUAL CURRENCY DERIVATIVE LISTINGS
In 2015, the CFTC determined that bitcoin and other virtual currencies were “commodities” for purposes
of the CEA, giving the CFTC regulatory authority over virtual currency futures contracts as well as the
authority to investigate and bring enforcement actions in connection with fraud and manipulation that
occur in the spot markets in violation of the CEA.
This view has been accepted by at least one district
court.
3
4
The CFTC has interpreted the term “virtual currency” broadly, to encompass any digital
representation of value that functions as a medium of exchange, and any other digital unit of account
used as a form of currency.
5
The Advisory, issued jointly by the CFTC’s Division of Market Oversight and Division of Clearing and
Risk, notes that, unlike traditional commodities, there exists neither a widely adopted commercial use for
virtual currencies nor robustly regulated financial markets through which to trade these products.
Therefore, the observable prices for virtual currencies are less clearly connected to any intrinsic value or
supply and demand than for other commodities. These factors present heightened concerns about
potential market manipulation and other problematic activity in connection with the trading of virtual
currency products. For example, according to a Bloomberg report, the Justice Department, working with
the CFTC, has opened a criminal probe into whether traders are manipulating the price of bitcoin and
other virtual currencies using illegal practices, including “spoofing” trades.
6
In response to these risks, the CFTC has been monitoring developments in these products and
discussing the risks they present with market participants. This effort includes a recent collaboration with
the Chicago Mercantile Exchange (“CME”) and Cboe Futures Exchange (“CFE”) to review bitcoin futures
contracts listed pursuant to Commission Regulation 40.2.
The Advisory is a continuation of this
interaction with market participants, providing guidelines for designated contract markets (“DCMs”), swap
execution facilities (“SEFs”) and derivatives clearing organizations (“DCOs”) in discharging their selfregulatory
responsibilities while keeping pace with unique challenges posed by virtual currency
derivatives. The Advisory is comprised of six brief sections, each of which is summarized below.
7
Enhanced Market Surveillance
The Advisory highlights the importance of heightened access to information by an exchange – i.e., a DCM
or SEF – regarding the underlying spot market(s) to produce a well-designed market surveillance
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Recent Virtual Currency Actions by the CFTC and State Regulators
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SULLIVAN & CROMWELL LLP
program in the context of virtual currency derivatives. Under existing regulations, each DCM and SEF
must establish and maintain an effective oversight program to prevent manipulation, price distortions and
disruptions of the delivery or cash-settlement process. The CFTC staff believes that a heightened level of
monitoring of the trading activities of the underlying spot market(s) for virtual currency derivatives is
warranted. Access to spot market data such as trader identities, prices, volumes, times and quotes from
the relevant market makers or traders would facilitate effective surveillance. Additionally, continuously
monitoring these data feeds from the spot market(s), especially around the settlement period, would help
identify anomalies in the spot market(s), which can in turn impact trading on the exchange. The Advisory
also highlights the importance of Federal know your customer and anti-money laundering regulations, or
the equivalent laws in the home jurisdiction of the relevant spot market(s), in providing transparency into
the data obtained from the relevant spot market(s). The guidance states that “[a]s the virtual currency
markets develop, staff expects that the exchanges’ virtual currency contracts will be based on virtual
currency spot markets that follow these or similar regulations.”
Close Coordination with CFTC Surveillance Staff
Consistent with the CFTC’s emphasis on continuously discussing new developments with market
participants, the CFTC staff expect to have regular discussions with exchanges concerning a wide range
of issues related to the surveillance of virtual currency derivatives. The CFTC staff also expect that
exchanges will provide surveillance information and data related to the settlement process upon request.
Large Trader Reporting
The CFTC’s Large Trader Reporting System requires reporting firms, which includes clearing members,
futures commission merchants and foreign brokers, to file daily reports showing futures and option
positions of traders at or above specific reporting levels outlined in CFTC Regulation 15.03(b).
However,
exchanges can set the reporting level in a particular commodity at a level lower than what is specified by
regulation. Given the nature of virtual currency markets, and the significance of the large trader reporting
regime in detecting market manipulation, the Advisory recommends that exchanges set the large trader
reporting threshold for any virtual currency derivative contract at five bitcoin (or the equivalent for other
virtual currencies). The current reportable position level for both the CME and CFE is set at five bitcoin,
which, as the contract unit for the CME contract is five bitcoin, translates into a reportable limit of only one
contract. Given the large price volatility of bitcoin and other virtual currencies, it may prove difficult to
determine the five-bitcoin equivalent for other currencies.
8
Outreach to Stakeholders
The Advisory notes the importance for a CFTC-registered derivatives exchange that proposes to list a
new virtual currency-based contract of taking “extra care” to engage meaningfully with relevant
stakeholders. Prior to any new listing of a virtual currency contract, the CFTC expects that an exchange
will solicit comments on issues relating to the listing that go beyond the contract’s terms and its
susceptibility to manipulation. The guidance emphasizes the importance of soliciting input from
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SULLIVAN & CROMWELL LLP
stakeholders other than those interested in trading or clearing the new contract, such as clearing
members that can provide insight into DCO risk management. Finally, the Advisory encourages
exchanges to include an explanation of any opposing views learned from this stakeholder engagement
process, and how the exchange addressed them, with any submission to the CFTC for the listing of a
new virtual currency derivative. Exchanges are also encouraged to include as much information as
possible in submissions for new listings.
DCO Risk Management
Upon learning of a DCO that will be clearing a proposed contract, the CFTC will request relevant
information relating to the DCO’s proposed initial margin requirements and the governance process for
approving the proposed contract, including its consideration of the views of the clearing members in
approving the proposed contract and the DCO’s response to any opposing views regarding the manner in
which the contract will be cleared. The DCO’s proposed initial margin requirements must be
commensurate with the risks of the proposed contract including risks that result from any unusual product
characteristics and the ability of proposed margin requirements to adequately cover potential future
exposures to clearing members based on an appropriate historic time period. The CFTC staff may require
the DCO to adjust the proposed margin requirement and submit supporting data. Currently, the required
initial margin for the CME contract is set at 43% of notional (47% for speculators) while the required initial
margin for the CFE contract is set at 40% of the daily settlement price (43% for speculators).
Staff Notice
While acknowledging that “the existing self-certification process for new contracts has worked well” so far,
the Advisory notes that a “lengthy engagement” between CFTC staff and the relevant exchange is “not
unusual for products that may implicate complex issues.” The Advisory notes that if the CFTC staff is not
able to confirm that a self-certified product actually does comply with the CEA and applicable regulations,
and an exchange nonetheless intends to proceed with the listing, the CFTC staff may notify the exchange
of its concerns in writing, and may also make that notice public and available to other regulators.
The CFTC staff made clear that the Advisory is not a compliance checklist; rather, it is guidance on the
CFTC’s priorities and expectations when reviewing newly listed virtual currency derivatives at this time.
CFTC Commissioner Rostin Benham described the Advisory as “another step in providing the public with
greater transparency into this process” while noting that the Advisory only “clarifies expectations, it does
not equate a change to the regulatory process.” The Advisory follows the release earlier this year by the
CFTC of a “backgrounder” memorandum describing the self-certification process for virtual currency
futures in the wake of the listing of the CME and CFE bitcoin futures contracts – a process that had been
criticized by some market participants, including clearing member firms that were not privy to the nature of
the informal review and discussion process.
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INFORMATION SHARING AGREEMENT AND OPERATION CRYPTOSWEEP
While the CEA is generally enforced by the CFTC, it specifically grants authority to state securities
regulators to enjoin certain violations of the CEA.
To further this provision, on May 21, 2018, the CFTC
and the NASAA entered into an Agreement that will set out an understanding between the CFTC and
participating state securities regulators with respect to the treatment of non-public information shared
between the CFTC and these state securities regulators when cooperating in the enforcement of the
CEA. The information shared under the Agreement could also lead to enforcement actions under state
securities laws, commodity codes or other laws. The NASAA negotiated on behalf of the state security
administrators that are its members, each of which will have to sign on individually to be a party to the
Agreement, and the NASAA will serve as a liaison to facilitate communication between the state security
administrators and the CFTC. CFTC Chairman Giancarlo applauded the cooperation as ensuring that the
“rapidly evolving financial technology space has the appropriate oversight to pursue bad actors, protect
market participants, and allow for market-enhancing innovation.”
10
Joseph P. Borg, NASAA President,
called the Agreement “particularly relevant given the recent epidemic of schemes involving
cryptocurrencies and other modern types of commodities.”
11
12
The Agreement was signed contemporaneously with the announcement of the initial results of “Operation
Cryptosweep,” a task force that was formed in April 2018 and that is being led by the NASAA with more
than 40 participating state and provincial regulators in the United States and Canada. In connection with
the announcement of Operation Cryptosweep, which has identified 30,000 virtual currency-related
domain name registrants to date, NASAA President Borg stated that “[t]he actions announced today are
just the tip of the iceberg.”
Borg described the “expanding exploitation of the crypto ecosystem by
fraudsters” as a “significant threat to Main Street Investors” adding that “[d]espite a series of public
warnings from security regulators at all levels of government, cryptocriminals need to know that state and
provincial securities regulators are taking swift and effective action to protect investors from their schemes
and scams.”
13
14
Operation Cryptosweep comes amid the steadily increasing focus of the Securities and
Exchange Commission (the “SEC”) and CFTC on targeting fraudulent activity in the virtual currency
markets and raising public awareness of the risks associated with ICOs and virtual currency-related
investment products, a critical component of Operation Cryptosweep. A week prior to the announcement
the SEC launched “HoweyCoins.com”, a phony website designed to mimic a typical too-good-to-be-true
ICO and demonstrate how easily fraudulent offerings of this type can be constructed.
The
announcement of Operation Cryptosweep also follows a recent analysis published by The Wall Street
Journal, which discovered red flags such as plagiarized investor documents, promises of guaranteed
returns and missing or fake executive teams in 271 out of the 1,450 ICOs in the sample.
15
16
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Copyright © Sullivan & Cromwell LLP 2018
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ENDNOTES
1
CFTC, Advisory with Respect to Virtual Currency Derivative Product Listings, CFTC Staff
Advisory No. 18-14 (May 21, 2018), available at https://www.cftc.gov/sites/default/files/
idc/groups/public/%40lrlettergeneral/documents/letter/2018-05/18-14_0.pdf.
2
CFTC, NASAA Sign Agreement for Greater Information Sharing Between Federal Commodities
Regulator and State Securities Regulators, CFTC and NASAA joint press release, CFTC release
No. 7730-18, available at https://www.cftc.gov/PressRoom/PressReleases/7730-18.
3
See In the Matter of: Coinflip, Inc., CFTC Docket No. 15-29, 2015 WL 5535736 (Sept. 17, 2015)
(“Bitcoin and other virtual currencies are encompassed in the definition and properly defined as
commodities”).
4
CFTC v. McDonnell, et al., No. 1:18-cv-00361 (E.D.N.Y. Mar. 6, 2018) (“[Virtual Currencies] fall
well within the common definition of “commodity” as well as the CEA’s definition of “commodities”
. . . .”).
5
Retail Commodity Transactions Involving Virtual Currency, 82 Fed. Reg. 60335 (Dec. 20, 2017),
available at http://www.cftc.gov/idc/groups/public/@lrfederalregister/documents/file/2017-27421a
.pdf.
6
Robinson, Matt, U.S. Launches Criminal Probe into Bitcoin Price Manipulation, Bloomberg (May
24, 2018) available at https://www.bloomberg.com/news/articles/2018-05-24/bitcoin-manipulationis-said-to-be-focus-of-u-s-criminal-probe?utm_content=crypto&utm_campaign=socialfloworganic&utm_source=twitter&utm_medium=social.
7
See 17 CFR § 40.2 and CFTC Backgrounder on Oversight of and Approach to Virtual Currency
Futures Markets (Jan. 4, 2018), available at http://www.cftc.gov/idc/groups/public/@newsroom/
documents/file/backgrounder_virtualcurrency01.pdf.
8
See 17 CFR § 15.03(b).
9
CFTC Backgrounder on Oversight of and Approach to Virtual Currency Futures Markets (Jan. 4,
2018), available at http://www.cftc.gov/idc/groups/public/@newsroom/documents/file/back
grounder_virtualcurrency01.pdf; see also our memo to clients CFTC Issues New Guidance
Relating to Virtual Currency Regulations, January 31, 2018, available at
https://www.sullcrom.com/siteFiles/Publications/SC_Publication_CFTC_Issues_New_Guidance_
Relating_to_Virtual_Currency_Regulations.pdf.
10
7 U.S.C. §13a-2.
11
The Joint Release.
12
Id.
13
NASAA, State and Provincial Securities Regulators Conduct Coordinated International Crypto
Crackdown (May 21, 2018), available at http://www.nasaa.org/45121/state-and-provincialsecurities-regulators-conduct-coordinated-international-crypto-crackdown-2/.
14
Id.
15
The phony website created by the SEC and corresponding “HoweyCoin” White Paper, available
at https://www.howeycoins.com/index.html.
16
Coulter Jones and Shane Shifflett, Buyer Beware: Hundreds of Bitcoin Wannabes Show
Hallmarks of Fraud, The Wall Street Journal (May 17, 2018), available at
https://www.wsj.com/articles/buyer-beware-hundreds-of-bitcoin-wannabes-show-hallmarks-offraud-1526573115.
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