The United Kingdom’s Financial Conduct Authority proposed to ban the sale, marketing and distribution in or from the UK to retail persons of all derivatives and exchange-traded notes referencing unregulated cryptoassets that can be widely exchanged on cryptoasset platforms or other forums.
Generally, the proposed ban would include derivatives and ETNs based on cryptocurrencies and so-called “utility tokens” to the extent they are created on public blockchains and are readily transferable. The ban would not include derivatives or ETNs referencing security tokens; digital tokens that are unregulated but not widely transferrable (e.g., tokens used on a private blockchain); or tokens that constitute e-money and are subject to the FCA’s Electronic Money regulations (e.g., potentially stablecoins). Futures, options and contracts for differences are types of derivatives that would be included in the proposed ban.
The proposed ban would also not extend to professional clients or eligible counterparties as defined under the FCA’s client categorization rules. (Click here to access The FCA’s Conduct of Business Sourcebook, §3.5.1 regarding professional clients and §3.6.1 regarding eligible counterparties.)
The FCA’s prohibition would apply to affected products sold, distributed or marketed in or from the UK to retail clients and sales to UK clients from the European Economic Area, even where the clients seek such products proactively. However, it appears that retail clients would be authorized to obtain affected products proactively from non-EEA sources. The proposed ban would also prevent UK brokers from selling to UK retail clients affected products that might be traded abroad lawfully (e.g., bitcoin futures currently authorized for trading in the United States on Commodity Futures Trading Commission-designated contract markets).
The FCA claimed that it was proposing its ban because of (1) the complexity of the affected cryptoassets and “the lack of transparency around their valuation”; (2) “the prevalence of market abuse and financial crime in the secondary market for cryptoassets (e.g. cyber theft)”; (3) retail customers’ apparent “lack of knowledge and understanding” regarding affected cryptoassets; and (4) particular characteristics of the relevant derivatives and ETNs, including leverage “and volatility of the underlying assets.”
The FCA presented various statistical analyses it claimed supported its concerns. According to the FCA, some of these observations demonstrate that affected cryptoasset markets “are not driven by external factors such as usage or technological developments, but instead are driven by speculation akin to gambling.”
The FCA acknowledged that, if adopted, its proposal might encourage retail clients to invest directly in unregulated tokens, or for impacted authorized (i.e., registered) firms, to encourage “retail clients to ‘opt-up’ to professional client status or move their accounts to affiliated non-UK entities.” FCA expects that adoption of its proposal would potentially avoid consumer losses between GB £75 million and GB £234.3 million.
The FCA claimed it considered but rejected recommending the use of mandatory risk disclosures as an alternative to a ban. The FCA said this is because “consumers are unlikely to follow advice from authoritative sources.” Moreover, “[t]he continued offer of [affected] products by firms with FCA authorisations may also perpetuate a false sense of safety.”
The FCA will accept comments on its proposal through October 3, 2019.
Unrelatedly, Congresswoman Maxine Waters, Chairwoman of the United States House Committee on Financial Services, and various subcommittee chairpersons requested that Facebook and its partners “immediately” consent to a moratorium on the development and introduction of Libra, its proposed cryptocurrency, and associated initiatives.
Last month, Facebook published a white paper describing Libra, whose stated goal is to create a secure, scalable blockchain and global virtual currency to help individuals currently outside the financial system benefit from an efficient payment system and to help reduce payment transaction costs for others. (Click here for details in the My View commentary to the article “Global AML Standards Setter Says Countries Should Require Virtual Asset Service Providers to Obtain and Transmit Certain Information Regarding Senders and Recipients for All Virtual Asset Transfers” in the June 23, 2019 edition of Bridging the Week.)
A moratorium is warranted, wrote Ms. Waters, because Libra “raises serious privacy, trading, national security, and monetary policy concerns for not only Facebook’s over 2 billion users, but also for investors, consumers, and the broader global economy.” Ms. Waters indicated that during the moratorium, the House Committee on Financial Services would hold hearings on cryptocurrencies generally and “explore legislative solutions.”
Regardless of Facebook’s response to the moratorium call, a hearing regarding the Libra proposal is scheduled by the House Committee on Financial Services for July 17.
In other legal and regulatory matters involving cryptoassets:
CFTC Approves New Clearing House as First Derivatives Clearing Organization for Fully Collateralized, Deliverable Virtual Currency Futures: The CFTC approved Eris Clearing LLC as the first derivatives clearing organization authorized to clear fully collateralized virtual currency futures contracts that may be settled by the making or taking of delivery of cryptocurrencies. In 2011, the CFTC approved Eris Exchange LLC, Eris Clearing’s indirect parent company, as a designated contract market. Marketed together as “ErisX,” Eris Clearing anticipates offering the clearing of digital asset futures contracts traded on Eris Exchange beginning later in 2019. ErisX began offering spot virtual currency contracts earlier this year.
Among conditions for its DCO registration, Eris Clearing must obtain and endeavor to maintain “to the extent commercially reasonable” insurance for the theft or loss of participant cryptocurrency collateral; must disclose to any potential clearing member material risks associated with the clearing of fully collateralized virtual currency futures; and, within three years of its DCO Order, must have an independent certified public accountant review its internal controls and provide the accountant’s report to the CFTC. Eris Clearing must also have an independent CPA audit its virtual currency balances annually, and must provide to the CFTC any audit report of internal controls it may obtain from any third-party service provider used in connection with the custody or storage of cryptocurrencies for clearing members. Eris Clearing was required to demonstrate compliance with 17 core principles under applicable law to obtain its DCO status, including establishing standards and procedures to protect members’ and participants’ funds, implementing and maintaining "adequate and appropriate" risk management capabilities and system safeguards. (Click here for background on these core principles.)
Contemporaneously with its receipt of DCO status, Eris Clearing also received certain no-action relief from the CFTC’s Division of Clearing and Risk from various requirements ordinarily required by DCOs that clear margined products. Staff concluded that Eris Clearing would not be obligated to perform these requirements because of its fully collateralized clearing model.
Bitfinex Repays US $100 Million of US $700 Million Tether Loan Subject of NY AG Lawsuit: The cryptocurrency exchange Bitfinex announced that it repaid US $100 million of its outstanding loan facility to Tether, the company managing the tether stablecoin.
Previously, the Office of the Attorney General for the State of New York obtained an ex parte order from a New York State court prohibiting companies associated with Bitfinex and Tether from accessing, loaning or encumbering in any way US dollar reserves supporting tether digital coins. The NY AG claimed that the same individuals ultimately own and operate both Bitfinex and Tether, as well as their related companies.
Among other things, charged the NY AG, executives of Bitfinex and Tether agreed for Tether to provide Bitfinex a line of credit of up to US $900 million sourced from the US dollar reserves supporting tether in order to help meet Bitfinex’s customers’ withdrawal demands. However, this arrangement, asserted the NY AG, was made without disclosure to tether holders. At the time of its lawsuit, claimed the NY AG, Bitfinex had borrowed US $700 million from Tether utilizing tether supporting balances.
(Click here for background on the NY AG’s lawsuit against Bitfinex and Tether in the article “NY Court Upholds Restriction on Stablecoin Transferring Tethered Funds to Affiliated International Exchange but Limits Time Period of Prohibition” in the May 19, 2019 edition of Bridging the Week.)
My View: On December 12, 1980, a small start-up company, Apple Computer Inc., launched an initial public offering where it raised less than US $100 million through the sale of 4.6 million shares priced at US $22. Investors throughout the United States were able to participate in this IPO; however individual investors of one state – Massachusetts – were famously barred from participating. This was because the state’s regulators said Apple was too risky an enterprise for its citizens to invest in and banned the IPO under regulations designed to eradicate “highfliers that don’t have solid earnings foundations.” Last Friday, Apple closed at over US $204/share (after multiple share splits throughout its history) and the company’s market capitalization hovered between US $900 billion and $1 trillion. (Click here for a representative article describing Apple’s IPO and Massachusetts’s ban.)
In retrospect, Massachusetts clearly got it wrong. Its fear of Apple was grounded in a lack of understanding. Its prevention of Massachusetts individual residents to participate in this IPO was a misguided application of the doctrine of in loco parentis (in place of the parents) and in retrospect, it did not know better at all than ordinary citizens.
It appears equally condescending for the FCA to propose banning derivatives based on cryptocurrencies for the entire class of “retail persons” solely because it believes that such persons, generically, cannot possibly understand the risks of the product. This particularly appears to be the case when the FCA concedes that its ban may not be entirely effective either in precluding retail persons from obtaining access to derivatives through non-UK based sellers or preventing retail persons from purchasing spot cryptocurrencies directly.
I have no view on whether any individual cryptocurrency will be around in its current form in 5, 10 or more years, let alone whether the price of any particular virtual currency will rise or fall. No one can dispute that the prices of cryptocurrencies have been highly volatile. Moreover, it is more than likely that additional virtual currencies will be lost through external hacks and internal fraud at intermediaries if not through design flaws of some cryptocurrencies themselves.
Notwithstanding, if the FCA is concerned about the integrity of cryptocurrencies and derivatives based on them, it should draft clearer disclosures and develop and impose appropriate standards on the marketers and sellers of such products rather than banning access by retail persons outright. This is the approach the CFTC has taken in the US in recently approving DCMs, DCOs and swap execution facilities to trade and clear virtual currency derivatives, and of the National Futures Association, in mandating disclosures to all customers by futures commission merchants and introducing brokers that engage in virtual currency transactions. (Click here for details regarding the NFA Advisory in the article “National Futures Association Proposes Interpretive Notice Requiring FCM, IB, CTA and CPO Disclosures Regarding Virtual Currency Activity” in the July 27, 2018 edition of Between Bridges. The effective date of the NFA Notice was October 31, 2018.) The FCA might even consider suitability standards that could require sellers to preclude certain individual retail purchasers who fail to satisfy certain minimum standards. But make these prohibitions individual-focused and not across an entire class.
Banning derivatives for a generic group of purchasers (and sellers) – all retail persons – regardless of individual suitability is wrong. This is especially the case where, from the outset, other alternatives exist to acquire cryptoasset exposure that retail persons desiring exposure can pursue. It is far better for a regulator to establish standards for derivatives on cryptocurrencies that can assist all investors and recognizes differences in individual capabilities.
Hopefully, the FCA gets it better for retail persons in 2019 than Massachusetts got it for its individual citizens who wanted to participate in the Apple IPO in 1980.
