The latest bipartisan crypto bill would give the CFTC new tools and authorities to regulate digital commodities, with a focus on market integrity and consumer protection.
On August 3, 2022, a bipartisan group of US senators introduced the Digital Commodities Consumer Protection Act of 2022 (the Bill). The Bill is the latest legislative proposal seeking to bring clarity to digital asset markets and the allocation of regulatory responsibility with respect to such markets. In comparison to other recent proposals, the Bill goes further toward the creation of a comprehensive supervisory regime for digital asset platforms, with a particular focus on market integrity and consumer protection (although it does not directly address securities issues).
The Bill would grant the Commodity Futures Trading Commission (CFTC) exclusive jurisdiction over “digital commodity trades” and would define the term “digital commodity” to expressly include Bitcoin and Ether. Whereas other recent proposals have proposed voluntary registration regimes, the Bill would make CFTC registration mandatory for “digital commodity platforms,” a term that would include digital commodity brokers, custodians, dealers, and trading facilities.
Importantly, and unlike other recent proposals, the Bill would expressly preempt state licensing requirements, including under state money transmitter regimes, for CFTC-registered digital commodity platforms. The Bill also contains a range of measures intended to further empower the CFTC to police against fraud, manipulation, and other manipulative practices in digital asset markets and on digital asset platforms. A number of additional key takeaways and insights are discussed below.
Senator John Thune stated that “this legislation would provide the CFTC with the necessary visibility into the marketplace to respond to emerging risks and protect consumers, while also providing regulatory certainty to digital commodity platforms.” CFTC Chairman Rostin Behnam commented positively on the Bill, stating that “we are at a critical inflection point where new legislative authority is needed to clarify ambiguities and provide a regulatory framework to the digital commodity market that protects customers, provides market integrity and certainty, and ensures financial stability.” CFTC Commissioner Kristin Johnson noted that the Bill is a “thoughtful” attempt to “integrate stronger investor protections and robust market integrity safeguards” into the digital asset markets.
Exclusive Jurisdiction With respect to Digital Commodity Trades
In terms of jurisdiction, the Bill would amend Section 2(c)(2) of the Commodity Exchange Act (CEA) to include a new paragraph (F) granting the CFTC exclusive jurisdiction over any account, agreement, contract, or transaction involving a “digital commodity trade.” However, this exclusive jurisdiction would not extend to any digital commodity transaction by a merchant or consumer who uses a digital commodity solely for the purchase or sale of a good or service.
The Bill would amend the CEA’s definition of a “commodity” to include a “digital commodity,” which would be defined to mean, subject to certain express inclusions and exclusions, “a fungible digital form of personal property that can be possessed and transferred person-to-person without necessary reliance on an intermediary.”
Significantly, the Bill’s definition of a “digital commodity” would expressly include “property commonly known as cryptocurrency or virtual currency, such as Bitcoin and Ether.” On the other hand, the Bill would expressly exclude from the definition of “digital commodity”:
- an interest in a physical commodity;
- a security;
- a digital form of currency backed by the full faith and credit of the US (i.e., a US government central bank digital currency);
- any other CFTC-regulated instrument (e.g., futures, options on futures, swaps); and
- any other instrument that the CFTC determines not to be a digital commodity.
The Bill would define the term “digital commodity trade” to mean a purchase or sale of a digital commodity in exchange for another digital commodity or any other consideration, including an offer to enter into a purchase or sale of a digital commodity, a loan or offer to enter into a loan of a digital commodity, or any similar activity.
Extension of Enforcement Authority to Digital Commodity Trades
The Bill would amend key sources of the CFTC’s existing futures market enforcement authority to apply to digital commodity trades as if such trades were futures contracts. These amendments to Sections 4b, 4c, and 6(c) of the CEA would have the effect of extending, for example, the CEA’s existing prohibitions on wash trades, spoofing, and other fraudulent devices and schemes to digital asset markets.
Mandatory Registration for Digital Commodity Platforms
Unlike the permissive approach to CFTC registration under the Lummis-Gillibrand Responsible Financial Innovation Act (for more information, see this Latham blog post), the Bill would establish a mandatory registration regime and amend the CEA to make it unlawful for any person to act as any category of “digital commodity platform” without registering with the CFTC in the relevant platform category. The Bill would empower the CFTC to prescribe rules permitting or otherwise authorizing registration in more than one digital commodity platform category or dual registration in an existing capacity with the CFTC (e.g., as a futures commission merchant or swap dealer).
The Bill would define the term “digital commodity platform” to mean a person who is one or more of the following:
“Digital commodity broker”: a person engaged, as an identifiable business, in (i) soliciting or accepting orders on behalf of another person for a digital commodity trade; (ii) accepting digital commodities from another person for the purpose of entering into digital commodity trades; or (iii) arranging digital commodity trades on behalf of another person.
“Digital commodity dealer”: a person who (i) has an identifiable business of dealing in a digital commodity as principal for its own account; (ii) makes a market in a digital commodity; (iii) holds themselves out as a dealer in a digital commodity; (iv) has an identifiable business of buying or selling digital commodities for conversion into other digital commodities, currency, or other consideration; (v) has an identifiable business of accepting digital commodities from a depositor with an obligation to return the digital commodities, consideration linked to the digital commodities, or both to the depositor; or (vi) other similar activity as determined by the CFTC.
“Digital commodity trading facility”: a trading facility that facilitates the execution or trading of digital commodity trades between persons.
“Digital commodity custodian”: a person who, as an identifiable business, maintains possession, custody, or control over digital commodities on behalf of another person. Notably, an insured depository institution or insured credit union would be expressly excluded from the scope of the digital commodity custodian definition.
Importantly, the Bill would expressly provide that digital commodity transaction validation (e.g., mining activity or operation of a node) would not, on its own, suffice to meet the definitions of a digital commodity broker, digital commodity dealer, or digital commodity trading facility.
In addition, the Bill would amend Section 4k of the CEA to incorporate a new subsection (4) to require registration by any “associated person” of a digital commodity broker or digital commodity dealer. For these purposes, the term “associated person” would encompass any partner, officer, employee, or agent (or any person occupying a similar status or performing similar functions) in any capacity that involves (i) the solicitation or acceptance of a digital commodity trade or (ii) the supervision of any person engaged in the solicitation or acceptance of a digital commodity trade, in each case other than in a solely clerical or ministerial capacity.
Trading in Listed Digital Commodities
The Bill would establish a regime for digital commodity trading facilities to self-certify new rules, rule amendments, and the listing for trading of contracts for a digital commodity. The self-certification process set forth in the Bill resembles the existing regime under the CEA for self-certification of futures contracts for listing by designated contract markets. In general, a rule or rule amendment would be effective 10 business days after self-certification or 30 business days after self-certification in the case of a listing of a digital commodity that has not previously been listed on any digital commodity trading facility.
The CFTC would be permitted to stay any such self-certification for no more than 90 days in the case of (i) a novel or complex issue that requires additional time to analyze, (ii) an inadequate explanation by the submitting digital commodity trading facility, or (iii) a potential inconsistency with the CEA. The CFTC would have the authority to disapprove a listing, rule, or rule amendment on the basis of inconsistency with the CEA. The CFTC would also have the authority to mandate the delisting of a contract for a digital commodity that has already been listed. The Bill would require the CFTC to prescribe rules governing standardized disclosures to be provided by a digital commodity trading facility addressing, for example, the operating structure and system of listed digital commodities.
The Bill would provide that a digital commodity broker or digital commodity dealer may only trade or arrange a trade for digital commodities that (i) are not readily susceptible to manipulation and (ii) have met the digital commodity trading facility listing requirements above.
Core Principles for Digital Commodity Platforms
In line with the CFTC’s principles-based approach to regulation in other contexts, digital commodity platforms would be required to comply with certain “core principles” in order to remain registered. Unless the CFTC determines otherwise in a rulemaking, digital commodity platforms would be afforded reasonable discretion in establishing the manner in which they comply with such core principles.
Some of the core principles proposed in the Bill would apply to digital commodity platforms generally. Thus, all digital commodity platforms would be required to:
- maintain records of all activities relating to the business of the platform, including a complete audit trail, for at least five years;
- not adopt any rules or take any actions that result in any unreasonable restraint of trade, or impose any material anticompetitive burden on trading or custody;
- implement conflict-of-interest systems and procedures, including structural and institutional safeguards to minimize conflicts of interest that might potentially bias the judgment or supervision of the digital commodity platform and contravene the core principles of fair and equitable trading and the business conduct standards of the CEA;
- maintain adequate financial, operational, and managerial resources to discharge each responsibility of the digital commodity platform;
- establish and maintain a program of risk analysis and oversight to identify and minimize sources of operational risk (including cybersecurity risk) through the development of appropriate controls and procedures and automated systems;
- establish and maintain emergency procedures, backup facilities, and a plan for disaster recovery;
- designate an individual to serve as chief compliance officer responsible for, among other things, establishing compliance policies and procedures and preparing an annual report on the compliance of the digital commodity platform with the requirements of the CEA;
- establish transparent governance arrangements to fulfill public interest requirements;
- establish and enforce fitness standards for directors and affiliates;
- treat and deal with all customer property that is received by the digital commodity platform as belonging to the customer;
- subject to limited exceptions, segregate and not commingle customer property; and
- only invest customer funds in US Treasuries or obligations whose principal and interest are fully guaranteed by the US.
Some of the core principles proposed in the Bill are specific to digital commodity trading facilities. Such principles would require that digital commodity trading facilities:
- establish and enforce rules and procedures for trading, trade processing, and participation that deter abuse;
- maintain the capacity to detect, investigate, and enforce those rules;
- only permit transactions in digital commodities that are not readily susceptible to manipulation;
- provide a competitive, open, and efficient market for executing transactions that protects the price discovery process of trading on the trading facility;
- provide a centralized market for executing transactions;
- establish and enforce rules to protect markets and market participants from abusive practices committed by any party;
- promote fair and equitable trading on the platform;
- monitor trading in digital commodities to prevent manipulation, price distortion, and disruptions of the delivery or settlement process through surveillance, compliance, and disciplinary practices and procedures, including investigations, sanctions, and methods for conducting real-time monitoring of trading and comprehensive and accurate trade reconstructions;
- obtain, report, or publish trading information in a timely manner;
- adopt rules for the exercise of emergency authority, including the authority to liquidate or transfer open positions or to suspend or curtail trading in consultation and cooperation with the CFTC; and
- establish and enforce disciplinary procedures and dispute resolution procedures.
Some of the core principles proposed in the Bill are specific to digital commodity brokers and digital commodity dealers. Such principles would require that digital commodity brokers and digital commodity dealers:
- establish fair and objective prices, disclose the basis for those prices, and not disrupt market functioning or hinder the price discovery process;
- keep full, complete, and systematic records of all transactions relating to their business of dealing or brokering digital commodity trades;
- keep all oral and written communications provided or received concerning quotes, solicitations, bids, offers, instructions, trading, and prices related to transaction execution;
- conform with such business conduct standards as may be prescribed by the CFTC relating to fraud, manipulation, and other abusive practices involving digital commodity trades and diligent supervision of the business of dealing or brokering digital commodity trades;
- establish robust and professional risk management systems; and
- establish and enforce internal systems and procedures to obtain any necessary business information, and disclose such information to the CFTC upon request.
Additional Takeaways and Insights
A number of other aspects of the Bill warrant specific mention:
Scope of digital commodity definition. The Bill would clearly designate Bitcoin and Ether as digital commodities. Its broad definition of a “digital commodity” would, on first impression, cover most virtual currencies and stablecoins. However, as noted above, the definition of “digital commodity” under the Bill is subject to an exclusion for securities. As a result, the Bill would not address or resolve the ongoing difficulty of assessing the security status of digital assets.
Digital asset lending activities. In light of recent market events, the definition of “digital commodity dealer” (particularly the reference to persons with an identifiable business of accepting digital commodities from a depositor with an obligation to return such digital commodities or linked consideration) would seem to capture and contemplate registration by digital asset lending platforms. Indeed, the core principles in the Bill would authorize the CFTC to adopt rules governing permissible lending of digital commodities by a digital commodity platform holding such digital commodities for customers. Also, the Bill would not appear to impact the SEC’s ability to consider crypto lending arrangements a securities offering.
Fees for registration. The Bill would require the CFTC to assess and collect fees for registering digital commodity platforms and conducting oversight of digital commodity trades. Such fees would be determined based on the volume of business of the digital commodity platform and the category of digital commodity platform.
SRO membership. Under the Bill, a digital commodity broker, digital commodity dealer, or digital commodity custodian would be required to be a member of a registered futures association. The Bill would permit the CFTC to delegate registration functions with respect to digital commodity platforms and the associated persons to a registered futures association. Currently, the only registered association is the National Futures Association.
Extra-territorial application. The Bill would amend Section 2(i) of the CEA to clarify that the digital commodity-related aspects of the CEA will extend, among other things, to activities outside the United States that have a reasonably foreseeable significant effect within the United States.
Application of money laundering requirements. The Bill would amend the definition of a “financial institution” under the Bank Secrecy Act to include a “digital commodity platform.” As a result, digital commodity platforms would be subject to the anti-money laundering requirements of the Bank Secrecy Act.
Bankruptcy Code amendments. The Bill would amend the definition of a “commodity broker” under the Bankruptcy Code to include a digital commodity platform. As a result, digital commodity platforms would be subject to the commodity broker-specific bankruptcy regime that currently applies to futures commission merchants and similar entities.
Dual registration with SEC. The Bill would clarify that a digital commodity platform registered with the CFTC may also be registered with the SEC as an exchange, a broker, a dealer, or another trading platform.
Preemption of state money transmission laws. Unlike the Lummis-Gillibrand Responsible Financial Innovation Act, the Bill would provide that registration as a digital commodity platform (or associated person) would preempt any applicable registration requirement under state laws relating to money transmission, virtual currency, and commodity brokers (other than state antifraud laws).
Customer protection requirements. The Bill would mandate that the CFTC adopt customer protection requirements that, among other things, require disclosure of certain matters by a digital commodity platform to its customers, establish a duty for a digital commodity platform to communicate in a fair and balanced manner based on principles of fair dealing and good faith, and establish standards governing marketing and advertising by digital commodity platforms.
Examinations and reports. The Bill would mandate that the CFTC examine and prepare a report on (i) the energy consumption and sources of energy used in connection with the most widely traded digital commodities and (ii) the participation of historically underserved customers in digital commodity markets.
The bill may be amended and improved over time as it takes a winding path through the Senate’s various committees before reaching the Senate floor, which may be unlikely to happen before the 118th session of Congress (beginning in January 2023). Latham & Watkins will continue to monitor legislative and regulatory developments in this area.