The Commodity Futures Trading Commission issued a “Backgrounder” last week, summarizing its oversight and approach to futures contracts based on virtual currencies.
The Commission specifically reviewed the process that led to the self-certification by the Chicago Mercantile Exchange and the CBOE Futures Exchange of cash-settled Bitcoin futures contracts, and by the Cantor Exchange of a Bitcoin binary options contract on December 1. (Click here for background on these self-certifications in the article “Three CFTC-Regulated Exchanges Self-Certify Bitcoin Derivatives Contracts” in the December 3, 2017 edition of Bridging the Week.) Both the CME and CBOE Bitcoin futures contracts commenced trading during December 2017.
Among other things, the CFTC noted that, in connection with the self-certification process, existing law does not authorize public input. Moreover, there are “limited grounds” for the CFTC to stop a self-certification. One such ground is that a DCM has filed a false statement; however, claimed the CFTC, “[i]n the case of the CME and CFE self-certifications, no such grounds were evident.” The Commission also suggested that, even had it held a public hearing or requested public input regarding the December 1 self-certified Bitcoin contracts, “it is unlikely that the outcome would have changed, as the CFTC staff found no basis to determine [the exchanges’] filings to be inconsistent with [applicable law] or CFTC regulations.”
However, the CFTC revealed that, “[w]ithin the limits and parameters of the current self-certification process” the Commission staff has conducted a “heightened review” of Bitcoin futures contracts. This review included checking for (1) derivative clearing organizations establishing “substantially high” initial and maintenance margin requirements for such instruments; (2) DCMs implementing large trader reporting obligations at five Bitcoins or less; (3) DCMs instituting information sharing arrangements with Bitcoin spot markets so they may access trade and trader data; and (4) DCMs monitoring Bitcoin spot market data regarding price settlements and other prices to identify “anomalies and disproportionate moves” between Bitcoin futures contracts and the spot markets, among other measures.
The CFTC previously issued a Backgrounder discussing its jurisdiction over derivatives based on virtual currencies and its self-certification of the three exchanges' cash-settled derivatives contracts on December 1, 2017 (click here to access). The current Backgrounder expands on elements of the Commission's prior writing.
A meeting of the Commission’s Market Risk Advisory Committee on January 31 will expressly consider the process of new product self-certification by DCMs, among other topics. A meeting of the CFTC’s Technology Advisory Committee will be held on January 23 that will address, among other matters, market developments, challenges and opportunities regarding virtual currencies.
Separately, during the prior few weeks:
- Challenges to NY BitLicense and Potential OCC Fintech Charter Quashed: A challenge to New York’s so-called “BitLicense” requirements was dismissed by a New York court on the grounds that petitioner Theo Chino lacked standing to assert such an objection. Mr. Chino sued the NY Department of Financial Services in October 2015 after he submitted an application for a virtual currency license in August 2015 that ultimately was returned by DFS in January 2016 “because it contained ‘extremely limited’ information” that the DFS said did not allow it to sufficiently evaluate Mr. Chino’s application. Mr. Chino claimed, among other things, that DFS only had authority to regulate financial products and services and that the oversight of virtual currency business activity fell outside this mandate. The court held that Mr. Chino abandoned his application process and failed to exhaust his administrative remedies prior to filing his litigation, and thus “there is nothing for this Court to review.” (Click here for a copy of the court’s decision.) Similarly, a US federal court in New York dismissed a challenge by the DFS to the authority of the Office of the Comptroller of the Currency to grant special-purpose national bank charters to financial technology companies. Since August 2015, OCC has been considering granting fintech charters to entities that engage in cryptocurrency and distributed ledger businesses. However, the court rejected DFS’s lawsuit, claiming that OCC has not yet finalized its decision and thus the court did not have standing to consider OCC's’s potential actions at this time, among other rationale. (Click here to access a copy of the court’s decision.)
- Texas Enjoins ICO, NASAA Warns About Cryptocurrencies and More ICO Private Lawsuits Filed: The Texas State Securities Board issued an emergency cease and desist order against Bitconnect, a UK-based cryptocurrency-issuing company, in connection with various digital currency-related investment programs and a proposed initial coin offering (click here to access the order). The Securities Board claimed that the investment programs were securities that were not registered with it, as required, and that the firm engaged in fraud and made materially misleading statements in connection with the offer or sale of the securities. Separately, the North American Securities Administrators Association—comprising representatives of all US state securities regulators—issued an investor advisory regarding the risks of investing in ICOs and cryptocurrencies (click here to access the advisory). Additionally, more private lawsuits were filed against backers of ICOs. Among actions filed was a purported class action lawsuit by Stormsmedia, LLC against Giga Watt, Inc. and other defendants in a federal court in Washington state and a purported class action lawsuit by Andrew Hodges and other plaintiffs against Monkey Capital, LLC in a federal court in Florida. Both actions alleged the illegal sale of unregistered securities among other wrongdoings. (Click here to access a copy of the Stormsmedia complaint, and here for Andrew Hodges’s complaint.) Previously, a number of purported class action lawsuits have been filed against backers of the Tezos ICO. (Click here for background in the article “Second Lawsuit Against Tezos ICO Backers Filed; CME Group Schedules Testing of US Dollar Futures Contract Based on Bitcoin” in the November 19, 2017 edition of Bridging the Week.)
- NFA Virtual Currency Reporting Obligations: The National Futures Association announced new reporting requirements for commodity trading advisors, commodity pool operators and introducing brokers that handle transactions involving certain virtual currency products. Effective December 14, CTAs and CPOs are required to notify the NFA after they execute their first transaction involving either a virtual currency or a virtual currency derivative by amending the firm-level section of their annual questionnaire. In addition, beginning for the first calendar quarter of 2018, CTAs and CPOs are required to identify the number of their pools or managed accounts that executed one or more virtual currency or virtual currency derivatives transactions during each calendar quarter by no later than 15 days after the end of the quarter. This information should be submitted through the firm’s annual questionnaire. Similar obligations have been instituted for IBs but they only pertain to virtual currency derivatives. (Click here to access NFA’s requirements for CTAs and CPOs, and here for IBs.)
- CBOE and NYSE Seek to List Bitcoin Futures ETFs: The Chicago Board Options Exchange requested the Securities and Exchange Commission grant it authority to list six Bitcoin futures exchange-traded funds. The SEC formally requested public comment to such requests on December 28, 2017, and January 2, 2018. (Click here and here to access the SEC announcements.) The New York Stock Exchange has also requested authority to list two Bitcoin futures ETFs. (Click here to access the NYSE filing.) Last year the SEC refused to approve a proposed rule change by the Bats BZX Exchange, Inc. to list and trade shares of the Winklevoss Bitcoin Trust, whose pricing was to be based on the prices of a spot Bitcoin exchange related to the Trust (click here for details).
- More Bitcoin Derivatives Coming: Seed CX Ltd, a CFTC-registered swap execution facility, announced that Bittrex Inc., a US-based spot cryptocurrency exchange, had acquired a controlling stake in it. Subject to CFTC approval, Seed CX indicated that it would offer forwards and options on established virtual currency and fiat pairs. (Click here for a copy of the Seed press release.)
- South Korean Cryptocurrency Exchange Files for Bankruptcy: Various media reported that Youbit, a South Korea-based cryptocurrency exchange, filed for bankruptcy on December 19 (click here for a sample article). The filing occurred after the exchange was hacked for a second time, causing it to lose almost 20 percent of its digital currencies.
My View and Legal Weeds: Without taking a view, the CFTC noted in its Backgrounder the “multifaceted, multi-regulatory approach” to the regulation of cryptocurrencies in the United States. I call the cryptocurrency regulatory landscape a hodgepodge, or more precisely, a mess—and that's just if you look at it solely from a US perspective. Ultimately, such an approach is not healthy and could impede the evolution of cryptocurrencies and blockchain technologies.
As I have written previously, under relevant law, the CFTC has exclusive jurisdiction over all options and transactions involving swaps or contracts of sale of a commodity for future delivery traded or executed on a regulated futures exchange (known as a designated contract market) or on a regulated swaps trading facility (known as a swap execution facility; click here to access 7 U.S.C. § 2(a)(1)A)). Moreover, the definition of commodity under applicable law is very broad. Generally, a commodity is defined as (1) any of certain enumerated traditional commodities (e.g., wheat, cotton, soybeans, livestock and livestock products); (2) all other goods and services (except onions and motion picture box office receipts); and (3) all services, rights and interests (except as related to motion picture box office receipts) in which contracts for future delivery are now or in the future dealt in. (Click here to access 7 U.S.C. § 1a(9).)
Persons handling financial instruments under the CFTC’s exclusive jurisdiction typically have requirements and obligations under law (e.g., registration with the CFTC) and the same requirements cannot be imposed by other regulators.
Outside the CFTC’s exclusive jurisdiction, nothing supersedes or limits the jurisdiction of the SEC or other federal or state regulatory authorities. What this means at the highest level is that if a financial instrument involves a derivative based on an asset that is a commodity but not also a security, the derivative likely will be subject to the CFTC’s exclusive jurisdiction. If a financial instrument involves a security with no futurity, it is likely regulated solely by the SEC and/or the states. (The Financial Crimes Enforcement Network of the US Department of Treasury and states may also regulate non-bank entities that engage in certain exchange- or custody-type activities involving virtual currencies.)
A problem with this bifurcated jurisdictional oversight arises when a financial instrument has elements of both securities and futures or swaps—for example, a futures contract on a broad-based stock index futures, a futures contract on a narrow-based stock index futures contract, or a futures contract based on an individual stock.
These hybrid products gave rise to jurisdictional court battles involving the SEC and CFTC in the CFTC’s early days (after it was created in 1974) that initially were resolved by a voluntary accord between the agencies in 1981 and shortly afterward by Congress. (Click here for background regarding the jurisdictional disputes and resolutions between the SEC and CFTC in “A Joint Report of the SEC and CFTC on Harmonization of Regulation” dated October 16, 2009, at pages 15-17.)
Now most potential jurisdictional issues related to futures and swaps based on securities have been resolved by law and there are relatively clear rules. For example, futures based on broad‑based indices are within the exclusive jurisdiction of the CFTC while futures based on narrow-based indices and individual securities—termed “security futures”—are under the joint jurisdiction of the SEC and CFTC. (Click here for a general background on the regulation of security futures products.) An equivalent division of jurisdiction has been established for swaps and security-based swaps.
But application of the jurisdictional rules between the CFTC and SEC requires an initial assessment as to whether the derivative’s underlying asset is a security or not. If it’s not, the CFTC has exclusive jurisdiction over the derivative and a host of requirements potentially follow, and SEC (and state) oversight is excluded. Sometimes, however, the nature of an underlying asset to a derivative can change over time and the result can shift principal jurisdiction over the derivative from the CFTC to the SEC or from the SEC to the CFTC. (Click here for an example of this in the Report of Investigation by the SEC Pursuant to Section 21(a) of the Securities and Exchange of 1934: Eurex Deutschland.)
The characteristic of some cryptocurrencies is similar to those of chameleon-like securities-related futures products that change their characteristics over time. First, in some cases, it is not clear what a cryptocurrency was in the first instance. Digital tokens may, like Bitcoin, be a pure virtual currency, which are rewarded to miners for their services and principally serve as a store of value, unit of account or a medium of exchange. Or cryptocurrencies may have initially been offered and sold as, and designed with a purpose similar to, a security but morph over time into a medium of exchange. Ether, for example, the digital token associated with Ethereum, appears to be a digital token with these characteristics as it began as a crowd sale in 2014, where participants purchased what effectively were shares in the Ethereum development project; today, Ethereum is mostly regarded as a medium of exchange. Currently, almost no one would consider Ether a security despite its characteristics at birth.
As a result, because of the ambiguous nature of cryptocurrencies in the first instance and their sometime changing purpose over time, it is imperative that potential jurisdictional issues between the CFTC and SEC be sorted out sooner not later!