Finally, unrelatedly, Grayscale Investments LLC announced the withdrawal of its application for approval from the SEC for its Bitcoin Investment Trust. Grayscale had hoped to list its trust on NYSE Arca.
Previously, the SEC disapproved the application of the Bats BZX Exchange, Inc. for a rule change to authorize it to list and trade shares of the Winklevoss Bitcoin Trust as commodity-based trust shares (click here to access SEC decision). Among other things, the SEC said that, for an exchange-traded product to be approved, the exchange must have surveillance-sharing agreements with significant markets for trading the underlying commodity or derivatives on that commodity, and significant markets must be regulated. Since those conditions did not exist for Bitcoin, said the SEC, BZX’s application was denied. However, the SEC subsequently agreed to reconsider its denial (click here for details).
Since BZX’s denial, LedgerX has been approved by the Commodity Futures Trading as a swap execution facility and derivatives clearing organization for fully collateralized swaps based on cryptocurrencies. (Click here for details in the article, “LedgerX Approved by CFTC as First Derivatives Clearing Organization for Fully Collateralized Swap Contracts Potentially Settling in Bitcoin” in the July 30, 2017 edition of Bridging the Week.) However, LedgerX has not yet begun trading.
Legal Weeds and My View: Under relevant law, the Commodity Futures Trading Commission 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.
However, 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 afterwards, 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, e.g., 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 that the underlying asset to a derivative is a security or not. If it’s not, exclusive jurisdiction over the derivative is under the CFTC and a host of requirements potentially follow, and the SEC (and states’) 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 digital tokens is similar to those of chameleon-like security futures products that change their characteristic over time. First, in some cases, it is not clear what a digital token was in the first instance. Digital tokens may, like Bitcoin, be a pure cryptocurrency, which are rewarded to miners for their own services and principally serve as a store of value, unit of account or a medium of exchange. Or digital tokens 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 digital tokens 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, in order to ensure smooth development of cryptocurrencies and the block chain. A first step would be for the CFTC and SEC to address potential overlaps voluntarily; a second, may be amendments to law.