On September 17, 2015, the Commodity Futures Trading Commission (CFTC) issued an order (Coinflip Order)1 settling charges brought against Coinflip, Inc., the operator of an online trading platform that facilitated the trading of derivatives on Bitcoin and other digital currencies, also referred to by the CFTC and other regulators as “virtual currencies”2 (Bitcoin Derivatives), including U.S. dollar cash-settled options. The CFTC found that Coinflip, Inc. had violated the Commodity Exchange Act (CEA) and CFTC rules by failing to register as a swap execution facility or designated contract market. The direct impact of the Coinflip Order is minimal, as the platform itself had already shut down due to lack of volume. However, the Coinflip Order represents a watershed in the development of virtual currencies, as it is the first time that the CFTC has affirmatively asserted that Bitcoin and other virtual currencies are “properly defined as commodities” and that the CFTC has jurisdiction over Bitcoin Derivatives.
The CFTC’s assertion that virtual currencies are commodities, by itself, should not be particularly surprising. The definition of “commodity” under the CEA is extremely broad,3 and CFTC Chairman Timothy Massad has expressed the view that Bitcoin Derivatives are within his agency’s purview.4 What is noteworthy, however, is the type of commodity the CFTC apparently views Bitcoin to be—i.e., not a currency but more akin to a precious metal or physical asset. This has clear implications for how Bitcoin Derivatives markets may develop in the future. Moreover, the CFTC formally asserting its jurisdiction over Bitcoin Derivatives will trigger important compliance and registration obligations for market participants. As the CFTC’s Director of Enforcement recently commented, “while there is a lot of excitement surrounding Bitcoin and other virtual currencies, innovation does not excuse those acting in this space from following the same rules applicable to all participants in the commodity derivatives markets.”5
What is Bitcoin?
Bitcoin is a de-centralized virtual currency, units of which are generated via “blockchain” computer software technology. Using the blockchain technology, computer users, called “miners,” use special mining software to solve certain math problems as part of the processing of Bitcoin transactions and the maintenance of a related public ledger system. In doing so, miners create (or “mine”) Bitcoin, which effectively compensate the miners for their computer processing efforts. While there is growing interest in the application of blockchain technology beyond its use in support of Bitcoin as a currency,6 its primary use, so far, has been to enable Bitcoin as a medium of exchange to buy and sell goods and services online and as a store of value that can be exchanged for U.S. dollars or other traditional currencies. The characterization of Bitcoin as a virtual currency is a significant one. As the CFTC points out in the Coinflip Order, “virtual currencies are distinct from ‘real’ currencies, which are the coin and paper money of the United States or another country that are designated as legal tender, circulate, and are customarily used and accepted as a medium of exchange in the country of issuance.”7 In the Coinflip Order, the CFTC importantly indicates that it views virtual currencies to be “exempt” commodities, which has the regulatory effect under the CEA and CFTC rules of treating Bitcoin and other virtual currencies like precious metals, rather than like traditional currencies or financial instruments.8
This characterization is consistent with views previously expressed by the Internal Revenue Service, which has ruled that Bitcoin should be treated as property for tax purposes,9 but it is at odds with the approach of other financial regulators and enforcement agencies, which continue to treat Bitcoin as a form of “money” or “currency,” albeit a virtual one. For example, the U.S. Treasury Department’s Financial Crimes Enforcement Network (FinCEN), which regulates “exchangers” and “administrators” of convertible virtual currencies, focuses on the attributes of virtual currency that enable them to act as “a substitute for real currency.”10 Accordingly, as described in our previous Sidley Updates, FinCEN regulates various virtual currency activities as “money transmission,” rather than as dealing in foreign exchange or any other financial activity.11 Similarly, state banking agencies continue to look to regulate various virtual currency activities as a form of money transmission, as evidenced by the recent release by the Conference of State Bank Supervisors of a model framework for such regulation12 and by the “BitLicense” regulations adopted by the New York Department of Financial Institutions.13 At the same time, the Department of Justice and the Securities and Exchange Commission (SEC) have each characterized Bitcoin as “money” in prosecuting alleged violations of federal criminal anti-money laundering statutes and the federal securities laws.14
These varying approaches to regulation reflect the unique, hybrid attributes of Bitcoin and similar virtual currencies that make them difficult to categorize within traditional regulatory frameworks. Accordingly, participants in virtual currency ecosystems should continue to expect that regulators and enforcement agencies will seek to encompass Bitcoin and other virtual currencies within a range of regulatory frameworks by focusing on the attributes of those virtual currencies that most closely align with the particular regulatory framework.
What does this mean for those trading virtual currencies?
The CFTC’s decision to classify Bitcoin as a “commodity” will have little direct impact on those currently trading, holding, or conducting transactions involving actual Bitcoin or other virtual currencies, rather than transactions involving Bitcoin Derivatives. As set forth in the CEA, commodity transactions in the cash or spot (i.e., near immediate delivery) markets are generally excluded from the CFTC’s jurisdiction. Nevertheless, those using or trading virtual currency should be aware that the CFTC does have the authority to prosecute manipulative activity in a commodity’s cash or spot markets, because the manipulation of a commodity’s cash or spot price can affect the related commodity derivatives markets.15
Section 2(c)(2)(D) of the CEA, which was added by the Dodd-Frank Wall Street Reform and Consumer Protection Act in 2010, also gives the CFTC enforcement jurisdiction over certain “retail commodity transactions.” This provision has been used on many occasions by the CFTC to target fraudulent precious metals speculative investment schemes. Pursuant to Section 2(c)(2)(D), it is generally unlawful to enter into an off-exchange “leveraged, margined, or financed” transaction in any commodity with any person or entity that is not an “eligible contract participant” (e.g., a typical retail investor is not an eligible contract participant) or an “eligible commercial entity,” unless the transaction results in actual delivery within 28 days. The CFTC’s determination that virtual currencies are “commodities” raises the possibility that the CFTC may use Section 2(c)(2)(D) to bring enforcement cases for certain types of unlawful off-exchange transactions in virtual currency that target retail investors.
The CFTC’s foray into regulating Bitcoin Derivatives, to the extent it encourages the development of markets for such contracts, may also provide new opportunities for those who trade or use virtual currencies. With the failure of the Mt. Gox exchange and the related disappearance of millions of dollars worth of Bitcoin still a fresh memory,16 those interested in trading virtual currency may have concerns about its safety and security. Cash-settled Bitcoin Derivatives could provide an investor with synthetic exposure to the value of Bitcoin without also exposing the investor to custody risk with respect to the Bitcoin itself. Additionally, given the historically high volatility of Bitcoin and other virtual currencies, the growth of a market for Bitcoin Derivatives may provide Bitcoin users and investors with a means to efficiently hedge against this volatility. Being able to hedge against volatility and price risk through the use of Bitcoin Derivatives may also make accepting Bitcoin as a payment method more attractive for retailers and financial institutions.
What does this mean for those who trade Bitcoin Derivatives?
The CFTC’s determination to treat virtual currencies as commodities has significant regulatory implications for those who trade Bitcoin Derivatives, as this means Bitcoin Derivatives—i.e., options, futures, forwards, and/or swaps for which a unit of virtual currency is the underlying interest—will be treated as commodity interests for purposes of the CEA and CFTC rules. As a result, any collective investment vehicle that invests in Bitcoin Derivatives will be a commodity pool, and any operator of such a vehicle will be a commodity pool operator that may be subject to registration with the CFTC. Further, those who provide advice on Bitcoin Derivatives will be commodity trading advisors that may be subject to registration with the CFTC. For those commodity pool operators relying on the de minimis trading exemption from commodity pool operator registration under CFTC Rule 4.13(a)(3), all positions in Bitcoin Derivatives will also need to be included as commodity interest positions for purposes of applying the thresholds under the limited trading tests. This contrasts with the treatment of foreign exchange (FX) swaps and forwards,17 which are excluded from consideration under the Rule 4.13(a)(3) trading tests, provided they qualify under the so-called Treasury exemption.18
Although not qualifying for the Treasury exemption, certain Bitcoin forwards may qualify for the CFTC’s “forward exclusion” from the swap definition.19 But in the absence of that exemption, market participants that trade over-the-counter and certain listed Bitcoin Derivatives should also be aware that their trading activity will be subject to the CFTC’s swaps regulations, under Title VII of Dodd-Frank, including, for example, clearing, reporting and recordkeeping requirements. Although the low volume of the Bitcoin Derivatives markets currently makes it unlikely that the CFTC would consider imposing a clearing mandate on Bitcoin Derivatives in the foreseeable future, Bitcoin swaps would be subject to swap data reporting and recordkeeping requirements. Moreover, once final rules are promulgated, Bitcoin Derivatives will be subject to margin requirements for uncleared swaps entered into between swap dealers and financial end users. Additionally, any market participants who make a market in Bitcoin swaps or regularly enter into Bitcoin swaps with counterparties should be aware that they may be acting as “swap dealers” and may be required to register as such with the CFTC, unless an applicable exemption or exclusion applies.
What does this mean for those who facilitate the trading of Bitcoin Derivatives?
As the operators of Coinflip learned, the CFTC’s determination that virtual currencies are commodities means that any person that operates a “facility for the trading or processing” of Bitcoin swaps or options must be “registered as a swap execution facility or as a designated contract market.”20 Likewise, any person that operates a facility for the trading or processing of Bitcoin futures must be registered as a designated contract market.21 Moreover, transactions in Bitcoin Derivatives executed on these facilities are subject to all of the CFTC’s rules governing designated contract market and swap execution facility activities.22
Those who do not operate formal trading facilities, but nevertheless act as intermediaries in Bitcoin Derivatives transactions—e.g., soliciting or accepting orders for the purchase of Bitcoin Derivatives but not accepting any money, securities or property to margin, guarantee or secure any such trades—may be acting as “introducing brokers”23 that are required to register as such with the CFTC.
What does this mean from a tax perspective?
In March 2014, the IRS issued guidance in the form of answers to frequently asked questions on certain aspects of the federal tax treatment of Bitcoin and other virtual currencies.24 The guidance provides that Bitcoin is treated as property for federal tax purposes.25 As a result, gain or loss from the sale or exchange of Bitcoin generally gives rise to capital gain or loss if the Bitcoin is held as a capital asset by the taxpayer.26 However, various aspects of the federal tax treatment of Bitcoin and Bitcoin Derivatives are not addressed by the guidance. For example, certain federal income tax provisions apply to transactions in “commodities” or depend upon whether property is traded on a domestic board of trade designated as a contract market by the CFTC.27 The CFTC’s assertion that virtual currencies are commodities may influence the interpretation or applicability of such provisions.
What does this mean from an enforcement perspective?
Any person who violates the CEA or CFTC rules with respect to transactions in Bitcoin Derivatives could be the subject of a CFTC civil enforcement action. If the CFTC staff becomes aware of possible violative conduct, including fraudulent, deceptive or manipulative practices, the CFTC may launch an investigation or commence an enforcement action before the agency’s administrative law judges or in federal court, seeking remedies including injunctions or cease-and-desist orders against further violations, large civil monetary fines, disgorgement of gains, customer restitution, trading bans with respect to CFTC registrants and non-registrants and registration revocations. The CFTC can also refer possible criminal conduct to the Department of Justice or local prosecutors.
With respect to swap transactions, including those based on virtual currencies, the CEA prohibits any person from entering into a swap knowingly or recklessly disregarding the fact that its counterparty will use the swap as part of a scheme to defraud others.
With respect to Bitcoin Derivatives, as well as any contract of sale involving virtual currencies in interstate commerce, the CFTC has the authority to investigate attempted or actual manipulative schemes and fraudulent behavior, and in its civil enforcement actions the CFTC need prove only reckless conduct rather than bad intent.