On May 21, the Commodity Futures Trading Commission’s Divisions of Market Oversight and Clearing and Risk issued a staff advisory to provide guidance to existent, registered trading facilities and clearinghouses for listing new derivatives contracts based on virtual currencies.
Although the Divisions indicated that designated contract markets, swap execution facilities, and derivatives clearing organizations could continue to self-certify new derivatives contracts based on virtual currencies (click here to access CFTC Rule 40.2), or voluntarily submit such contracts for Commission review and approval (click here to access CFTC Rule 40.3), they identified five particular areas where they would expect relevant entities to augment their ordinary procedures in light of what staff considered “[t]he significant risks associated with virtual currency markets.” These areas are market surveillance; coordination with CFTC staff; large trader reporting; stakeholders’ outreach; and risk management by DCOs.
Among other things, the Divisions expect SEFs and DCMs to monitor for and prevent manipulation, which would require them to have “adequate visibility into the underlying cash markets,” anchored by an information sharing agreement with such markets. If a registered trading facility identified a potential problem, it would be expected to make “appropriate inquiries, which may include obtaining spot market trader level data.” Over time – but apparently not necessarily today – the Divisions expect the spot markets on which DCMs’ or SEFs’ derivatives contracts are based to follow federal anti-money laundering or similar requirements.
The Divisions also expect that registered trading facilities reach out “meaningfully” to relevant stakeholders while developing a new contract’s terms and conditions. Specifically, the Divisions suggested that DCMs and SEFs reach out not only to members and other stakeholders who propose to trade a new virtual currency derivatives contract, but also to those members and other persons who do not.
Staff will also consider whether proposed initial margin requirements for DCOs are sufficient to cover potential future exposures to clearing members based on an “appropriate historic time period.” How a DCO considered the views of clearing members – including dissenting views – will also be evaluated by staff.
The Divisions noted that they reserve the right to notify any registered trading facility in writing of any concerns they may have with a self-certification that does not appear to comply with applicable law and CFTC regulations, make such notice public, and transmit a copy to other regulators, “as appropriate.”
On December 1, 2018, three regulated trading facilities – the Chicago Mercantile Exchange, the CBOE Futures Exchange and the Cantor Exchange – self-certified with the CFTC cash-settled derivatives contracts based on Bitcoin. (Click here for details in the article “Three CFTC-Regulated Exchanges Self-Certify Bitcoin Derivatives Contracts,” in the December 3, 2017 edition of Bridging the Week.)
- My Big Coin Pay: The parties in the CFTC’s My Big Coin Pay, Inc. litigation continued to tussle over whether the Commission has jurisdiction and standing to bring its anti-fraud case against defendants. (Click here for background on this CFTC enforcement action in the article “Defendants in CFTC Crypto Case First Argue Commission Lacks Anti-Fraud Authority Then Some Consent Voluntarily to Jurisdiction” in the April 8, 2018 edition of Bridging the Week.)
Among other things, defendant Randall Crater and the relief defendants argued in papers to support a motion to dismiss that the CFTC has no jurisdiction to bring its enforcement action alleging fraud in connection with the sale of the virtual currency known as “My Big Coin,” because the virtual currency was not a commodity under applicable law. This is because, said the defendants, the virtual currency was neither a good nor an article, or a service, right or interest in which contracts for future delivery are dealt in. If My Big Coin was not a commodity, then the CFTC has no authority to prosecute a fraud case against them under applicable law, claimed the defendants.
Moreover, the defendants argued that the CFTC has no standing to bring a general anti-fraud case against them relying on a fraud-based manipulation prohibition adopted as part of the Dodd-Frank Wall Street Reform and Consumer Protection Act that solely prohibits market-based fraud but not general fraud. (Click here to access Commodity Exchange Act § 6(c)(1), 7 U.S.C § 9(1).) The defendants relied on the recent federal court decision involving Monex Deposit Company in California in proposing such an argument (see discussion of the decision, below).
The CFTC rejected the defendants’ legal arguments, claiming that My Big Coin was either a good or an article, and thus a commodity, or in the alternative was a category of virtual currencies, like Bitcoin, for which futures contracts currently exist. In addition, the CFTC said that the reasoning of the Monex decision was incorrect. The Commission claimed that the relevant law prohibited “any manipulative or deceptive device” (emphasis added), and rejected the federal court’s view that “or” should be read as “and.”
- Monex: The CFTC determined not to amend its complaint against Monex Deposit Company following the decision of a federal court in California last month to dismiss the Commission’s enforcement against the firm and other defendants for alleged fraud in connection with their financed sale of precious metals to retail persons. Instead, the Commission will solely appeal the court’s decision.
Last month, the court held that:
- actual delivery of precious metals in financed transactions to retail persons falls outside the CFTC’s authority when ownership of real metals is legally transferred to such persons within 28 days – the so-called “Actual Delivery Exception” – even if the seller retains control over the commodities because of the financing beyond 28 days; and
- the CFTC cannot use the prohibition against persons engaging in any manipulative or deceptive device or contrivance in connection with the sale of any commodity in interstate commerce enacted as part of Dodd-Frank to prosecute acts of purported fraud except in instances of fraud‑based market manipulation.
(Click here for background on the Monex decision in the article “California Federal Court Dismissal of CFTC Monex Enforcement Action Upsets Stable Legal Theories” in the May 6, 2018 edition of Bridging the Week.)
- Titanium Blockchain: The Securities and Exchange Commission brought an enforcement action in a federal court in California against Titanium Blockchain Infrastructure Services Inc., Michael Stollery, TBIS’s founder, chief executive officer and president, and related defendants for allegedly committing fraud in connection with the initial coin offering of a crypto asset known as “BAR.” In connection with this offering, claimed the SEC, the defendants falsely promoted business relationships with well-known public companies that they did not have and used fake testimonials. The SEC said the defendants also claimed they would provide “a bevy of trademarked products and services.” However, the SEC alleged they had no such trademarks.
The SEC alleged that, through its ICO, the defendants raised as much as the equivalent of US $21 million from late November 2017 through at least January 25, 2018. BAR was a security that was required to be registered or lawfully exempt, said the SEC, and it was not. The SEC seeks preliminary and permanent injunctions, disgorgement and civil penalties, among other remedies.
- NASAA: The North American Securities Administrators Association announced an ongoing campaign to identify potential investment frauds in the cypto asset arena. The initiative – known as "Operation Crypto Sweep" – resulted in over 70 inquiries and investigations and 35 pending or completed enforcement actions involving ICOs and crypto assets through May 22. The members of NASAA participating in this initiative are from states and provinces in the United States and Canada.
My View: Fortunately or unfortunately, depending on your perspective, regulatory edicts and federal court decisions, but not Congress, will likely determine how virtual currencies and other crypto assets will be regulated in the US in the near term. To me this is unfortunate as this path is likely, at least in the interim, to lead to different views and approaches being taken in different parts of the US.
The oversight of crypto assets in the US – split among the SEC, CFTC, states, and other regulators – must be rationalized to avoid unnecessary impediments to blockchain technology evolution and to prevent fraudsters from taking advantage of regulatory arbitrage. The sooner this process begins, the better.
That being said, under existing law, the better view is that all crypto assets – including virtual currencies – are commodities. This is because they are goods or articles. They are not intangible articles like services, rights or interests. As the New York Court of Appeals recently held in connection with source code, crypto assets represent computer code that is tangible “in the sense of ‘material’ or ‘having physical form’.” This is because computer code stored on a computer takes up space on a drive. As a result, it must be physical in nature. (Click here for background on this NY Appeals Court decision in the article “Investment Bank Ex-Employee’s Conviction Upheld for Theft of High-Frequency Trading Algorithmic Code” in the May 6, 2018 edition of Bridging the Week.) Similarly, the Internal Revenue Service treats virtual currencies as property. (Click here to access a relevant March 2018 IRS guidance.)
Moreover, as I have observed previously, the fact that the applicable definition of commodity under law excludes box office receipts “or any index, measure, value, or data related to such receipts” from the reference to “all other goods and articles,” evidences the intent of Congress to view the term “goods and articles” broadly. Indeed, the exclusion of box office receipts specifically suggests that all other types of receipts are included in the definition of a commodity regardless of form. Presumably this would include records of physical fiat currencies, electronic credits of fiat currency and all other potential types of payments that could be reflected in receipts – e.g., payments by all virtual currencies. (Click here for the definition of commodity under the Commodity Exchange Act, 7 U.S. Code §1a(9).)
Random Observations: The last two sentences of the CFTC staff advisory on self-certifications by DCMs, SEFs and DCOs are very curious for a matter where presumably the Commission has exclusive jurisdiction. The sentences read:
To bring greater transparency to the process, if Commission staff is unable to confirm that the contract being self-certified complies with the CEA and regulations, but the exchange lists (or intends to list) the contract, staff may notify the exchange of its concerns in writing. Additionally, Commission staff may make such notice public and transmit a copy of such letter to other regulators, as appropriate.
Given that the CFTC ordinarily has exclusive jurisdiction over the self-certification of new futures and swaps contracts by DCMs and SEFs (as applicable), the only time this threat would appear meaningful would be if a trading facility self-certified a derivative based on a commodity that might be deemed a security by the Securities and Exchange Commission (e.g., a security futures contract if the derivative was a futures contract). Are these sentences then an implicit warning to DCMs and SEFs not to list derivative contracts on new virtual currencies (e.g., Ether or Ripple) without prior approval of some kind from the SEC that such commodities are not also securities? If yes, hopefully such approval will not take too long a time! (Click here for a link to the FIA webinar and related PowerPoint presentation entitled “Beyond Bitcoin” where attorneys from Katten Muchin Rosenman LLP, including me, presented a framework to help consider whether Ether and Ripple should today be regarded as securities; I believe the better argument is no.)