About Steven Lofchie

Steven Lofchie is Senior Fellow of Legal Studies at the Center for Financial Stability and Co-chairman of the Financial Services Department at Cadwalader, Wickersham & Taft LLP.

CFTC Requests Comment on Proposed Interpretation of “Actual Delivery” in Virtual Currency Transactions

The CFTC requested comment on a Proposed Interpretation of the term “actual delivery” in the context of virtual currency retail transactions. The CFTC describes the “actual delivery” exception to regulation of leveraged transactions in virtual currencies as retail commodity transactions.

The CFTC restated the position that a virtual currency is a commodity, which means that leveraged, margined or financed transactions in virtual currencies with non-eligible contract participants (“non-ECPs”) are “retail commodity transactions” subject to CFTC oversight under Section 2(c)(2)(D) of the Commodity Exchange Act. Regulation of retail commodity transactions is subject to a statutory exemption for transactions in which actual delivery of the commodity occurs within 28 days of the transaction. In connection with virtual currency, the CFTC pointed to an Eleventh Circuit decision finding a virtual currency trading platform liable for failing to register with the CFTC on the grounds that the platform “did not actually deliver bitcoins purchased from them,” but instead “held the purchased bitcoins in bitcoin deposit wallets that it owned and controlled.”

The CFTC’s Proposed Interpretation includes a “broad” interpretation of the term “virtual currency.” In the CFTC’s view, virtual currency “encompasses any digital representation of value (a ‘digital asset’) that functions as a medium of exchange, and any other digital unit of account that is used as a form of a currency (i.e., transferred from one party to another as a medium of exchange); may be manifested through units, tokens, or coins, among other things; and may be distributed by way of digital ‘smart contracts,’ among other structures.”

In order to prove “actual delivery” of virtual currency in connection with retail commodity transactions, the proposal would establish that a market participant would be required to be able to demonstrate:

  • that a customer has the ability to (i) take possession and control of the entire quantity of the commodity, whether it was purchased on margin, or using leverage, or any other financing arrangement, and (ii) use it freely in commerce (both within and away from any particular platform) no later than 28 days from the date of the transaction; and
  • the offeror and counterparty seller (including any of their respective affiliates or other persons acting in concert with the offeror or counterparty seller on a similar basis) does not retain any interest in or control over any of the commodity purchased on margin, leverage, or other financing arrangement at the expiration of 28 days from the date of the transaction.

The Proposed Interpretation provides several examples to illustrate practical applications.

Comments will be due 90 days after publication in the Federal Register.

In addition, the CFTC launched a resource page on virtual currency. The page includes a new Customer Advisory on understanding the risks associated with trading in virtual currency.

CFTC Requests Comment on Proposal to Create New Type of Clearing Membership

The CFTC requested comment on a proposal by Chicago Mercantile Exchange, Inc. to create a new category of direct clearing member called a “Direct Funding Participant” (“DFP”).

As previously covered, the proposal would allow a DFP firm to clear trades on a CME-operated exchange solely for its own account, as long as obligations to CME’s clearinghouse that arose from the firm’s DFP activity were guaranteed by at least one other clearing member registered with the CFTC as a futures commission merchant (“DFP Guarantor”). Unlike existing customers of FCMs, a DFP would post collateral to and settle all payments with the clearinghouse directly. The CME represented that the DFP program would allow firms to eliminate certain customer risk through individual account segregation, and would allow the DFP’s collateral to prevent exposure to the risk of pro rata loss allocation that it might otherwise face if the DFP instead were a customer of an FCM.

In response to a request from the CFTC, the CME provided additional information and proposed further amendments, including:

  • adding further information on financial resource sizing under the DFP program;
  • clarifying exchange membership requirements for DFPs;
  • updating the form of Reimbursement Agreements; and
  • adding text describing types of permissible service arrangements between DFP Guarantors and DFPs.

Comments on the proposal must be submitted to the CFTC by January 12, 2018.

Lofchie Comment: Historically, the CFTC had allowed clients of an FCM to have a separate account that was walled off from other clients of the FCM. See CFTC Financial and Segregation Interpretation No. 10: Treatment of Funds Deposited in Safekeeping Accounts. Eventually, the CFTC effectively prohibited the use of such accounts by denying that they would receive favorable treatment in insolvency. See CFTC Advisory: Responsibilities of Futures Commission Merchants and Relevant Depositories with Respect to Third Party Custodial Accounts. The CME proposal would, in effect, allow for the recreation of Interpretation 10, albeit in somewhat different legal form.

SEC Chair Jay Clayton Urges Caution regarding ICOs and Cryptocurrencies

SEC Chair Jay Clayton asserted that initial coin offerings (“ICOs”) are likely to involve the sale of assets that qualify as securities, and urged investors to proceed with caution when considering ICO or cryptocurrency-related investments. His formal statement is directed at investors and market professionals acting as gatekeepers, and warns the latter group to focus on their responsibilities under the securities laws.

Chair Clayton urged market professionals to review the SEC report on the application of securities laws to initial coin offerings. In the report, the SEC applied longstanding securities law principles to determine that particular ICO tokens qualified as securities and, thus, were subject to relevant federal securities laws. Chair Clayton asserted that tokens and offerings that incorporate features and marketing efforts that emphasize the potential for profits based on the entrepreneurial or managerial efforts of others bear the hallmarks of securities. He warned professionals that they cannot avoid regulatory requirements simply by representing that a particular token or coin provides utility or “structuring it to provide some utility.” He said that such representations “elevate form over substance.” While Chair Clayton acknowledged the possibility that certain cryptocurrencies and ICO tokens may not comprise securities, he urged regulators and other market participants to fulfill their responsibilities in order to ensure investor protection. He also noted that he has instructed the SEC Division of Enforcement to police ICO offerings vigorously, and warned that in addition to securities registration, promoters should consider broker-dealer and exchange registration requirements.

Chair Clayton also urged market professionals to act with particular vigilance when dealing with cryptocurrency transactions. He encouraged broker-dealers and other market participants that allow for payments in cryptocurrencies to ensure that cryptocurrency transactions do not interfere with their ability to meet anti-money laundering and know-your customer obligations. While cryptocurrencies may or may not ultimately be considered as securities, Chair Clayton added, the SEC will closely monitor their impact on and interaction with the securities markets.

CFTC Chair J. Christopher Giancarlo praised Chair Clayton for his statement, noting that virtual currency markets are still largely unregulated and present challenges for regulatory agencies. According to Chair Giancarlo, “CFTC and SEC staff are in regular communication on these issues,” and investors should be aware of associated volatility and risk.

CFTC Issues Guidance on CTA Registration Requirements Arising from MiFID II Research Payment Provisions

The CFTC Division of Swap Dealer and Intermediary Oversight (“DSIO”) published interpretative guidance to clarify commodity trading advisor (“CTA”) registration requirements in light of the MiFID II research compensation provisions. The guidance provides that a futures commission merchant (“FCM”), swap dealer (“SD”) or introducing broker (“IB”) that gives commodity trading advice for a separate fee will not be required to register as a CTA, provided the advice is solely incidental to the firm’s business as an FCM, SD or IB.

The guidance was issued in response to MiFID II, which, upon its implementation on January 3, 2018, will require investment managers that are directly or contractually subject to its research provisions (“MiFID Managers”) to “unbundle,” or make separate payments for, investment research and execution services. The CFTC Letter states that the relief is not limited to research payments received from MiFID Managers. Consequently, an FCM, SD or IB may receive separate payment for commodity research from any entity, provided the research is solely incidental to the firm’s business as an FCM, SD or IB in light of all relevant facts and circumstances.

Lofchie Comment: The CFTC Letter follows a recent SEC no-action letter permitting broker-dealers to receive cash payments for research services from MiFID Managers without being subject to regulation as “investment advisers” under the Investment Advisers Act of 1940. However, the CFTC Letter is broader than the SEC Letter in two important respects. First, unlike the SEC Letter, the CFTC Letter permits firms to enter into separate research payment arrangements with any client, not only MiFID Managers. This enables global managers that may have both MiFID and non-MiFID Managers to implement uniform payment arrangements across their operations without having to develop separate payment arrangements for MiFID and non-MiFID Managers. Second, while the SEC granted time-limited relief that expires in July 2020, the CFTC Letter has no time limit.

Notwithstanding these more liberal aspects of the CFTC approach, the CFTC Letter contains an important limitation in that the research services must be solely incidental to the firm’s business as a FCM, SD or IB. This may impact firms that provide commodity research for a fee to clients that do not have a trading relationship with the firm.

U.S. Banking Agencies Support Finalization of International Capital Standards Reforms

The Basel Committee’s oversight body, the Group of Central Bank Governors and Heads of Supervision, finalized reforms to the Basel III international capital standards. The reforms’ key elements include revisions to (i) the standardized approach for credit risk, (ii) the standardized approach for operational risk, (iii) the internal ratings-based approach for credit risk, (iv) the credit valuation system framework, and (v) the measurement of the leverage ratio and a leverage ratio buffer for global systemically important institutions. In addition, the reforms will modify the floor for calculating banks’ risk-weighted assets that are generated by their internal models. The final standards text detailing the reforms and a summary document containing short descriptions were made available by the Basel Committee.

In an interagency release, U.S. banking agencies (the Board of Governors of the Federal Reserve Board, the FDIC, and the Office of the Comptroller of the Currency) expressed support for the final reforms. The agencies explained that the reforms “are intended to improve risk sensitivity, reduce regulatory capital variability, and level the playing field among internationally active banks.” The agencies will assess how to appropriately apply the reforms in the United States and propose any changes through the standard rulemaking process.

European Commission Recognizes U.S. DCMs and SEFs as “Equivalent”

The European Commission (“EC”) announced a decision recognizing certain CFTC-regulated DCMs and SEFs as “eligible for compliance” with EU trading obligations for certain derivatives. CFTC staff recommended that the CFTC adopt a similar order exempting EU-authorized trading facilities from U.S. registration requirements. The decisions follow the recent agreement between the CFTC and EC to adopt a “common approach” to derivatives trading on certain platforms.

According to the EC, this recognition will allow for EU counterparties to trade derivatives on CFTC-authorized designated contract markets (“DCMs”) and swap execution facilities (“SEFs”) based in the United States. In accordance with the decision, traders will be able to use U.S. trading platforms for such transactions even as MiFID II (and its derivatives trading obligation) becomes applicable on January 3, 2018. The trading obligation will require certain derivatives transactions to be executed on EU venues or venues designated as equivalent by the EC. The European Commission noted that its decision does not affect the ability of EU counterparties to trade on CFTC-regulated DCMs and SEFs with respect to derivatives that are not subject to the EU trading obligation.

CFTC Chair J. Christopher Giancarlo urged his fellow commissioners to “act expeditiously in approving” an exemptive order for EU trading facilities. CFTC Director of the Division of Market Oversight Amir Zaidi added that the CFTC is “close behind” with its own order.

Lofchie Comment: This is a significant success. CFTC Chair Giancarlo had, at once, both reached out to the Europeans in regard to the mutual acceptance of “comparable regulations” and cautioned the Europeans against imposing regulatory requirements that would disadvantage U.S. financial intermediaries.  See CFTC Chair J. Christopher Giancarlo Criticizes “EU Plan to Invade U.S. Markets.”

Futures Exchanges Self-Certify Bitcoin Futures Products

CME Group (“CME”), CBOE Futures Exchange (“CBOE”) and the Cantor Exchange each announced that they have “self-certified” new bitcoin products. CME and CBOE self-certified the initial listing of bitcoin futures products, while Cantor self-certified a contract for bitcoin binary options.
CME Group self-certified the initial listing of its bitcoin futures contract beginning on December 18, 2017. CME stated that the bitcoin futures will be cash-settled based on the CME CF Bitcoin Reference Rate – a “once-a-day reference rate of the U.S. dollar price of bitcoin.” The contract will be made available for trading on the CME Globex electronic trading platform, and for submission for clearing through CME ClearPort. CME Group CEO and Chair Terry Duffy said that the contract “will be subject to a variety of risk management tools, including an initial margin of 35 percent, position and intraday price limits, and a number of other risk and credit controls that CME Group offers on all of its products.”

CBOE said that its product will be cash-settled based on the Gemini’s price for bitcoin (in U.S. dollars). CBOE has not yet announced the launch date.

The Cantor Exchange is also yet to announce a launch date, but declared that the “bitcoin swaps” will be unleveraged, allow for the ability to trade across a range of bitcoin prices and trade for dates that are one month, two months and three months in advance.

Noting the “relatively nascent” and “largely unregulated” markets here, which involve a commodity “unlike any the Commission has dealt with in the past,” CFTC Chair J. Christopher Giancarlo explained that the CFTC worked with the exchanges and facilitated “significant enhancements” to provide for greater investor protections. At the same time, he said, investors should remain cognizant of the “potentially high level of volatility and risk in trading these contracts.”

The CFTC stated that it will continuously monitor the exchanges as trading in bitcoin futures commences. The CFTC said it will focus on size and development of the market, changes in positions, open interest, initial margin requirements, variation margin payments and stress testing. The monitoring process also will encompass designated contract markets, derivatives clearing organizations, clearing firms and investors taking part in bitcoin futures products. The CFTC also released a fact sheet providing information on the self-certification process, under which exchanges are able to certify products pursuant to their own determination that such products are in compliance with the CEA and CFTC Rules.

The CFTC promised cooperation with the National Futures Association (“NFA”) in monitoring bitcoin futures-related activity of member firms. The NFA released an Investor Advisory outlining important precautions for investors considering trading bitcoin futures.

Lofchie Comment: What does this do to clearinghouse risk?

Representatives Introduce Resolution to Block CFPB Payday Lending Rule

A bipartisan group of congressional representatives introduced a resolution to overturn the Consumer Financial Protection Bureau’s (“CFPB”) recently adopted “Payday, Vehicle Title, and Certain High-Cost Installment Loans” rule. The rule limits certain “payday” loans by requiring lenders to test a borrower’s ability to repay before providing a loan that would obligate the borrower to repay all or most of the debt at once, among other requirements.

The bill is sponsored by Representative Dennis Ross (R-FL) and co-sponsored by Representatives Alcee Hastings (D-FL), Tom Graves (R-GA), Henry Cueller (D-TX), Steve Stivers (R-OH) and Collin Peterson (D-MN). The resolution attempts to stop the rule using the same Congressional Review Act authority (recently used to block the implementation of the CFPB’s mandatory arbitration rule, see previous coverage). Under the Congressional Review Act, if the relevant committee in either chamber of Congress submits a joint resolution disapproving of an agency rule, then the rule can be overturned by a simple majority vote in Congress within 60 legislative days of finalization.

Representative Ross said that the rule will detrimentally impact citizens who rely on small-dollar lending “to make ends meet” and claimed that the CFPB usurped state authority by adopting the rule:

“I and my colleagues in Congress cannot stand by while an unaccountable federal agency deprives our constituents of a lifeline in times of need, all while usurping state authority. Today, we are taking bipartisan action to stop this harmful bureaucratic overreach dead in its tracks.”


Lofchie Comment: The CFPB’s payday rules are of the type that sound good in theory, but may injure borrowers that the rules were meant to protect. For example, while it sounds perfectly reasonable to say that the interest rate on payday loans is too high, it is necessary for lenders to take into account the costs of making very small loans and the high potential for loss. Given these costs, a low interest rate likely makes the business unprofitable. It is reasonable to ask, therefore, whether the intent of the CFPB rule was to bring down the rate of interest on CFPB lending (which is likely to fail) or to shut down payday lending altogether (a goal unlikely to be appreciated by borrowers).

FRB Vice Chair Warns about Risks Presented by Privately Developed Digital Currencies

Board of Governors of the Federal Reserve System Vice Chair for Supervision Randal Quarles described innovation in the U.S. payment system and highlighted the risks presented by digital currencies.

In remarks at the 2017 Financial Stability and Fintech Conference, Mr. Quarles asserted the need to find a balance between innovation and stability in the payment system. He explained that while innovation in this area has traditionally been inhibited by high barriers to entry, those obstacles get removed as more users adopt new technologies. At the same time, Mr. Quarles said, the reduction of technological barriers may result in the introduction of additional risk.

As an example of this additional risk, Mr. Quarles discussed the dangers inherent in the use of digital currencies. He described how the main payment networks use centralized technology to process and safeguard the public’s electronic fund transfers. Regulated banking institutions provide deposit money to the public and are a main source of trust for these systems. Digital currencies, however, are not backed by secure assets and do not carry the same level of trust. The widespread use of currency that “cannot be predictably redeemed for the U.S. dollar in times of adversity” may have serious implications for liquidity, price risk and credit risk, he said. If a digital currency becomes the center of a large-scale payment system, he cautioned, it would be unclear how the system would be able to respond to economic stress.

Mr. Quarles also urged a high level of caution with respect to the prospect of a central-bank-issued digital currency. He noted the potential risk of serious cyber attacks and extensive legal issues that would accompany any foray by the U.S. into central-bank-issued digital currencies. He encouraged continued study in the area, particularly surrounding “secure limited-purpose digital currencies for use as a settlement asset for wholesale payment systems.”

Going forward, Mr. Quarles stressed the importance of enhancing the stability of the existing payment system, and of continuously working to find improvements that are not likely to have detrimental effects on safety and resiliency. He encouraged cooperative efforts to build a safer and more efficient system based on existing institutions.

Lofchie Comment: Vice Chair Quarles raises reasonable concerns about how a virtual currency would perform in a time of stress. One specific worry – that a central bank would adopt digital currency – seems unlikely, given that the central bank would, thereby, lose control over its own currency. A more realistic concern is that fears of an unreliable central bank (think Venezuela) would motivate a population’s movement away from use of that bank’s currency.

FINRA Solicits Comments on Payments for Market-Making Rule

As part of a retrospective review, FINRA requested comments on FINRA Rule 5250 (the “Rule”), which generally prohibits a member firm from accepting payment from an issuer or its affiliates or promoters in exchange for making a market in the issuer’s securities. The rule prohibits a member or associated person from accepting payment or other considerations from an issuer or its affiliates and promoters, except for (i) payment for bona fide services, (ii) reimbursement of payments for SEC or state registration fees and listing fees imposed by a self-regulatory organization, and (iii) payment expressly provided for under the rules of a national securities exchange.

FINRA noted that the Rule was implemented to prevent conflicts of interest that may arise from payments for making a market in an issuer’s securities. FINRA is seeking input in several areas, including:

  • the effectiveness of the Rule, the impact of market changes on the need for the Rule, and alternative approaches to accomplish the goals of the Rule;
  • experiences with the implementation of the Rule, including ambiguities and compliance challenges;
  • the economic impact and unintended consequences of the Rule; and
  • ways to improve the Rule and related interpretations and administrative processes.

Comments must be received by January 29, 2018.

Lofchie Comment: On its face, FINRA Rule 5250 seems common-sensical. However, given the high costs of making a market in securities, and reports that there are few firms that are willing to go to the effort and expense in making markets in the securities of small issuers, it may be appropriate to allow issuers to provide a broker-dealer some reward for being willing to commit capital to make a market in the issuer’s stock, particularly if the fact of the payments and perhaps the amount and conditions were fully disclosed. Certainly it is an idea worth exploring if the regulators wish to encourage firms to provide liquidity to small issuers.