CFTC Chair Giancarlo Details Risks of Virtual Currency

CFTC Chair J. Christopher Giancarlo reasserted the “obligation of futures exchanges to ensure that virtual currency futures are not susceptible to manipulation, and of futures clearinghouses to ensure that such products are adequately risk managed.” In remarks at the ABA Derivatives and Futures Section Conference in Naples, Florida, CFTC Chair J. Christopher Giancarlo described the impact of virtual currencies on the U.S. derivatives markets and reiterated his support for a deference-based approach to the U.S. and European Union cross-border regulation of swaps.

Chair Giancarlo said that virtual currencies have already had significant effects on the markets. He raised questions about their actual value, given their high volatility and instability as a store of value. He also argued that virtual currencies represent a small asset class that receives outsized media attention, but warned that they present serious risks.

While acknowledging that the CFTC has been criticized for not holding public hearings prior to self-certification of Bitcoin futures, Chair Giancarlo argued that there is no provision in the statute for public input on CFTC staff reviews of such new product actions. Mr. Giancarlo declared that the CFTC is attentive to these concerns, and offered an eight-point checklist of objectives that the CFTC will undertake in future reviews of such certifications.

As to the appropriateness of trading Bitcoin or other cryptocurrencies, Chair Giancarlo reported that the CFTC reached an agreement with two of the primary exchanges for additional measures to be taken with respect to exchange trading of these products. These measures include:

  • Designated contract markets (“DCMs”) setting exchange large-trader reporting thresholds at five Bitcoins or less;
  • DCMs entering direct or indirect information-sharing agreements with spot market platforms to allow access to trade and trader data;
  • DCMs agreeing to engage in the monitoring of price settlement data from cash markets, and in identifying anomalies and disproportionate moves;
  • DCMs agreeing to conduct inquiries, including at the trade settlement and trader level, when anomalies or disproportionate moves are identified;
  • DCMs agreeing to regular communications with CFTC surveillance staff on trade activities that include providing trade settlement and trader data upon request;
  • DCMs agreeing to coordinate product launches to enable the CFTC’s market surveillance branch to monitor minute-by-minute developments; and
  • DCOs setting substantially high initial and maintenance margin for cash-settled instruments.

With regard to cross-border derivatives regulation, Chair Giancarlo affirmed his support of the recent CFTC margin comparability determination with the European Commission. He said that the comparability determination constitutes complete substituted compliance, meaning that the CFTC will defer to European regulators when market participants follow EU margin rules, even if this means certain non-financial counterparties are not subjected to variation margin rules when they would be under the CFTC framework.

Lofchie Comment: The SEC and the CFTC have taken philosophically opposing views with respect to the ability of investors to trade in cryptocurrencies. The SEC Division of Investment Management previously announced that it would not allow the registration of an investment company to go forward if the company were to be significantly involved in trading cryptocurrencies. By contrast, Chair Giancarlo has acknowledged the risks of these products, but determined not to prevent trading in them.

To some extent, the different conclusions reached by the regulators may reflect the differing investor bases. Investment companies are likely to attract a retail investor base, while futures traders are more likely to be institutions. Further, through his negotiations with the exchanges, Chair Giancarlo was actually in a better position than the SEC would have been to impose additional prudential requirements on the trading of cryptocurrencies. Still, Chair Giancarlo leaves himself vulnerable to second-guessing if there are material negative developments with trading cryptocurrencies, while the SEC has taken the politically safer path. In so doing, Chair Giancarlo should be respected for his willingness to take some political risk on the basis of the view that the Government can not, and should not, prevent individuals from deciding to take economic risk.

Chair Giancarlo Outlines CFTC Approach to Virtual Currency Regulation

CFTC Chair J. Christopher Giancarlo asserted the CFTC’s commitment to regulating virtual currency trading effectively. In a public statement, he highlighted the agency’s scrutiny of new launches of virtual currency futures markets in light of recent launches of bitcoin futures under “self-certification procedures.” He announced a meeting of the CFTC’s market risk advisory committee to consider the efficacy of the self-certification process. He reiterated the CFTC view that virtual currency is a “commodity” as that term is defined in the CEA, and thus is subject to CFTC regulation. Chair Giancarlo contended that the CFTC is delivering a regulatory response centered on “consumer education, asserting CFTC authority, surveilling trading in derivative and spot markets, prosecuting fraud, abuse, manipulation and false solicitation and active coordination with fellow regulators.”

Chair Giancarlo also highlighted an upcoming meeting of the CFTC Technology Advisory Committee to consider challenges, opportunities, and market developments of virtual currencies. He said that virtual currency and virtual currency derivatives offer potential benefits, but market participants must be vigilant, as they also present certain heightened risks.

The CFTC also published a document providing information on CFTC oversight of and approach to virtual currency futures markets. The document includes an explanation of the self-certification process as applied to virtual currency futures products.

Lofchie Comment: The SEC also recently issued a statement asserting jurisdiction over certain transactions involving blockchain products. (See SEC Chair Jay Clayton Urges Caution regarding ICOs and Cryptocurrencies.) This raises the possibility of a regulatory dispute over jurisdiction. Each agency is perfectly correct in interpreting the relevant statutes to the effect that at least some transactions involving virtual currency or other blockchain products will fall within the ambit of that agency, and perhaps within the ambit of both. What is significant in the regulatory pronouncements is not the possibility for regulatory disagreement, but rather that both regulators are seeking to exercise their consumer protection functions.

Global Markets into 2018

The Center for Financial Stability (CFS) hosted a small private workshop for leaders in finance to delve into issues that will shape the future of asset values and investment management on December 6.

CFS Special Counselor Jack Malvey set the stage with an essay “Toward the Mid-21 st Century Global Financial System” –
www.CenterforFinancialStability.org/research/MalveyGlobal_Dec_2017.pdf

Workshop topics included:

– Geopolitics and Big Picture Challenges through 2020 – AI, cyber, etc;
– Global Macro, Quantitative Tightening, and Financial Stability;
– Financial Industry Transitions – Active versus Passive Management, etc; and
– Opportunities and Risks (a selection follows).

OPPORTUNITIES

– Buy cash today – the rate of return will be extraordinarily high.
– Central banks will more actively incorporate financial stability into actions and mandates.
– Emerging markets will outperform.
– The Fed desires to move further away from the zero lower bound.
– NPLs in China are overstated / bank earnings mitigate and neutralize risks.
– Global macro investment opportunities via uneven tightening.

RISKS

– I will buy cash – but tomorrow.
– Bitcoin correction.
– Limited attractive equity names based on valuation / similar to Tokyo in 1989.
– Geopolitical tensions will increase with North Korea, China, Russia, and Saudi Arabia.
– Inflation surprise / data may be misread.
– Artificial intelligence channeled for ill.

Best wishes into the Holiday Season and 2018!

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.

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.

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?

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.

CFTC Provides Guidance on Virtual Currencies

The CFTC published a “primer” that (i) provides a high-level overview of virtual currencies, (ii) outlines the CFTC’s oversight of the space and (iii) cautions market participants of the risks associated with virtual currencies.

The primer outlines potential use-cases for virtual currencies and blockchain, as well as situations in which CFTC jurisdiction is indicated. The report notes that virtual currencies are commodities, but acknowledges that, beyond preventing fraud or manipulation, the CFTC generally does not oversee “spot” markets in commodities; i.e., short-term trades settled by the delivery of the relevant product.

The primer, produced by the CFTC’s “LabCFTC,” is intended to be the first in a series of publications intended to help market participants understand technological innovation in the financial space and the CFTC’s role.

Lofchie Comment: The division of authority between the CFTC and the SEC can be quite complex.  That said, the CFTC is absolute correct in noting the fact that “virtual currency” or an “ICO” may be both (i) a “commodity” for purposes of the Commodity Exchange Act and (ii) a “security” for purposes of the securities laws.  The primer also correctly acknowledges that the CFTC does not have authority over ordinary cash-market transactions in a commodity, but only in derivative or certain financing transaction with respect to a commodity.  Accordingly, persons trading in these assets must be mindful that the terms of the transaction will determine the financial regulations to which they are subject.

SEC Determines Interests in Virtual Organizations Are Subject to U.S. Securities Laws

The SEC determined that tokens sold to investors by a “virtual” organization may be considered securities and, thus, are subject to applicable federal securities laws.

In an Investigative Report, the SEC explained that organizations using blockchain or other distributed ledger technology in capital-raising activities must ensure compliance with securities laws. In the report, the SEC scrutinized an incident involving a “Decentralized Autonomous Organization” (“DAO”). A DAO is described as “a ‘virtual’ organization embodied in computer code and executed on a distributed ledger or blockchain.” In this matter, the DAO offered tokens in exchange for initial cryptocurrency investments and eventually was victimized by a hacker who diverted significant cryptocurrency assets raised by the DAO. The SEC investigated whether the DAO had violated securities law by offering and selling unregistered securities.

The SEC decided not to pursue charges but sounded a warning to issuers:

“[Registration] requirements apply to those who offer and sell securities in the United States, regardless whether the issuing entity is a traditional company or a decentralized autonomous organization, regardless whether those securities are purchased using U.S. dollars or virtual currencies, and regardless whether they are distributed in certificated form or through distributed ledger technology.”

In an Investor Bulletin, the SEC cautioned investors about potential risks associated with initial coin offerings. The SEC explained the function of distributed ledger technologies, such as blockchain, as well as virtual currency and how it is traded via the exchanges. The SEC warned investors that virtual currency offerings may be particularly susceptible to fraud and theft, and that tracing these currencies is difficult. The SEC noted that virtual currency offerings are often unregistered and operate unlawfully or overseas. As a result, recovering stolen virtual currency can be particularly difficult. The SEC warned investors to be wary of several signs that may indicate investment fraud, including “guaranteed” high rates of return, unsolicited offers and unlicensed issuers.

Lofchie Comment: Notwithstanding the somewhat exotic nature of the relevant asset (i.e., the virtual currency), the SEC’s finding that an asset that represents an ownership interest in a profit-making venture (or that depends on the management expertise of others) is a completely unsurprising result and well within the bounds of existing law.

Bitcoin Exchanges Targeted in Cyberattacks

At least two prominent bitcoin exchanges were targeted by cyberattacks that interrupted normal operations and trading.

BTC-e and Bitfinex were targeted by distributed denial-of-service (“DDoS”) attacks, a form of cyberattack which typically uses multiple compromised systems to flood a target with message traffic that exceeds its processing capacity.  The attacks temporarily disrupted service for both exchanges but reportedly did not cause a loss of funds or protected information. According to a CNBC report, service interruptions like those caused by the DDoS attacks could allow traders to “manipulate the bitcoin market.”

Both exchanges have resumed normal service.