SEC and CFTC Leaders Vow to Cooperate on Virtual Currency Regulation

Chair of the SEC Jay Clayton and Chair of the CFTC J. Christopher Giancarlo described their agencies’ approaches to the regulation of virtual currency and pledged to collaborate to provide investor protection.

In testimony before the U.S. Senate Banking Committee, Mr. Giancarlo noted that some observers tout the transformative potential of distributed ledger technology, while others characterize it as overblown hype with no real utility. He emphasized the importance of perspective, saying that virtual currencies receive media attention that is disproportionate to their small market size. The novel nature of virtual currencies presents a unique set of challenges for regulators, he said. With regard to CFTC authority and oversight, Mr. Giancarlo said that the CFTC does not have regulatory jurisdiction over cash or spot transactions in virtual currency, but does have regulatory jurisdiction over derivatives on virtual currencies. He highlighted several recent efforts by the CFTC to communicate its authority over virtual currencies and enforce federal commodities regulations against bad actors in the virtual currency markets.

Mr. Giancarlo also stressed the importance of perspective when considering the impact of the exchange trading of Bitcoin futures, again emphasizing the small size of the market. He addressed concerns about the self-certification process employed by exchanges to list virtual currency futures products, and reiterated that the CFTC has developed a heightened review process to ensure that virtual currency futures were not susceptible to manipulation. In the interest of facilitating transparency, he stated, the CFTC is requesting that exchanges disclose to the CFTC which steps were taken to solicit public input with regard to particular virtual currency product listings.

Mr. Giancarlo asserted that broadening CFTC authority to include virtual currency spot markets would represent a “dramatic expansion of the CFTC’s regulatory mission.” Considering the retail investor-oriented nature of virtual currencies, he said that they may require closer regulatory oversight, and encouraged Congressional consideration of exploring policy solutions to facilitate more effective federal regulation of virtual currencies. He acknowledged the many potential benefits of virtual currencies and distributed ledger technology, and encouraged a “proper balance of sound policy, regulatory oversight, and private sector innovation.”

SEC Chair Clayton emphasized that initial coin offerings (“ICOs”) often contain the hallmarks of securities and should be subject to federal securities laws. As the virtual currency and ICO markets experience exponential growth, Mr. Clayton expressed optimism for the potential financial benefits, but stressed that retail investors deserve an appropriate degree of investor protection. He pointed to the global nature of the product, the widespread lack of regulation, and cybersecurity deficiencies as significant red flags surrounding many ICOs, and said that no ICO has registered with the SEC. Mr. Clayton underscored the risks associated with ICOs, and warned that naming conventions do not absolve ICO issuers of their SEC-registration obligations.

Mr. Clayton further stated that the SEC has not approved any exchange-trade products holding virtual currencies, and also expressed concern about trading platforms that are not federally regulated and may not afford investors with an appropriate level of protection. He emphasized that the SEC does not have direct oversight over currency or commodity transactions, including trading platforms. He highlighted SEC enforcement efforts in the virtual currency space, and vowed to take a collaborative approach with the CFTC and other regulators to oversee the virtual currency markets.

New FINRA Rules to Protect Senior Investors Take Effect

Two FINRA rule changes designed to prevent the exploitation of seniors and other vulnerable adults took effect on February 5th.

The changes amended FINRA Rule 4512 (“Customer Account Information”) and created new FINRA Rule 2165 (“Financial Exploitation of Specified Adults”). Accordingly, firms are now (i) required to make reasonable efforts to obtain the name of a trusted contact person for a senior or other vulnerable customer with an account, and (ii) permitted to place temporary holds on disbursements of funds or securities from the accounts of certain customers when the firm has a reasonable suspicion that these customers are being financially exploited. FINRA also published responses to Frequently Asked Questions to help firms prepare for and adjust to the changes.

The rule changes were approved by the SEC in March 2017.

Lofchie Comment: The protection of seniors is an issue of large and increasing social importance. However, it would be better if this issue were addressed by federal or state law, rather than by SRO regulation.  The FINRA rule “permitting” broker-dealers to put a hold on disbursements is complicated in cases where such a hold would not be sanctioned by state law. Conversely, the failure of a firm to exercise its “authority,” however questionable, may put the firm at risk from FINRA or an investor.

In light of the above conflicting considerations, firms need to think carefully about the procedures they put in place with respect to new Rule 2165.  Firms should give particular care as to how decisions are documented.

CFTC Chair Unveils New Measure of Swaps Market Size and Risk

CFTC Chair J. Christopher Giancarlo introduced a new measure for the size of the rates segment of the swaps markets and called for a new “paradigm” in describing that market.

In remarks delivered at Derivcon 2018 in New York, Mr. Giancarlo characterized notional value as a highly flawed metric for the size and risk of the swap market, and emphasized that reliance on the metric for regulatory purposes leads to poor allocation of public resources. In particular, he noted that the common use of notional amounts in public discourse without normalizing for duration or offsetting positions creates an impression that the market is much larger than it is in actual risk terms, and has led to misguided policy decisions.

Mr. Giancarlo unveiled a new metric for measuring the size of the rate swap markets developed by CFTC Chief Economist Bruce Tuckman. This measure would evaluate market size based on entity-netted notionals (“ENNs”), which are produced by converting notional amounts for rate swaps of all durations into five-year risk equivalents, and then netting long and short exposures in the same currency between pairs of market participants. Mr. Giancarlo explained that ENNs are designed to describe the amount of market risk transfer in the interest rate swaps markets. Using this method of calculating risk, the aggregate risk transfer amount is sized much more consistently with other major markets, such as the debt market, and can be evaluated accordingly.

Mr. Giancarlo encouraged consideration of the ENN including its potential uses for regulation, but noted that his intention was not to come up with a specific alternative to the current swap dealer de minimis calculation methodology. He also emphasized that ENNs are not intended to quantify credit or operational risk.

Lofchie Comment: Query whether the new measure will be adopted by those who believe that there is a political advantage in exaggerating the size of the swaps market? It sounds a lot more ominous to describe a swap as having a billion dollar notional than it does to describe it as having a four dollars and thirty-seven cents market value.

 

CFTC Commissioner Quintenz Encourages Swap Data Reporting Enhancements

CFTC Commissioner Brian Quintenz suggested various improvements to the swap data reporting regime, including advancing global harmonization efforts, streamlining reporting requirements and enhancing reporting accuracy.

Mr. Quintenz asserted that, while significant progress has been made in the area of swap data reporting, there is still room for improvement. For instance, he explained that implementation of mandatory swap reporting to swaps data repositories (“SDRs”) and, in turn, anonymous publishing of data for the public, improved transparency; at the same time, submissions were often incorrect or incomplete, detracting from the value of the data sets. While Mr. Quintenz said that 95% of credit default swap trades now have complete counterparty and price information, he acknowledged that other areas that contribute to market transparency are still lacking.

Mr. Quintenz said that difficulties in harmonizing data reporting standards across jurisdictions has hindered the ability of regulators to easily analyze swap data and measure risk exposures in the market. He added that there has been substantial progress in this area, with the development of unique product identifiers to identify OTC transactions across jurisdictions and forthcoming guidance regarding critical data elements. If harmonization efforts are integrated as planned, Mr. Quintenz sees potential for easier and more accurate global aggregation and measurement of risk.

Mr. Quintenz referenced a review by the Division of Market Oversight that identified two “primary objectives” for enhancing the CFTC swap data reporting regime: (i) receiving accurate, complete and high-quality transactional data, and (ii) streamlining reporting from market participants. Acknowledging certain ambiguity regarding the responsibilities of each counterparty for verifying the accuracy of SDR data, Mr. Quintenz contended that the reporting counterparty is the logical entity to confirm the accuracy of data. Mr. Quintenz further argued that SDRs should be required to reject trades with incomplete data fields and that the CFTC should develop clear standards for fields that are required to be reported for an SDR to consider it complete. He also suggested lengthening reporting deadlines, perhaps by moving to a T+1 deadline.

Finally, Mr. Quintenz advocated for the CFTC to propose data fields that are consistent with Committee on Payments and Infrastructures and the International Organization of Securities Commissioners (CPMI-IOSCO) guidance for both real-time and regulatory reporting. He emphasized the importance of working to advance harmonization efforts to maximize ability to aggregate global data.

Lofchie Comment: Whatever the regulators eventually do with trade reporting and trade data, they should focus on getting data that is useful and not on getting data fast or in quantity.  It has been too often the case that Congress or the regulators declare that “knowledge is good,” and they mandate that the industry provide data without considering how it can be standardized, transmitted, stored and used.  While Form PF for hedge funds is my ordinary whipping post for the collection of useless data because of the poor design of the questions, in truth the absolute standard for useless data has to be CFTC Rules Part 44, which required reporting to the regulators information as to swaps that were entered into before the enactment of Dodd-Frank.  Presumably, the regulators will find a use for the data some time after the location of Jimmy Hoffa’s body (assuming it is not in the same landfill).

SEC Shuts Down ICO

The SEC obtained a court order freezing the assets of an allegedly fraudulent initial coin offering claiming to use cryptocurrency to “revolutionize banking.”

According to the SEC’s Complaint, Jared Rice Sr., Stanley Ford and their company, AriseBank (collectively, the “Defendants”), offered investors the “AriseCoin” cryptocurrency, which they claimed would fund the world’s first decentralized bank. The SEC alleged that AriseCoin was an improperly unregistered security, and that Defendants made various fraudulent misrepresentations to solicit investments from retail investors. Among the misrepresentations was the claim that AriseBank was FDIC-insured and had raised over $600 million in two months. In addition, the SEC contended that Defendants failed to disclose AriseBank executives’ relevant criminal histories to investors.

In addition to freezing the Defendants’ assets, the court appointed a digital receiver over AriseBank.

The SEC charged Defendants with violating Securities Act Sections 5(a), 5(c) and 17(a)(2), and Exchange Act Section 10(b) and Rule 10b-5.