On October 10, 2019, CFTC Chairman Heath Tarbert commented on Ether’s status as a commodity:
“We’ve been very clear on bitcoin: bitcoin is a commodity under the Commodity Exchange Act. We haven’t said anything about Ether – until now. It is my view as Chairman of the CFTC that Ether is a commodity, and therefore it will be regulated under the CEA. And my guess is that you will see, in the near future, Ether-related futures contracts and other derivatives potentially traded … It’s my conclusion as Chairman of the CFTC that Ether is a commodity and therefore would fall under our jurisdiction.”
Ethereum is an open source, public, blockchain-based distributed computing platform and operating system. Ether is a cryptocurrency generated by the Ethereum platform. Ether is also the underlying currency behind the Ethereum blockchain; although, like Bitcoin, it has become a tradeable digital currency, it primarily functions as the fuel for running commands on the Ethereum platform. The CFTC Chairman’s signal that it will now treat a cryptocurrency such as this as a commodity represents a significant development in the digital asset regulatory landscape. Digital assets like Ether should now expect to be subject to the CFTC’s rules and regulations, and industry participants should be prepared to face the compliance burdens associated with the CFTC’s registration, anti-fraud and anti-manipulation obligations.
The mission of the CFTC is to foster open, transparent, competitive and financially sound markets. To achieve this aim, the CFTC administers and enforces the Commodity Exchange Act (“CEA”) and its respective regulations. The CFTC has exclusive jurisdiction over, among others, any transaction “for the contract of sale of a commodity for future delivery,” with certain exceptions. Consequently, commodities are generally subject to the regulatory requirements of the CEA. In addition, market participants in commodities face CFTC registration requirements for traders, advisors, agents and exchanges as well as enforcement actions brought by the CFTC’s Division of Enforcement for violations of fraud and manipulation rules and regulations. As Chairman Tarbert now categorizes Ether as a commodity, we expect it could become subject to the full gamut of the CFTC’s regulations and actions.
Fraud and Manipulation Rules Generally
Following the passage of the Dodd Frank Wall Street Reform and Consumer Protection Act, the CFTC adopted rules and regulations prohibiting the employment, or attempted employment, of manipulative or deceptive conduct. The CEA’s fraud rule was modeled after Section 10(b) and Rule 10b-5 of the Securities and Exchange Act of 1934 as amended to broadly prohibit fraud and fraud-based manipulation. Relatedly, the CEA’s manipulation rule makes it unlawful for any person, directly or indirectly, to manipulate or attempt to manipulate the price of any swap or commodity in interstate commerce. These new rules broadened the CFTC’s existing authority to prohibit fraud and manipulation by eliminating the requirement to show an artificial price, lowering scienter from specific intent to recklessness in certain instances, and expanding the prohibition on false reporting to include “any false statement of material fact” to the CFTC in any context.
The CFTC’s fraud rule makes it unlawful for any person, directly or indirectly, in connection with any swap or contract of sale of any commodity, or contract for future delivery on or subject to the rules of any regulated exchange or trading facility, to intentionally or recklessly:
- Use or employ, or attempt to use or employ, any manipulative device, scheme or artifice to defraud;
- Make, or attempt to make, any untrue or misleading statement of a material fact or to omit to state a material fact necessary in order to make the statements made not untrue or misleading;
- Engage, or attempt to engage, in any act, practice, or course of business that operates or would operate as a fraud or deceit upon any person; or
- Deliver or cause to be delivered, or attempt to deliver or cause to be delivered, a false or misleading or inaccurate report concerning crop or market information or conditions that affect or tend to affect the price of any commodity in interstate commerce, knowing or acting in reckless disregard of the fact that such report is false, misleading or inaccurate.
The CEA stated that there is no violation of the fraud rule when a person mistakenly transmits, in good faith, false or misleading or inaccurate information to a price reporting service. Nonetheless, the CFTC takes a broad view of the rule’s reach, indicating in the rule’s release that it will interpret the rule “not technically and restrictively, but flexibly to effectuate its remedial purposes.”
The CFTC’s manipulation rule makes it unlawful for any person, directly or indirectly, to manipulate or attempt to manipulate the price of any swap or commodity. The CFTC’s traditional four-part test for manipulation guides its enforcement efforts. Under this test, a violation occurs when:
- The alleged manipulator had the ability to influence market prices.
- The alleged manipulator specifically intended to create or effect a price or price trend that does not reflect legitimate forces of supply and demand.
- Artificial prices existed.
- The alleged manipulator caused the artificial prices.
Common Violations of the CEA
Common violations of the CEA’s fraud and manipulation rules include failures to register with the CFTC as well as various forms of fraud and manipulation schemes. The CFTC aggressively enforces violations of the CEA, which may now extend to digital asset market participants following Chairman Tarbert’s comments on Ether’s status as a commodity.
Lately, the CFTC has brought cases against individuals and entities that make false representations regarding cryptocurrency trading expertise and activity. For example, the CFTC on October 16, 2019 charged a Nevada company with fraudulently soliciting US$11 million worth of Bitcoin and cash as part of a Ponzi-like scheme that included misrepresentations of trading expertise and guaranteed rates of return. Similarly, on June 18, 2019, the CFTC charged a Bitcoin trader and his firm with misappropriating $147 million in Bitcoin through material misrepresentations and omissions in a pyramid-like scheme. The CFTC has thus already initiated enforcement of the CEA against participants in the digital asset industry and seems poised to extend its scope of enforcement activities to other forms of CEA violations conducted by those in the digital asset industry. Furthermore, the most recent version of the proposed CFTC Reauthorization Act of 2019, as favorably reported to the House by the House Agriculture Committee, would materially extend the commission’s extraterritorial jurisdiction by amending the CEA to provide that its provisions prohibiting fraud, manipulation, attempted fraud, and attempted manipulation would apply to “activities outside the United States where such activities, independently or in conjunction with activities in the United States, have or would have a reasonably foreseeable substantial effect within the United States.”
Failure to Register
The CFTC requires registration of any:
- Commodity Pool Operator — An individual or organization that operates a commodity pool and solicits funds for that commodity pool;
- Commodity Trading Advisor — An individual or organization that, for compensation or profit, advises others, directly or indirectly, as to the value of or the advisability of trading futures contracts, options on futures, retail off-exchange forex contracts or swaps;
- Futures Commission Merchant — An entity that solicits or accepts orders to buy or sell futures contracts, options on futures, retail off-exchange forex contracts or swaps, and accepts money or other assets from customers to support such orders;
- Introducing Broker — An individual or organization that solicits or accepts orders to buy or sell futures contracts, forex, commodity options, or swaps but does not accept money or other assets from customers to support these orders; or
- Associated Person — An individual who solicits orders, customers or customer funds (or who supervises persons so engaged) on behalf of a futures commission merchant, retail foreign exchange dealer, introducing broker, commodity trading advisor or commodity pool operator.
The CFTC takes failures to register seriously and has already signaled a willingness to bring enforcement actions against those in the digital asset business. For example, on October 31, 2019, the CFTC charged a Switzerland-based digital asset exchange for its failure to register as a Futures Commission Merchant. The CFTC fined the exchange US$100,000 and seized its online domain. Since the CFTC may now treat other cryptocurrencies as a commodity, entities that operate in the digital asset market must now harbor heightened vigilance with respect to their CFTC registration obligations.
Common fraud tactics that may now extend to transactions in digital assets include schemes known as “fictitious sales.” Typically, fictitious sales take the form of wash sales and accommodation trades.
A wash sale occurs when one sells or trades securities at a loss and, within 30 days before or after the sale, one either buys substantially identical securities, acquires substantially identical securities in a fully taxable trade, or acquires a contract or option to buy substantially identical securities. Wash sales typically are accomplished in two ways: by a trader (1) buying and selling with himself or herself; or (2) buying and selling with another person pursuant to a prearranged plan or understanding.
Accommodation trading, on the other hand, occurs when a trader engages in non-competitive trading, usually to assist another with illegal trades, such as a sale at a below market price intended to create a short-term trading loss for tax purposes that is later reversed. Traders in digital assets must now ensure that their activities do not fall into either of these fictitious sale categories.
Violating Bids and Offers
Violating bids and offers is another common fraud tactic that may extend to the digital asset landscape. The CFTC interprets its fraud rule in this context as operating in any trading environment where a person is not utilizing trading algorithms that automatically match the best price for bids and offers. The CFTC prohibits purchases of any contract on a registered entity at a price that is higher than the lowest available price offered for such contract or selling a contract on a registered entity at a price that is lower than the highest available price bid for such contract. Parties transacting in commodities like Ether must now evaluate and maintain compliance with such bid and offer restrictions.
Spoofing, defined as bidding or offering with the intent to cancel the bid or offer before execution, is a common manipulation tactic that extends into the trading of digital assets. The CFTC enforces its anti-spoofing measures against significant market participants. For example, on October 1, 2019, the CFTC ordered two prominent trading firms and a bank to pay a total of US$3 million in civil monetary penalties in connection with multiple acts of spoofing on various commodity exchanges. Since cryptocurrencies are now under the purview of the CFTC’s authority, it is important for market participants to refrain from the types of activities that may trigger enforcement actions by the CFTC.
Misappropriation and Front-Running
The CEA prohibits the misappropriation of non-public information to enter into commodity, option or swap transactions. Under a misappropriation theory generally, fraud occurs when a person misappropriates confidential information for trading purposes, in breach of a duty owed to the source of the information. The CEA extends misappropriation theory to any person who engages in deceptive or manipulative conduct in connection with any swap or contract of sale of any commodity in interstate commerce or contract for future delivery.
Front-running occurs when one takes a futures or option position based upon non-public information (perhaps misappropriated) regarding an impending transaction by another person in the same or related future or option. By trading ahead of non-public information, this activity violates the CEA’s prohibition on fraud. Participants in the digital asset market must therefore refrain from misappropriation and any subsequent front running with respect to information regarding digital assets like Ether and their attendant transactions.
The CFTC’s jurisdiction and regulatory framework over market participants’ proper registration, as well as over fraudulent and manipulation activities, should now be expected to extend to the digital assets industry. Accordingly, industry participants should prepare to shoulder the associated compliance burden by building and maintaining strong compliance controls and procedures and implementing policies that ensure timely and ongoing compliance with the CEA.