On October 17, 2017, the Commodity Futures Trading Commission’s LabCFTC recently released “A CFTC Primer on Virtual Currencies” (the Primer). LabCFTC was launched by the CFTC in May 2017, as the “focal point for the CFTC’s efforts to promote responsible FinTech innovation and fair competition.” LabCFTC was “designed to make the CFTC more accessible to FinTech innovators … to inform the Commission's understanding of new technologies… [and as] an information source for the Commission and the CFTC staff on responsible innovation that may influence policy development.” It is notable that LabCFTC’s first publication, in PowerPoint format, addresses virtual currency and related issues; however, the first publication states that the Primer “is not intended to describe the official policy or position of the CFTC, or to limit the CFTC’s current or future positions or actions.”
The Primer is divided into three sections: first, it provides an overview of virtual currencies and potential uses of virtual currencies and blockchain technologies; second, it discusses the role of the CFTC in respect to virtual currency and related permitted and prohibited activities; and third, it notes the risks of virtual currencies. It does not, however, offer any insight into the CFTC’s view on the breadth of the definition of “virtual currency” or on whether any particular types of transactions involving blockchain tokens will be subject to CFTC jurisdiction.
Overview
To define virtual currency, the Primer refers to and imports the Internal Revenue Service (IRS) definition from IRS Notice 2014-21: “a digital representation of value that functions as a medium of exchange, a unit of account, and/or a store of value… In some environments, it operates like ‘real’ currency … but it does not have legal tender status” in the US Virtual currency that has an equivalent value in real currency, or that acts as a substitute for real currency, is referred to as ‘convertible’ virtual currency; the Primer cites Bitcoin as one example of a convertible virtual currency. Though the Primer cites the IRS definition, it expressly disclaims that the CFTC is adopting that definition; it “is instead offered as an aid to enhance public understanding of virtual currencies.”
Sample Potential Use Cases of Blockchain Technology. The Primer recognizes that blockchain or distributed ledger technology can be used within public and private systems in a wide variety of applications, including by financial institutions for trading and payment platforms, regulatory reporting, compliance with know your customer and anti-money laundering requirements, by governments for general records management and regulatory reporting and oversight, and cross-industry, for smart contracts, resource and asset sharing agreements and proof of identity when entering into a contract. The examples do not, however, make clear whether the CFTC considers all digital asset represented on blockchains to fall within the definition of virtual currency, or otherwise to be a commodity.
Role of the CFTC
Virtual Currencies are Commodities; Jurisdiction of the CFTC. The Primer notes that the definition of commodity included in the Commodity Exchange Act is broad, and can include a physical commodity such as an agricultural product or a natural resource, a currency or interest rate, and includes “all services, rights, and interests … in which contracts for future delivery are presently or in the future dealt in.” The CFTC first found that Bitcoin and other virtual currencies are properly within the ambit of “commodity” in 2015. The CFTC has oversight over futures, options and derivatives contracts and its jurisdiction is implicated “when a virtual currency is used in a derivatives contract, or if there is fraud or manipulation involving a virtual currency traded in interstate commerce.”
Initial Coin Offerings, Virtual Tokens and CFTC Oversight. The Primer mentions that the Securities and Exchange Commission (SEC) last summer released a Section 21(a) report on the DAO tokens, determining that those particular tokens met the definition of “security” under the federal securities laws. The Primer asserts that “there is no inconsistency between the SEC’s analysis and the CFTC’s determination that virtual currencies are commodities and the virtual tokens may be commodities or derivatives contracts depending on the particular facts and circumstances.” The CFTC “looks beyond form and considers the actual substance and purpose of an activity when applying the federal commodities laws and CFTC regulations.”
Accordingly, both the CFTC and SEC have now announced that they will consider these issues on a case-by-case basis, depending on the particular facts and circumstances. Coinbase’s Securities Law Framework provides guidelines in applying existing regulation to each blockchain project’s facts and circumstances. It is important to note that depending on the structure of a transaction or platform, both the CFTC and SEC could assert overlapping jurisdiction, based on facts and circumstances and each Commission’s interpretation of its statutes. In other words, being subject to the jurisdiction of the CFTC does not insure that there will be no SEC regulatory implications and vice versa.
Risks
The “Risks” section of the Primer is structured by the CFTC as a series of warnings to investors and includes several risks, as follows.
Operational Risks. The Primer acknowledges that the virtual currency market has many platforms for converting one type of virtual currency into another currency, or into fiat currency. However, the CFTC cautions that many of these platforms are not subject to the supervision that applies to regulated exchanges and may be missing critical system safeguards and customer protection related systems.
Cybersecurity Risk. Virtual currency may present cybersecurity risk since some platforms may commingle customer assets in shared accounts, which can affect whether and how the currency can be withdrawn, and may be vulnerable to hacks, resulting in the theft of virtual currency and the loss of customer assets.
Speculative Risks. Virtual currency may present speculative risk since, among other things, the market has been subject to substantial volatility and may be subject to price manipulation.
Fraud and Manipulation Risk. The Primer also cautions against the risk of fraud and manipulation.
Conclusion
The Primer represents another regulator contribution to the world of blockchain tokens. For blockchain projects that create tokens, we reiterate our often expressed view that the features and functions of the platform and the tokens must be analyzed carefully when determining which regulatory regime(s) apply. In other words, the context determines the regulation.
Finally, (and most importantly) don’t commit fraud.
