The CFTC would take center stage in the regulation of spot digital asset markets under Title IV of the RFIA.
Latham & Watkins presents a blog series on the Responsible Financial Innovation Act, which was introduced in the US Senate on June 10, 2022, to create a framework for digital assets, cryptocurrency, and blockchain technology. This third post in the series covers CFTC and commodities regulatory issues.
Title IV of the Responsible Financial Innovation Act ( RFIA) is arguably the keystone of the proposed regulatory framework and would make various amendments to the Commodity Exchange Act (CEA), ultimately giving the Commodity Futures Trading Commission (CFTC) principal regulatory authority over digital asset markets.
As explored in greater detail below, the RFIA would:
- provide statutory confirmation of the “commodity” status of digital assets;
- create a new category of CFTC-registrant in the form of “Digital Asset Exchanges;”
- address the custody and segregation requirements applicable to futures commission merchants (FCMs) holding customer digital assets;
- address the bankruptcy treatment of digital assets; and
- provide the CFTC with authority to collect fees from industry participants in order to fund expenses relating to the regulation of digital asset markets.
In a Washington Post Live conversation on June 8, 2020 that also included bill sponsors Senators Lummis and Gillibrand, CFTC Chairman Rostin Behnam lauded the bill and said he was “thrilled” that steps are being taken towards regulating and putting guardrails around digital assets and blockchain technology.
Title IV of the RFIA would amend the CEA to provide some long-overdue clarity on the regulatory categorization of digital assets and virtual currencies.
As early as 2015, the CFTC has taken the position that various digital assets and virtual currencies constitute “commodities” for purposes of the CEA, but has done so through enforcement actions and regulatory guidance rather than formal rulemaking (see, for example, a discussion of the “actual delivery” guidance in this Latham post). Importantly, the RFIA would amend the definition of a “commodity” under Section 1a(9) of the CEA to expressly include “digital assets.” For purposes of the CEA, the term “digital asset” would be defined by reference to the RFIA’s general definition of a “digital asset” (which would sit in a new Chapter 98 “Digital Assets” under Title 31 “Money and Finance” of the United States Code) as a natively electronic asset that confers economic, proprietary, or access rights or powers; is recorded using cryptographically secured distributed ledger technology, or any similar analogue.
However, a “digital asset” for purposes of the CEA would expressly exclude an asset that provides the holder of the asset with certain enumerated rights or financial interests in a business entity, such as a debt or equity interest, liquidation rights, dividend entitlements, or profit/revenue shares. Since the drafting of this exclusion contemplates a digital asset that confers rights in a business entity, it is not entirely clear whether a digital asset conferring entitlements to, for example, intellectual property royalties or other payments in the absence of a clear interest in or claim on a relevant business entity would be excluded from the definition of a “commodity.”
Notably, “commodity” status under the CEA would extend to the RFIA’s notion of “ancillary assets,” which are digital assets sold in connection with the purchase and sale of a security through a scheme that constitutes an investment contract (see a discussion from a securities law perspective in this Latham post). There is, however, some internal inconsistency in the drafting of the bill, in that:
- the bill’s definitions provide that “digital asset” includes an ancillary asset and, based on the transitive property and the amendments to the definition of “commodity,” it would follow that an “ancillary asset” is a “commodity”; but
- the bill’s amendments to the US federal securities laws provide that an “ancillary asset” is only presumed to be a “commodity,” a presumption that can be rebutted by a finding in a court of competent jurisdiction.
As discussed further below, the RFIA would also amend the CEA to add “digital asset exchange” as a new defined term for a “trading facility that lists for trading at least 1 digital asset.” The term “registered digital asset exchange” would also be added and defined as a digital asset exchange that is registered with the CFTC pursuant to the registration regime discussed below.
Expanded CFTC Regulatory Jurisdiction With Respect to Spot Digital Assets
The RFIA would add a new paragraph (F) to the end of Section 2(c)(2) of the CEA granting the CFTC exclusive jurisdiction over any agreement, contract, or transaction involving a contract of sale of a digital asset (including ancillary assets). However, this conferral of exclusive jurisdiction would be subject to a carve-out preserving the jurisdiction of the Securities and Exchange Commission (SEC) with respect to the periodic reporting requirements applicable when an ancillary asset is issued as part of an offering of an investment contract.
In addition, proposed Section 2(c)(2)(F) of the CEA would expressly provide that the CFTC shall only exercise jurisdiction over an agreement, contract, or transaction involving a contract of sale of a digital asset that is “fungible.” In this regard, the RFIA would specifically provide that the RFIA’s notion of a fungible commodity would not include “digital collectibles and other unique assets.” While this is obviously an attempt to place non-fungible tokens (NFTs) outside of the CFTC’s expanded regulatory remit under the RFIA, as drafted the RFIA does not provide a comprehensive definition of “fungibility” and there are likely to be use cases and circumstances in which the eligibility of NFTs for this carve-out will not be clear. For example, many NFTs may arguably have some limited degree of fungibility. In addition, there are potential use cases in which ostensibly “non-fungible” tokens represent entitlements to real-world assets that may themselves exhibit greater or lesser degrees of fungibility.
Furthermore, there would also be an exclusion from the exclusive jurisdiction conferred on the CFTC for “custodial activities with respect to a digital asset of an entity supervised or regulated by a State or other Federal regulatory agency.” This language would clearly carve out, for example, prudential regulatory oversight of the digital asset custody activities of chartered banks and trust companies by applicable state and federal banking regulators. However, this language is interesting in that it qualifies the CFTC’s exclusive jurisdiction only with respect to otherwise regulated custodial activities and does not address, for example, otherwise regulated digital asset trade execution or transmission activities. Indeed, as discussed further below, the current draft of the RFIA would establish a permissive registration regime under which market participants may, but are not required to, register as a digital asset exchange. While the RFIA’s permissive registration regime is seemingly predicated on the assumption that market participants may choose to continue operating in an otherwise lawful fashion (for example, pursuant to existing state money transmitter licensing), there is some potential ambiguity as to whether existing regimes addressing non-custodial digital asset activities are sufficiently preserved and carved out from the exclusive jurisdiction being conferred on the CFTC.
Clarifications to the CFTC’s Retail Leveraged Transaction Jurisdiction
The CFTC has devoted significant attention to the offering of digital asset transactions on a leveraged, margined, or financed basis to retail investors. It has previously brought a number of enforcement actions relying on the CFTC’s jurisdiction with respect to such transactions under Section 2(c)(2)(D) of the CEA and published guidance on the application of the “actual delivery” exception from such authority.
The RFIA would amend Section 2(c)(2)(D) of the CEA to provide that the CFTC’s jurisdiction with respect to transactions offered to retail customers on a leveraged, financed, or margined basis would not apply to contracts of sale of a digital asset that (a) result in “actual delivery” within two days (in comparison with 28 days under the current actual delivery exception), or (b) are executed on a registered digital asset exchange or with a registered futures commission merchant.
Registered Digital Asset Exchanges as a New CFTC-Registrant Category
The RFIA would add a new Section 5i to the CEA, titled “Registration of Digital Asset Exchanges.” Pursuant to this new section, any trading facility that offers or seeks to offer a market in digital assets may register with the CFTC as a “digital asset exchange.”
In addition to permitting de novo registration as a digital asset exchange, proposed Section 5i of the CEA would also provide that existing CFTC-registrants that are registered as a designated contract market (DCM) or swap execution facility (SEF) that fulfills the section’s requirements would be permitted to elect to also be considered a registered digital asset exchange. On the other hand, proposed Section 5i would make clear that registration as a digital asset exchange only would not permit the offering of commodity futures, options, or swaps without also being registered as a DCM or SEF.
Notably, the RFIA takes a “carrot” rather than “stick” approach to the registration of digital asset exchanges. As currently drafted, the RFIA provides that a trading facility may register as a digital asset exchange and it does not make it unlawful to engage in the activity of a digital asset exchange without registration. While there will likely be perceived benefits of registration in terms of market and customer confidence and treatment of customer assets (see FCM discussion below), one of the principal incentives of pursuing registration as a digital asset exchange is likely to be the enhanced ability to offer leveraged, margined, or financed transactions provided by the RFIA. As noted above, the RFIA would provide an exception for transactions offered on a registered digital asset exchange from the CFTC’s authority with respect to retail offering of transactions on a leveraged, margined, or financed basis. To date, most digital asset market participants have not been able to offer such transactions under an exemption. As a result, many digital asset exchanges have withdrawn their margin products in the US in order to avoid registration as an FCM given absent an exemption, retail leveraged or financed digital asset transactions are regulated as if they were futures contracts. Read this Latham post for further discussion on the retail leverage commodity rules as applied to digital assets.
On the other hand, the bill does not expressly provide for federal preemption of the application of state money transmission laws to registered digital asset exchanges. Indeed, other titles of the RFIA clearly assume an ongoing role for state money transmission regimes in the digital asset space (see Latham’s post). Accordingly, the RFIA does not clarify whether federally registered digital asset exchanges would also need to seek state money transmission licenses.
As with the CFTC’s approach to other more recently adopted SEF registration regime and the more long-standing DCM registration regime, the RFIA proposes a principles-based approach to the registration and regulation of digital asset exchanges. In this regard, a registered digital asset exchange would be required to comply with certain “core principles,” but would be afforded reasonable discretion in determining the manner in which it does so. Among other things, these principles would require a registered digital asset exchange to ensure it permits trading only in digital assets that are not readily susceptible to manipulation and to establish standards and procedures that are designed to protect and ensure the safety of customer money, assets, and property. Importantly, the core principles would address custody and treatment of customer assets, including requiring digital asset exchanges to treat and deal with all money, assets, and property of any customer as belonging to the customer and prohibiting commingling (although the RFIA would permit customers to elect to opt out of these segregation and commingling protections).
Digital Assets, FCMs, and Treatment of Customer Assets
In addition to adding the new digital asset exchange registrant category, the RFIA addresses the obligations of existing CFTC-registrants, particularly FCMs, when dealing with digital assets.
In particular, the RFIA would amend Section 4d of the CEA to address the obligations of FCMs with respect to the “Segregation of Digital Assets.” In this regard, the RFIA would define a “digital asset customer” as a customer involved in a cash or spot, leveraged, margined, or financed digital asset transaction in which the FCM is acting as the counterparty. An FCM would be subject to an express obligation to treat and deal with all money, assets, and property of any digital asset customer received as belonging to such customer, and would be prohibited from commingling such money, assets, and property of the FCM or another customer (although the RFIA would permit customers to elect to opt out of these segregation and commingling protections). An FCM would be subject to a general obligation to hold customer money, assets, and property in a manner that minimizes the customer’s risk of loss of, or unreasonable delay in the access to, such money, assets, and property. An FCM would be obligated to hold property of a customer with a licensed, chartered, or registered custodian subject to regulation by the CFTC, SEC, an appropriate state or federal banking agency, or an appropriate foreign governmental authority in the home country of the custodian.
Notably, an FCM would be prohibited from acting as a counterparty in any agreement, contract, or transaction involving a digital asset that has not been listed for trading on a registered digital asset exchange.
Bankruptcy Treatment of Digital Assets
The RFIA would make a number of amendments to the CEA and the Bankruptcy Code to clarify the treatment of digital assets in bankruptcy. In particular, the RFIA would amend the definition of a “commodity broker” under the Bankruptcy Code to include a “digital asset exchange.” As a result, digital asset exchanges would be subject to the commodity broker-specific bankruptcy regime that currently applies to FCMs and similar entities. The RFIA would also make a number of conforming changes to the provisions of the Bankruptcy Code, including to address the status of digital assets as “customer property,” the application of the Bankruptcy Code’s voidable transfer provisions, and the application of the concepts of “commodities contracts” and “contractual rights” in the digital asset context.
Application of AML/KYC Requirements
Registered digital asset exchanges would be subject to clear anti-money laundering (AML) and know your customer (KYC) requirements. First, the RFIA would specifically provide that a registered digital asset exchange shall also register as a money services business with the Secretary of the Treasury. Money services businesses are subject to AML/KYC requirements overseen by the Financial Crimes Enforcement Network (FinCEN). Second, the RFIA would amend the definition of a “financial institution” under the Bank Secrecy Act to specifically include a registered digital asset exchange. This amendment is notable in that the definition of a “financial institution” under the Bank Secrecy Act and FinCEN’s implementing regulations extends to some CFTC-registrants (such as FCMs and introducing brokers) but not others (such as DCMs and SEFs).
Industry Funding of CFTC Regulation
The RFIA would add a new Section 24 to the CEA permitting the CFTC by rule to collect fees to fund expenses relating to regulation of digital asset cash and spot markets. Such fees would be “designed to recover the costs to the Federal Government of the annual appropriation to the [CFTC] Congress.” As presently drafted, such fees would only be imposed on registered entities engaged in cash or spot digital asset activities in relation to the regulation of those activities under the Act. In addition, such fees would be reduced for newly registered entities with less than $100 million in daily trading volume.
The RFIA represents a meaningful, bipartisan step towards clarity in the US regulatory treatment of digital assets. The RFIA’s proposed amendments to the definition of a “commodity” and introduction of the digital asset exchange registrant category would squarely position the CFTC as the principal agency with authority to regulate spot digital asset markets. Importantly, through the ability to assess industry fees, the RFIA would also provide the CFTC with greater financial wherewithal to do so. While the bill is a long way from becoming law, the expansion of CFTC authority and responsibility with respect to digital asset markets is an area to watch.