Introduction

National Futures Association(NFA) is requiring that member commodity pool operators (“CPOs”) and commodity trading advisors (“CTAs”) immediately notify NFA if they operate a pool or manage an account that engages in a transaction involving any virtual currency or virtual currency derivative. Separately, the Commodity Futures Trading Commission (“CFTC” or “Commission”) has published a proposed interpretation of the term “actual delivery” in the context of retail commodity transactions in virtual currency. These actions reflect the enhanced regulatory oversight of virtual currency against the backdrop of spectacular volatility in such products and the recent launch of futures contracts involving virtual currency products. [1]

NFA Reporting Requirements -- ACTION REQUIRED

In a recent Notice to Members, NFA announced the new reporting requirement for CPOs and CTAs. [2] Until further notice, the obligation applies on a continuous basis — any CPO or CTA that is not currently operating a pool or managing an account engaged in virtual currency or related derivatives transactions must notify NFA if the pool or managed account begins trading these products. The required method of notifying NFA is by amending the firm-level section of the annual questionnaire, which now includes questions relating to virtual currency products.

In addition, beginning with the first quarter of 2018, CPOs and CTAs that operate pools or manage accounts that engage in transactions involving virtual currencies or related derivatives also must report the number of their pools or managed accounts that engaged in one or more transactions involving a virtual currency as well as the number of their pools or managed accounts that engaged in one or more transactions involving a virtual currency derivative during each calendar quarter. This information must be submitted to NFA via the firm's questionnaire no later than 15 days after the end of a quarter. NFA will issue a separate notice reminding Members of this obligation. Please note that the reporting requirements for CPOs and CTAs apply to transactions involving virtual currency itself, such as bitcoin, as well as to derivatives, including futures, options or swaps, on virtual currency. [3]

Proposed Interpretation of “Actual Delivery”

Background

The Dodd-Frank Act generally grants the CFTC regulatory authority over retail off-exchange commodity transactions that are offered on a leveraged or margined basis, or financed by the offeror, the counterparty or a person acting in concert with either of them. [4] However, certain transactions are excluded from that authority, including “a contract of sale that results in actual delivery within 28 days or such other longer period as the Commission may determine by rule or regulation based upon the typical commercial practice in cash or spot markets for the commodity involved.’’ [5] Accordingly, the meaning of the term “actual delivery” is crucial in determining whether the CFTC has general regulatory jurisdiction over a particular transaction or whether only proscriptions on fraud or manipulation might apply. The CFTC previously issued an interpretation of the term “actual delivery” for commodities generally, setting forth examples of actual delivery that require transfer of title and possession of the commodity to the purchaser or a depository acting on the purchaser’s behalf. [6]

Prior Cases

Within a year after the CFTC published the 2013 Guidance, the Eleventh Circuit issued an opinion affirming a preliminary injunction obtained by the Commission in CFTC v. Hunter Wise Commodities, LLC., which further reinforced the CFTC’s interpretation of actual delivery in the 2013 Guidance. [7] Subsequently, in a series of enforcement actions culminating with consent orders, the CFTC held that virtual currency is a commodity. However, virtual currency is not treated like fiat currency with respect to the delivery period for “spot” transactions, which is two days, but instead is subject to the longer 28-day period. In the first enforcement action against a platform that offered virtual currency transactions to retail customers on a leveraged, margined, or financed basis without registering under the CEA, the CFTC found in the settlement order that the virtual currency platform violated CEA Sections 4(a) (illegal, off-exchange transactions) and 4d (failure to register as an FCM) because the unregistered entity ‘‘did not actually deliver bitcoins purchased from them’’ as required by the actual delivery exception. [8] Rather, the entity ‘‘held the purchased bitcoins in bitcoin deposit wallets that it owned and controlled.’’ [9] Following that order, the CFTC received requests for guidance with regard to the meaning of the term “actual delivery” in the specific context of virtual currency transactions, which led to the issuance of the Proposed Interpretation.

Terms of the Proposed Interpretation

The CFTC stated that ‘‘actual delivery’’ within the context of virtual currency requires:

(1) A customer having 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

(2) 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) not retaining 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. [10]

The Proposed Interpretation does refer specifically in its examples of what would constitute actual delivery of virtual currency to a purchaser’s blockchain wallet or a third-party wallet or other relevant storage system that has entered into an agreement with the purchaser to hold virtual currency as agent for the purchaser, provided that the purchaser’s or third-party wallet or storage system is not affiliated with or controlled by the counterparty seller or third-party offeror in any manner. [11] Among other things, the CFTC may look at whether the offeror or seller retain any ability to access or withdraw any quantity of the virtual currency purchased from the purchaser’s account or wallet. [12]

The Proposed Interpretation also includes a request for comment on various specific questions, including “what types of circumstances would ensure a purchaser has obtained ‘full control’ of the commodity. For example, is possession of a unique key or other credentials that allow full access and ability to transfer virtual currency sufficient to provide full control? Similarly, how should the Commission view full control by a user in light of commonly used cybersecurity techniques and money transmitter procedures otherwise required by law?” [13]

The 90-day comment period closes on March 20, 2018.

Conclusion

The new NFA reporting requirements and the CFTC’s Proposed Interpretation with respect to virtual currency reflect increasing regulator concern about this burgeoning product area. That should not be surprising given that the bitcoin price increased approximately 1,500% in 2017. [14] NFA is requiring that reporting of involvement in virtual currency and related derivatives transactions by CPOs and CTAs be made through the annual questionnaire, the traditional method by which NFA stays abreast of the activities of its members and accordingly adjusts its regulatory oversight and risk-based examination schedule. This indicates that NFA may cast a wide net in the virtual currency area and not confine itself only to virtual currency derivatives, which may also be indicative of the still developing definitional challenges surrounding these products. The CFTC reiterates “that it does not intend to impede market-enhancing innovation or otherwise harm the evolving virtual currency marketplace with this interpretation,” and believes that the interpretation will be helpful in furthering such innovation. [15] The CFTC also notes that it “takes seriously its goal of protecting U.S. retail market participants engaged in the virtual currency marketplace,” [16] which is reflected in the recent filing of the first antifraud enforcement action involving bitcoin and not derivatives thereof. [17] While the CFTC asserts that its traditional exclusive jurisdiction over derivatives includes virtual currency derivatives, it also recognizes the recent Securities and Exchange Commission (“SEC”) statement regarding the application of federal securities laws to certain initial coin offerings (‘‘ICOs’’). [18] The Proposed Interpretation states that “[d]epending on their use, the tokens or units issued in an ICO may be commodities, commodity options, derivatives, or otherwise fall within the Commission’s virtual currency definition described in this interpretation. However, any such tokens that are deemed securities (and trade in a manner that qualifies as a retail commodity transaction) would be excepted from the retail commodity transaction definition pursuant to [CEA] Section 2(c)(2)(D)(ii)(II).” [19] Therefore, the potential for further CFTC/SEC jurisdictional overlap exists and additional cooperative efforts between the agencies may be necessary. In any event, 2018 promises to be a year full of activity in the marketplace and by regulators with respect to virtual currency and related derivatives.

[1] Both the CFTC and NFA use the term “virtual currency.” Many commentators use the term “cryptocurrency.” The CFTC takes the view that cryptocurrency is essentially a subset of virtual currency, noting that “One prominent type of virtual currency is cryptocurrency.” Retail Commodity Transactions Involving Virtual Currency (“Proposed Interpretation”), 82 Fed. Reg. 60335, 60338 & n.47 (December 20, 2017), available by clicking here. The CFTC uses the term ‘‘virtual currency’’ and ‘‘digital currency’’ interchangeably in its proposed interpretation, although it acknowledges that one view is that ‘‘digital currency’’ includes fiat currencies, while ‘‘virtual currency’’ does not. Id. at n.46.

[2] Notice I-17-28 (December 14, 2017), available by clicking here.

[3] NFA has issued separate notices requiring futures commission merchants (“FCMs”) and introducing brokers (“IBs”) to report activity related to virtual currency futures. The reporting requirements for FCMs apply only if NFA is the designated self-regulatory organization for the firm (i.e., it is not an exchange member) and only relate to futures involving virtual currency, and the IB reporting requirements only relate to derivatives involving virtual currency.

[4] Commodity Exchange Act (“CEA”) Section 2(c)(2)(D)(i).

[5] CEA Section 2(c)(2)(D)(ii)(III)(aa).

[6] Retail Commodity Transactions Under Commodity Exchange Act, 78 Fed. Reg. 52426 (August 23, 2013) (“2013 Guidance”).

[7] CFTC v. Hunter Wise Commodities, LLC, et al., 749 F.3d 967 (11th Cir. 2014).

[8] In re BFXNA INC. d/b/a BITFINEX, CFTC Docket No. 16–19 (June 2, 2016) (consent order).

[9] Id.

[10] Proposed Interpretation at 60339.

[11] Proposed Interpretation at 60340. The 2013 Guidance did not specifically refer to wallets.

[12] Proposed Interpretation at 60339 & n.67.

[13] Proposed Interpretation at 60341.

[14] As further evidence of potential volatility, an unidentified trader or traders on LedgerX, a swap execution facility registered with the CFTC, recently entered into binary bitcoin call options that expire in December with a strike price of $50,000 — about triple its current price. If bitcoin is below $50,000 on December 28, 2018, the options will expire worthless, and the $1 million premium will be lost. If bitcoin reaches that level, the options will give their owners the right to buy 275 bitcoins for $50,000 apiece. See https://www.wsj.com/articles/a-million-dollar-bet-that-bitcoin-will-hit-50-000-1513809578.

[15] Proposed Interpretation at 60339.

[16] Id.

[17] CFTC v. Gelfman Blueprint, Inc. and Nicholas Gelfman, Case No. 17-7181 (S.D.N.Y., filed September 21, 2017).

[18] K&L Gates has issued a separate Alert further discussing the SEC actions in this area, which is available by clicking here.

[19] Proposed Interpretation at 60341.