The Securities and Exchange Commission (SEC) isn’t the only federal agency flexing its regulatory muscle in response to the explosive growth of virtual currencies, such as bitcoin. Because virtual currencies are considered commodities, the Commodity Futures Trading Commission’s (CFTC) also has oversight under the Commodity Exchange Act (CEA).
Virtual Currency as a “Commodity”
The definition of “commodity” in the CEA is broad. It encompasses a physical commodity, such as an agricultural product (e.g., wheat, cotton) or natural resource (e.g., gold, oil), as well as a currency or interest rate. The CEA definition of “commodity” also includes “all services, rights, and interests . . . in which contracts for future delivery are presently or in the future dealt in.”
In 2015, the CFTC first found that Bitcoin and other virtual currencies are properly defined as commodities. Accordingly, the CFTC has oversight over futures, options, and swaps. It also regulates commodity derivatives contracts that are based on underlying commodities. While its regulatory oversight authority over commodity cash markets is limited, the CFTC maintains general anti-fraud and manipulation enforcement authority over virtual currency cash markets as a commodity in interstate commerce.
In October, the CFTC’s new financial technology (fintech) innovation group, LabCFTC, published “A CFTC Primer on Virtual Currencies.” It outlines the agency's role and oversight of virtual currencies and also cautions investors and users of the potential risks involved with virtual currencies.
In the primer, the CFTC confirmed that it agrees with the SEC’s position that initial coin offerings (ICOs) may qualify as securities and will apply similar analysis with regard to commodities. “There is no inconsistency between the SEC’s analysis and the CFTC’s determination that virtual currencies are commodities and that virtual tokens may be commodities or derivatives contracts depending on the particular facts and circumstances,” the agency stated. “The CFTC looks beyond form and considers the actual substance and purpose of an activity when applying the federal commodities laws and CFTC regulations.”
CFTC Regulation of Virtual Currency Market
While it is keeping a watchful eye on the industry, the CFTC has given the green light to several entities seeking to capitalize on the growing virtual currency market. They include:
- TeraExchange, LLC, a Swap Execution Facility (“SEF”) registered with the CFTC, entered into the virtual currency market in 2014 by listing a Bitcoin swap for trading. Trading on a SEF platform is limited to “eligible contract participants,” a type of sophisticated trader, which includes various financial institutions and persons, with assets above specified statutory minimums.
- North American Derivatives Exchange Inc. (“NADEX”), a designated contract market (“DCM”), listed binary options based on the Tera Bitcoin Price Index from November 2014 to December 2016. Retail customers may trade on NADEX.
- LedgerX, LLC (“LedgerX”) registered with the CFTC as a SEF and Derivative Clearing Organization (“DCO”) in July 2017. It plans to list digital currency options.
Nonetheless, the CFTC has also advised that certain activities are expressly precluded. They include:
- Price manipulation of a virtual currency traded in interstate commerce.
- Pre-arranged or wash trading in an exchange-traded virtual currency swap or futures contract.
- A virtual currency futures or options contract or swap traded on a domestic platform or facility that has not registered with the CFTC as a SEF or DCM.
- Certain schemes involving virtual currency marketed to retail customers, such as off-exchange financed commodity transactions with persons who fail to register with the CFTC.
Like the SEC, the CFTC strongly advises investors to conduct due diligence when considering opportunities involving virtual currency. The specific risks highlighted by the CFTC include substantial market volatility and price swings, cybersecurity concerns, and the lack of supervision over exchanges.
Latest CFTC Virtual Currency Guidance
Last month, the CFTC launched a virtual currency resource Web page, cftc.gov/bitcoin, which is intended to be a central repository for the CFTC’s resources about virtual currency. The agency also announced a Proposed Interpretation concerning its authority over retail commodity transactions involving virtual currency, such as Bitcoin. It specifically establishes the CFTC’s view regarding the “actual delivery” exception that may apply to virtual currency transactions.
Section 2(c)(2)(D) of the CEA provides the CFTC with direct oversight authority over “retail commodity transactions,” which are defined as agreements, contracts or transactions in any commodity that are entered into with, or offered to, retail market participants on a leveraged or margined basis, or financed by the offeror, the counterparty or a person acting in concert with the offeror or counterparty on a similar basis. These transactions fall under the purview of the CEA “as if” they were a commodity future. However, the CEA includes an exception for contracts of sale that result in “actual delivery” within 28 days from the date of the transaction.
The CFTC’s Proposed Interpretation establishes two primary factors necessary to demonstrate “actual delivery” of retail commodity transactions in virtual currency:
(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.
The Proposed Interpretation is open for public comment for 90 days from publication in the Federal Register.
Of course, a number of legal and regulatory questions remain unanswered. We encourage businesses and investors to consult with an experienced business attorney before engaging in transactions involving virtual currencies. We will also continue to post legal updates on our website, so please check back regularly.
If you have any questions or if you would like to discuss the matter further, please contact me, Dan Brecher, at 201-806-3364.