Commentaries

Bridging the Week by Gary DeWaal: June 18 - 22 and June 25, 2018 (Cryptocurrencies; Fiat Currencies; Trust; Fraud; Jurisdiction; Administrative Law Judges)

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Published Date: June 24, 2018

Last week, the Bank for International Settlements strongly criticized cryptocurrencies, claiming that trust in digital tokens could disappear at any time because of the “fragility of the decentralized consensus through which transactions are recorded.” Moreover, BIS said that if cryptocurrencies are successful, their use could crash the Internet. BIS contrasted the instability of cryptocurrencies with the general stability and global acceptance of fiat currencies and current payment mechanisms. Venezuelan bolivars anyone? Separately, the Commodity Futures Trading Commission requested a federal appeals court to review and reverse a recent adverse decision against it potentially undercutting its authority to bring fraud cases against persons transacting in commodities where no derivatives are involved and even where leveraged commodity transactions involving retail persons are at play. As a result, the following matters are covered in this week’s edition of Bridging the Week:

Because of work travel and holiday, the next regularly scheduled edition of Bridging the Week will be July 16.

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Briefly:

Notwithstanding, BIS indicated that blockchain technology could have “promise in other applications.”

BIS is an international financial organization based in Switzerland that is owned by 60 central banks worldwide. Its objective is to assist central banks achieve monetary and financial stability and to serve as a bank for central banks and international organizations. (Click here for background.)

According to BIS, fiat currencies – unlike cryptocurrencies – are generally widely trusted because of the role of central banks and their “clear monetary policy and financial stability objectives; operational, instrument and administrative independence; and democratic accountability, so as to ensure broad-based political support and legitimacy.” BIS acknowledged, however, that fiat currencies haven’t always maintained trust, providing multiple examples, including the current currencies of Venezuela and Zimbabwe.

BIS indicated that cryptocurrencies endeavor to promote trust by having a defined protocol that sets forth how participants can transact; by generating and maintaining on an ongoing basis a ledger that provides a record of all transactions; and by having a decentralized network that continuously updates the ledger to reflect new transactions that comply with the defined protocol – in large part to avoid the “double-spending problem.” 

However, says BIS, although it may be costly to create fake transactions involving cryptocurrencies on decentralized ledgers, it’s not impossible. Moreover, cryptocurrencies do not scale like traditional fiat money. First, claims BIS, the cost of generating decentralized trust is “enormous” in a proof-of-work cryptocurrency system as miners compete to add verified blocks to an existing blockchain using extensive computing power. Additionally, as more transactions occur, a blockchain system may become too congested, causing an increase in fees and a delay in verifying transactions. Indeed, widespread use of decentralized blockchain technology could even cause the Internet to stop functioning as blockchains sit on top of and use the Internet for their transactions. Finally, argues BIS, cryptocurrencies have “unstable value” because of the absence of a central issuer whose function is to promote the stability of the relevant currency. 

As a result, suggests BIS, trust in cryptocurrencies could disappear at any time.

Some blockchain technology may have promise, acknowledges BIS, but only where “the benefits of decentralized access exceed the higher operating cost of maintaining multiple copies of the ledger” – for example, in providing low volume, cross-border payment services.

BIS’s report also addressed some of the challenges of regulating cryptocurrencies and considered whether central banks should issue digital currencies. BIS indicated that, to date, no “strong case” has been made for such issuance.

Separately, the following developments occurred last week related to cryptocurrencies:

My View: In the old days Macy’s never had a nice thing to say about Gimbels. (This is a reference to two legendary department stores that used to be located near each other in Herald Square, New York City and were fierce competitors.)

BIS’s report provides a traditional overview of the purpose and value of money from the vantage point of the global central bank to individual jurisdictions’ central banks. It attacks cryptocurrencies generally by mostly debasing proof-of-work digital assets (which incentivize miners to validate and add new blocks to blockchains in a competition that rewards the winner with new digital tokens), and Bitcoin, specifically. It holds out the possibility that some blockchain technology is promising, but seemingly disassociates digital tokens from decentralized distributed ledger technology generally.

Unfortunately, the BIS report doesn’t really discuss cryptocurrencies that don’t rely on proof of work and thus don’t require the drastic use of electricity that it finds so problematic. Moreover, the report also seems to suggest that all decentralized cryptocurrencies have the same type of governance, and thus the same potential breakdown of trust issues. Moreover, it ignores that newer cryptocurrencies are being offered that endeavor to address perceived weaknesses in earlier digital currencies.

It is hard to predict how cryptocurrencies may evolve and whether cryptocurrencies that exist today will exist tomorrow (let alone in their current form). However, there are many who do not have the level of trust in fiat currencies that BIS suggests generally exists in the world, and BIS correctly notes that the history of government-issued money is littered with currencies that have effectively failed.

At least some cryptocurrencies may potentially provide an alternative store of value like gold. Absent lethal government intervention, the market will decide which cryptocurrencies succeed or fail and whether any become useful mediums of exchange – much like it decides today which fiat currencies thrive or collapse. As far as BIS – to paraphrase Shakespeare – "the [organization] doth protest too much methinks."

(Click here for a more balanced counterview regarding the potential of cryptocurrencies that evaluates both the potential uses of cryptocurrencies and blockchain technology along with some of the associated risks in a January 2018 research paper by the Federal Reserve Bank of St. Louis.)

The district court rejected the CFTC’s legal theories, holding that actual delivery of precious metals in financed transactions to retail persons falls outside the CFTC’s jurisdiction when ownership of real metals is legally transferred to such persons within 28 days. This is the case even if the seller retains control over the commodities because of financing beyond 28 days. The court also held that the CFTC cannot use the Dodd-Frank enacted prohibition against persons engaging in any manipulative or deceptive device or contrivance in connection with the sale of any commodity in interstate commerce to prosecute acts of purported fraud except in instances of fraud‑based market manipulation. (Click here for background on the district court’s decision in the article “California Federal Court Dismissal of CFTC Monex Enforcement Action Upsets Stable Legal Theories” in the May 6, 2018 edition of Bridging the Week.)

In its motion, the CFTC said the district court was wrong on the law in its analysis of both provisions.

First, the CFTC argued that the Dodd-Frank provision prohibits the type of fraud it charged. (Click here to access the relevant provision of law, 7 U.S.C § 9(1).) The Commission said the district court came to its incorrect conclusion by rewriting the statute (i.e., saying that “manipulative or deceptive device” should be read as “manipulative and deceptive device”). However, this is inconsistent with the intent of Congress in drafting this provision which was to mimic the anti-fraud provision of the Securities and Exchange Commission (Click here to access SEC Rule 10b-5).

Second, the Commission said that the phrase “actual delivery” in the relevant statute means the “formal act of transferring something” and must involve “a transfer of possession and control.” The CFTC argued that Monex’s purported delivery only involved a bookkeeping entry and provided no control to customers – until they repaid the amount they borrowed to purchase or sell the commodity. Accordingly, the Commission had jurisdiction to bring its enforcement action. (Click here to access the relevant provision of law, 7 U.S.C § 2(c)(2)(D)(ii)(III).)

The CFTC initially filed its motion as a Consent Order. However, on the same day, the Commission refiled its motion, saying that Monex and the other defendants did not agree to the motion filing. (Click here to access a copy of the CFTC’s earlier filing.)

Legal Analysis: The outcome of this CFTC appeal is not only important for the CFTC and Monex, but for other defendants in CFTC enforcement actions alleging fraud in connection with the sale of virtual currencies.

For example, the parties in the CFTC’s My Big Coin Pay, Inc. litigation disagree over whether the Commission has jurisdiction and standing to bring its anti-fraud case against defendants. Like Monex, the defendants in this action argue that the CFTC has no standing to bring a general anti-fraud case against them relying on the fraud-based manipulation prohibition adopted as part of Dodd-Frank. The defendants also argued that the CFTC has no jurisdiction to bring its enforcement action alleging fraud in connection with the sale of the virtual currency known as “My Big Coin,” because the virtual currency was not a commodity under applicable law. This is because, said the defendants, the virtual currency was neither a good nor an article, or a service, right or interest in which contracts for future delivery are dealt in. (Click here for background in the article “CFTC Staff Issues Advisory to Trading Facilities and Clearinghouses for Listing New Futures or Swaps Contracts Based on Virtual Currencies” in the June 3, 2016 edition of Bridging the Week.)

Specifically, in a majority opinion written by Justice Elena Kagan, the Court held that the SEC’s appointment of ALJs violated the so-called “Appointments Clause” of the US Constitution. This provision – Article II § 2 cl. 2 – states that “Congress may by law vest the appointment of such inferior officers, as they think proper, in the President alone, in the courts of law, or in the heads of departments.”

The Court rejected the view that because all SEC ALJ decisions must be reviewed by the SEC commissioners, ALJs did not exercise discretion because they could not issue final decisions. The Court held that ALJs exercise “significant discretion.”

In the instant action, Raymond Lucia and his investment company were accused by the SEC of making misleading statements in connection with the promotion of a retirement savings program called “Buckets of Money.” The SEC filed an administrative proceeding against Mr. Lucia, and after a hearing, the relevant ALJ held that Mr. Lucia had violated applicable law, fined him US $300,000, and barred him from the investment industry for life. Ultimately, Mr. Lucia appealed this decision to the SEC and later to the Court of Appeals for the District of Columbia, but both upheld the ALJ’s authority. The US Supreme Court reversed it.

Although the Court failed in its ruling to indicate whether persons previously penalized by SEC ALJs might generally now have some type of recourse, it indicated that Mr. Lucia should now be retried by an appropriate tribunal because of his timely appeal. If the SEC determined to bring this case before a properly appointed ALJ that would be okay, but it could not be the same ALJ who heard Mr. Lucia’s first action.

My View: Late last year, SEC commissioners ratified the appointment of all then-current SEC ALJs. At the time, the SEC alerted the Supreme Court in light of the pendency of this appeal that “[b]y ratifying the appointment of its ALJs the Commission has resolved any concerns that administrative proceedings presided over by its ALJs violate the Appointments Clause.” (Click here to access an SEC press release regarding this action.) It appears at least five justices of the Supreme Court did not agree with this position.

More Briefly:

For further information

Bank of England Study Says Banks Subject to Leverage Ratio Clear Fewer Client Transactions:
https://www.bankofengland.co.uk/working-paper/2018/the-impact-of-the-leverage-ratio-on-client-clearing

Bank for International Settlements Expresses Strong Reservations Regarding Cryptocurrencies:
https://www.bis.org/publ/arpdf/ar2018e5.pdf

Broker-Dealer Fined US $42 Million by SEC for Misleading Customers Regarding Orders Destination:
https://www.sec.gov/litigation/admin/2018/33-10507.pdf

CFTC Commissioner Argues That Agency Should Not Necessarily Follow Europe in Imposing HFT Trading Requirements:
https://www.cftc.gov/PressRoom/SpeechesTestimony/opaquintenz14

Expedited Federal Court of Appeals Review of Monex Lower Court Decision Requested by CFTC:
/ckfinder/userfiles/files/Amended%20Motion%20to%20Expedite%20CFTC%20v_%20Monex%20Appeal.pdf

International Bank Fined US $65 Million by CFTC for Attempted ISDAFIX Manipulation and Making False Reports:

NFA Plans to Conform FCM and IB AML Requirements to New FinCEN Beneficial Ownership Rules:
https://www.nfa.futures.org/news/PDF/CFTC/NFA_CR_2-9c_and_related_Interp_Notc_2-9_FCM_and_IB_AML_Program.pdf

SEC Chairman Says Culture Is Not an Option:
https://www.sec.gov/news/speech/speech-clayton-061818

US Supreme Court Rules SEC Administrative Judges Appointed Unconstitutionally:
https://www.supremecourt.gov/opinions/17pdf/17-130_4f14.pdf

The information in this article is for informational purposes only and is derived from sources believed to be reliable as of June 23, 2018. No representation or warranty is made regarding the accuracy of any statement or information in this article. Also, the information in this article is not intended as a substitute for legal counsel, and is not intended to create, and receipt of it does not constitute, a lawyer-client relationship. The impact of the law on any particular situation depends on a variety of factors; therefore, readers of this article should not act upon any information in the article without seeking professional legal counsel. Katten Muchin Rosenman LLP may represent one or more entities mentioned in this article. Quotations attributable to speeches are from published remarks and may not reflect statements actually made. Views of the author may not necessarily reflect views of Katten Muchin or any of its partners or other employees.

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ABOUT GARY DEWAAL

Gary DeWaal

Gary DeWaal is currently Special Counsel with Katten Muchin Rosenman LLP in its New York office focusing on financial services regulatory matters. He provides advisory services and assists with investigations and litigation.


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