Bridging the Week by Gary DeWaal


Bridging the Week by Gary DeWaal: December 4 – 8 and December 11, 2017 (Bitcoin Futures; Report Card; Initial Coin Offering; Disclosing Customer Information)

AML and Bribery    Bitcoin Ecosystem    Block Trades and EFRPs    Bridging the Week    Compliance Weeds    EMEA Regulation (sans Capital and Liquidity)    Exchanges and Clearing Houses    Fraud and Anti-Fraud    Initial Coin Offerings    Introducing Brokers    Legal Weeds    My View    Policy and Politics    Registration    Retail Forex and Metals   
Published Date: December 10, 2017

After a week that witnessed Bitcoin soaring to over US $17,000 at one point, CBOE Futures Exchange commenced trading cash-settled Bitcoin futures on Sunday night – albeit with a temporary website crash. But CFE’s launch of its newest futures contract, as well as other upcoming scheduled launches of cash-settled Bitcoin derivatives contracts, is not without controversy. Separately, CME Group exchanges received a generally good report card from the Commodity Futures Trading Commission following a rule enforcement review. However, CFTC staff raised concerns about certain warning letters issued by constituent exchanges and recommended that either the exchanges or futures commission merchants heighten surveillance to ensure that suspended traders don’t trade. As a result, the following matters are covered in this week’s edition of Bridging the Week:

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Last week, FIA – the exchange-traded derivatives industry organization – also published a letter it wrote to CFTC Chairman J. Christopher Giancarlo expressing regret that no "proper" public discussion and input had occurred prior to CFE, CME Group and the Cantor Exchange self-certifying Bitcoin Futures derivatives on December 1. According to FIA, “[a] more thorough and considered process would have allowed for a robust public discussion among clearing member firms, exchanges and clearinghouses to ascertain the correct margin levels, trading limits, stress testing and related guarantee fund protections and other procedures needed in the event of excessive price movements.”

Prior to launching its Bitcoin Futures, CFE announced that it had set its base initial margin requirement for hedgers and Trading Privilege Holders at 40 percent of the contract’s notional value using the daily settlement price. Initial margin for speculators was established at 44 percent of the contract’s notional value. CFE noted that brokerage firms were authorized to impose higher requirements.

CFE also said it would permit block trades in Bitcoin Futures beginning 6 pm ET on December 17 with a minimum threshold of 50 contracts. Exchange of Contracts for Related Position transactions are also authorized, but all spot Bitcoin positions must be transacted through the Gemini Exchange – the same exchange whose official auction price will be used to set the final settlement price of expiring CFE Bitcoin Futures.

Nadex proposes to offer Bitcoin spreads that will be cash-settled contracts within a floor to ceiling range. Under Nadex’s contract – which appears likely to be marketed largely to retail clients – if Bitcoin’s price exceeds the ceiling, the value of the contract remains at the defined maximum and if Bitcoin’s price drops below the floor, the value of the contract remains at the defined minimum.

Nadex’s Bitcoin spreads will derive their pricing data from the Terabit Index published by the TeraExchange. This index incorporates prices from nine spot Bitcoin exchanges. (Click here for details.) Nadex is both a CFTC-registered designated contract market and a derivatives clearing organization. Nadex previously offered cash-settled Bitcoin binary options beginning in 2014 that it delisted in December 2016.

Chicago Mercantile Exchange Bitcoin Futures are also scheduled to launch on December 17 for trade date December 18.

(Click here for details regarding the December 1 self-certification by CME, CFE and Cantor, as well as background on derivatives contracts of those exchanges, as well as of LedgerX and the TeraExchange in the article “Three CFTC-Regulated Exchanges Self-Certify Bitcoin Derivatives Contracts” in the December 3, 2017 edition of Bridging the Week. Click here for a discussion by senior CFTC executives regarding Bitcoin, the Commission’s self-certification process for new derivatives contracts, and some insight into the CFTC’s deliberations leading up to the three exchanges’ December 1 self-certification.)

Compliance Weeds: Legal and Compliance staff supporting firms' trading or facilitation of trading by third parties in cash-settled-Bitcoin futures should ensure their understanding of each of the terms of the new contracts – which may be quite different from one another – and consider among other matters at least the following topics:

  1. How adequate are the firm's disclosures related to unusual characteristics of Bitcoin futures (e.g., that margin requirements may routinely increase when a customer's long positions increase in value. This is because initial margin will be set, on some exchanges, as a percentage of total contract value)? Do the firm's disclosures adequately describe unusual conditions the firm may have imposed on customers trading Bitcoin futures (e..g, no naked short positions allowed, no give-in trades permitted or a premium to exchange-minimum margin required)? Has the firm considered highlighting exchanges' authority, if applicable, to set market prices unrelated to market activity under extraordinary circumstances? Is the firm's customer agreement adequately drafted to authorize the firm to take actions it may deem warranted should Bitcoin futures experience extraordinary volatility?
     
  2. In connection with exchange for related position transactions, what is a related product to a Bitcoin futures contract that has a reasonable degree of price relationship? Generally, the related position component of an EFRP transaction must be the cash commodity or a by-product, a related product, or an over-the-counter product that has a "reasonable degree of price correlation" to the relevant futures contract (click here, e.g., to access CME Group Rule 538C). Consider what other cryptocurrencies or forked versions of Bitcoin might be regarded as reasonably correlated and the time frame for assessing this. Last month, FCStone Merchant Services LLC and INTL FCStone Financial, Inc., affiliated companies, agreed to pay a collective fine of US $280,000 to resolve an enforcement action brought by the CFTC related to EFRP transactions executed by FCStone Merchant for its own account between December 2013 and March 2014. The firms were sued by the CFTC when FCStone Merchant entered into EFRPs involving CME-traded Canadian Dollar futures and physical canola seed. These transactions, said the Commission, were entered into by FCStone Merchant to help a client manage its financial inventory storage costs associated with canola production and currency risk. However, explained the CFTC, because the two components of the purported EFRPs did not have “a reasonable degree of price correlation,” they did not constitute appropriate EFRPs under the applicable CME rule. (Click here for background in the article, "Trading Firm and Broker Affiliate Settle CFTC Enforcement Action for Trading Firm’s Alleged EFRP Transactions With Insufficiently Correlated Futures and Physical Legs" in the November 19, 20916 edition of Bridging the Week.)
     
  3. What is a reasonable price of a block trade involving Bitcoin futures (when permitted)? Generally, prices of block trades must be "fair and reasonable" (click here to access, e.g., CME Group Rule 526D). Consider what is a fair and reasonable price when the futures markets may be extraordinarily volatile and the different spot markets in Bitcoin may be showing very different last prices and bid/offer spreads. In 2016, ​JSC VTB Bank (VTB), a Russia-based bank, and VTB Capital PLC (VTB Capital), a UK-based bank that was ultimately 94% owned by VTB, were sued by the CFTC for engaging in block trades with each other contrary to CME Group rules because the prices of their block trades were not fair and reasonable. This was despite the block trades' prices reflecting the midpoint between the prevailing bid-ask spread of related swap contracts at the time when relevant CME futures contracts were illiquid. (Click here for details in the article, “Futures Block Trades' Prices at Midpoint of Related Swaps Bid-Ask Were Not Fair and Reasonable Says CFTC in Enforcement Action” in the September 25, 2016 edition of Bridging the Week.)
     
  4. How should an account be liquidated when a client defaults in a margin payment related to positions in Bitcoin futures or under other circumstances? Keep in mind that exchanges typically prohibit the entry of orders with reckless disregard for the impact on the marketplace (click here to access, e.g., CME Group Rule 575D). Earlier this year, Saxo Bank A/S, a member firm, agreed to pay an aggregate fine of US $190,000 to the Chicago Board of Trade and the Chicago Mercantile Exchange to resolve two disciplinary actions against it for the way it liquidated futures positions of its customers that were under-margined. According to the exchanges, on multiple dates between October 2014 and March 2015, Saxo employed a liquidation algorithm that automatically entered market orders for the entire amount of an under-margined customer’s positions. It did so, said the exchanges, without considering market conditions. As a result, claimed the exchanges, on at least three occasions on the CBOT and two occasions on the CME, the liquidation caused “significant price movements.” ​(Click here for background in the article “CME Group Settles Disciplinary Action Alleging that Automatic Liquidation of Under-Margined Customers Positions By Non-US Futures Broker Constituted Disruptive Trading” in the March 20, 2017 edition of Bridging the Week.)

​It is better for firms to systematically think through these and other potential issues now rather than later.

My View: Last week, many clearing firms were scurrying to determine whether they would permit clients to trade Bitcoin futures and what margin requirements and/or other restrictions would apply. There appeared to be no uniform response. Sadly, however, no matter what protective measures any individual clearing firm took, it would be at risk at a clearing house because of the protective measures another clearing member might not take. This is because, when cleared transactions are leveraged and risk is mutualized, no matter how cautious any one clearing firm may be, it is exposed to the risk of default of other clearing members who may not be nearly as cautious – particularly in connection with the trading of a likely very volatile product like Bitcoin futures. This is why FIA has historically (as well as last week) advocated that clearinghouses expose an appropriate amount of their own capital to its default waterfall (i.e., have “skin in the game”) to ensure that the consequences of default are shared appropriately between clearing members and clearinghouses. Appropriate skin in the game by clearinghouses helps ensure that clearing members continue to act responsibly, and that clearinghouses only process products that would not expose them to too high risks.

Compliance Weeds: The Terabit Index that will underlie Nadex’s new Bitcoin spread contract derives its prices from nine spot Bitcoin exchanges: BitKonan, Bitfinex, Bitstamp, HitBTC, Independent Reserve, itBit, Kraken, LakeBTC and OKCoin. None of these exchanges are subject to functional federal regulation (e.g., subject to trade practice surveillance requirements) and only one, itBit, has a New York virtual currency license (click here for a list of firms currently possessing a NY “BitLicense.”) On August 11, Bitfinex announced it would cease accepting accounts from individual US persons, noting, among other reasons, “[w]e anticipate the regulatory landscape [in the US] to become even more challenging in the future” (click here for details). CME and CFE Bitcoin futures contracts will also ultimately settle to prices derived from non-functionally regulated spot Bitcoin exchanges, some of which likewise do not possess a NY BitLicense.

Correction: The initially issued Bridging the Week for December 11 incorrectly said that the CME Bitcoin Futures contract would list November 17; this has been corrected to December 17.

According to the SEC, the ICO – which was orchestrated by Dominic Lacroix and Sabrina Paradis-Royer of Quebec, Canada, through their unincorporated entity, PlexCorps – was marketed as a means for investors to obtain a new “tokenized currency” that would net early purchasers a very high rate of return. These returns would supposedly derive from the appreciation in value that would result from investments PlexCorps would make with the ICO’s proceeds; proceeds distributed to investors from PlexCorps’ profits; and the appreciation in value of PlexCoins when traded on digital asset exchanges.

However, charged the SEC, the defendants’ offering was fraudulent and the proceeds of the ICO were never to be used for legitimate business development. Instead, said the SEC, the proceeds “were intended to fund Lacroix and Paradis-Royer’s expenses including home décor projects.”

The SEC charged all the defendants with engaging in securities fraud and Mr. Lacroix and PlexCorps with offering to sell securities for which no registration statement had been filed.

Previously, Quebec’s financial services regulator – the Autorité des marchés financiers – obtained ex parte orders against Mr. Lacroix and Ms. Paradis-Royer preventing them from engaging in securities transactions. (Click here for background in the article “Canada AMF Cautions Against Solicitations of New Virtual Currency” in the August 13, 2017 edition of Bridging the Week.)

The SEC said that the defendants raised US $15 million through the ICO.

An ICO involves the issuance of a new cryptocurrency on a blockchain in return for fiat currency or an existing cryptocurrency such as Bitcoin or Ether. An ICO is typically marketed through use of a white paper that broadly describes the purpose of the new cryptocurrency and an investor’s stake in the underlying project funded by the new cryptocurrency’s launch, if and as relevant.

Unrelatedly, Sal Mansy of Detroit, Michigan, was sentenced to one year and one day imprisonment, among other sanctions, for operating a Bitcoin exchange without registering his enterprise with the Financial Crimes Enforcement Network as a money-service business (“MSB”). Mr. Mansy and TV Toyz were charged by a federal grand jury in Maine in 2015 with knowingly operating an unregistered MSB, and pleaded guilty earlier this year.

Legal Weeds: In July 2017, the SEC published a Report of Investigation that concluded that digital tokens issued by an entity for the purpose of raising funds for projects – even if using distributed ledger or Blockchain technology – may be securities under federal law. If so, such securities must be registered with the Commission or eligible for an exemption from registration requirements. Moreover, the SEC concluded that any person offering trading facilities like an exchange for digital tokens that are securities must be registered as a national securities exchange or be exempt from such registration requirement.

The SEC’s Report follows an investigation by the SEC’s Division of Enforcement which concluded that digital tokens offered and sold during April and May 2016 by DAO, an unincorporated virtual organization created by Slock.it UG, a German corporation, were securities subject to the SEC’s registration requirements. According to the SEC, investors purchased DAO tokens through transactions on the Ethereum Blockchain in exchange for approximately 12 million Ether that was valued at approximately US $150 million at the time.

Notwithstanding its finding, the SEC determined not to take an enforcement action against the DAO entity, Slock.it, any of the natural person founders of the DAO entity or any entity that offered secondary trading in DAO tokens “based on the conduct and activities known to the Commission at this time.” The Commission also declined to take an enforcement action against any intermediary, including any trading facility, involved in the transactions.

According to the SEC, US federal securities laws “may apply to various activities, including distributed ledger technology, depending on the particular facts and circumstances, without regard to the form of the organization or technology used to effectuate a particular offer or sale.”

(Click here for details on the SEC’s July 2017 Report of Investigation in the August 3, 2017 Advisory “SEC Warns That Digital Tokens May Be Securities” by Katten Muchin Rosenman LLP.)

International regulators, such as the Australian Securities and Investment Commission, have published similar guidance as the SEC regarding the application of their own laws to ICOs and other countries, such as China, have outright banned ICOs. (Click here to access ASIC’s advisory and here to access the article “China Bans ICOs While HK SFC Joins Regulator Procession Warning Digital Tokens in ICOs May Be Securities” in the September 10, 2017 edition of Bridging the Week.)

Since issuance of the DAO Report, the SEC has created a special Cyber Unit within its Division of Enforcement to focus on cyber-related matters, including ICOs. (Click here for more details in the article “SEC Enforcement Division Establishes Cyber Unit That Will Examine ICOs” in the October 1, 2017 edition of Bridging the Week.)

The charges against the defendants in the PlexCoin matter are the first filed by the SEC’s new Cyber Unit. However, the SEC has previously brought litigation in the ICO space. In September 2017, the SEC filed an enforcement action against two companies and their sole owner – who also was the chief executive officer and president of both companies – for engaging in a fraudulent initial coin offering. The companies were Recoin Group Foundation, LLC and DRC World Inc., while the sole owner was Maksim Zaslavskiy. (Click here for details in the article “SEC Files Lawsuit Against Companies and Backer for Purportedly Fake Initial Coin Offerings” in the October 1, 2017 edition of Bridging the Week.)

However, staff made a number of recommendations, including that warning letters should not be issued in circumstances involving “misconduct “ similar to a few cases identified in the report that alleged wash trades, disruptive trading and spoofing. Although CME Group staff believed that warning letters were warranted based on the particular circumstances of each identified incident, CFTC staff argued that formal disciplinary action would have been more appropriate to serve “as a deterrent not only to the respondents, but also other market participants.”

CFTC staff also recommended that CME Group exchanges should (1) formally monitor for prohibited trading activity by persons who receive trading suspensions as part of their penalties or require futures commission merchants to review for such activity; (2) “document and explain” how it assesses a financial sanction when it notes that a respondent’s financial condition warrants a lesser financial penalty,” and (3) document why a business conduct committee rejects a settlement offer. CFTC staff suggested that documentation regarding rejected settlements would help promote consistency among different BCCs dealing with similar facts and circumstances.

No response of CME Group was published by the CFTC in connection with its rule enforcement review.

My View: The CFTC does not like exchange-issued warning letters. In its June 2016 rule enforcement review of the CBOE Futures Exchange, LLC, the Division of Market Oversight criticized the exchange for issuing warning letters when CFTC staff believed substantive violations of exchange rules had occurred. (Click here to access the relevant rule review.) According to CFTC staff, “[w]hile a warning letter may be appropriate for certain violations of recordkeeping or audit trail rules, the Division believes that issuing a warning letter for a substantive trading violation is never appropriate.” However, under the applicable CFTC rule, exchanges have broad authority to issue warning letters subject to only one restriction: they may only issue a single warning letter to a person for any one type of violation during a one-year rolling period (click here to access CFTC Rule 38.711). There is no language limiting an exchange’s use of warning letters to only non-substantive offenses. Absent extraordinary circumstances, the CFTC should defer to an exchange’s application of its own judgment to assess how its rules are best administered. At a minimum, the CFTC should not effectively amend its own rules through rule enforcement reviews that are not subject to public comment.

Earlier this year, ICE Futures settled disciplinary actions against AC Power Financial Corporation and Jason Vaccaro, the firm’s president, for a combined fine of US $225,000 for Mr. Vaccaro’s alleged use of nonpublic information “received from his Introducing Broker” related to a customers’ block trades unrelated to any negotiation of a block trade between Mr. Vaccaro and such customers. It now appears the IB was EOX.

Moreover, ICE Futures, at the same time, also resolved a disciplinary action against Susquehanna Energy Partners for a fine of US $100,000 for purportedly giving a verbal standing order to an IB that resulted in block trades being allocated after the fact, as opposed to placing individual block trades, as required by the exchange’s rules. Again, it now appears the IB was EOX.

(Click here for details of these two ICE Futures disciplinary actions in the article “ICE Futures U.S. Settles Disciplinary Actions Against Three Respondents for Alleged Block Trade Violations For US $325,000 Combined Fine” in the May 14, 2017 edition of Bridging the Week.)

Separately, Korea Investments & Securities Co., LTD, agreed to pay a fine of US $65,000 to settle charges brought by the New York Mercantile Exchange that its traders, on multiple occasions from February 1 through May 31, 2016, purportedly crossed orders on Globex involving Crude Oil futures, without waiting five seconds as required under the applicable exchange rule. (Click here to access NYMEX Rule 539.C.3.a.) KIS was also charged with a failure to supervise for not educating its employees regarding exchange rules and for not ensuring that each of its employees used unique Tag 50 IDs.

A&A Trading Inc. consented to pay a fine of US $60,000 to settle a disciplinary action brought by the Chicago Mercantile Exchange that, on 12 dates between October 2015 and February 2016, its employees entered matching buy and sell orders on Globex involving Live Cattle futures in order to freshen the delivery dates of customer accounts. A&A was also charged with the failure of its employees to each use unique Tag 50 IDs.

Compliance Weeds: Training, training and more training – and make it specific! In a number of recent cases, CME Group exchanges have charged firms with failure to supervise, in part, because they did not provide their employees with training regarding applicable exchange rules.(Click here for background in the article “Two Firms Settle With CME Group Exchanges for Not Supervising Employees Who Allegedly Engaged in Disruptive Trading Practices” in the September 10, 2017 edition of Bridging the Week.) Although it is very impracticable to meaningfully train employees on the intricacies of each exchange’s rules, it appears increasingly advisable that firms at least affirmatively identify any unique prohibitions or requirements of particular venues in core compliance procedures and/or training materials, as well as generically describe applicable regulatory prohibitions and requirements (e.g., no wash trades, no spoofing). Employees should be advised how to access each trading venue's particular rules and guidances.

More briefly:

For further information:

CME Group Exchanges Receive CFTC Report Card on Enforcement Program; Grades “Generally Adequate” But Use of Some Warning Letters Criticized:
http://www.cftc.gov/idc/groups/public/@iodcms/documents/file/rercmegroupdisciplinary113017.pdf

CME Rule Scheduled to Permit Transfer Trades as of Prior Date With Prior Date Settlement Price:
http://www.cmegroup.com/market-regulation/rule-filings/2017/12/17-498_1.pdf

EU and CFTC Announce Mutual Recognition of Trading Facilities for Derivatives:
https://ec.europa.eu/info/sites/info/files/171205-joint-statement-ec-cftc_en.pdf

FINRA Seeks Comment on Changes to Arbitration Procedure to Process Requests to Delete Customer Dispute Information From CRD Registration System:
http://www.finra.org/sites/default/files/notice_doc_file_ref/Regulatory-Notice-17-42.pdf

First Cash-Settled Bitcoin Futures Contract Begins Trading on CFTC-Overseen Exchange; Industry Organization Bemoans Self-Certification Process:

ICE Futures U.S. Charges Introducing Broker and Employees With Impermissibly Disclosing Customer Order Information and Executing Block Trades Contrary to Requirements:

NFA Proposes Rule Change to Augment Cost Disclosure to Retail Foreign Exchange Dealer Customers:
https://www.nfa.futures.org/news/PDF/CFTC//ProposedAmendmentstoNFAComplianceRules2-36and2-43RetailForexCosts.pdf

SEC Obtains Emergency Asset Freeze to Stop Purportedly Fraudulent Initial Coin Offering:
https://www.sec.gov/litigation/complaints/2017/comp-pr2017-219.pdf

The information in this article is for informational purposes only and is derived from sources believed to be reliable as of December 9, 2017. 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 for 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.


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