Last week, the chairmen of the Commodity Futures Trading Commission and the Securities and Exchange Commission provided their insight into the risks of cryptocurrency activities before a Senate committee. During his testimony, CFTC Chairman J. Christopher Giancarlo suggested it might be appropriate to extend federal oversight to spot virtual currencies and exchanges to avoid gaps in current regulation. Additionally, the first trader convicted of spoofing under a Dodd-Frank amendment to existing law expressly designed to prohibit such activity appealed his conviction to the Supreme Court, claiming the law change was unconstitutionally vague. As a result, the following matters are covered in this week’s edition of Bridging the Week:
Bridging the Week will not be published on February 19, 2018, because of the Presidents' Day holiday in the United States.
Mr. Giancarlo stated that “[a]ppropriate federal oversight” could include data reporting and capital requirements, cyber security standards, and measures to prevent fraud and price manipulation, as well as anti-money laundering and “know your customer” protections. He said that “a rationalized federal framework” may be preferable to the current quilt of state-by-state money transmitter regulations. Mr. Clayton observed during his testimony that both he and Mr. Giancarlo had previously noted their openness to considering “whether increased federal regulation of cryptocurrency trading platforms is necessary or appropriate.”
Although Mr. Giancarlo indicated that the CFTC’s regulatory approach of “do no harm” is the right approach in connection with distributed ledger technology, virtual currencies likely require “more attentive regulatory oversight” because of the involvement of retail investors. He added that any augmentation of the CFTC’s regulatory oversight regarding virtual currencies would constitute a “dramatic extension” of the CFTC’s mission and require an amendment to applicable law.
During his testimony, Mr. Clayton cautioned “Main Street investors” to be mindful when investing in cryptocurrencies of any type, particularly those issued as part of initial coin offerings that should be registered as securities and are not or that are not lawfully exempt. Like Mr. Giancarlo, Mr. Clayton questioned whether “our historic approach to the regulation of sovereign currency transactions is appropriate for these new markets” in virtual currencies.
My View: As I indicated in this blog last week, it may be appropriate for Congress to give the CFTC jurisdiction over the purchase and sale of cryptocurrencies in interstate commerce, to the extent such instruments are not securities (i.e., virtual currencies such as Bitcoin, Ether and Litecoin). However, this jurisdiction should be exclusive so as to avoid overlap and inconsistency in approach with the multiple state regulators and the SEC. (Click here to access My View to the article “Senate Ag Committee Asks Questions About Bitcoin Oversight; Senate Finance Committee Schedules Hearing” in the February 4, 2018 edition of Bridging the Week.)
Certainly, virtual currencies are not the same as fiat currencies. Most critically, unlike fiat currencies, virtual currencies have no government backing. Moreover, although virtual currencies may be intended to be a medium of exchange, unit of account and/or a store of value – the traditional characteristics of money –, because of high transaction costs, systems' limitations on capacity, and the reluctance of many merchants to accept virtual currencies for payment, virtual currencies today may be more analogous to precious metals than fiat currencies. Notwithstanding, many regard the potential for virtual currencies to serve as a supplement to government-backed money as huge because of their association with decentralized distributed ledger technologies.
As a result, today, it is likely that most exchanges of virtual currencies between persons reflect investment decisions, rather than traditional currency conversions or transmissions of money, and intermediaries facilitating such transactions act more like traditional exchanges and brokerage firms in the derivatives or securities space, rather than money transmitters. However, such intermediaries are today more often than not regulated as money transmitters by state authorities as well as by the Financial Crimes Enforcement Network of the US Department of Treasury, and the regulation of such intermediaries often does not address types of conduct (e.g., trading practices) routinely addressed by the CFTC in its oversight activities of registered exchanges and brokerage entities. (Click here to access a relevant FinCEN guidance. Click here, however, to access an article about the New York State Department of Financial Services' recent efforts to oversee market conduct by Bitlicense holders.) Accordingly, it appears preferable to have the CFTC, not the states, regulate such entities in order to promote a uniform standard.
Moreover, virtual currencies may have initially been created during a so-called "mining" process to reward persons who maintain the integrity of the relevant blockchain system (i.e., proof of work), or they may have been created as part of an ICO and used to remunerate system administrators through fees. In some cases, virtual currencies may have been derived both ways. Issuance of a virtual currency through an ICO might implicate SEC oversight.
Today the SEC takes a very broad view of what constitutes a security. This view is principally premised on the agency's interpretation of the landmark Supreme Court 1946 decision of SEC v. W.J. Howey (click here to access) that labeled as an investment contract (and thus, as a security) any (1) investment of money (2) in a common enterprise (3) with a reasonable expectation of profits (4) to be derived solely from the entrepreneurial or managerial efforts of others. The SEC argues that an investment contract could also exist when persons invest money in a project and expect profits through the appreciation in value of their investment attributable to the entrepreneurial or managerial efforts of others, even if such "profits" can be realized solely by investors reselling their investments. As a result, the SEC argues that an investment contract could include instruments that convey no traditional ownership rights on its holders or any direct rights to revenue – such as many digital tokens issued as part of ICOs. (Click here for background regarding the SEC’s view of Howey in the article “SEC Declines to Prosecute Issuer of Digital Tokens That It Deems Securities Not Issued in Accordance With US Securities Laws” in the July 26, 2017 edition of Between Bridges. Click here for additional insight into the SEC’s view in the article “Non-Registered Cryptocurrency Based on Munchee Food App Fails to Satisfy SEC’s Appetite for Non-Security” in the December 17, 2017 edition of Bridging the Week.)
However, under this approach, privately issued gold coins promoted by their issuers could potentially be deemed investment contracts by the SEC, as well as special edition automobiles hyped by their manufacturers and similarly promoted assets. In these instances, purchasers would reasonably expect to realize a premium to ordinary market value if they resell their asset because of the entrepreneurial or managerial efforts of others designed to create buzz around their asset. This seems like an attenuated view of what should be considered a security, but it appears consistent with the SEC’s current reasoning. This view could potentially capture some virtual currencies within the definition of a security as well. (Click here to see this possibility raised in Question 9 in the CFTC's request for comment in connection with its proposed guidance on "actual delivery" for retail commodity transactions involving virtual currencies (December 20, 2017) – at page 60341.)
Therefore, Congress should consider amending applicable law to give the CFTC exclusive authority over the purchase and sale of cryptocurrencies in interstate commerce other than securities. However, in doing so, Congress must make clear that virtual currencies meeting some minimum criteria are not securities and empower the CFTC and SEC to define rules to address jurisdiction where there still may be overlapping authority.
Mr. Coscia claimed that the amendment – which prohibits any trading, practice or conduct on a Commodity Futures Trading Commission-regulated trading facility that “is, is of the character of, or is commonly known to the trade as, ‘spoofing’ (bidding or offering with the intent to cancel the bid or offer before execution)”– is unconstitutionally vague. (Click here to access Commodity Exchange Act § 6c(a)(5).) Mr. Coscia – who also was convicted of engaging in commodities fraud – additionally argued that intent alone cannot transform bona fide trading activity into fraud.
In 2015, after a seven-day trial in a federal court in Chicago, Mr. Coscia was convicted of commodities fraud and spoofing in connection with his trading activities on CME Group exchanges and ICE Futures Europe from August through October 2011. Mr. Coscia had initially been indicted for such offenses in October 2014. In July 2013, Mr. Coscia settled civil actions related to the same conduct underlying his criminal indictment with the CFTC, the UK Financial Conduct Authority and CME Group exchanges by payments of aggregate fines of approximately US $3.1 million, disgorgement of profits and a one-year trading suspension.
According to his indictment, during the relevant time, Mr. Coscia utilized two computer-driven algorithmic trading programs that repeatedly placed small buy or sell orders in a market, followed by the rapid placement and retraction of large orders—so-called “quote orders”—on the opposite side of his small orders. He supposedly did this in order to deceive the market and help ensure the execution of his small orders at favorable prices.
After the initial small orders were executed and he cancelled all his quote orders, Mr. Coscia would reverse the process—placing new small orders on the opposite side of the market as his initial filled orders and large quote orders on the opposite side of the new small orders. He allegedly traded this way in order to ensure the fills of the new small orders and profits on the overall transaction.
In July 2016, Mr. Coscia was sentenced to three years’ imprisonment. His conviction was unanimously upheld in August 2017 by a three-judge Federal Court of Appeals panel in Chicago. (Click here for background on this appeal and Mr. Coscia’s prior regulatory actions in the article “Federal Appeals Court Upholds Conviction and Sentencing of First Person Criminally Charged for Spoofing Under Dodd-Frank Prohibition” in the August 7, 2017 edition of Between Bridges.)
My View: As I have previously written, the Dodd-Frank anti-spoofing provision is badly drafted because it uses a term that is assumed to be commonly understood and is followed by a parenthetical that is too broad in scope. The provision fails to reference the totality of the transaction that is potentially problematic – namely the placement of an order with the intent to cancel it prior to its execution to induce the non-bona fide execution of an opposite-side-of-the-market order.
As a result, it may seem clearer now what was intended to be prohibited by this provision solely as a result of numerous exchange disciplinary actions, CFTC enforcement cases, and criminal prosecutions since the relevant provision’s adoption in 2010, but it was not clear in 2011 – at the time of Mr. Coscia’s alleged wrongful conduct and right after the legal provision became effective. Moreover, the plain language of the provision remains fundamentally flawed.
Indeed, through its imprecision, the Dodd-Frank anti-spoofing provision technically makes illegal on its face relatively ordinary trading conduct that no one – not even the CFTC – would likely consider nefarious. The Department of Justice’s own criminal complaints charging spoofing belie that placement of orders and cancelling them alone is problematic – it is that behavior coupled with the intent to execute opposite-side-of-the-market orders initially away from the prevailing best bid and offer that is wrongful. (Click here for background in the article “CFTC Names Four Banking Organization Companies, a Trading Software Design Company and Six Individuals in Spoofing-Related Cases; the Same Six Individuals Criminally Charged Plus Two More” in the February 4, 2018 edition of Bridging the Week.)
For example, when a trader places a stop-loss order, he or she does not intend for the order to be executed, because presumably that would mean the market is trending in a direction opposite his or her view or expectation. However, he or she would accept an execution if the conditions of the stop-loss order was realized. The CFTC, in its May 28, 2013 Antidisruptive Practices Authority guidance (click here to access) seems to acknowledge the ambiguity in the nature of some orders that, when placed, are desired to be cancelled prior to any potential execution. According to the CFTC, “a spoofing violation will not occur when the person’s intent when cancelling a bid or offer before execution was to cancel such bid or offer as part of a legitimate, good-faith attempt to consummate a trade. Thus the Commission interprets the statute to mean that a legitimate, good-faith cancellation or modification of orders (e.g., partially filled orders or properly placed stop-loss orders) would not violate [the spoofing prohibition].”
CME Group, in its interpretation of its rule related to market disruption, goes even further by suggesting there is a difference between intent and hope when placing an order. According to CME, “[m]arket participants may enter stop orders as a means of minimizing potential losses with the hope that the order will not be triggered. However, it must be the intent of the market participant that the order will be executed if the specified condition is met.” (Click here to access CME Group Advisory, RA-1516-5.)
Potentially, every person that a regulator might seek to prosecute for spoofing will likely hope that most orders are not executed. However, such persons will perform on every transaction that is executed – whether hoped for or not. No enforcement action has ever charged that an alleged spoofer failed to perform on a supposed spoof order when executed.
Moreover, in its Advisory, CME Group also provides a number of other examples where the intent of a trader is not necessarily to have all his or her orders executed at the time of order placement, but the consequence is not deemed impermissible spoofing — e.g., placing a quantity larger than a market participant expects to trade in electronic markets subject to a pro rata matching algorithm and placing orders at various price levels throughout an order book solely to gain queue position, and subsequently cancelling those orders as markets change.
Unfortunately, the Dodd-Frank anti-spoofing provision has it wrong. There is nothing inherently problematic about spoofing as expressly defined. Deception, to some extent, is part of smart trading. No trader knowingly reveals all his or her strategy or intent as part of an order placement. Using exchange-authorized iceberg orders to disguise order volume is expressly legitimate, for example. As CME Group wrote in a comment letter to the CFTC about what should be deemed illegal spoofing, it is not the intent to cancel orders before execution that is necessarily problematic, it’s “the intent to enter non bona fide orders for the purpose of misleading market participants and exploiting that deception for the spoofing entity’s benefit” (emphasis added; click here to access CME letter to CFTC dated January 3, 2011).
The parenthetical in the anti-spoofing provision of law defines spoofing potentially to include too many legitimate and otherwise authorized trading practices, and thus is too vague to be meaningful or constitutional.
Compliance Weeds: Notwithstanding my or anyone else’s negative views regarding the impreciseness of the Dodd-Frank language against spoofing as drafted, traders and other market participants must refrain from engaging in trading activities involving the placement or orders that are not intended to be executed – particularly to induce execution of opposite-side-of-the-market orders away from the prevailing best bid or offer. Moreover, firms employing traders or carrying accounts of traders should have policies and procedures reasonably designed to detect spoofing, and to act promptly upon reports of potentially problematic trading by automated surveillance systems or otherwise. Additionally, software developers and their employers should not assist the development of custom software that appears intended to be used for spoofing or other prohibited conduct. These were the clear messages two weeks ago when the CFTC and the Department of Justice coordinated announcements regarding the filing of civil enforcement actions by the CFTC, naming five corporations and six individuals, and criminal actions by the DOJ against eight individuals – including six of the same persons named in the CFTC actions – for engaging in spoofing activities in connection with the trading of futures contracts on United States markets, as well as prior CFTC actions.
Compliance Weeds: Earlier this year, FINRA issued its annual Regulatory and Examinations Priorities Letter setting forth the areas of focus for its inspections of member firms this year. FINRA’s attention will principally be on fraud, high-risk firms and natural person brokers, operational and financial risks, sales practice risks and market integrity. (Click here for details in the article “FINRA Announces 2018 Examination Priorities; Will Review Role of Firms and Salespersons in Facilitating Cryptocurrency Transactions and ICOs” in the January 15, 2018 edition of Bridging the Week.)
As I wrote previously, the beginning of the year provides a natural opportunity for registrants to review their written policies and procedures to ensure they still reflect actual practices. It is easy, over time, for policies and procedures to go stale. Unfortunately, if something goes wrong, it will not be helpful to have actual practices that are inconsistent with written policies, or written policies that are so generic they provide no real basis for actual practices. Both the SEC’s and FINRA’s publication of their 2018 examination priorities also give registrants an opportunity to consider the efficacy of areas of their compliance programs on which they know regulators will focus.
Specifically, such businesses, including those additionally licensed as money transmitters in the state, must put in place measures “to effectively detect, prevent, and respond to fraud, attempted fraud, and similar wrongdoing,” including manipulation. According to NYS DFS, “market manipulation is a form of wrongdoing about which VC entities must be especially vigilant, given that such manipulation presents serious risks both to consumers and to the safety and soundness of financial services institutions.”
Acceptable policies, said NYS DFS, must at a minimum identify applicable fraud-related and “similar risk areas,” including manipulation; provide “effective” procedures and controls to protect against identified risks; assign responsibility for monitoring such risks; and provide for periodic evaluation and revision of implemented procedures and controls. Moreover, VC businesses must “immediately upon discovery” notify NYS DFS in writing of any wrongdoing and follow-up “as soon as practicable” with additional information regarding material developments, including actions taken.
Currently, there are only six licensed NY VC businesses: four have so-called BitLicenses (bitFlyer USA, Coinbase, Inc., XRP II and Circle Internet Financial), and two are licensed limited purpose trust companies authorized to conduct a virtual currency business (Gemini Trust Company and itBit Trust Company).
Separately, in other developments regarding cryptocurrencies:
Legal Weeds: NY’s BitLicense regime, adopted in 2015, established a licensing requirement for all financial intermediaries who engage in a virtual currency business activity from New York or to a NY resident.The regulations impact a wide spectrum of potential businesses, although they exclude merchants and consumers who use virtual currencies in connection with transactions for goods or services, persons chartered under the NY banking law and approved to engage in a virtual currency business activity (including limited purpose trust companies), and persons who engage in the mere “development and dissemination of software in and of itself.”
In general, under NY’s Bitlicense regime, all financial intermediaries engaging in a virtual currency business must apply and obtain a so-called BitLicense, and maintain certain minimum standards and programs to help ensure customer protection, cybersecurity and anti-money laundering compliance.
Under the regulations, what constitutes a virtual currency should be broadly construed and includes any digital unit that is utilized as a medium of exchange or as a form of digitally stored value. However, virtual currencies do not include certain digital units that are used solely with online gaming platforms or as a part of a customer affinity or rewards program (with some restrictions), or that are used as part of prepaid cards.
Likewise, a virtual currency business activity is broadly defined and includes (1) receiving virtual currency for transmission or transmitting virtual currency except where the transaction is for non-financial purposes and only involves a nominal amount; (2) storing or holding virtual currency for others; (3) buying and selling virtual currency as a customer business; (4) engaging as a customer business in the conversion or exchange of (a) fiat currency or other value into virtual currency, (b) virtual currency into fiat currency or other value, or (c) one form of virtual currency into another form of virtual currency; or (5) controlling, administering or issuing a virtual currency.
Applications for a BitLicense require extensive information about the applicant and its principals. Among the required information is a description of the firm’s proposed business activities, all relevant written policies and procedures, and fingerprints and a third-party-prepared background report on each principal. Fingerprints and a photograph will also be required for each employee who may have access to customer funds.
Each virtual currency firm must have and enforce written compliance policies addressing anti-fraud, anti-money laundering, cybersecurity, privacy and information security. Virtual currency firms must maintain at all times “such capital in an amount and form as the superintendent determines is sufficient to ensure the financial integrity of the [l]icensee and its ongoing operations.”
The NYS DFS’s new guidance imposes new obligations on VC businesses in addition to requirements under the existing Bitlicense regime.
(Click here for further background regarding NY’s BitLicense requirements in the article “New York BitLicense Regulations Virtually Certain to Significantly Impact Transactions in Virtual Currencies” in a July 8, 2015 Advisory by Katten Muchin Rosenman, LLP.)
For further information:
ESMA Issues Guidelines to Avoid Conflicts of Interest at CCPs:
First Trader Criminally Convicted for Spoofing Requests Supreme Court Overturn Decision, Claims Applicable Statute Is Unconstitutionally Vague:
IFUS Clearing Member Settles Charges of Not Filing Customer Large Trader Reports in Five Instances:
Newest CFTC Commissioner Encourages Movement on Regulation AT:
NYS Financial Services Regulator Ups the Obligations of State-Licensed Virtual Currency Entities:
SEC and CFTC Chairs Warn Senate Banking Committee of Cryptocurrency Risks; CFTC Chair Suggests Federal Oversight of Spot Virtual Currency Activities:
SEC Examinations Unit Announces 2018 Examination Priorities; Protecting Main Street Investors Is Key:
Three Affiliated Entities of Worldwide Investment Firm Fined by HK Regulator Over US $5 Million Equivalent for Multiple Securities Rules Breaches:
US Broker-Dealer Agrees to US $1.5 Million Fine to Resolve FINRA Charges Related to Capital and Customer Protection:
The information in this article is for informational purposes only and is derived from sources believed to be reliable as of February 10, 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 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.