In this op-ed, Batteh offers a perspective on the recent settlement between Hong Kong-based bitcoin exchange Bitfinex and the US Commodity Futures Trading Commission.
Businesses may loathe burdensome regulation, but they almost always welcome regulatory certainty, even if they are certain they don’t like the particular regulation. Regulatory certainty is predictable and allows businesses to comply with rules, to plan, and to avoid risks, like the risk of the government deciding to shut down their business.
Many of my clients tell me they would rather know what the rules are, even if they are bad rules, than operate in an uncertain regulatory environment with the threat of a costly enforcement action looming.
Trading in digital currencies or “tokens” – including bitcoin – is becoming more commonplace.
Today, bitcoin, ether and hundreds of other tokens are traded on global exchanges. While we can all be certain that digital currencies are here to stay, regulatory certainty around the exchange trading of digital currencies is lacking in many jurisdictions.
Exchanges play an important function in the blockchain ecosystem because they provide a place for price discovery of digital tokens, which is one of the key components of secure and successful blockchains.
Having regulatory certainty around the exchange trading of digital currency is a prerequisite to further mainstream investment in blockchain technology. Businesses want to know that there are regulated, well-run exchanges for the trading of digital tokens which support the blockchains they use.
Last week, the CFTC took yet another step in providing greater regulatory certainty for participants in digital currency markets when it announced its latest bitcoin enforcement case against Bitfinex.
Before discussing the significance of this case, it is helpful to understand the evolution of CFTC regulation in this area.
Last year, the CFTC affirmatively planted a flag in the world of digital currency when the agency stated, in two separate enforcement actions, that digital currencies are “commodities” for the purpose of the Commodity Exchange Act (“CEA” or the “Act”).
The two settlement orders stand for the proposition that digital currencies are encompassed in the definition of, and properly defined as, “commodities,” within the Act. Accordingly, digital currencies are subject to the applicable provisions of the CEA and its attendant regulations. This is particularly important to keep in mind in the context of trading digital currencies on exchanges.
The CFTC has a long history of aggressive enforcement in the area of retail foreign currency (“forex,” or “FX”) and commodity trading on so-called “spot” exchanges. Spot trading occurs when two parties buy and sell a commodity, “on the spot,” and the exchange occurs instantly; by analogy, think of cash on the barrel. This type of trading is largely outside the jurisdiction of the CFTC.
A short review of CFTC cases highlights many enforcement actions involving fraudulent schemes whereby individuals or companies acted as brokers or exchanges offering spot forex trading to retail customers. Offering parties in these cases told investors that they could control large positions with a small initial investment (i.e., leveraged trading).
Unbeknownst to the customer, there never was any foreign currency. The fraudsters would solicit customers to place buy and sell orders, but there was never any counterparty to buy or sell the commodity.
In fact, there was nobody on the other side of the trade: just the fraudster who would abscond with the customer’s funds. The traded commodity was never actually delivered to the customer, and instead, it was either held by the operator of the scheme or non-existent. By the time the fraud was realized, the investor’s money was long gone.
While the CFTC was sometimes successful in bringing these “boiler room” cases, the jurisdictional hurdle of proving that these so-called spot contracts were actually futures contracts within the CFTC’s jurisdiction was high.
In response to these scams, the CFTC did two things: 1) it began to aggressively pursue enforcement cases against these bad actors, shutting down their businesses and obtaining civil monetary penalties (“CMP”), disgorgement of ill-gotten profits, and in some cases, compensation for customer losses whenever possible; and 2) it obtained a legislative change via Section 742 of the Dodd-Frank Act, by adding Section 2(c)(2)(D) to the CEA in 2010.
This amendment makes it easier for the CFTC to shut down these types of exchanges. The statutory change provides the CFTC the authority to bring a cause of action against unregistered operators offering leveraged, margined, or financed trading of commodities (like bitcoin or other digital currencies).
CEA Section 2(c)(2)(D)’s jurisdictional provision applies broadly to any agreement, contract, or transaction in any commodity that is entered into with, or offered to (even if not entered into with), a retail customer 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.
The Section further provides that such an agreement, contract, or transaction is subject to Sections 4(a), 4(b), and 4b of the Act “as if the agreement, contract, or transaction was a contract of sale of a commodity for future delivery.”
In layman’s terms, in most cases, if you are offering trading in leveraged commodity contracts, you have to trade them on a registered futures exchange such as the Chicago Mercantile Exchange or the Intercontinental Exchange. Bye bye margin trading on unregistered digital currency exchanges. But wait! There is an important exception.
Section 2(c)(2)(D)(ii)(III)(aa) excepts from the CFTC’s jurisdiction, a contract of sale that results in “actual delivery” within 28 days …” The term “actual delivery” is clarified somewhat in an interpretive guidance issued by the CFTC in 2013. Under the guidance, unless the commodity is delivered to the customer in full, including the leveraged or financed portion of the trade, actual delivery will be deemed to have not been made.
Arguably, the Bitfinex settlement touches on all of these issues. The CFTC alleged that Bitfinex offered financed bitcoin trading without actually delivering bitcoins to the customer in certain instances.
Instead, according to the CFTC, Bitfinex held customers’ bitcoin at the exchange. In response to discussions with the CFTC, Bitfinex made changes to its offering to come into compliance with the CEA. While the concept of delivery is evolving and novel in the digital token space, given that Bitfinex still offers financed trading, one can assume that Bitfinex has received an overt (or at least tacit) blessing from the CFTC to continue financed trading.
While no company wants to be hit with an enforcement action, the outcome of this case is notable and somewhat remarkable. As part of the settlement, Bitfinex agreed to a CMP of $75,000 for alleged violations of the CEA.
A $75,000 CMP might seem like a big number, but in the world of CFTC enforcement settlements, this is tiny and the equivalent to a slap on the wrist or a speeding ticket. Let’s unpack how the CFTC got to this relatively low civil penalty.
Based on the facts set out in this order, it appears that Bitfinex tried to be a good corporate citizen and to affirmatively seek regulatory clarity from the CFTC. Bitfinex actively cooperated with the CFTC and provided information to the CFTC on a voluntary basis.
Second, almost as important as what is in the order, is what is not explicitly stated in the order. There is no allegation of fraudulent conduct on the part of Bitfinex (i.e., they were not running a pump-and-dump scheme or misappropriating customer funds). Bitfinex was not cheating customers. They were just trying to navigate regulatory uncertainty.
Third, Bitfinex took affirmative, remedial steps to make sure their activity comported with the delivery requirements of the CFTC before the CFTC asked them to do so. As noted above, the order acknowledges that Bitfinex made changes to its offering to attempt to come into compliance.
While Bitfinex avoided a crushing blow from the CFTC’s Division of Enforcement, other exchange operators should consider themselves on notice.
It is very likely that the CFTC will take a much more punitive approach to exchanges that continue to offer leveraged trading that does not comport with the letter and spirit of the delivery requirements. A digital currency exchange operator that does not comply with the leveraged commodity trading rule can expect to be the subject of an enforcement proceeding – which will likely entail a costly investigation, a hefty CMP, and the possibility of being shut down.
A trader trying to decide where to trade digital currency should strongly weigh the exchange’s history and its willingness to engage with regulators. While a CMP levied by a regulator won’t affect the funds of the trader, one must consider the exchange’s long-term ability to operate and to remain solvent if it were to be hit with a sizable fine.
In the end, this settlement should be seen as a positive development for all exchanges, traders and the miners who are the backbone of blockchains.
Greater regulatory certainty will lead to stronger and more secure blockchains by ensuring that businesses can invest in blockchains knowing that they have a robust, regulated market for price discovery, and that miners are fairly compensated for their efforts with fairly priced digital currencies.
Author's Note: I acknowledge the help of Kwon Y. Park, a consultant and counsel at Delta Strategy Group, for his assistance in editing this article.
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