On June 2nd, the U.S. Commodity Futures Trading Commission (the “CFTC”) announced an enforcement order and settlement with BFXNA Inc. d/b/a Bitfinex, an online platform for exchanging and trading cryptocurrencies (the “Platform”). This posting will summarize that order with the goal of helping our readers make sense of the current state of the law with respect to the CFTC’s regulation of bitcoin and other cryptocurrencies.
KEY REGULATORY PRINCIPLES
Before turning to the facts of this particular enforcement order and settlement (the “Order”), it is helpful to review the current state of the law with respect to the the CFTC’s regulation of bitcoin and other cryptocurrencies. The following are the key regulatory principles, as excerpted from the Order (detailed citations have been omitted in the interest of readability).
- Bitcoin is a Commodity – A cryptocurrency like bitcoin falls within the definition of a “commodity” under section 1a(9) of the Commodity Exchange Act (the “CEA”).
- The CFTC Has Regulatory Jurisdiction Over Retail Commodity Transactions – Section 2(c)(2)(D) of the CEA gives the CFTC regulatory jurisdiction over any leveraged, margined or financed transaction that involves a commodity if one of the parties does not meet the definition of an eligible contract participant or an eligible commercial entity under section 1a(18) or 1a(17) of the CEA, respectively. It is worth noting that a party that facilitates a retail commodity transaction (without actually being a counterparty to that transaction) is subject to the CFTC’s regulatory jurisdiction to the same extent as if that party was a counterparty to that transaction.
- Transactions That Result In “Actual Delivery” Within 28 Days Are Not Considered to Be Retail Commodity Transactions – Section 2(c)(2)(D) of the CEA excepts a transaction from regulation as a retail commodity transaction, if that transaction is a contract of sale that results in “actual delivery” within 28 days. Actual delivery denotes a transfer of possession and control and constitutes an act of giving real and immediate possession to the buyer or the buyer’s agent. Actual delivery is distinct from constructive delivery. The Order cited to case law and, ultimately, Black’s Law Dictionary, for the propositions that constructive delivery: 1) occurs when there is an electronic transfer of documents indicating control or possession without a physical transfer of the commodity; and 2) constitutes an act that amounts to a transfer of title by operation of law when actual transfer is impractical or impossible. Further, the Order indicates that delivery is “actual” when it exists in fact and is real, rather than constructive. The Order also referenced a 2013 CFTC Interpretation regarding the phrase “actual delivery” for purposes of the exception from regulation of a transaction as a retail commodity transaction. Under that interpretation, the CFTC looks beyond the four corners of legal documentation and analyzes the marketing, management and performance of a particular agreement, contract or transaction. The following are the specific factors considered under the interpretation: ownership, possession, title, and physical location of a commodity; the relationships between the buyer, seller, and possessor of the commodity; and the manner in which a sale is recorded and completed. To this end, the Order echoes a point made in the interpretation – actual delivery will not have occurred if only a “book entry” is made by the seller purporting to show that delivery of the commodity has been made.
- Retail Commodity Transactions Are Regulated Like Futures Contracts – Section 2(c)(2)(D) of the CEA treats retail commodity transactions as if they were commodity futures contracts. In essence, this means that a retail commodity transaction must be offered and entered into over a CFTC-regulated board of trade (i.e., in common parlance, a “futures exchange”).
- Futures Commission Merchant Status of a Party Facilitating Retail Commodity Transaction – Section 4d(a) subjects a person that engages in activities that bring it within the definition of a futures commission merchant (“FCM”) to regulation by the CFTC. According to the Order, Section 1a(28) of the CEA defines an FCM in pertinent part to include any person that: 1) solicits an order for a retail commodity transaction; or 2) accepts money or property from a customer in connection with that transaction (emphasis added, citing to a case in which a federal district court entered a summary judgment order against a purported precious metals wholesaler for failing to register as an FCM). It is worth noting that the actual text of section 1a(28) of the CEA defines an FCM to be a person that: 1) solicits an order for such a transaction and 2) accepts money in connection with that transaction (emphasis added).
KEY REGULATORY ISSUES
Given these key regulatory principles, the Order can be described as focusing on three key regulatory issues:
- Status of Platform Transactions as Retail Commodity Transactions – Whether transactions entered into over the platform (“Platform Transactions”) constituted retail commodity transactions;
- Qualification of Platform Transactions for the Actual Delivery Exception – Whether the Platform Transactions involved a contract of sale that resulted in actual delivery within 28 days, such that the transactions would be eligible for the exception from regulation as retail commodity transactions; and
- Futures Commission Merchant Status of Platform Provider – Whether Bitfinex (the “Platform Provider”) engaged in activities that required it to register as an FCM.
This posting will summarize and analyze the CFTC’s resolution of these issues. First, however, it is necessary to understand more about the Order’s description of the key facts involving the Platform.
KEY FACTS – EXCHANGE TRADING AND MARGIN TRADING
The Order described two different features available through the Platform: the “Exchange Trading” feature and the “Margin Trading” feature.
- The Exchange Trading Feature – This feature allowed users to exchange dollars for cryptocurrencies or to trade cryptocurrencies for cryptocurrencies. Settlement occurred in two different ways during different portions of the period under review (04/2013 through 02/2016).
- Platform Wallet With All Private Keys Held by Platform Provider – Prior to August 2015, any cryptocurrencies purchased by one party (the “Buyer”) were held for the Buyer’s benefit in the Platform Provider’s omnibus settlement wallet (the “Platform Wallet”). The Platform Provider held all of the private keys associated with this wallet.
- Individually Enumerated, Multi-Signature Wallet With Keys Controlled by Platform Provider – From August 2015 on, cryptocurrencies purchased using the Exchange Trading feature were settled to the Blockchain on an intra-day basis and held in multi-signature wallets established by a third-party firm. The Platform Provider retained control over the private keys to these wallets, which were individually enumerated for each counterparty to a Platform Transaction.
- The Margin Trading Feature – This feature allowed one Platform user (a “Financing Recipient”) to borrow dollars and cryptocurrencies from another Platform user (a “Margin Funding Provider”). The Financing Recipient would use the borrowed funds to buy or sell cryptocurrencies over the Platform. The Platform Provider administered and enforced the contracts established between the Margin Funding Providers and the Financing Recipients, although the Platform Provider was not a counterparty to any such contract. The Platform had a 30% initial margin requirement, which means that a Financing Recipient had to deposit 30% of the loan value (presumably this deposit was made with the Platform Provider, although the Order is silent on this point). Additionally, if a Financing Recipient’s equity in a position fell below 15%, then the related position was forcibly liquidated in order to ensure repayment of the loan. Settlement on purchases and sales related to this feature occurred in two different ways during different portions of the period under review (04/2013 through 02/2016).
- Platform Wallet With All Private Keys Held by Platform Provider and Lien Against Cryptocurrency in Favor of Margin Funding Provider – Prior to January 2016, any cryptocurrencies purchased by the Financing Recipient, as Buyer, were held for its benefit in the Platform Wallet. The Platform Provider held all of the private keys associated with this wallet and the Financing Recipient had no rights to access or use the currencies until released by the Platform Provider (which would only occur after Financing Recipient repaid its loan). The Platform Provider considered cryptocurrencies in the Platform Wallet as belonging to the Financing Recipients, but subject to a lien in the amount of the loan plus any fees owed to the Margin Funding Providers.
- Individually Enumerated, Multi-Signature Wallet With Keys Controlled by Platform Provider – From January 2016* on, cryptocurrencies purchased using the Margin Trading feature were held in individually enumerated, multi-signature wallets. The Platform Provider continued to retain control over the private keys to these wallets. (*Based upon the language in the Order, it is unclear whether the change in settlement was implemented with respect to the Margin Trading Feature in August 2015 or January 2016; although, it does seem to be clear that such change was implemented by January 2016.)
THE CFTC’S ANALYSIS OF THE ISSUES – THE APPLICATION OF THE REGULATORY PRINCIPLES TO SOME OF THE FACTS
As a threshold item, it is worth noting that the CFTC did not mention the Exchange Trading feature by name in the portion of the Order that discussed the violations of the CEA by the Platform Provider. Perhaps the absence of the application of these regulatory principles to the Exchange Trading feature by name leaves open the possibility that, under a different set of facts, the use of Blockchain enabled, multi-signature wallet technology can qualify for the actual delivery exception under section 2(c)(2)(D) of the CEA.
Nevertheless, the Order did very clearly analyze the key legal issues in light of the facts relating to the Margin Trading feature. The following is a summary of that analysis:
- Status of Platform Transactions as Retail Commodity Transactions – The Order indicated that many users did not qualify as eligible contract participants or eligible commercial entities. Further, the Platform facilitated leveraged, margined or financed transactions through the Margin Trading feature. Since cryptocurrencies constitute commodities, the Order concluded that the Margin Trading feature involved retail commodity transactions that “fell squarely within the [CFTC’s] jurisdiction” under Section 2(c)(2)(D) of the CEA.
- Qualification of Platform Transactions for the Actual Delivery Exception – According to the Order, the Platform “did not transfer possession and control” of any cryptocurrency to a Financing Recipient unless and until all liens on that currency were released (emphasis added). Rather, prior to the release of the liens, the cryptocurrency was held in an omnibus settlement wallet in in the Platform Provider’s own database with all of the wallet’s keys held by the Platform Provider. In the context of the Margin Trading feature, the CFTC made the following statement: “[The Platform Provider’s] accounting for individual customer interests in the bitcoin held in the omnibus settlement wallet in its own database was insufficient to constitute “actual delivery”.‘ Further, the CFTC pointed out that actual delivery did not occur with respect to the individually-enumerated, multi-signature wallets, since the Financing Recipients “had no contractual relationship with the third party firm that established the wallets“. Finally, in support of the position that possession and control had not transferred, the CFTC observed that “[the Platform Provider] had the authority to force liquidate customers’ positions without the customers’ prior consent if their equity fell beneath a preset level” and, as a result, the Platform Provider had possession and control over the cryptocurrencies transacted in multi-signature wallets.
- Status of Platform Provider as an FCM – Given the role of the Platform Provider in facilitating the Margin Trading feature, the Platform Provider was held to have both accepted orders for retail commodity transactions and received funds in respect of the transactions. Accordingly, the Order found that the Platform violated the provisions of the CEA that required it to be registered as an FCM.
FINAL THOUGHTS: MAKING SENSE OF IT ALL
The Order is noteworthy for several reasons.
- CFTC Regulation Is Not Just About Derivatives – The jurisdiction of the CFTC over retail commodity transactions is not a surprise to derivatives legal practitioners. However, not all market participants appreciate the scope of the CFTC’s regulatory jurisdiction. The Order very clearly demonstrates that scope of jurisdictional authority.
- Possession and Control is At the Heart of Actual Delivery – A transaction that settles into a lien-encumbered omnibus wallet does not appear to constitute actual delivery. And, a multi-signature wallet that is encumbered by a lien does not seem to qualify for the “actual delivery” exception under the Order, particularly when a platform provider holds all of the keys to the wallet and there is no independent contractual relationship between the purchaser and the third-party firm that established the wallet. But, as previously noted, the Order does not address actual delivery outside of the context of a lien-encumbered wallet where all of the keys are held by a platform provider. This suggests that actual delivery may occur in other contexts that involve Blockchain enabled, multi-signature wallets, assuming the presence of facts sufficient to demonstrate that possession and control of the cryptocurrency have been transferred to the purchaser of that currency.
- Registering as an FCM Will Not Resolve All of the Regulatory Issues – It is inevitable that some market participants may hastily conclude that the resolution of the legal issues presented by the Order is to register as an FCM. But, doing that does not change the fact that the exchange-trading requirements that apply to futures contracts apply to retail commodity transactions. In other where words, being registered and regulated as an FCM will not resolve all of the regulatory issues that flow from the fact that retail commodity transactions are regulated like futures contracts.
The settlement order and related press release are available here.
Good day. Good knowledge. DR2
*This blog post was originally posted in Derivatives & Repo Report on June 6 , 2016.