The CFTC Expands Its Regulatory Approach to Cryptocurrencies
In the past few months, the U.S. Commodity Futures Trading Commission (CFTC) has taken several actions to flesh out its regulatory approach to cryptocurrency transactions that are classified as commodities. These new regulations have a dual focus on consumer protection and technological innovation. The National Futures Association (NFA), an industry self-regulatory body designated by the CFTC, has also issued an investor advisory on the subject.
Regulatory caution on cryptocurrency supervision
The CFTC is responsible for regulating bitcoin products that can be classified as commodity interests while the US Securities and Exchange Commission (SEC) oversees products that should be classified as securities, such as initial coin offerings (ICOs). In January 2018, the CFTC outlined the agreed jurisdictional approach of various US regulatory agencies in a CFTC backgrounder on cryptocurrencies, as well as a summary of its own journey in this area.
To help shape its approach to cryptocurrencies and other technology-driven challenges, the CFTC set up LabCFTC in May 2017, which wasted no time in publishing a primer on virtual currencies in October 2017. LabCFTC was launched from the CFTC’s Office of General Counsel, with a mandate to help manage “the interface between technological engagement and innovation, regulatory modernization, and existing rules and regulations.” As a result, it’s likely that this part of the CFTC will exert significant influence on how the regulator engages with cryptocurrency regulation overall.
The regulator’s primary concern is keeping citizens safe from potential bitcoin-related scams. However, it is also being circumspect in its approach to cryptocurrency regulation as it does not want to stifle financial innovation. For example, at a recent US Congressional hearing on cryptocurrencies, Daniel Gorfine, director of the CFTC’s LabCFTC and the regulator’s chief innovation officer, called on legislators to hold back from drafting new rules around cryptocurrencies themselves. Gorfine said, “While some may seek the immediate establishment of bright lines, the reality is that hasty regulatory pronouncements are likely to miss the mark, have unintended consequences, or fail to capture important nuances regarding the structure of new products or models.”
So far, the US regulatory approach has tried to be both creative and collaborative. In mid-December 2017, bitcoin futures started trading on the Chicago Mercantile Exchange (CME), which at the time was hailed as a significant breakthrough for the cryptocurrency. However, bitcoin’s price plummeted from record highs after the launch, and the Federal Reserve Bank of San Francisco has recently published a paper linking the two events. It asserts that the listing on the CME gave bitcoin bears the opportunity to voice their opinion. It is entirely possible that US regulators encouraged the listing on the CME with this potential effect in mind.
Preventing manipulation, enhancing transparency
Another recent CTFC action around cryptocurrencies is a CFTC Staff Advisory issued in May 2018 intended for designated contract markets, swap execution facilities, and derivative clearing organizations (DCOs). It is focused on addressing regulatory concerns about potential market manipulation, a lack of transparency on some trading platforms, and the high levels of volatility in many cryptocurrencies. The staff advisory makes several key points, including:
- Enhanced market surveillance – The CFTC’s examiners will be reviewing the oversight program these organizations should have in place around their cryptocurrency products to prevent market manipulation and other forms of financial crime. For example, the regulator will be seeking to understand how deep a view these organizations have into the underlying cryptocurrency spot markets, and what is in place to comply with anti-money laundering rules, particularly Know Your Customer (KYC) requirements.
- Close coordination with CFTC Surveillance Group – The CFTC is now expecting these organizations to regularly discuss the surveillance of virtual currency derivatives contracts and provide surveillance information as well as settlement process data to CFTC staff.
- Large Trader Reporting – To help combat market manipulation, the CFTC recommends that the organizations set a large trader reporting threshold for any virtual currency derivative contract at five bitcoins (or the equivalent for other virtual currencies).
- Outreach to members and market participants – The regulator is expecting the organizations to engage in a range of outreach activities across its stakeholder base as it develops its cryptocurrency products. For example, prior to listing a new contract on virtual currency, the CFTC expects the organization to solicit comments and views on issues relating to the listing beyond those that relate to the contract’s terms and conditions and its susceptibility to manipulation, to try and elicit a more rounded view of the development of these markets.
- DCO risk management – The CFTC will be reviewing the margin requirements that DCOs set for new contracts, and seek information on the governance requirements around approving the new contracts.
- Staff notice – The CFTC encourages engagement with its staff well in advance of the launch of new cryptocurrency products and reserves the right to notify organizations in writing if they list a product for which they have not sought engagement from CFTC staff.
These points continue the CFTC’s overall approach to cryptocurrency regulation so far. Rules and processes for existing financial products are being applied to cryptocurrencies, although perhaps at a more risk-heightened level and with certain modifications.
NFA addresses transparency issues
In July, the National Futures Association (NFA) notified the CFTC that it will be adopting an interpretive notice, Disclosure Requirements for NFA Members Engaging in Virtual Currency Activities. The NFA’s board is concerned that “these products may be attracting customers who do not fully understand their nature, the substantial risk of loss that could arise from trading them, and the limitations of the NFA’s oversight role.”
The new rules institute a range of disclosure requirements for NFA members seeking to engage with cryptocurrency products. This includes giving potential investors a copy of the NFA’s Investor Advisory—Futures on Virtual Currencies Including Bitcoin as well as including boilerplate language the NFA drafted into investor documents.
The NFA also calls for risks to be more openly disclosed in customer documents. For example, commodity pool operators (CPOs) and commodity trading advisors (CTAs) that engage in underlying or spot virtual currency transactions in a pool or managed account must – in disclosure documents, offering documents and promotional materials – address risk factors associated with any of the following areas:
- Unique features of virtual currencies
- Price volatility
- Valuation and liquidity
- Opaque spot markets
- Virtual currency exchanges, intermediaries and custodians
- Regulatory landscape
- Transaction fees
To understand the full range of new disclosure requirements, it’s important to read the Disclosure Requirements for NFA Members Engaging in Virtual Currency Activities in full.
This follows on from a December 2017 NFA notice implementing additional reporting requirements for CPOs and CTAs that execute transactions involving any virtual currencies or virtual currency derivatives on behalf of a pool or managed account. Beginning with the first quarter of 2018, the NFA has required CPOs and CTAs to notify the NFA if they have made such transactions and report on the number of their pools or managed accounts that trade virtual currencies or virtual currency derivatives. This information must be submitted to the NFA through the firm’s Firm and Disaster Recovery Information Questionnaire no later than 15 days after the end of each calendar quarter. The NFA added this reporting requirement in response to the rise in the number of CFTC-regulated trading venues that have launched, or have announced plans to offer derivatives on virtual currency products, including bitcoin.
There’s no doubt that US regulators will continue to publish new materials on cryptocurrencies as the year progresses. Major issues, such as how the custody rule applies to cryptocurrency holdings, remain outstanding. How should firms that wish to engage in cryptocurrencies prepare? Five key steps include:
- Updating compliance policies and procedures – The cryptocurrency regulatory space is evolving much quicker than rule-making around other financial products traditionally have. Compliance teams should set regular – quarterly, if not more often – reviews of new requirements and update internal policies and procedures.
- Reviewing marketing materials – Regulators have cryptocurrency marketing materials in their sights, so be sure that the firm’s materials are fully compliant and include any new disclosure requirements. Regulators have indicated that they want to see disclosures fully represented the risks present. Bring in outside expertise, if necessary.
- Consider third-party risk – Firms keen to engage with cryptocurrencies may decide to begin working with new organizations they have not previously had relationships with. Thorough third-party due diligence is essential in these cases.
- Train employees – Enhanced regulatory scrutiny of the cryptocurrency space means employees must understand how to conduct themselves when discussing these products with clients. Providing the right training is essential to ensure the firm’s culture carries over into this new area.
- Engage with stakeholders – Regulators are advocating broader stakeholder engagement by organizations as a way of helping to manage potential emerging risks. This means speaking with customers, potential customers, service providers, and internal teams about cryptocurrency offerings. Such engagement may also provide insight into potential opportunities.