Bridging the Week by Gary DeWaal: June 18 - 22 and June 25, 2018 (Cryptocurrencies; Fiat Currencies; Trust; Fraud; Jurisdiction; Administrative Law Judges)
Last week, the Bank for International Settlements strongly criticized cryptocurrencies, claiming that trust in digital tokens could disappear at any time because of the “fragility of the decentralized consensus through which transactions are recorded.” Moreover, BIS said that if cryptocurrencies are successful, their use could crash the Internet. BIS contrasted the instability of cryptocurrencies with the general stability and global acceptance of fiat currencies and current payment mechanisms. Venezuelan bolivars anyone? Separately, the Commodity Futures Trading Commission requested a federal appeals court to review and reverse a recent adverse decision against it potentially undercutting its authority to bring fraud cases against persons transacting in commodities where no derivatives are involved and even where leveraged commodity transactions involving retail persons are at play. As a result, the following matters are covered in this week’s edition of Bridging the Week:
Bank for International Settlements Expresses Strong Reservations Regarding Cryptocurrencies (includes My View);
Expedited Federal Court of Appeals Review of Monex Lower Court Decision Requested by CFTC (includes Legal Weeds);
US Supreme Court Rules SEC Administrative Judges Appointed Unconstitutionally (includes My View); and more.
Because of work travel and holiday, the next regularly scheduled edition of Bridging the Week will be July 16.
Bank for International Settlements Expresses Strong Reservations Regarding Cryptocurrencies: In its 2018 Annual Report, the Bank for International Settlements expressed strong reservations regarding cryptocurrencies. This is because, said BIS, trust in cryptocurrencies “could evaporate at any time”, cryptocurrency technology is inefficient and requires significant energy use, and cryptocurrencies cannot scale in response to demand, are susceptible to congestion, and are subject to great price volatility.
Notwithstanding, BIS indicated that blockchain technology could have “promise in other applications.”
BIS is an international financial organization based in Switzerland that is owned by 60 central banks worldwide. Its objective is to assist central banks achieve monetary and financial stability and to serve as a bank for central banks and international organizations. (Click here for background.)
According to BIS, fiat currencies – unlike cryptocurrencies – are generally widely trusted because of the role of central banks and their “clear monetary policy and financial stability objectives; operational, instrument and administrative independence; and democratic accountability, so as to ensure broad-based political support and legitimacy.” BIS acknowledged, however, that fiat currencies haven’t always maintained trust, providing multiple examples, including the current currencies of Venezuela and Zimbabwe.
BIS indicated that cryptocurrencies endeavor to promote trust by having a defined protocol that sets forth how participants can transact; by generating and maintaining on an ongoing basis a ledger that provides a record of all transactions; and by having a decentralized network that continuously updates the ledger to reflect new transactions that comply with the defined protocol – in large part to avoid the “double-spending problem.”
However, says BIS, although it may be costly to create fake transactions involving cryptocurrencies on decentralized ledgers, it’s not impossible. Moreover, cryptocurrencies do not scale like traditional fiat money. First, claims BIS, the cost of generating decentralized trust is “enormous” in a proof-of-work cryptocurrency system as miners compete to add verified blocks to an existing blockchain using extensive computing power. Additionally, as more transactions occur, a blockchain system may become too congested, causing an increase in fees and a delay in verifying transactions. Indeed, widespread use of decentralized blockchain technology could even cause the Internet to stop functioning as blockchains sit on top of and use the Internet for their transactions. Finally, argues BIS, cryptocurrencies have “unstable value” because of the absence of a central issuer whose function is to promote the stability of the relevant currency.
As a result, suggests BIS, trust in cryptocurrencies could disappear at any time.
Some blockchain technology may have promise, acknowledges BIS, but only where “the benefits of decentralized access exceed the higher operating cost of maintaining multiple copies of the ledger” – for example, in providing low volume, cross-border payment services.
BIS’s report also addressed some of the challenges of regulating cryptocurrencies and considered whether central banks should issue digital currencies. BIS indicated that, to date, no “strong case” has been made for such issuance.
Separately, the following developments occurred last week related to cryptocurrencies:
Square, Inc.: The New York State Department of Financial Services granted Square, Inc., a virtual currency license (better known as a BitLicense). DFS has now approved nine firms for BitLicenses or virtual currency charters. (Click here for background on NYS’s Bitlicense requirements in the July 8, 2015 Advisory, “New York BitLicense Regulations Virtually Certain to Significantly Impact Transactions in Virtual Currencies” by Katten Muchin Rosenman LLP.)
Tether: Tether Limited released a report by its outside legal counsel, Freeh, Sporkin & Sullivan LLP, where the counsel noted it is “confident” that Tether’s “unencumbered” assets as of June 1, 2018, exceeded the balance of its United States dollar-backed Tether digital coins. FSS somewhat qualified its conclusion by noting that it is not an accounting firm, did not conduct its review in accordance with generally accepted accounting principles, and made no representation regarding the sufficiency of information it was provided and it relied on in coming to its conclusion. Tether is a digital currency that has claimed it maintains an equivalent value of fiat currency to support its face value (i.e., one US dollar value Tether is associated with one US dollar maintained by Tether). (Click here for background on Tether.)
PlexCoin: The Securities and Exchange Commission obtained an additional emergency court order to freeze the assets of Dominic Lacroix, one of the alleged promoters of the PlexCoin digital token initial coin offering that the SEC halted last year. According to the SEC, the ICO – which was orchestrated by Mr. 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. According to the SEC, Mr. Lacroix recently and surreptitiously used accounts of his brother to dispose of digital assets obtained during the PlexCoin ICO. (Click here for further background on the SEC’s litigation against PlexCorps and other defendants in the article “SEC Obtains Emergency Asset Freeze to Stop Purportedly Fraudulent Initial Coin Offering” in the December 10, 2017 edition of Bridging the Week.)
My View: In the old days Macy’s never had a nice thing to say about Gimbels. (This is a reference to two legendary department stores that used to be located near each other in Herald Square, New York City and were fierce competitors.)
BIS’s report provides a traditional overview of the purpose and value of money from the vantage point of the global central bank to individual jurisdictions’ central banks. It attacks cryptocurrencies generally by mostly debasing proof-of-work digital assets (which incentivize miners to validate and add new blocks to blockchains in a competition that rewards the winner with new digital tokens), and Bitcoin, specifically. It holds out the possibility that some blockchain technology is promising, but seemingly disassociates digital tokens from decentralized distributed ledger technology generally.
Unfortunately, the BIS report doesn’t really discuss cryptocurrencies that don’t rely on proof of work and thus don’t require the drastic use of electricity that it finds so problematic. Moreover, the report also seems to suggest that all decentralized cryptocurrencies have the same type of governance, and thus the same potential breakdown of trust issues. Moreover, it ignores that newer cryptocurrencies are being offered that endeavor to address perceived weaknesses in earlier digital currencies.
It is hard to predict how cryptocurrencies may evolve and whether cryptocurrencies that exist today will exist tomorrow (let alone in their current form). However, there are many who do not have the level of trust in fiat currencies that BIS suggests generally exists in the world, and BIS correctly notes that the history of government-issued money is littered with currencies that have effectively failed.
At least some cryptocurrencies may potentially provide an alternative store of value like gold. Absent lethal government intervention, the market will decide which cryptocurrencies succeed or fail and whether any become useful mediums of exchange – much like it decides today which fiat currencies thrive or collapse. As far as BIS – to paraphrase Shakespeare – "the [organization] doth protest too much methinks."
(Click here for a more balanced counterview regarding the potential of cryptocurrencies that evaluates both the potential uses of cryptocurrencies and blockchain technology along with some of the associated risks in a January 2018 research paper by the Federal Reserve Bank of St. Louis.)
Expedited Federal Court of Appeals Review of Monex Lower Court Decision Requested by CFTC: The Commodity Futures Trading Commission, as expected, filed a motion for expedited review of the decision of a US district court in California, dismissing its enforcement action against Monex Deposit Company and other defendants. Last year, the CFTC charged Monex with engaging in illegal off-exchange futures transactions because it entered into leveraged transactions to retail persons without making actual delivery within 28 days, and with committing fraud, relying on authority under the Dodd-Frank Wall Street Reform and Consumer Protection Act.
The district court rejected the CFTC’s legal theories, holding that actual delivery of precious metals in financed transactions to retail persons falls outside the CFTC’s jurisdiction when ownership of real metals is legally transferred to such persons within 28 days. This is the case even if the seller retains control over the commodities because of financing beyond 28 days. The court also held that the CFTC cannot use the Dodd-Frank enacted prohibition against persons engaging in any manipulative or deceptive device or contrivance in connection with the sale of any commodity in interstate commerce to prosecute acts of purported fraud except in instances of fraud‑based market manipulation. (Click here for background on the district court’s decision in the article “California Federal Court Dismissal of CFTC Monex Enforcement Action Upsets Stable Legal Theories” in the May 6, 2018 edition of Bridging the Week.)
In its motion, the CFTC said the district court was wrong on the law in its analysis of both provisions.
First, the CFTC argued that the Dodd-Frank provision prohibits the type of fraud it charged. (Click here to access the relevant provision of law, 7 U.S.C § 9(1).) The Commission said the district court came to its incorrect conclusion by rewriting the statute (i.e., saying that “manipulative or deceptive device” should be read as “manipulative and deceptive device”). However, this is inconsistent with the intent of Congress in drafting this provision which was to mimic the anti-fraud provision of the Securities and Exchange Commission (Click here to access SEC Rule 10b-5).
Second, the Commission said that the phrase “actual delivery” in the relevant statute means the “formal act of transferring something” and must involve “a transfer of possession and control.” The CFTC argued that Monex’s purported delivery only involved a bookkeeping entry and provided no control to customers – until they repaid the amount they borrowed to purchase or sell the commodity. Accordingly, the Commission had jurisdiction to bring its enforcement action. (Click here to access the relevant provision of law, 7 U.S.C § 2(c)(2)(D)(ii)(III).)
The CFTC initially filed its motion as a Consent Order. However, on the same day, the Commission refiled its motion, saying that Monex and the other defendants did not agree to the motion filing. (Click here to access a copy of the CFTC’s earlier filing.)
Legal Analysis: The outcome of this CFTC appeal is not only important for the CFTC and Monex, but for other defendants in CFTC enforcement actions alleging fraud in connection with the sale of virtual currencies.
For example, the parties in the CFTC’s My Big Coin Pay, Inc. litigation disagree over whether the Commission has jurisdiction and standing to bring its anti-fraud case against defendants. Like Monex, the defendants in this action argue that the CFTC has no standing to bring a general anti-fraud case against them relying on the fraud-based manipulation prohibition adopted as part of Dodd-Frank. The defendants also argued that the CFTC has no jurisdiction to bring its enforcement action alleging fraud in connection with the sale of the virtual currency known as “My Big Coin,” because the virtual currency was not a commodity under applicable law. This is because, said the defendants, the virtual currency was neither a good nor an article, or a service, right or interest in which contracts for future delivery are dealt in. (Click here for background in the article “CFTC Staff Issues Advisory to Trading Facilities and Clearinghouses for Listing New Futures or Swaps Contracts Based on Virtual Currencies” in the June 3, 2016 edition of Bridging the Week.)
US Supreme Court Rules SEC Administrative Judges Appointed Unconstitutionally: The United States Supreme Court held that the appointment of Securities and Exchange Commission administrative law judges by staff, and not by SEC commissioners, violated the US Constitution. This is because SEC ALJs have a continuing (as opposed to occasional or temporary) position where they exercise significant discretion. Thus, under prior Supreme Court precedent, they are “officers” under the Constitution and not mere employees, and thus can be appointed to their positions solely by the President of the United States, courts of law, or heads of department.
Specifically, in a majority opinion written by Justice Elena Kagan, the Court held that the SEC’s appointment of ALJs violated the so-called “Appointments Clause” of the US Constitution. This provision – Article II § 2 cl. 2 – states that “Congress may by law vest the appointment of such inferior officers, as they think proper, in the President alone, in the courts of law, or in the heads of departments.”
The Court rejected the view that because all SEC ALJ decisions must be reviewed by the SEC commissioners, ALJs did not exercise discretion because they could not issue final decisions. The Court held that ALJs exercise “significant discretion.”
In the instant action, Raymond Lucia and his investment company were accused by the SEC of making misleading statements in connection with the promotion of a retirement savings program called “Buckets of Money.” The SEC filed an administrative proceeding against Mr. Lucia, and after a hearing, the relevant ALJ held that Mr. Lucia had violated applicable law, fined him US $300,000, and barred him from the investment industry for life. Ultimately, Mr. Lucia appealed this decision to the SEC and later to the Court of Appeals for the District of Columbia, but both upheld the ALJ’s authority. The US Supreme Court reversed it.
Although the Court failed in its ruling to indicate whether persons previously penalized by SEC ALJs might generally now have some type of recourse, it indicated that Mr. Lucia should now be retried by an appropriate tribunal because of his timely appeal. If the SEC determined to bring this case before a properly appointed ALJ that would be okay, but it could not be the same ALJ who heard Mr. Lucia’s first action.
My View: Late last year, SEC commissioners ratified the appointment of all then-current SEC ALJs. At the time, the SEC alerted the Supreme Court in light of the pendency of this appeal that “[b]y ratifying the appointment of its ALJs the Commission has resolved any concerns that administrative proceedings presided over by its ALJs violate the Appointments Clause.” (Click here to access an SEC press release regarding this action.) It appears at least five justices of the Supreme Court did not agree with this position.
SEC Chairman Says Culture Is Not an Option: Echoing themes articulated by the UK Financial Conduct Authority in a recently published article, Jay Clayton, Chairman of the Securities and Exchange Commission, indicated that culture is “not optional” at financial services firms. According to Mr. Clayton, managers must be aware of the culture of their firms and the key drivers of that culture, and that the chances of achieving a company’s cultural goals increase if managers understand where the company’s culture stands “relative to those goals.” This is particularly relevant when circumstances arise not contemplated by written policies and procedures. As an illustration of this, Mr. Clayton provided an example of a broker lying to a customer about the purchase price of a bond sold to the customer. Although the lie might not be a regulatory problem, he said, “your culture should reject it.” (Click here for background on FCA’s think piece on culture in the article “FCA Publishes Thought Piece on Enhancing Culture in Financial Services” in the March 18, 2016 edition of Bridging the Week.)
Bank of England Study Says Banks Subject to Leverage Ratio Clear Fewer Client Transactions: The Bank of England published a study confirming that imposition of leverage ratio requirements on banks for clearing customer derivatives – even when fully margined – results in the banks reducing their willingness to handle customer business. This, noted the BOE, may have “negative implications” for institutions unsuccessfully seeking access to cleared transactions, as it may force them to adopt more expensive alternative hedging strategies. (The leverage ratio requires banks to hold a minimum amount of common stock and certain disclosed reserves – so-called “Tier 1” capital – as a percentage of their total exposure.) Specifically, reported the BOE, after introduction of a leverage ratio requirement on UK banks in January 2016, they reduced their cleared client transactions by 5 percent and operated with four to five fewer clients compared to non-UK clearing members.
International Bank Fined US $65 Million by CFTC for Attempted ISDAFIX Manipulation and Making False Reports: JP Morgan Chase Bank, N.A. agreed to pay a US $65 million fine to the Commodity Futures Trading Commission for purportedly engaging in attempted manipulation of the ISDAFIX benchmark from beginning in January 2007 through January 2012. The CFTC claimed that JP Morgan engaged in two types of manipulation: “submission attempted manipulation” where the firm endeavored to benefit its trading positions by submitting false indicated prices to establish daily ISDAFIX reference rates, and “trading attempted manipulation,” where the company entered bids and offers in targeted interest rate products near the fixing time to try to influence the reference rate. The CFTC noted JP Morgan’s “significant cooperation” in accepting its offer of settlement, including tolling the statutory period for the CFTC to bring its legal action. Separately, Deutsche Bank AG agreed to pay a fine of US $205 million to New York’s Department of Financial Services to resolve claims that, from 2007 to 2013, it engaged in various trading and other practices involving foreign exchange to benefit the bank at the expense of its customers.
Broker-Dealer Fined US $42 Million by SEC for Misleading Customers Regarding Orders Destination: Merrill Lynch, Pierce, Fenner & Smith Incorporated consented to pay a fine of US $42 million to the Securities and Exchange Commission to resolve allegations that it failed to disclose to customers the location of many executed orders. The SEC claimed that, from 2008 through May 2013, the firm routed more than 15 million customer orders to third-party proprietary trading firms and wholesale market makers for execution, when it told its customers that all the transactions had been handled internally. This false information was conveyed to customers, alleged the SEC, in false reports of the transactions, invoices, and responses to customer questionnaires and other communications. Even after Merrill Lynch corrected what it internally called “masking,” the firm programmed systems to continue to falsely represent the location of executed transactions prior to May 2013, charged the Commission. Merrill Lynch admitted the facts alleged by the Commission and acknowledged its conduct violated applicable law, as part of its settlement.
CFTC Commissioner Argues That Agency Should Not Necessarily Follow Europe in Imposing HFT Trading Requirements: Commodity Futures Trading Commissioner Brian Quintenz strongly criticized the European Union for proposing in 2016 to undo an agreement between it and the Commission that provided a framework to recognize each regulator’s oversight of local clearinghouses (“CCPs”) as equivalent. Under the European Union’s 2016 proposed legislation, CFTC-licensed clearinghouses that are deemed systematically significant would be required to adopt European regulation and be subject to enhanced oversight by the European Securities and Markets Authority and the European Central Bank. (Click here for background on this EU proposal in the article “EC Proposes Two-Tier System for Classifying Third-Country CCPs; Certain Systemically Important CCPs May Be Required to Relocate to the EU" in the June 18, 2017 edition of Bridging the Week.) In a speech last week before the Institute of International Bankers in New York City, Mr. Quintenz said that the CFTC should not grant any additional equivalence determinations requested by EU authorities until this matter has been satisfactorily resolved. Additionally, Mr. Quintenz said that the CFTC should not “automatically” adopt the same type of restrictive requirements for high-frequency traders and regarding position limits as have recently been instituted in the European Union.
NFA Plans to Conform FCM and IB AML Requirements to New FinCEN Beneficial Ownership Rules: The National Futures Association proposed rule and interpretive notice amendments that would formally align its anti-money laundering requirements for futures commission merchants and introducing brokers with recently implemented regulations by the Financial Crimes Enforcement Network of the US Department of Treasury that require financial institutions to identify and verify beneficial owners of legal entity customers. NFA also proposed new obligations for FCMs and IBs to maintain appropriate risk-based procedures to conduct ongoing customer due diligence also consistent with FinCEN’s requirements. NFA’s new requirements should be effective this week absent objection by the Commodity Futures Trading Commission.