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Bridging the Week: October 16 – 20 and October 23, 2017 (Cryptocurrencies Primer; Pre-Open; EFRPs; Spoofing Again)

Last week, the Commodity Futures Trading Commission endeavored to explain virtual currencies as simply as possible, including their purpose, regulatory oversight and risks. In my view, they did a pretty good job. Additionally, CME Group issued two advisories – one on Globex pre-open orders and the second on exchange for related position transactions – warning of conduct that could constitute disruptive trading and eliminating a current obligation on future commission merchants. As a result, the following matters are covered in this edition of Bridging the Week:

  • CFTC Issues ABC’s on Virtual Currencies – Actually the Bitcoin, Ether and Ripple (includes Legal Weeds);

  • CME Group Proposes to Eliminate Requirement for Clearing Members to Detect Non-Bona Fide EFRPs; Cautions Traders on Orders During the Globex Pre-Open (includes Compliance Weeds);

  • COMEX and CME Sanction More Traders for Purported Spoofing (includes Compliance Weeds);

  • Affiliated Broker-Dealers Required by FINRA to Pay in Excess of US $3.4 Million in Restitution to Clients for Unsuitable Recommendations of Volatility-Linked Exchange-Traded Products (includes My View); and more.

Video Version:

Article Version:

Briefly:

  • CFTC Issues ABC’s on Virtual Currencies – Actually the Bitcoin, Ether and Ripple: Last week, the Commodity Futures Trading Commission’s LabCFTC issued a helpful overview of digital currencies, discussing what a virtual currency is and how digital currencies and distributed ledger technology might be used; the role of the CFTC in the oversight of virtual currencies; and risks of transacting in digital currencies as well as suggestions to mitigate such risks.

Among other things, the Commission noted that, under relevant law, the definition of commodity “is broad” and it has previously determined (since 2015) that virtual currencies constitute commodities. As a result, said the Commission, the CFTC’s jurisdiction is implicated when a virtual currency underlies a derivatives contract or when there is fraud or manipulation in connection with a virtual currency traded in interstate commerce.

The CFTC acknowledged that the Securities and Exchange Commission has said that certain digital tokens may be securities under federal securities laws, but observed “[t]here is “no inconsistency” between the SEC’s analysis and the CFTC’s determination that virtual currencies are commodities and that virtual tokens may be commodities or derivatives contracts depending on the facts and circumstances.”

The CFTC noted that one of the purported advantages of the distributed ledger – that it is immutable – may not be true, and that persons transacting in virtual currencies could lose their assets should the digital wallet holding their private key (i.e., the private digital code used to access owned cryptocurrency) be compromised by illicit access.

LabCFTC is the recently established CFTC function meant to promote “responsible financial technology innovation” and serve as the agency’s focal point for interactions with the FinTech community.

Last week, LedgerX commenced trading as a CFTC-approved swap execution facility and derivatives clearing organization transacting swap contracts referencing and settling in Bitcoin (click here for details).

Legal Weeds: For those just beginning their knowledge quest regarding virtual currencies, digital tokens and distributed ledger technology, the publication “A CFTC Primer on Virtual Currencies” published last week by the Commission is a very helpful first read. However, the primer should just be the starting point for persons endeavoring to gain knowledge

Structurally, virtual currencies are just one type of digital token; the other types are, as noted by the SEC in its DAO order, securities, and utility tokens that provide the holder access to a particular project as a user or developer with certain predefined rights. (Click here for background on the SEC’s views regarding certain digital tokens in the article “SEC Warns That Digital Tokens May Be Securities” in an August 3 Advisory by Katten Muchin Rosenman LLP.)

The nature of a digital token could also morph over time, functioning as a security at birth (e.g., to reward investors for funding a project) and a virtual currency later. A derivative based on such a digital token might be deemed to be a security future under law and potentially be subject to oversight by both the SEC and CFTC.

Likewise, it is important to recognize that the CFTC and SEC are not the only ones interested in regulating cryptocurrencies. The Financial Crimes Enforcement Network of the US Department of Treasury as well as states may impose obligations on persons who exchange or keep custody of cryptocurrencies for customers. At least one state currently has express obligations on such persons separate and distinct from regulations aimed at so-called money transmitters. (Click here to access an applicable 2013 FinCEN Guidance, and here to access the article “New York BitLicense Regulations Virtually Certain to Significantly Impact Transactions in Virtual Currencies” in a July 8, 2015 Katten Advisory.)

Moreover, a model state code has recently been finalized that may be adopted by individual states, adding more potential regulation to this area. (Click here to access the article “Model State Virtual Currency Law Finalized Finally” in the October 15, 2017 edition of Bridging the Week.) International regulators are also considering the application of their own laws in this space. (Click here to access the article “Singapore Regulator Joins Other Regulators in Warning Initial Coin Offerings May Impact Local Laws” in the October 8, 2017 edition of Bridging the Week.)

(Click here for a more detailed but basic overview of cryptocurrencies and distributed ledger technology in the chapter “Distributed Ledger Technologies” in the February 27 IOSCO Research Report on Financial Technologies (pages 47 – 64).)

  • CME Group Proposes to Eliminate Requirement for Clearing Members to Detect Non-Bona Fide EFRPs:Cautions Traders on Orders During the Globex Pre-Open: CME Group issued a new Market Regulation Advisory Notice regarding the placement of orders during the CME Globex pre-open, as well as an amendment to an existing MRAN clarifying the required time for reporting of exchange for related position transactions and the obligations of clearing members for EFRPs by their customers. Both MRANs are scheduled to be effective November 2.

Under its new MRAN, CME Group advised traders that no market on open orders may be placed on Globex. Alternatively, traders may place orders prior to the Globex open with a specific price, or by giving a broker or other party who may handle customer orders complete discretion over price and time of execution. Such an order – known as a DRT (disregard the tape) order – would give the order executor full discretion to execute all, some or none of the order.

The CME Group cautioned that persons placing orders during the Globex pre-open materially above or below the indicated opening price might be deemed to engage in a disruptive trading practice, as such order might cause “aberrant price movement” during the relevant time period.

In the amended MRAN, CME Group indicated that, absent “mitigating circumstances,” all EFRP transactions must be submitted to the exchange for reporting as soon as possible but by no later than end of the business day that the EFRP was executed. Moreover, clearing members would no longer have to apply “due diligence” to determine if a customer’s EFRP was legitimate. However, a clearing member would be expected to take “appropriate action” if it had actual or constructive knowledge that an EFRP was non-bona fide.

Compliance Weeds: Although much attention has been focused on the CFTC’s and exchanges’ prohibition against placing an order without the intent at the time of order placement for the order to be executed (e.g., “spoofing”), market participants must be equally cognizant of exchanges’ prohibition against persons entering or causing the entry of order messages with the intent to disrupt or with reckless disregard for the consequences of such messages on the orderly trading of the market. (Click here to access CME Group Rule 575.D. and here for ICE Futures U.S. Rule 4.02(l)(1)(C) and (D).) Exchanges have used these prohibitions to prosecute traders for:

  • purportedly misusing user-defined spreads (click here to access the article “CME Group Resolves Two Disciplinary Actions Alleging Market Disruption” in the October 1, 2017 edition of Bridging the Week);

  • trading in an alleged disruptive fashion at a contract’s termination (click here to access the article “Two Firms Settle With CME Group Exchanges for Not Supervising Employees Who Allegedly Engaged in Disruptive Trading Practices” in the September 10, 2017 edition of Bridging the Week); and

  • supposedly testing the liquidity of a market (click here to access the article “CME Group Exchanges Charge One Trader With Impermissibly Entering Orders To Test Gold Market Latency and Another With Failure to Timely Complete Delivery” in the June 4, 2017 edition of Bridging the Week).

CME Group has also brought a disciplinary action against a non-US brokerage entity for liquidating customers’ orders following non-payment of margin calls without considering the impact of the liquidation on market prices. (Click here to access the article “CME Group Settles Disciplinary Action Alleging That Automatic Liquidation of Under-Margined Customers’ Positions By Non-US Futures Broker Constituted Disruptive Trading” in the March 20, 2017 edition ofBetween Bridges.)

  • COMEX and CME Sanction More Traders for Purported Spoofing: Xian Qun Tang and Antonia Simoes, non-members, were adjudged by a business conduct committee of the Commodity Exchange, Inc. of engaging in spoofing-type transactions involving the placement and cancellation of layered orders on one side of the market without the intent to execute such orders. Neither person answered formal charges levied against them by Comex.

    Mr. Tang was required to pay a fine of US $50,000 and disgorge profits of over US $35,000. Ms. Simoes was required to pay a US $50,000 fine. Both respondents were also permanently barred from trading on any CME Group exchange.

    Compliance Weeds: The use of iceberg orders – where only a portion of a trader’s order is visible to the marketplace— is not by itself considered to be a disruptive market practice. However, when utilized as part of a scheme to mislead other market participants, the use of iceberg orders can be cited by a regulator to help demonstrate the intent of a market participant to mislead others in violation of applicable rules. (Click here to access CME Group Market Regulatory Advisory Notice RA1516-5, Q/A 9.)

    In 2016, ICE Futures U.S. charged another trader with a violation of its market disruption prohibitions because on multiple occasions the trader engaged in a “pattern of activity” where he would enter an iceberg order at the best bid or offer. He would then enter a large fully displayed order on the opposite side of the market that “appeared to create artificial pressure and appeared to mislead market participants into trading opposite the pre-positioned iceberg order,” alleged IFUS. IFUS claimed that the trader would then cancel his large order within seconds of his iceberg order being executed. (Click here for more details in the article “IFUS Charges Trader With Possible Spoofing and Market Disruption While Another Entity Is Charged With Allegedly Liquidating Positions in a Disorderly Fashion to Avoid Speculative Limits Issues” in the March 13, 2016 edition of Bridging the Week.)

  • Affiliated Broker-Dealers Required by FINRA to Pay in Excess of US $3.4 Million in Restitution to Clients for Unsuitable Recommendations of Volatility Linked- Exchange-Traded Products: Two affiliated Wells Fargo broker-dealers agreed to pay customers in excess of US $3.4 million to resolve charges that, from July 1, 2010, through May 1, 2012, they sold to customers volatility-linked exchange-traded products that were unsuitable for such customers. The Wells Fargo BDs agreed to make such payment to resolve a disciplinary action brought by the Financial Industry Regulatory Authority that claimed the firms regularly made recommendations to purchase such ETPs to unsuitable customers. In part, claimed FINRA, this was because relevant Wells Fargo salespersons believed such products could be used by customers as a hedge on their equity portfolio in case of a market downturn, when, in fact, volatility-linked ETPs are mostly a short-term trading product that deteriorates in value over time.

In 2009, said FINRA, the Wells Fargo BDs placed restrictions on which retail customers could purchase non-traditional ETPs; however, they did not extend the restrictions to volatility-linked ETPs until May 2012. FINRA said no fine was warranted in this disciplinary action because (1) prior to detection by FINRA in 2012, the Wells Fargo BDs detected and corrected their purported “supervisory deficiencies” related to volatility-linked ETPs; (2) the firms were previously fined US $2.1 million in May 2012 for similar violations in connection with non-traditional ETPs; and (3) the firms substantially assisted FINRA in determining the amount of restitution that should be paid to customers.

Simultaneously with publication of the disciplinary action against the Wells Fargo BDs, FINRA published a reminder to members of sales practice obligations for volatility-linked ETPs (click here to access).

My View: It is refreshing to see a regulator identify a potential rule infraction by a regulated entity and not automatically fine the entity because the regulator recognized that the entity had proactively identified and remedied the problem and cooperated with the regulator. The Commodity Futures Trading Commission recently announced a new program where it would give substantial penalty discount to a person if it promptly self-reported a rule violation; fully cooperated with the CFTC’s investigation of the issue; and remediated the problem. (Click here for details in the article “New Math: Come Forward + Come Clean + Remediate = Substantial Settlement Benefits Says CFTC Enforcement Chief” in the October 1, 2017 edition of Bridging the Week.) 

More briefly:

  • Clearinghouses Strong Concludes CFTC After Stress Tests: The Commodity Futures Trading Commission determined that the Chicago Mercantile Exchange, ICE Clear US Inc. and LCH Ltd were all able to generate sufficient liquidity to fulfill their settlement obligations on time during a test of their settlement liquidity in the case of a failure of the same two systematically important clearing members at each clearinghouse. This test, as of August 16, was the second systemic stress test of clearinghouses by the CFTC; the first was conducted in 2016. (Click here for background in the article “Five Regulated Clearinghouses Pass CFTC-Administered Stress Tests” in the November 20, 2016 edition of Bridging the Week.)

  • ISDA Takes First Steps to Establish Foundation for Future Use of Distributed Ledger Technology and Smart Contracts: The International Swaps and Derivatives Association released a conceptual model of the required elements of trade events and actions in order ultimately to provide a “standard blueprint” regarding how derivatives are traded and managed through their lifecycle. This model once finalized is anticipated to enable more effective use of distributed ledger technology and smart contracts in trade processing, said ISDA. ISDA indicated that its next step is to issue a request for quote to create a digital version of its so-called “common domain model.”

  • Canadian Regulators Find More Than Half of Registrants Experienced Security Incident in 2016: The Canadian Securities Administrators reported that over half of registered firms experienced a cybersecurity incident during 2016. Phishing accounted for the largest quantity of events, followed by malware incidents and fraudulent efforts to transfer funds or securities through email. CSA suggested helpful components of policies and procedures to address cybersecurity risks, including components of an incident response plan, training, due diligence over third parties and insurance.

  • NFA Will Raise Fees: The Executive Committee of the National Futures Association voted to increase NFA’s assessment charge 100 percent from $.01 to $.02 per side effective January 1, 2018. NFA reduced its fee to its current rate in October 2014. NFA says its increase is necessary to fund its operations “without compromising the quality of its regulatory program” and to ensure adequate reserves.

For further information:

Affiliated Broker-Dealers Required by FINRA to Pay in Excess of US $3.4 Million in Restitution to Clients for Unsuitable Recommendations of Volatility Linked- Exchange-Traded Products:
http://www.finra.org/sites/default/files/WF_AWC_101617.pdf

Canadian Regulators Find More Than Half of Registrants Experienced Security Incident in 2016:
https://lautorite.qc.ca/fileadmin/lautorite/reglementation/valeurs-mobilieres/0-avis-acvm-staff/2017/2017oct19-33-321-avis-acvm-en.pdf

CFTC Issues ABC’s on Virtual Currencies – Actually the Bitcoin, Ether and Ripple:
http://www.cftc.gov/idc/groups/public/documents/file/labcftc_primercurrencies100417.pdf

Clearinghouses Strong Concludes CFTC After Stress Tests:
http://www.cftc.gov/idc/groups/public/@newsroom/documents/file/dcr_ecl1017.pdf

CME Group Proposes to Eliminate Requirement for Clearing Members to Detect Non-Bona Fide EFRPs; Cautions Traders on Orders During the Globex Pre-Open:

COMEX and CME Sanction More Traders for Purported Spoofing:

ISDA Takes First Steps to Establish Foundation for Future Use of Distributed Ledger Technology and Smart Contracts:
http://isda.derivativiews.org/2017/10/17/a-first-step-towards-the-future/
http://www2.isda.org/news/isda-publishes-common-domain-model-concept-paper-as-first-step-to-realize-potential-of-new-technologies
http://assets.isda.org/media/edbc86cb/abd4def0-pdf/

NFA Will Raise Fees:
https://www.nfa.futures.org/news/newsNotice.asp?ArticleID=4950

©2019 Katten Muchin Rosenman LLP

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About this Author

Gary DeWaal, Securities Attorney, Katten Law Firm, New York
Special Counsel

Gary DeWaal focuses his practice on financial services regulatory matters. He counsels clients on the application of evolving regulatory requirements to existing businesses and structuring more effective compliance programs, as well as assists in defending and resolving regulatory disciplinary actions and enforcement matters. Gary also advises buy-side and sell-side clients, as well as trading facilities and clearing houses, on the developing laws and regulations related to cryptocurrencies and digital tokens.

Previously, Gary was a senior...

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