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The CFTC’s Active Week: Virtual Currencies in Focus

This past week has been an especially active one for the U.S. Commodity Futures Trading Commission (CFTC). On Monday, in a speech to the North American Securities Administrators Association (NASAA), CFTC Chairman Giancarlo announced a Memorandum of Understanding (MOU) to increase cooperation between state securities regulators and the CFTC — particularly with respect to prosecuting potential fraud and market abuse as it pertains to virtual currencies. The CFTC Chairman also previewed a staff advisory relating to Virtual Currency Derivative Product Listings, which was released later that same day. Wrapping up the week, the press reported that the Department of Justice, in cooperation with the CFTC, has opened a criminal investigation into whether traders are manipulating the price of Bitcoin and other virtual currencies.

The CFTC Chairman’s Speech and the NAASA MOU

The MOU’s purpose is to increase cooperation in “enforcing the Commodity Exchange Act, which state securities regulators and state attorneys general are statutorily authorized to do alongside the CFTC.” To that end, the MOU establishes “protocols and procedures, for the access, use and confidentiality of information and treatment of non-public information in the course of law enforcement.” This includes sharing investigative leads, whistleblower tips, complaints, and referrals. In order to reap the benefits of such information sharing, individual state jurisdictions will have to sign on to the MOU. The MOU formalizes a long-standing informal cooperative relationship between the CFTC and individual state securities administrators.

In his speech to NAASA, CFTC Chairman Giancarlo emphasized that information shared under the MOU could generate enforcement actions not only under federal laws but under state securities and commodities laws as well. The CFTC Chairman highlighted new technologies and emphasized the rapid pace of innovation with respect to financial technology. He asked that regulators be proactive in building a regulatory and statutory framework that is ahead of the curve — one that “prevents and punishes fraud and criminality, gives clarity and coherence to these emerging technologies, and anticipates the evolution of new instruments such as virtual currencies.” He pointed out that innovation and technology could also provide regulators with an advantage in market regulation.

The CFTC Chairman closed this portion of his remarks by highlighting his agency’s recent enforcement actions involving virtual currency and emphasized that the Commission will continue working closely with other agencies to aggressively prosecute those engaged in fraud and manipulation (in both traditional and virtual currency markets). He then went on to preview the advisory on virtual currencies saying, “front-line regulators… should be proactive, flexible and engage in heightened review of new virtual currency contracts and their oversight to ensure proper surveillance of the trading and clearing of these contracts given the risks.”

The Advisory

Shortly thereafter, the CFTC’s Division of Market Oversight and Division of Clearing and Risk issued a joint staff advisory outlining guidance exchanges and clearinghouses should adhere to when listing derivatives contracts based on virtual currencies. The CFTC staff have said the advisory reflects, “current thinking based upon our growing experience with virtual currency derivatives. As new products are brought forth, the staff will re-evaluate and revisit the advisory as necessary to address any new and emerging issues.” This indicates the agency will utilize a regulatory framework flexible enough to address the evolving landscape of virtual currencies.

The introduction to the advisory also emphasized that the guidance was not to serve as a “compliance checklist” but rather that it “clarifies the Commission staff’s priorities and expectations in its review of new virtual currency derivatives to be listed on a designated contract market (“DCM”) or swap execution facility (“SEF”), or to be cleared by a derivatives clearing organization (“DCO”).” In large part, the guidance is focused on asking entities listing virtual currency derivatives to surveil underlying spot markets and share relevant data with the Commission, such that the Commission is better equipped to target manipulation and fraud given that the Commission does not have direct oversight over virtual currency spot markets.

The advisory addresses the following five key areas for registered entities listing virtual currency derivative products:

  1. Enhanced Market Surveillance – The CFTC staff urged exchanges hosting virtual currency derivative contracts to implement “well-designed market surveillance program[s].” The Commission expects such exchanges to identify anomalies and disproportionate moves in trading through such programs and share their findings with the CFTC. In this section, as mentioned above, the Commission stressed harnessing reliable data from underlying virtual currency spot markets is essential to regulating the industry and targeting fraud and manipulation. The CFTC staff went so far as to suggest that “a heightened level of monitoring, with respect to trading activities on the spot market, is warranted.”
  2. Close Coordination with CFTC Surveillance Group – In addition to the sharing of information outlined in ‘Enhanced Market Surveillance’ the CFTC expects entities listing virtual currency derivative contracts to provide the Commission staff with data related to the settlement process that enables the CFTC to conduct its own independent surveillance. Put another way, registered entities must be equipped to provide the CFTC with data relating to the spot markets, so that the CFTC can better root out market abuse.
  3. Large Trader Reporting – Exchanges offering virtual currency derivatives products will be expected to file large trader reports for any derivative contract above five Bitcoin or its equivalent in other digital currencies. The Commission believes this will cover 70-90% of total open interest. Currently clearing members, Futures Commissions Merchants (“FCMs”) and foreign brokers file daily reports with the Commission showing futures and options positions of traders with positions above certain reporting levels. Again, the focus of these guidelines, from the perspective of the CFTC, is to identify problems in the spot markets, which without industry cooperation, the Commission would not have direct access.
  4. Outreach to Members and Market Participants – The Commission expects the exchanges to take “extra care” in engaging “meaningfully with relevant stakeholders.” The theory being an exchange’s broad outreach to market participants helps to better inform the exchange as it develops relevant terms and conditions and related rules and procedures. Before listing a new contract on virtual currency the Commission expects the exchange to solicit feedback from a wide-range of stakeholders, and include such feedback (particularly opposing views and how those views are addressed by the exchange) in any submission to the Commission. Along with guidelines above, what the Commission has laid out in this section is beyond what is strictly required by regulations.
  5. Derivatives Clearing Organization’s Risk Management – In addition to the information solicited from registered entities listing virtual currency derivatives contracts, noted above, the Commission are looking to the DCOs clearing such contracts to provide further information, particularly as it relates to initial margin. The staff notes agency expectations that initial margin requirements for virtual currencies derivatives should exceed the requirements of less volatile commodities. If staff believes the initial margin level by a DCO is not adequate, it reserves the right to have the DCO make appropriate adjustments.

Following the release of the Advisory, Democratic CFTC Commissioner Rostin Behnam released a separate statement. He said the advisory would provide greater transparency for listing new products. However, he added he would like to see the commission set parameters for determining when self-certification for new derivatives and other products might not be appropriate and consider instead the use of the formal rulemaking.

Department of Justice Investigation

On the heels of the advisory release, the press reported that the Justice Department has launched a criminal investigation into whether traders are manipulating the price of Bitcoin and other digital currencies. The investigation will be undertaken in conjunction with the CFTC and as such the two agencies will work in close concert. The investigation is reportedly focused on illegal manipulative and fraudulent practices that can influence prices — such as spoofing, another area of focus for the CFTC, which has both a dedicated Spoofing Task Force and Virtual Currency Task Force. Such an investigation certainly serves to further increase the scrutiny virtual currency markets in the U.S. face.

© 2019 Covington & Burling LLP

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About this Author

Anne M. Termine, Covington, securities litigation attorney
Of Counsel

Anne Termine is a member of the firm’s Global Futures and Derivatives Practice and leads the Derivatives Enforcement Team. She is also a member of the white collar defense and investigations practice. Ms. Termine advises clients in handling internal investigations and regulatory enforcement inquiries related to the derivatives markets and the cryptocurrency markets.

Prior to joining Covington, Ms. Termine was a Chief Trial Attorney in the U.S. Commodity Futures Trading Commission's (CFTC) Division of Enforcement, where she was responsible for investigating and...

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Stephen Humenik, regulatory and public policy lawyer, Covington
Of Counsel

Stephen M. Humenik leads the firm’s futures and derivatives practice. He has extensive experience on cross-border regulatory, compliance and enforcement matters involving the U.S. Commodity Futures Trading Commission (CFTC) and markets for derivatives and physical and financial commodities. Mr. Humenik applies his business, operational, and government experience to the implementation of CFTC regulations, including the registration, trading, clearing and other compliance obligations of the Dodd-Frank Act and other global regulatory reforms.

202-662-5803