Bridging the Week by Gary DeWaal


Bridging the Week by Gary DeWaal: December 10 - 14 and December 17, 2018 (Bitcoin; Ether; Blue Sheets; CPO Internal Controls; Disruptive Trading)

AML and Bribery    Bitcoin Ecosystem    Blue Sheets    Bridging the Week    Cleared Swaps    Compliance Weeds    Cryptosecurities    Culture and Ethics    Exchanges and Clearing Houses    Investment Advisers    Legal Weeds    Managed Money    My View    Position Limits    Sales Practices    Supervision    Systems and Controls    Trade Practices (including Disruptive Trading)   
Published Date: December 16, 2018

The Commodity Futures Trading Commission issued a request for input regarding the virtual currency ether. It wants to understand better how bitcoin and ether are different, and any unique qualities of ether (ETH), as it potentially considers permitting regulated markets to list futures or other derivatives based on ETH. Separately, the Securities and Exchange Commission fined three broker-dealers in aggregate over US $6 million for not providing accurate trading information as requested through electronic blue sheets. In two circumstances, 100 percent of all EBS requests during the relevant time periods were purportedly responded to with inaccurate information. As a result, the following matters are covered in this week’s edition of Bridging the Week:

This is the final regular edition of Bridging the Week for 2018. Bridging the Week will resume its regular Monday publication schedule on January 7, 2019.

Video Version:

Article Version

Briefly:

In its RFI, the CFTC seeks responses to 25 specific questions, including what are key use cases that demonstrate the functionalities and capabilities of the Ethereum network; does a proof of stake (POS) block validation system have a greater potential to be manipulated than a proof of work (POW) system; how does the governance of the bitcoin and Ethereum blockchains differ; and are there best practices for the creation and security of Ethereum wallets? However, the CFTC will accept any relevant comments even if not addressed by specific questions.

Comments must be provided to the CFTC by 60 days after publication of its RFI in the Federal Register.

Ether is another virtual currency like bitcoin, and for the past year has typically been among the top three cryptocurrencies on the basis of market capitalization. ETH is the currency (often referred to as ”fuel”) of the Ethereum blockchain network where it can be used to pay for computations or transaction fees. Ethereum was developed by Vitalik Buterin and two colleagues and first formally described in a white paper in 2013. (Click here to access the Ethereum white paper as currently posted (including recent edits) on GitHub.)

The first ether block was created in July 2015 after a public pre-sale of approximately 60 million ether beginning in July 2014. At the time of the pre-sale, approximately six million additional ether were created and used to compensate early contributors and pay for Ethereum development expenses prior to the genesis block, and an additional six million ether were created and held in reserve by the Ethereum Foundation. Today, like bitcoin, Ethereum blocks are created through a POW mining function where persons solve a mathematical problem for a reward of ether digital coins. However, the frequency of block creation is much greater on Ethereum than on the bitcoin blockchain, and the reward mechanism for miners solving mathematical problems for ether is different from bitcoin. 

Ultimately, Ethereum is intended to switch from a POW validation system to a POS consensus system called Casper where persons’ right to create blocks are anticipated to be based on their commitment to risk their own ether to validate a new block and a pseudo-random process to choose the block validator from among potential validators. The timing of Ethereum’s migration from a POW to POS validation system is still pending, but the change may occur as soon as 2019. 

Unlike bitcoin whose supply is capped at 21 million, there is no upward cap on the amount of ether although its issuance is currently limited to 18 million/year, and this amount is expected to decline after the Ethereum network implements a POS validation system.(Click here for a very good comparison of bitcoin and ether in the article “Comparing Bitcoin and Ethereum” by Lotte Fekkes (Radboud University, Bachelor Thesis, January 2018); click here for specific questions and answers regarding ether published by the Ethereum Foundation.)

Despite being a virtual currency, ether was principally purposed to serve as payment for transactions on the Ethereum blockchain, including those implemented by so-called smart contracts that would drive decentralized applications developed by programmers. Generally, a smart contract references self-executing software code often associated with a blockchain that automatically causes actions to occur between parties based on preprogrammed conditions being met without the involvement of a central authority. (Click here for background on smart contracts in the article “LabCFTC Tries to Smarten Public Regarding Smart Contracts” in the December 2, 2018 edition of Bridging the Week.)

In other legal developments regarding cryptoassets:

In February 2018, the Swiss Financial Market Supervisory Authority (FINMA) endeavored to provide some clarity of its own oversight of different types of digital tokens – which it named "payment tokens," "utility tokens" and "asset tokens." FINMA claimed that it was not the issuance of a token through an initial coin offering that made it a security; rather, it was the nature of the token that was issued.​ (Click here for details in My View to the article, "SEC Sues Bitcoin-Denominated Trading Platform for Operating an Unlicensed Securities Exchange; Principal Criminally Charged" in the February 25, 2018 edition of Bridging the Week.)

Legal Weeds/My View: Earlier this year, William Hinman, the Director of the Division of Corporation Finance of the Securities and Exchange Commission, said that the virtual currency ether is not a security. It may have once been a security, but not today. As a result, transactions involving ether are not securities transactions. 

Moreover, Mr. Hinman indicated that he could envision that certain utility tokens might also not be securities. He said that such a conclusion might be appropriate “where there is no longer any central enterprise being invested in or where the digital asset is sold only to be used to purchase a good or service available through the network on which it was created.”

In evaluating whether a digital token is likely a security, Mr. Hinman set forth 13 considerations, including:

Unfortunately, Mr. Hinman’s comments were solely his personal views, and did not reflect the official views of the SEC. It would be helpful if the SEC, like the CFTC has done in connection with its ether RFI, were to engage formally with the public to divine a bright line between security and utility tokens. 

The CFTC is commended for issuing its RFI on ether. Hopefully the CFTC can use input from its public solicitation to help develop a standard template that could be used by prospective developers of new futures or derivatives contracts based on virtual currencies to expedite approvals or self-certifications of such contracts on cryptocurrencies other than bitcoin and ether. Also, let's hope the CFTC won’t hold-up proposed contracts based on ether currently in process while it waits for and evaluates responses to its RFI.

(Click here for further background on ether and the Ethereum blockchain, as well as Mr. Hinman’s position on security and utility digital tokens, in the article “Anything but Sleep Inducing: SEC Corporate Finance Director Says Ether Not a Security and Canada Issues Guidance on Utility Tokens” in the June 17, 2018 edition of Bridging the Week.)

According to the SEC, both Citadel – from November 2012 through August 2016 – and Natixis – from December 2012 through February 2017 – included incorrect trade execution time on 100 percent of their EBS submissions. Because of coding errors, both firms converted execution times to Greenwich Mean Time as opposed to Eastern Time. For Citadel, these errors were included in 2,774 responses to EBS requests filed with the Commission involving 80 million trades, while for Natixis, these mistakes were in 1,237 responses involving almost 150,000 trades.

Many of Citadel’s and Natixis’s EBS responses also reflected other errors too, said the SEC.

From May 22, 2015, through March 30, 2018, said the SEC, MUSA had errors on almost all its 860 EBS submissions; erroneous information was included for 677,613 out of 687,176 transactions. In its submissions, MUSA made errors regarding order execution times, exchange codes, transaction type identifiers, opposing broker number and contra-party identifiers. The SEC claimed that MUSA also failed to include 2,151 securities transactions in its filings.

Generally, the SEC alleged that each of the broker-dealers failed to have adequate pre-submission controls to validate that information in their EBS submissions was accurate.

Each of the companies voluntarily settled its SEC action. In resolving these matters, the SEC noted respondents' remedial efforts, including retention of outside consultants and implementation of enhanced controls.

Compliance Weeds: Just a few months ago, the SEC fined Convergex Execution Solutions, LLC (now known as Cowen Execution Services, LLC), a registered broker-dealer, US $2.75 million for submitting to it data that was incomplete or deficient in response to a high number of electronic blue sheet requests. (Click here for details in the article “Feeling Blue (Sheets): Broker-Dealer Resolves SEC Enforcement Action for Faulty Electronic Regulatory Submissions for US $2.75 Million Fine” in the September 16, 2018 edition of Bridging the Week.

In July 2016, Citigroup Global Markets Inc. agreed to pay a US $7 million fine to the Securities and Exchange Commission to resolve charges that, from 1999 through 2014, it submitted 2,382 erroneous blue sheets with it and 753 erroneous blue sheets with the Financial Industry Regulatory Authority. According to the SEC, these errors occurred as a result of a coding error in Citigroup’s electronic blue sheet computer system that was not detected until 2014.

Earlier in 2016, Deutsche Bank Securities Inc. agreed to pay a fine of US $6 million to resolve charges brought by FINRA that it filed “thousands” of deficient blue sheets with it and the SEC from 2008 through 2015. 

Under an SEC rule, broker-dealers must submit to the SEC upon request true and complete copies of trading records they are required by law to make and keep. Another SEC rule requires broker-dealers to submit such securities transactions records to the SEC electronically upon request. (Click here to access SEC Rule 17a-4(j) and here for SEC Rule 17a-25. Click here to access Securities Exchange Act § 17(a)(1), 15 U.S.C. § 78q(a)(1).)

Relevant entities that may be required to file electronic blue sheets with regulators should periodically review submissions against source information to ensure their systems are properly capturing and processing such data correctly. In each of the Citadel, MUSA and Natixis orders, the SEC expressly cited the companies for not having adequate pre-submission controls to validate that their EBS submissions were complete (e.g., in the case of Natixis, to implement sufficient “periodic sampling or manual validation” of EBS data prior to submission).

(Click here for additional background in the article “Computer Coding Error Results in Broker-Dealer Blue Sheets’ Errors Over 15 Years and US $7 Million SEC Fine” in the July 17, 2016 edition of Bridging the Week.)

More Briefly:

Although NFA recognizes that what constitutes an “adequate internal control system” may vary from CPO to CPO based on its size and complexity of operations, NFA will require all CPOs to formally implement an internal control system designed to prevent fraudulent actions by employees, management and third parties; to help secure the integrity of customer funds; and to “provide reasonable assurance” that financial reports are accurate and that a CPO complies with applicable Commodity Futures Trading Commission and NFA requirements. CPOs should also have an escalation policy for employees to report violations of their internal control systems to management, and “whether and when a matter should be reported to [a] firm’s regulator.” A CPO’s internal control system should be documented in writing.

Under the proposed NFA guidance, CPOs must conduct a periodic risk assessment to determine where their most “critical” risks arise and design controls to address those risks. Critically, persons involved with handling pool funds, trade execution activities, financial records and risk management should be different from persons who supervise such activities. The NFA recommends that all CPOs' internal control procedures should address pool subscriptions, redemptions and transfers; risk management and investment; the valuation of pool funds; and the use of administrators. 

According to the NFA, "[t]he effective date associated with this rule submission has not been determined. NFA generally establishes the appropriate effective date after it has received the CFTC’s approval and develops a member education program, if necessary."

Separately, NFA also proposed rule changes to incorporate references to swaps, counterparties and related parties , as appropriate, in relevant rules, and to make clear that certain of its rules apply to all commodity interests, while some to only specific membership classes.

Note: this article was modified on December 18 regarding the effective date.

  • BIS Economists Argue that CCP - Bank Interactions May Lead to Destabilizing Feedback Loop Under Certain Stress Scenarios: Three economists from the Bank of International Settlements argued in a paper published on December 16 that interdependencies between central counterparty clearing houses and large bank clearing members related to the clearing of over-the-counter derivatives could lead to a "destabilizing feedback loop" under certain stress scenarios, amplifying stress. This situation could arise, said the authors, because of balance sheet interlinkages and the structure of default fund waterfalls where OTC derivatives clearing is "highly concentrated" among banks and CCPs. Accordingly, recommended the authors, the risks of banks and CCPs should be considered together and not separately in connection with stress tests. The three authors of the report are Umar Faruqui, Wenqian Huang and Elod Takats.

Separately, Krishna Mohan agreed to pay a fine of US $10,000 and be barred from trading on any CME Group exchange for three years for engaging in spoofing-type trading activities from November through December 2013. Mr. Mohan was also accused of not fully answering certain questions during an exchange interview. Last month, Mr. Mohan pleaded guilty in a federal court in Texas to manipulating commodities futures trading on the CME and the CBOT for over two years by placing orders with no intent of execution. (Click here for background in the article “Three Traders Plead Guilty to Spoofing Violations” in the November 11, 2018 edition of Bridging the Week.)

Finally, Ziemba Capital Management LLC agreed to pay a fine of US $40,000 for violating CME spot month position limits in Lean Hogs futures contracts. CME found that on various times from the close of business on December 7, 2017, through December 12, 2017, accounts owned or controlled by the principals of ZCM violated the 950 spot-month limit when their positions were aggregated.

For further information

Authority of Broker-Dealers to Rely on Investment Advisers for Their Own CIP Obligations Extended by SEC:
https://www.sec.gov/divisions/marketreg/mr-noaction/2018/sifma-120718-17a8.pdf

BIS Economists Argue that CCP - Bank Interactions May Lead to Destabilizing Feedback Loop Under Certain Stress Scenarios:
https://www.bis.org/publ/qtrpdf/r_qt1812h.pdf

CFTC Seeks to Fuel Up Its Knowledge of Ether:
https://www.cftc.gov/sites/default/files/2018-12/federalregister121118.pdf

CME Group Exchanges Fine Non-Members for Disruptive Trading That Does Not Involve Layering:

FINRA Highlights Top Examination Findings for 2018:
http://www.finra.org/industry/2018-report-exam-findings

NFA Proposes Internal Controls Framework for CPOs to Enhance Supervision:

New Jersey Federal Court Finds ICO-Issued Cryptoasset a Security for Motion to Dismiss:
/ckfinder/userfiles/files/Solis%20v_%20Latium%20MtD.pdf

SEC OCIE Reminds IAs of Obligations Regarding Electronic Messaging:
https://www.sec.gov/files/OCIE%20Risk%20Alert%20-%20Electronic%20Messaging.pdf

SEC Settles with Non-Registered Fund Investing in Digital Assets:
https://www.sec.gov/litigation/admin/2018/33-10582.pdf

Switzerland Says Although Its Laws Can Accommodate Blockchain Technologies, Some Adjustments Would Help:
https://www.newsd.admin.ch/newsd/message/attachments/55110.pdf

Two Former Executives of Claimed First-in-Kind Decentralized Bank Settle SEC Charges for Fraudulent ICO:
https://www.sec.gov/litigation/complaints/2018/finaljudgment-pr2018-280.pdf

Undetected Coding Errors Lead to More Than US $6 Million in SEC Fines for Three Broker-Dealers for Blue Sheet Reporting Violations:

The information in this article is for informational purposes only and is derived from sources believed to be reliable as of December 15, 2018. No representation or warranty is made regarding the accuracy of any statement or information in this article. Also, the information in this article is not intended as a substitute for legal counsel, and is not intended to create, and receipt of it does not constitute, a lawyer-client relationship. The impact of the law for any particular situation depends on a variety of factors; therefore, readers of this article should not act upon any information in the article without seeking professional legal counsel. Katten Muchin Rosenman LLP may represent one or more entities mentioned in this article. Quotations attributable to speeches are from published remarks and may not reflect statements actually made. Views of the author may not necessarily reflect views of Katten Muchin or any of its partners or other employees.


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