Bridging the Week by Gary DeWaal: September 14 to 18 and 21, 2015 (Virtual Currencies; Large Trader Reports; Leverage Ratio; Penson; Double Jeopardy; LME Position Limits)

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Published Date: September 20, 2015

Last week was a week of many firsts in the financial services industry worldwide. For the first time, the Commodity Futures Trading Commission formally indicated that virtual currencies were commodities and thus swaps based on Bitcoin must be traded on a swap execution facility or a designated contract market. In addition, the CFTC brought its first enforcement action against a swap dealer for failing to file, as required by regulation, accurate large trader reports for certain swap positions involving physical commodities. Finally, the London Metal Exchange proposed position limits for the first time too. As a result, the following matters are covered in this week’s edition of Bridging the Week:

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CFTC Says Virtual Currencies Are a “Commodity” Under Federal Law, Files Charges Against Coinflip for Operating an Unregistered Bitcoin Options Trading Platform

The Commodity Futures Trading Commission filed and simultaneously settled charges against Coinflip, Inc. and Francisco Riordan, its founder and chief executive officer, for operating a trading facility for Bitcoin options – Derivabit – without it being registered as a swap execution facility or a designated contract market.

According to the CFTC, because Bitcoin and other virtual currencies are “properly” defined as “commodities” under applicable law, all trading facilities for commodity options on Bitcoin must be registered with it as a SEF or a DCM, said the CFTC.

Since from at least March 2014 through July 2014, Coinflip operated Derivabit as a trading facility for Bitcoin options without proper registration, it violated applicable law, claimed the CFTC. Additionally, said the Commission, Mr. Riordan was liable for Coinflip’s violation as its so-called “controlling person.”

To resolve the CFTC’s charges, Coinflip and Mr. Riordan agreed to cease and desist from violating applicable law. No financial penalty was included in the settlement.

Although Timothy Massad, Chairman of the CFTC, previously implied that virtual currencies are “commodities” under applicable law and within the remit of the CFTC, this enforcement action marked the first unequivocal statement of the Commission’s view. (Click here for Mr. Massad’s December 10, 2014 testimony before the U.S. Senate Committee on Agriculture, Nutrition and Forestry, including his statements on the CFTC’s jurisdiction over virtual currencies.)

Two weeks ago, LedgerX LLC received temporary registration as a SEF by the CFTC in order to list and clear fully collateralized, physically settled options on Bitcoin. The firm’s application as a derivatives clearing organization is still pending.

Legal Weeds: Although in its Coinflip order the CFTC simply proclaimed that Bitcoin and other virtual currencies are “commodities” under applicable law, its legal conclusion appears correct. Under applicable law, commodities are broadly defined as any goods, articles, services, rights and interests “in which contracts for future delivery are presently or in the future dealt in” with two exceptions: onions and motion picture box office receipts, or any "index, measure, value or data related to such receipts.” Moreover, with limited exceptions (most notably, involving securities), the CFTC has exclusive jurisdiction under applicable law with respect to all trading of commodities of the nature of options, futures and swaps, including over most market participants. Inevitably, at some point, there likely will be a challenge to the New York State Department of Financial Service’s effort to regulate certain virtual currency transactions and intermediaries through imposition of its so-called “BitLicense” and other requirements to the extent such obligations impact activities and persons under the exclusive jurisdiction of the CFTC. Stay tuned! (Click here for to review the relevant provision of law related to the definition of a commodity and here for the scope of the CFTC’s exclusive jurisdiction. Click here for background on the NYS Department of Financial Services’ “BitLicense” requirements in the article “NYDFS Issues BitLicense Framework for Regulating Virtual Currency Firms” in the June 7, 2015 edition of Bridging the Week.)


Compliance Weeds: The CFTC maintains an extensive large trader reporting program that must be strictly complied with by reporting entities. For futures and related options, large trader data must be provided to the Commission by futures commission merchants and foreign brokers. Generally, if at the end of a day a reporting firm has a customer with a position at or exceeding the Commission’s reporting level in any single futures or options expiration month, the firm must report all of the customer’s positions in futures and options in that commodity no matter the size positions in the other months. (Click here for current CFTC reporting levels for futures.) Similarly, clearing members and swap dealers are required to file daily with the CFTC large trader reports for physical commodity swaps and swaptions when their positions exceed the equivalent of 50 related futures contracts (such swaps and swaptions must relate to certain covered agricultural and exempt futures contracts; click here to access a list of relevant covered contracts). The report must include certain required information in a format mandated by the Commission – including converting swap positions to futures contracts equivalent levels. (Click here to access the helpful CFTC publication “Large Trader Reporting for Physical Commodity Swaps: Division of Market Oversight Guidebook for Part 20 Reports” published June 22, 2015.)

My View: Most importantly, in his speech, Mr. Hoenig acknowledged that banks can reduce some of the deleterious impact of the leverage ratio caused by their affiliated futures commission merchants if their FCMs agree to forego earning investment income on customer cash deposits. This can be accomplished through amendments to customer agreements (he does not contemplate any amendments to law or rules). According to Mr. Hoenig, “[i]f the resulting contract ensures the FCM truly is acting merely as an agent, it need not record an asset.” Moreover, Mr. Hoenig suggested that the FCM could even retain the economic impact of the investment income by having the client retain “…the income on the invested funds and then [paying] a fee to the clearing member.” Although this appears to be a practical fix to at least some of the tsuris caused by application of the leverage ratio to FCMs’ clearing business, it is premised on a fallacy. According to Mr. Hoenig, “[a]s substantial as derivatives risks were [during the 2008 financial crisis] to the broader economy, they remain no less substantial, opaque, and interconnected today. If anything the case for more capital is greater today.” It is not clear why Mr. Hoenig claimed that transparency is still an issue for all derivatives when, in the United States, as recently as the second quarter of 2015, almost 75 percent of all average daily notional volume of interest rate derivatives and CDS index markets were centrally cleared and information on all cleared and non-cleared swaps are now mandated to be reported.

My ViewIt would not be surprising if some question the appropriateness of the Commodity Futures Trading Commission bringing this me-too enforcement action against Mr. McMahon, given the CFTC’s limited resources and the fact that the CME Group has previously prosecuted and sanctioned Mr. Mahon for apparently the identical conduct – and more of it! However, given the egregiousness of the alleged violations, it is not surprising that the CFTC would seek a broader trading ban – beyond just CME Group markets – for Mr. McMahon. Although the commencement of a CFTC enforcement action on the heels of a virtually identical exchange action most likely does not violate the double jeopardy prohibition of the US constitution (because it does not subject a person twice in jeopardy for “life or limb” for the same offense; click here to review the Fifth Amendment to the US Constitution), it reasonably strikes many as fundamentally unfair and a questionable allocation of scarce CFTC resources. The CFTC should rarely and only in the most egregious circumstances exercise its authority to bring “me too” cases and make clear, when it does, why it is doing so.  

And more briefly:

For more information, see:

Australian-Based Swap Dealer Sanctioned by CFTC in First Case for Violations of Large Trader Reporting Requirements for Physical Commodity Swap Positions:

Canadian Citizen Pleads Guilty to US Criminal Charges Related to Securities Layering and Spoofing:

CFTC Agricultural Advisory Committee to Meet September 22:

CFTC Says Virtual Currencies Are a “Commodity” Under Federal Law, Files Charges Against Coinflip for Operating an Unregistered Bitcoin Options Trading Platform:

CFTC Proposes to Amend Definition of “Material Terms” to Reduce Reconciliation Obligations of Swap Counterparties:

CFTC Staff Issues Interpretations for DCOs:

Company and CEO Agree to Pay SEC US $30 Million to Resolve Allegations They Traded on Hacked Non-Public News:

FDIC Vice Chairman Thomas Hoenig Defends Application of Leverage Ratio to Cleared Derivatives, Offers Avenue of Partial Relief:

Federal Court Maintains Prohibition Against SEC Prosecuting Barbara Duka in In-House Tribunal:

See also, Stay of Lynn Tilton action:

FINRA Identifies Best Practices for Liquidity Risk Management and Issues Guidance:

IOSCO Proposes Measures to Support Cross-Border Regulation:

LME Proposes Position Limit Regime:

One CFTC Commissioner Challenges Commission’s Position Limits and Aggregation Proposal, Another Recommends Ground Rules for Algorithmic Traders:

Speech of Sharon Bowen:
Speech of J. Christopher Giancarlo:

SEC Discloses Elements of Cybersecurity Exams:

SEC Penalizes Four Individuals for Defunct Clearing Firm’s Improper Margin Loans, Sues One Customer:

Hall Complaint:
Settlement Order:

Trader Fined US $171,000 by CFTC for Deceptive Trade Allocation Scheme Utilizing Block Trades; CME Group Previously Alleged Similar Wrongdoing:

The information in this article is for informational purposes only and is derived from sources believed to be reliable as of September 19, 2015. 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.


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Gary DeWaal

Gary DeWaal is currently Special Counsel with Katten Muchin Rosenman LLP in its New York office focusing on financial services regulatory matters. He provides advisory services and assists with investigations and litigation.

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