Bridging the Week by Gary DeWaal: August 14 to 18 and August 21, 2017 (Wash Trades; Spoofing; Bank Capital; Virtual Currency Businesses)

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Published Date: August 20, 2017

A non-US-based commodity firm that allegedly tried to square up its books at month-end by placing matched buys and sells on a US futures exchange was charged with wash trading by the Commodity Futures Trading Commission. At the time – on or after first notice day in the relevant delivery month – the firm was precluded from transferring trades through book entry transfer transactions because of exchange rules. And last month an organization renowned for drafting model state laws approved a statutory framework for state regulation of persons engaged in a virtual currency business. As a result, the following matters are covered in this week’s edition of Bridging the Week:

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Compliance Weeds: On IFUS, traders may transfer positions between accounts where no change in beneficial ownership is involved and under certain other limited circumstances. However, transfer trades that offset positions in the spot month may not occur on or after the first notice day of the delivery month. Potentially offsetting long and short positions held by the same beneficial owner on or after the first notice day may only be closed out by transactions executed in the market; privately negotiated transactions such as an exchange for related position; or satisfied through the normal delivery process. However, positions may be transferred during this prohibited time period for offset if the trade date of the transferred position is the same as the transfer date. Transfers of futures, when authorized, may be done at the original market price, prior day’s settlement price or current day’s settlement price. Options may be transferred at original market premium or a premium of zero. (Click here to access IFUS Rule 4.37.) Wash trades on IFUS occur “when there is an act of entering into, or purporting to enter into, transactions with no intent to obtain a bona fide market position or activity that gives the false appearance of an executed transaction(s), but does not subject the Principal to any market risk or change in position or aid in price discovery.” On IFUS, anyone who initiates, places, accepts or accommodates a transaction that he/she “knew or should have known” would result in a wash trade potentially violates the exchange’s prohibition against wash trades. This could include brokers that accept and execute a wash trade for a customer. (Click here for back in IFUS Wash Trade FAQ – February 2016.)

Compliance Weeds: This appears to be an unusual case where a person charged under an anti-spoofing provision was alleged, on each occasion, to have placed only a single large order on the opposite side of a market from a small order. Apparently, as intimated by IFUS’s Disciplinary Notice, the order book imbalances caused by the single large and one opposite small orders were sufficient to induce execution of the small orders. Previous enforcement actions alleging spoofing typically have involved multiple layered orders on one side of the market used to cause an artificial increase or decrease in prices in order to facilitate the execution of a single smaller order on the other side. (Click here for a background on a more conventional enforcement action involving spoofing in the article “Federal Appeals Court Upholds Conviction and Sentencing of First Person Criminally Charged for Spoofing Under Dodd-Frank Prohibition” in the August 8, 2017 edition of Between Bridges.)

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In mid-July a model law for the regulation of virtual currency businesses was adopted by the National Conference of Commissioners on Uniform State Laws (ULC) for potential adoption by each of the states of the United States.

The model law – known as the Uniform Regulation of Virtual Currency Business Act (VCBA) – proposes the regulation of all persons engaged in a “virtual currency business activity” absent an exemption. Among other things, such activity includes exchanging, transferring or storing virtual currency with or on behalf of residents. Under the VCBA, virtual currency is any digital representation of value that is used as a medium of exchange, unit of account or store of value and does not constitute legal tender.

The proposed law would not apply to transactions subject to certain federal laws (e.g., the Securities Exchange Act or the Commodity Exchange Act) or to activity by certain persons. These persons include (1) banks; (2) persons engaged in money transmission and already licensed by the relevant state, authorized to engage in virtual currency business activity, and compliant with certain specifically enumerated requirements of the VCBA; (3) persons that use virtual currency solely for their own behalf, including investing and buying and selling; and (4) regulated securities or commodities intermediaries that do not engage “in the ordinary course of business” in virtual currency business activities with residents, among others.

Persons engaging in business with residents whose volume of virtual currency business exceeds US $35,000 annually must have a license issued under the VCBA. A lesser registration requirement is proposed for persons whose volume of virtual currency business with residents is US $35,000 or less annually but more than US $5,000. However, the requirements to qualify as a registrant are not significantly less than as a licensee.

Potential licensees must complete an application containing a host of specific information required about the licensee itself and each control person, as well as evidence of a minimum net worth and reserves that a state may require (but anticipated not to be less that US $25,000), and other documents. Required documents and information include, for example, (1) a description of the five-year business history of the applicant including its website addresses and social media pages; (2) a list (including address and telephone number) of each person the applicant intends to use to conduct its regulated business; and (3) a set of fingerprints for each of the registrant's executive officers and relevant managers. Before a license is granted, a licensee must post a surety bond or other security satisfactory to the state in an amount determined by the state to secure "the licensee's faithful performance of its duties" under the VCBA.

Applicants for licenses agree that the relevant state department may conduct an investigation into the applicant's financial resources and other matters, including the "competence, experience, character and general fitness" of each executive officer and relevant manager, and also consent to pay the "reasonable costs" of such investigation.

Proposed licensees and registrants must prepare and, once granted their status, maintain policies and procedures addressing information and operational security; business continuity; disaster recovery; anti-fraud; anti-money laundering; preventing funding of terrorist activity; and adherence to the VCBA and other relevant state and federal laws.

The VCBA contemplates virtual currency businesses being able to obtain a license in one state, and using that license to gain authority in other states. States are required to grant or deny licenses no later than 30 days after a filed application is complete and licenses should be renewed annually. A failure by a state to process or approve a license application within 30 days will automatically constitute a denial.

Licensees and registrants are obligated to maintain for at least five years certain transaction and other records, and may be subject to state inspections and enforcement actions. Licensees and registrants are obligated to hold sufficient virtual currency in each type (e.g., Bitcoin, Ether) to at least meet their aggregate obligations to customers in the type.

The VCBA has been approved but not yet finalized; a final model law should be issued by year-end for consideration by state legislatures.

The ULC, founded in 1892, is a not-for-profit and nonpartisan entity consisting of state-appointed lawyers that proposes legislation to bring “clarity and stability to critical areas of state statutory law.” Among other major model laws that the ULC has adopted is the Uniform Commercial Code. (Click here for background regarding the ULC.)

Legal Weeds: In June 2015, the New York State Department of Financial Services issued final regulations requiring a so-called “BitLicense” and establishing minimum standards for all financial intermediaries who engage in a virtual currency business activity from New York or to a NY resident. The regulations cover a wide spectrum of potential businesses, although they exclude merchants and consumers who use virtual currencies in connection with transactions for goods or services, persons chartered under the NY banking law and approved to engage in a virtual currency business activity, and persons who engage in the mere “development and dissemination of software in and of itself.”

Under the DFS’s BitLicense requirements all financial intermediaries engaging in a virtual currency business must apply and obtain a BitLicense, and maintain certain minimum standards and programs to help ensure customer protection, cybersecurity and anti-money laundering compliance. (Click here for details in the article “New York BitLicense Regulations Virtually Certain to Significantly Impact Transactions in Virtual Currencies” in a July 8, 2015 Advisory by Katten Muchin Rosenman LLP.)

The Financial Crimes Enforcement Network of the US Department of Treasury requires all persons that engage in a business of (1) exchanging virtual currency for real currency, funds or other virtual currency, or (2) in issuing a virtual currency who has the authority to withdraw such virtual currency from circulation to comply with its registration, reporting and recordkeeping requirements for money service businesses, unless exempted. (Click here for a summary of these requirements; click here to access a FinCEN guidance on persons administering, exchanging or using virtual currencies.)

The Commodity Futures Trading Commission exercises jurisdiction over derivatives based on virtual currencies, while the Securities and Exchange Commission recently indicated that certain digital tokens issued to raise funds for projects may be securities subject to its regulation. (Click here for background in the article “LedgerX Approved by CFTC as First Derivatives Clearing Organization for Fully Collateralized Swap Contracts Potentially Settling in Bitcoin” in the July 30, 2017 edition of Bridging the Week, and here to access the article “SEC Warns That Digital Tokens May Be Securities” in an August 3, 2017 Advisory by Katten Muchin Rosenman LLP.)

My View: The very minimal level of business activity that requires licensing under the VCBA – US $35,000 annually – seems artificially low, given the very high bar to obtain a license. Moreover, the requirements to register for conducting even a lower amount of business (as opposed to obtaining a license) are not sufficiently lighter to be meaningful. These thresholds should be reconsidered before the VCBA is seriously considered by any state. Moreover, if a complete application for a virtual currency business activity license is not processed by a state within the requisite time for review – 30 days – a license is deemed denied. This outcome hardly motivates states to process applications in a timely fashion. If anything  a failure of a regulator to process an application timely should result in a license being deemed automatically approved. Additionally, it seems too open-ended that a state is authorized to charge an applicant the "reasonable costs" of an investigation into its qualification. There should be a fixed formula or maximum fee associated with investigations as well as a cap on the maximum surety bond or other form of security that a state may require. Finally, the ULC should amend the current incorrect reference in the VCBA to the "Commodities Exchange Act of 1936," to the law's correct name, the Commodity Exchange Act of 1936. As a proud former CFTC employee, I always take it personally when I see the agency mistakenly referred to as the Commodities Futures Trading Commission or the CEA referenced as the Commodities Exchange Act!

For further information:

Banking Regulators Give Capital Break for Cleared Derivatives:

CME Group Clearing House Proposes to Eliminate Mandatory Guaranty From All Five-Percent or More Shareholders:

Federal Appeals Court Rules in Favor of FCM Seeking Return of Customer Assets From Sentinel Management Ruins:

Former Floor Broker Agrees to US $200,000 Fine to Resolve ICE Futures U.S. Spoofing Allegations:

ICE Futures U.S. Proposes to Amend Disruptive Trading Guidance to Clarify That Certain User-Defined Strategies Are Prohibited:

Investment Adviser CCO Fined and Suspended for One Year for Firm’s Alleged Misleading Registration Filing:

Model State Law Regarding Virtual Currency Businesses Virtually Finalized:

NFA Bars Former Broker From Membership for Unauthorized Trading and Transferring Winning Trades From Customers to Himself:

Non-US Commodity Firm Settles CFTC Allegations of Wash Trading for US $300,000 Fine:

SEC Agrees to Dismissal of All Charges Against Alleged Key Players in London Whale Incident:

The information in this article is for informational purposes only and is derived from sources believed to be reliable as of August 20, 2017. 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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