Bridging the Week by Gary DeWaal: March 12 to 16 and 19, 2018 (Swaps De Minimis Level; SLR; SEFs; Insider Trading; ICOs)

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Published Date: March 18, 2018

J. Christopher Giancarlo, Chairman of the Commodity Futures Trading Commission, laid out his priorities for the remainder of 2018 in a speech before the FIA at its annual conference last week. Unrelatedly, the Securities and Exchange Commission filed suit against the former chief information officer of a division of a major company that was hacked and sustained a substantial data breach last year for trading on knowledge of the breach prior to public disclosure of the incident. He was also criminally indicted for his actions. As a result, the following matters are covered in this week’s edition of Bridging the Week:

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Separately, in their own speeches in Florida last week, CFTC Commissioners Rostin Behnam and Brian Quintenz each criticized the potential extension of the supervisory authority of the European Securities and Markets Authority over both EU and third-country clearinghouses, including the Chicago Mercantile Exchange and ICE Clear US. (Click here for background in the article “EC Proposes Two-Tier System for Classifying Third-Country CCPs; Certain Systemically Important CCPs May Be Required to Relocate to the EU” in the June 18, 2017 edition of Bridging the Week.) Mr. Behnam indicated that any change to the existing EU-CFTC practice of recognizing host regulator equivalence oversight “is unacceptable.” Mr. Quintenz said that the CFTC should retaliate against the European Union should it adopt the proposal, including beginning now by not granting requests for no-action relief by European national market regulators from various CFTC rules and orders.

In his presentation, Mr. Giancarlo also indicated that while he is committed to “moving forward” on a final position limits rule, he would not finalize rulemaking until it could be done “properly” by a full Commission of five commissioners. There are currently only three CFTC commissioners. The CFTC last proposed amendments to its position limits regime in May 2016. (Click here for background in the article “CFTC Proposes to Authorize Exchanges to Grant Physical Commodity Users Non-Enumerated Hedging Exemptions and Other Relief Related to Speculative Position Limits” in the May 27, 2016 version of Bridging the Week.)

Mr. Giancarlo – who voted against the last proposed iteration of Regulation Automated Trading – also indicated that he was “open” to considering whether there are parts of Reg AT that might serve as the foundation for a “new and truly effective rule.” However, he said that the goal “must be an effective rule, not just any rule,” and suggested no timeline for rolling out a new version of Reg AT. The CFTC last proposed a version of Reg AT in November 2016. (Click here for background in the article “Proposed Regulation AT Amended by CFTC; Attempts to Reduce Universe of Most Affected to No More Than 120 Persons” in the November 6, 2016 edition of Bridging the Week.)

The CFTC issued an order in October 2017 extending until December 29, 2019, the aggregate gross notional amount level of swaps activity an entity must exceed during the prior 12 months to require registration as a swap dealer to US $8 billion (click here to access the relevant CFTC order). Absent the order, the threshold would have decreased to US $3 billion. In his speech before the FIA, Mr. Giancarlo indicated that staff has now presented the CFTC commissioners with swap dealing data and analysis that he hoped would enable them to “reach a consensus” on an appropriate de minimis level prior to year-end.

In 2015, before he was nominated as CFTC chairman, Mr. Giancarlo issued a white paper that severely criticized the Commission’s swaps trading rules and proposed an alternative framework that he claimed more accurately reflected congressional intent. He recommended that, instead of continuing with overly proscriptive regulations governing SEF trading, the CFTC should encourage flexibility consistent with the congressional mandate. Before the FIA, Mr. Giancarlo indicated that he would present to the Commission for its consideration by year-end a rule proposal more aligned with congressional intent that would better permit US swap intermediaries to “fairly compete” globally.

The supplemental leverage ratio requires large US banks to set aside 5 percent of their assets as a guard against losses. Currently, these assets include cash posted as margin by customers for their swaps and other derivatives trading activity through the banks’ future commission merchant subsidiaries. Mr. Giancarlo has frequently voiced his opposition to this treatment and noted that the US Department of Treasury recently expressed its concerns about this policy too. Last week, Mr. Giancarlo indicated that “[w]e will work hard” with other regulators to address this treatment which he said “is not reflective of a clearing member’s true exposure to swaps.” (Click here for an example of Mr. Giancarlo’s stated views in the article “Acting CFTC Chairman Giancarlo Gives Rehearsal Speech to ISDA Prior to Senate Committee Confirmation Hearing” in the May 14, 2017 edition of Bridging the Week. Click here for background on Treasury’s views in the article “US Department of Treasury Recommends Modifications to Volcker and Bank Capital Rules, and Rationalization of Financial Regulation” in the June 18, 2017 edition of Bridging the Week.)

My View: Mr. Giancarlo’s priorities for the CFTC parallel recommendations of the Department of Treasury for the CFTC issued in two reports last year. (Click here for background in the article “Treasury Calls for Better Coordination to Improve SEC and CFTC Efficiencies; Recommends Review of SROs to Minimize Conflicts and Increase Transparency” in the October 8, 2017 edition of Bridging the Week.) It would be helpful for the CFTC to itemize in one location all the recommendations by Treasury as well as those identified as part of its Project KISS initiative, and give its views regarding which recommendations it is likely to pursue and by when. If nothing more, this will help remove some uncertainty regarding possible future developments and permit market participants to plan future operations more reliably. (For background on Project KISS, click here to access “Derivatives Industry Wishes Upon a CFTC KISS Star and Hopes Dreams Come True” in the October 8, 2017 edition of Bridging the Week.)

Legal Weeds: Actions sounding in insider trading are no longer within the sole purview of the SEC. The Commodity Futures Trading Commission has now brought two enforcement actions charging persons with insider trading for misappropriating their employer’s trading information. In the first action brought in 2015, the CFTC alleged that Arya Motazedi, a gasoline trader for a large publicly traded corporation, similarly misappropriated trading information of his employer for his own benefit. In the second action, the CFTC brought and settled charges against Jon Ruggles, a former trader for Delta Airlines, for trading accounts in his wife’s name based on his knowledge of trades he anticipated placing for his employer. Both actions were grounded in a provision of law under the Dodd-Frank Wall Street Reform and Consumer Protection Act and a CFTC rule that prohibit use of a manipulative or deceptive device or contrivance in connection with futures or swaps trading. (Click here to access Commodity Exchange Act Section 6(c)(1), US Code § 9(1), and here to access CFTC Rule 180.1. Click here for background on these CFTC enforcement actions in the article “Ex-Airline Employee Sued by CFTC for Insider Trading of Futures Based on Misappropriated Information” in the October 2, 2016 edition of Bridging the Week.)

Unrelatedly, the Joint Economic Committee of Congress presented its 2018 Economic Report of the President. In it, the Committee provided an overview of the growth of cryptocurrencies and initial coin offerings in 2017 and acknowledged the disparate regulatory treatment of digital tokens in the United States. Among other things, the Committee recommended that “[r]egulators should continue to coordinate among each other to guarantee coherent policy frameworks, definitions, and jurisdiction” going forward not to inhibit the development of blockchain technology. (Click here to access a copy of the Committee’s report; see pages 201-227.)

My View: The SEC takes a very broad view of what constitutes a security. This view is principally premised on the agency’s interpretation of the landmark 1946 Supreme Court decision of SEC v. W.J. Howey (click here to access) that labeled as an investment contract (and thus, as a security) any (1) investment of money (2) in a common enterprise (3) with a reasonable expectation of profits (4) to be derived solely from the entrepreneurial or managerial efforts of others. The SEC argues that an investment contract could also exist when persons invest money in a project and expect profits through the appreciation in value of their investment attributable to the entrepreneurial or managerial efforts of others, even if such “profits” can be realized solely by investors reselling their investments. As a result, the SEC argues that an investment contract could include instruments that convey no traditional ownership rights on its holders or any direct rights to revenue – such as many digital tokens issued as part of ICOs. (Click here for background on the SEC’s views in the article “Non-Registered Cryptocurrency Based on Munchee Food App Fails to Satisfy SEC’s Appetite for Non-Security” in the December 17, 2017 edition of Bridging the Week.)

However, under this approach, privately issued gold coins promoted by their issuers could potentially be deemed investment contracts by the SEC, as could special edition collectible automobiles hyped by their manufacturers. In these instances, purchasers would reasonably expect to realize a premium to ordinary market value if they resell their asset because of the entrepreneurial or managerial efforts of others designed to create buzz around their asset. This seems like an attenuated view of what should be considered a security. For example, under the SEC’s interpretation, persons who pre-purchased a first generation Tesla Roadster in 2008 prior to its rollout – expecting it would rise in value because of hype and promotional efforts of Elon Musk on behalf of Tesla electric cars generally – would likely also be driving a security. However, this outcome makes no sense. The SEC’s view could also potentially capture some virtual currencies within the definition of a security as well.

Gibraltar’s definition of a security is far more narrow and appropriate and commonsensical. According to Gibraltar Finance, “[m]ost often, [digital] tokens do not qualify as securities under Gibraltar or EU legislation.” This is because “they represent the advance sale of products that entitle holders to access future networks or consume future services.” There is no direct or indirect tie to an underlying project’s income stream, and there are no distribution rights in case of a project’s insolvency.

According to Gibraltar Finance, digital tokens are “representations of something else, whether tangible or intangible.” As such, they are analogous to derivatives, as “trading tokens is not necessarily the same activity as treading its underlying asset (where one exists).”

This analysis makes sense and provides a roadmap for a rational allocation of regulatory oversight in the United States over cryptocurrencies. Digital tokens that are directly or indirectly tied principally to the income flow of a project or accord the holders rights in insolvency are securities that, along with their offer and sale, implicate federal and state securities laws. Cryptocurrencies that are not securities and do not serve principally as a medium of exchange are a derivative instrument (perhaps a privilege) on commodities, potentially implicating the exclusive jurisdiction of the Commodity Futures Trading Commission – although applicable law and CFTC regulations may have to be amended to make this unequivocal. When digital tokens are designed to serve principally as a medium of exchange and serve as such, they are virtual currencies and should be treated analogously to fiat currencies under law. (Click here for an overview of the current regulation of cryptocurrencies in the US in the testimony of Mike Lempres, Chief Legal and Risk Officer of Coinbase, on March 13 before the House Committee on Financial Services, Subcommittee on Capital Markets, Securities, and Investment.)

More briefly:

For further information:

CBOT Settles With Nonmember for Purported Wash Sales to Transfer Positions:

CFTC Chairman Reveals Key Priorities Before Florida Industry Conference :

FCA Publishes Thought Piece on Enhancing Culture in Financial Services:

Former Company Unit CIO Sued by SEC for Insider Trading Based on Knowledge of Cybersecurity Breach:

Gibraltar Suggests Many ICO-Issued Digital Tokens Are Commercial Products, Not Securities:

South Carolina Securities Commissioner Obtains C&D Against Crypto Mining Company for Selling Unregistered Securities:

Transaction Fee Cap Pilot Program for NMS Stocks Proposed by SEC:

The information in this article is for informational purposes only and is derived from sources believed to be reliable as of March 17, 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 are not necessarily reflective of views of Katten Muchin or of any of its partners or employees.

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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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