Bridging the Weeks by Gary DeWaal: October 22 to November 2 and November 5, 2018 (UK and HK Regulation of Cryptoassets; EFRPs; Order Routing Disclosures; EU CCP Overreach)

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Published Date: November 04, 2018

During the prior two weeks, three financial authorities in the United Kingdom as well as the Hong Kong Securities and Futures Commission issued reports assessing distributed ledger technology and risks associated with the trading of cryptoassets. As part of their studies, the SFC determined to restrict investments in HK funds trading cryptoassets to professional HK investors, while the UK authorities committed to consider whether all derivatives based on cryptocurrencies should be banned for UK retail investors. In the United States, futures exchanges brought a number of disciplinary actions alleging violations of rules related to exchange for related position transactions, spoofing, pre-execution communications, and audit trail requirements for clearing members and clients connecting by direct access to an exchange's electronic trading system. As a result, the following matters are covered in this week’s edition of Bridging the Weeks:

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Separately, the Hong Kong Securities and Futures Commission announced it would require the licensing of and compliance with applicable regulatory requirements by all firms that manage or intend to manage portfolios investing in cryptoassets, as well as firms that distribute funds investing in such financial instruments subject to a de minimis exception. These obligations would apply whether or not the cryptoassets were of the nature of securities or futures clearly within the SFC’s remit.

Additionally, the SFC indicated it will consider whether cryptoasset platforms not currently subject to oversight are suitable for regulation by potentially placing them in its regulatory sandbox. If SFC considers such trading platforms are appropriate for regulation, it will grant participating trading platforms a license and subject them to close oversight. Alternatively, it may determine that perceived risks cannot be “sufficiently addressed” and determine to grant no licenses. Among other things, participating firms would have to agree to limit their services solely to professional investors and ensure that no security issued as part of an initial coin offering was traded prior to 12 months following its launch.

The SFC announced the establishment of a regulatory sandbox for firms offering innovative financial technology during September 2017 (click here to access details).

UK Authorities

A taskforce comprising three UK financial authorities concluded that, generally, DLT “has the potential to deliver significant benefits in financial services and other sectors in the future” and committed to support its development. However, it found “limited evidence” of benefits in the current generation of cryptoassets, but said these may arise in the future. Moreover, the taskforce identified certain risks associated with cryptoassets: risks of financial crime, risks to consumers, risks to market integrity and potential implications for financial stability.

As a result, the UK financial authorities agreed to consult on implementing “one of the most comprehensive responses globally” to address the use of cryptoassets for illegal activities; to potentially ban the sale of derivatives based on cryptoassets to retail persons; to issue guidance on how certain cryptoassets are already captured by the existing “regulatory perimeter”; and whether the regulatory perimeter requires expansion to capture all cryptoassets.

Among other objectives, the UK financial authorities expressly committed to clarify by the end of 2018 how existing regulation applies to security tokens, and how initial coin offerings might be overseen by early 2019. The UK financial authorities also said they would consider by early 2019 how virtual currencies (termed “payment tokens” in the United Kingdom), as well as related firms such as exchanges and wallet holders, could be regulated


Going forward, HK firms managing funds that solely invest in cryptoassets that are not securities or futures contracts will nonetheless require a license enabling them to deal in securities if they distribute interests in their funds to persons in Hong Kong. Likewise, HK firms that are already licensed for asset management activity for handling funds dealing in securities or futures contracts will also be subject to SFC oversight if they invest solely or partially in cryptoassets that do not constitute securities or futures. These requirements will not apply if a relevant fund invests less than 10 percent of its gross asset value in cryptoassets.

To address perceived risks of cryptoassets, SFC has developed terms and condition that all licensed portfolio managers intending to invest in cryptoassets should observe. Among these terms are that only professional investors should be permitted to invest in a cryptoassets portfolio  Generally under HK law individuals are professional investors if they have an investment portfolio of HK $8 million or more (approximately US $1 million or more), or for corporations, a portfolio of HK $8 million or more or total assets of not less than HK $40 million (approximately US $5 million). (Click here to access relevant definitions under the HK Securities and Futures (Professional Investor) Rules.)

Similarly, if the SFC ultimately determines to grant a license to a cryptoasset platform operator in its regulatory sandbox, the firm will be licensed similarly to an automated trading service and be subject to certain core principles. In addition to limiting access to professional investors and prohibiting the trading of ICO-issued coins until at least 12 months after launch, SFC will require all cryptoasset transactions to be pre-funded and without leverage and that all trading activity occur under a single legal entity, among other requirements.

In other recent noteworthy developments regarding cryptoassets:

My View: Distributed ledger technology and associated cryptoassets continue to provide challenges to international regulators as the new technologies often do not fit neatly within existing laws. Although uniform best practices are appropriate for market participants to adopt voluntarily, there is a great danger that uniform or near uniform international regulations could stifle innovation. 

For example, the new requirement by the SFC that restricts the participation in HK funds investing in cryptoassets to HK professional investors, as well as a possible prohibition against UK retail persons being able to purchase derivatives based on cryptocurrencies, is directly contrary to approval in the United States by the Commodity Futures Trading Commission of derivatives based on bitcoin accessible to all market participants, and guidance by the National Futures Association that permits funds accessible to all to invest in cryptoassets provided appropriate disclosures are made. 

Uniformity in regulations sounds like a good thing, provided the regulations are right; however, what is right is in the eye of the beholder and may vary from person to person. As a result, efforts to promote common worldwide regulation of DLT and associated cryptoassets is likely inappropriate at the current time, when the relevant technologies are in their infancy and often misunderstood. 

It would be better at this point for regulators to agree, at most, on common broad objectives (e.g., eradicate fraud, heighten anti-money laundering requirements), but encourage individual jurisdictions to adopt regulations they believe most suitable in light of their own particular experiences. This way, controversial regulations might, at worse, inhibit innovations locally but will not have a deleterious international impact.

Unrelatedly, George E. Warren agreed to pay a fine of US $20,000 to resolve charges that on February 1, 2018, it sold one EFRP to a counterparty involving February 2018 NY Harbor ULSD futures and bought another EFRP from the same counterparty involving March 2018 NY Harbor ULSD futures at the identical price. NYMEX claimed these transactions were contingent on each other and were executed to avoid market risk.

Separately, Jacek Jarosz was sanctioned by CME for entering into several orders without the intent to trade from June 14 through August 4, 2017. CME alleged that Mr. Jarosz entered into smaller NASDAQ 100 futures orders on one side of the market, and subsequently entered larger NASDAQ 100 futures orders on the other side of the market to induce execution of his smaller orders. After receiving fills of his smaller orders, Mr. Jarosz allegedly cancelled his larger orders. Mr. Jarosz resolved his CME disciplinary action by agreeing to pay a fine of US $25,000 and consenting to a 15-day all CME Group exchanges trading ban.

A number of other individual nonmembers were also sanctioned by the Commodity Exchange, Inc. and the New York Mercantile Exchange for engaging in purported spoofing-type conduct and not participating in exchange disciplinary actions. Each was fined from US $50,000 to US $100,000 and permanently barred from any CME Group exchange trading. The individuals were Shi Bing Cheng, Wei Fan, Wang Jian, and Wang Yiwu.

Two individuals – Michael Caponiti and Christopher Kenny – agreed to the imposition of sanctions by Nymex for engaging in pre-execution discussions to consummate trades from February 10, 2017, through June 15, 2017, without afterwards submitting Requests for Quote and Requests for Cross, as required by exchange rules. Mr. Kenny agreed to pay a fine of US $10,000 and be barred from all CME Group exchange trading for five business days, while Mr. Caponiti consented to the imposition of a penalty of US $25,000.

Finally, five clearing members or direct access clients of clearing members were recently summarily fined by ICE Futures U.S. for not retaining audit trail data corresponding to orders they placed by direct access to IFUS's electronic trading system. Under IFUS rule, each clearing member is responsible to maintain or cause to be maintained and produce upon request of the exchange audit trail information for all orders submitted to the exchange through its direct access connection and any order routing system; each person authorized by a clearing member for direct access is also required to maintain or cause to be maintained the same audit trail record. ABN AMRO Bank N.V., BNP Paribas, INDY Research Labs, LLC, and Macquarie Futures USA LLC were each fined US $2,500 for their purported violations while Quiet Light Trading LLC was penalized US $5,000.

Compliance Weeds: Although the amount of IFUS’s fines on clearing members and certain clients for noncompliance with audit trail requirements was small, the number of fines serves as a reminder that each designated contract market has express requirements regarding the audit trail each clearing member and certain clients must maintain in connection with direct access orders. (Click here to access CME Rule 536.B and here to access IFUS Rule 4.19. Click here to access CME Group Market Regulation Advisory Notice RA1520-5.)

Moreover, the CFTC recently fined a futures commission merchant US $160,000 for not retaining required electronic audit trail information for 65 clients. This problem was discovered when the CFTC found gaps and missing transaction records in the firm’s production in response to a request for documents related to one client. Afterward, the FCM initiated an internal investigation and discovered its more widespread breakdowns. These were caused by the failure of an archiving system to copy data supplied to the firm by an external vendor from January 24, 2014, through August 28, 2015. The CFTC noted that, although the FCM had a recordkeeping system in place, it had no system to monitor whether its archiving system was properly collecting or storing data. (Click here to access the relevant CFTC order.)

More Briefly:

The information that must be disclosed, upon request, for not-held orders pertains to the internal handling of such orders; the routing of such orders to different trading centers; the execution of such orders; and how such orders provided or removed liquidity along with the average transaction rebates or fees paid by the broker-dealer. Broker-dealers are not required to provide not-held reports to any customer if, during the prior six months, (1) not held NMS orders constituted less than 5 percent of the customer’s total NMS stock orders, or (2) if a customer’s trades involved, on a monthly average basis, less than US $1 million of notional value of not-held orders in NMS stocks. 

The SEC’s new amendments will be effective 60 days after they are published in the Federal Register while compliance is required by 180 days after publication. NMS is a reference to the US national market system, including all formal US stock exchanges and the Nasdaq market. Not-held orders give brokers price and time discretion for execution, while a broker-dealer must try to execute a held order immediately.

Moreover, as proposed, all systemically important third-country-recognized CCPs would be subject to potential on-site inspections by ESMA in connection with investigations. 

J. Christopher Giancarlo, Chairman of the Commodity Futures Trading Commission, previously threatened retaliation if the EU were to exercise “extraterritorial overreach” and threaten US markets and market participants. (Click here to access Mr. Giancarlo’s October 17 keynote speech at FIA Expo.)

Previously, CFTC staff had granted this relief contingent on the UK broker maintaining the US FCM's customers' securities in an individual client segregated account at a UK clearinghouse; however, since January 3, 2018, because of changes in EU law, authorized clearinghouses have elected not to offer ISAs to indirect clients in indirect clearing arrangements.

This no-action relief was obtained because of concerns that CFTC rules might preclude a US FCM from posting customer securities with a UK-based broker for deposit with a UK clearinghouse because UK clearinghouses generally accept securities from their clearing members subject to title transfer or a limited right of reuse. Under CFTC rules, an FCM may not commingle customer funds with its own money, securities or property. (Click here to access no-action letter previously granted by the CFTC’s Division of Swap Dealer and Intermediary Oversight and here to access CFTC Rule 30.7(e))

Additionally, FINRA alleged the firm took the view that the requirement on Forms U4 and U5 to identify “a claim for compensatory damages of $5,000 or more” only required disclosure if a customer expressly requested reimbursement in that amount. In response, the firm did not report incidents where a customer did not per se request such amount, but from the totality of the complaint, it was clear this is what the customer wanted. Relying on this incorrect view, FINRA stated the firm failed to file at least 31 reportable customer complaints from March 2013 through November 2017.

Form U4 is used to register individuals with FINRA (or transfer individual registrations from one FINRA member to another), while Form U5 is used to terminate individuals’ licenses.

For further information

Bank Fined by CME for Non-Bona Fide EFRPs After Surveillance System Breaks Down:

CME Group:

ICE Futures U.S.:

Bitcoin Dealer Pleads Guilty of Operating an Unlicensed Money Transmission Business:

Broker-Dealer Fined US $2.75 Million by FINRA for Breakdowns in AML Program and Customer Complaint Reporting:

IFUS to Launch BAKKT Bitcoin Daily Futures December 12

CFTC Staff Amends Ability of FCMs to Post Customer Securities as Margin With UK Brokers:

EU Proposes Comprehensive Oversight Over Non-EU CCPs:

Investor Lawsuit Against Coinbase Alleging Impropriety in Listing of Bitcoin Cash for Trading Dismissed – for Now:

More Disclosure by Broker-Dealers Regarding Client Order Routing and Handling Required by New SEC Rule:

NFA Sanctions Swap Dealer US $900,000 For Not Adequately Assessing Risks of Uncleared Swaps:

Ongoing Operation Cryptosweep Results in Termination of Five ICOs by Two State Regulators:

SEC Notes Many Open ICO Investigations in Annual Overview of Enforcement Activities:

Treasury Updates OFAC Sanctions List:

UK Regulators Contemplate Banning All Cryptocurrency-Based Derivative Sales to Retail Clients While HK SFC Restricts Investments in Virtual Currency Portfolios to Professional Investors:


UK Financial Authorities:

The information in this article is for informational purposes only and is derived from sources believed to be reliable as of November 4, 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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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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