Bridging the Week by Gary DeWaal: March 11 – 15 and March 18, 2019 (Positioning for New Position Limits Proposal; Custody and Cryptoassets; Supervision for Swap Dealers)

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Published Date: March 17, 2019

Last week, J. Christopher Giancarlo promised a “workable” revised position limits proposed rule before he leaves as chairman of the Commodity Futures Trading Commission sometime this summer. Separately, the Securities and Exchange Commission’s Division of Investment Management sought comments on how its Custody Rule applies to cryptoassets. As a result, the following matters are covered in this week’s edition of Bridging the Week:

​​ The next regularly scheduled edition of Bridging the Week will be April 1, 2019.

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The CFTC last proposed amendments to its position limits regime in December 2016. (Click here for background in the article “CFTC Adopts Final Rules Related to Aggregation of Positions and Owned Entity Exemption; Re-Proposes Position Limits Rules” in the December 11, 2016 version of Bridging the Week.)

Mr. Giancarlo was also optimistic that, prior to the end of his tenure as chairman, the Commission will finalize a number of unspecified Project KISS initiatives, as well as propose “various” new cross-border rules, including to establish a framework for non-US clearinghouses (“CCP”) that do not pose a substantial risk to the US financial system to register with the CFTC as derivatives clearing organizations under an alternative, presumably lighter framework, giving “enhanced deference” to the CCP’s home regulator. Project KISS – Keep it Simple Stupid – was a CFTC initiative announced two years ago, to holistically review the Commission’s rules, regulations and practices to make them simpler, less burdensome and less expensive, where possible. (Click here for more information regarding Project KISS in the article “CFTC Chairman Nominee Warns of Tough Love to Come: KISS But Also Aggressive and Assertive Enforcement” in the March 19, 2017 edition of Bridging the Week.)

On the same day Mr. Giancarlo was delivering his remarks at the FIA conference in Florida, Heath Tarbert, the nominee to replace him, testified before the US Senate Committee on Agriculture, Nutrition and Forestry in Washington, DC. Mr. Tarbert stressed the importance of empowering the agricultural sector with means “to hedge risk and receive fair prices.” He noted the transformation of derivatives markets by digital technologies, and said the CFTC “must remain committed to promulgating regulations that allow technological innovations to flourish.” Mr. Tarbert’s nomination must be approved by the Senate Committee and then by the full Senate before he may become the next CFTC chairman.

Memory Lane: In November 2013, the CFTC proposed new rules related to derivatives speculative position limits, addressing absolute levels for 28 so-called “core referenced futures contracts” involving various agricultural commodities, energy products and metals. These limits were proposed to apply on a futures equivalent basis across all referenced contracts (e.g., related futures, options and swaps). The proposed rules also addressed what constituted bona fide hedging positions. The recommended rules were meant to replace final rules adopted by the CFTC in 2011 that were vacated by a US District Court during September 2012. (Click here for details regarding the CFTC’s 2013 proposed position limit rules in the article “CFTC Proposes Revised Position Limit Rules” published on November 12, 2013 by Katten Muchin Rosenman LLP.)

In May 2016, the CFTC proposed some modifications and additions to its 2013 proposed regulations and guidance related to speculative position limits in order to potentially authorize relevant derivatives exchanges to recognize certain derivatives positions as constituting non-enumerated bona fide hedges or enumerated anticipatory hedges. The CFTC also proposed to grant derivatives exchanges authority to recognize certain spread positions as justifying an exemption from speculative position limits too. (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 edition of Between Bridges.)

Most recently, in December 2016, the CFTC re-proposed its position limits rules. Compared to its November 2013 proposed rules, the Commission’s most recent proposals: (1) reduced the number of core referenced contracts subject to express oversight by the Commission for position limits purposes from 28 to 25; (2) revised spot month, single and all-months position limits on the 25 referenced contracts; (3) defined bona fide hedging to more closely parallel the definition in existing law and to address many concerns raised in response to the CFTC’s 2013 proposal; and (4) authorized persons to apply for non-enumerated hedging exemptions from qualified exchanges, even for referenced contracts.

The Division solicited comment through a letter to the Investment Adviser Association. In the letter, the Division also asked for  views on non-delivery versus payment transactions by investment advisers.

Because custody includes both the authority to access clients’ securities and funds in addition to physical possession, the SEC has expressly recognized a limited exception to the Custody Rule – the “authorized trading exception” – that permits an investment adviser to issue instructions to a qualified custodian to effect or settle trades solely on a delivery versus payment basis. (Click here to access fn. 10 to the SEC’s 2003 release adopting final rules for the custody of funds or securities of clients by investment advisers.) This means that, under the SEC’s explicit approval, investment advisers may only trade or transfer funds or securities out of a client’s account when there is a “corresponding transfer of securities or funds into the account.” However, when authorizing this DVP exception, the SEC was silent on non-DVP transactions. The Division now desires to understand what instruments trade on a non-DVP basis; what risks of fraud or loss may be associated with non-DVP trading and how they are controlled; what role custodians play in non-DVP trading; and how evolving technologies, such as distributed ledger technology, may contribute to enhanced or diminished customer protection for non-DVP trading, among other questions. (Click here for access to the 2013 Division release on Inadvertent Custody that also discusses the authorized trader exception in fn 1.)

Separately, the Canadian Securities Administrators and the Investment Industry Regulatory Organization of Canada solicited input on how regulatory requirements pertaining to securities or derivatives exchanges could be “tailored” for cryptoasset trading platforms located in Canada or that have Canadian participants. Among other things the CSA and IIROC are trying to better understand for cryptoasset trading platforms: custody and verification, price determination, surveillance of trading activities, systems and business continuity planning, conflict of interest issues, and insurance. The Canadian regulators will accept comments through May 15, 2019.

Finally, the SEC will host a forum to address distributed ledger technology and related issues including initial coin offerings and cryptoasset platforms, on May 31 at the SEC’s headquarters in Washington, DC. The event will also be webcast on the SEC’s website.

In other legal and regulatory developments involving cryptoassets:

My View: Mr. Hinman’s June 2018 analysis of digital tokens and recognition that the characteristics of a digital token (such as ether) may change over time – likely resulting in a different legal categorization – now appears to be formally embraced by Mr. Clayton. However, Mr. Clayton still seems to take a very broad view of when an initial offering of cryptoassets constitutes an investment contract, thus qualifying the digital tokens as securities. Although saying each scenario presents unique facts and circumstances (relying on the landmark Supreme Court decision, SEC v. W.J. Howey and its progeny), Mr. Clayton suggests that almost all investments in common ventures “premised on a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others” render the underlying cryptoasset a security – whether the profits are achieved directly from a venture (e.g., through profits) or market appreciation. (Click here to access the Howey decision. Click here for insight into Mr. Clayton’s views on the potential morphing characteristic of cryptoassets and the application of Howey to cryptoassets in an interview on November 27, 2018, with Glenn Hutchins, a co-founder of Silver Lake Partners).

However, at the fringes, it still is unclear when market appreciation might be considered derived from a promoter’s hype as opposed to investor sentiment. A recent settlement by the SEC suggested that if a promoter takes too many steps to list a cryptoasset initially sold to raise funding for a project on an exchange for trading – even if the token was designed solely to be used in connection with the project – the digital token will likely be viewed as a security by the Commission. (Click here for background in the article “ICO Promoter Settles SEC Enforcement Action for No Fine After Self-Reporting Potential Securities Law Violations” in the February 24, 2019 edition of Bridging the Week.)

As a result, it appears to me that, applying the SEC’s broad view of Howey, smart kids who purchased and held, as collectibles, Beanie Babies from Ty Inc. years ago and later eagerly resold them on eBay for a profit, potentially could be regarded to have been transacting in securities depending on the amount of advertising and other promotional activities by Ty. Such an outcome makes no sense. There needs to be formal SEC clarification – perhaps creating a safe harbor along the lines of Colorado’s new Digital Token Act.

Concurrently, NFA also proposed amendments to its general supervisory rule – Rule 2-9 (click here to access) — to make clear it applies to all commodity interest activities of futures commission merchants, introducing brokers, commodity pool operators, and commodity trading advisors. This embraces the swaps activities of such members, as well as their futures activities. NFA also stated in its interpretive notice that non-US located swap dealers and major swap participants relying on substituted compliance with home jurisdiction requirements (instead of Commodity Futures Trading Commission requirements) may nonetheless be held liable for failure to supervise under NFA’s new proposed rule under “appropriate facts and circumstances.”

Compliance Weeds: The CFTC wields “failure to supervise” very broadly and often as a stand-alone violation.

In September 2017, Merrill Lynch, Pierce, Fenner & Smith Incorporated agreed to pay a fine of US $2.5 million to resolve charges brought by the CFTC that, from January through October 2010, the firm failed to diligently supervise responses to a CME Group Market Regulation investigation related to block trades executed by its affiliate, Bank of America, N.A. (“BANA”) on the Chicago Mercantile Exchange and the Chicago Board of Trade. However, from the facts included in the CFTC’s settlement order with Merrill as well as BANA’s separate settlement with the US Attorney’s Office for the Western District of North Carolina, it was unclear what Merrill might have failed to supervise. From all referenced facts, it appears that Merrill was misled by BANA regarding BANA’s handling of the relevant block trades and had no reason to believe it was being misled. (Click here for background in the article “FCM Agrees to Pay US $2.5 Million CFTC Fine for Relying on Affiliate’s Purportedly Misleading Analysis of Block Trades for a CME Group Investigation” in the September 24, 2017 edition of Bridging the Week.)

During the same month, the CFTC also brought and settled enforcement actions against two commodity pool operators for failure to supervise. In one action, the CFTC charged Tillage Commodities, LLC, a CFTC-registered CPO, with failure to supervise for not monitoring and detecting unauthorized wire transfers processed by the administrator of a fund it operated, Tillage Commodities Fund, L.P. In the second action, the CFTC alleged that Logista Advisors LLC, a CFTC-registered CPO and commodity trading advisor, failed to detect one of its employee’s alleged spoofing-type trading of crude oil futures on a non-US exchange, and then failed to provide to its futures commission merchant and the non-US exchange accurate explanations of the trading in response to the non-US exchange’s inquiry. To resolve these enforcement actions, Tillage agreed to pay a fine of US $150,000 while Logista consented to remit a fine of US $250,000.

In the Tillage case, the CFTC did not charge the CPO for the actions of its fund administrator in responding to the fake transfer instructions. It solely charged the firm for not monitoring bank accounts regularly to increase its likelihood of detecting possible fraudulent transfers and for not having policies and procedures to engage in such monitoring.

In the Logista case, the alleged spoofing occurred on a non-US exchange. However, the CFTC did not charge the CPO with spoofing. The Commission charged the CPO with not detecting its employee’s purported spoofing even after it was alerted of the potential issue following the non-US exchange’s detection of the possible wrongful trading activity, and with not conducting a reasonable review of the trading (including talking to its trader) prior to responding to the non-US exchange’s request for an explanation of the trading. Logista, said the CFTC, also did not have policies and procedures to detect spoofing, and did not itself detect the alleged spoofing.

The Logista enforcement action echoed the CFTC’s enforcement action against Advantage Future LLC during September 2016, where the firm and two of its senior officers also settled charges related to the firm’s handling of the trading account of one customer in response to three exchanges’ warnings and for the firm’s alleged failure to follow its own risk management policies. (Click here for background in the article “FCM, CEO and CRO Sued by CFTC for Failure to Supervise and Risk-Related Offenses” in the September 25, 2016 edition of Bridging the Week.)

CFTC registrants and members should maintain robust procedures and practices to ensure all elements of their sales, operational and financial activities are adequately supervised. This means not solely requiring that an activity be undertaken appropriately in the first instance, but that such activity is regularly reviewed and periodically tested more comprehensively to help ensure there have been no breakdowns and that the activity was designed and implemented correctly.

More Briefly:

In 2017, the CFTC charged Monex with engaging in illegal off-exchange futures transactions because it entered into leveraged transactions to retail persons without making actual delivery within 28 days, and with committing fraud, relying on authority under the Dodd-Frank Wall Street Reform and Consumer Protection Act.

The district court rejected the CFTC’s legal theories, holding that actual delivery of precious metals in financed transactions to retail persons falls outside the CFTC’s jurisdiction when ownership of real metals is legally transferred to such persons within 28 days. This is the case even if the seller retains control over the commodities because of financing beyond 28 days. The court also held that the CFTC cannot use the Dodd-Frank enacted prohibition against persons engaging in any manipulative or deceptive device or contrivance in connection with the sale of any commodity in interstate commerce to prosecute acts of purported fraud except in instances of fraud‑based market manipulation. (Click here for background on the district court’s decision in the article “California Federal Court Dismissal of CFTC Monex Enforcement Action Upsets Stable Legal Theories” in the May 6, 2018 edition of Bridging the Week.)

Before the Court of Appeals, the CFTC argued that the district court’s view of the law was incorrect as it “did not apply the text of the statute” and has caused confusion in the meaning of the relevant provisions nationwide. It asked the appeals court to restore “what Congress wrote” in the plain language of the relevant statutes. Counsel for Monex asked for affirmation of the district court’s decision.

Separately, The Chicago Board of Trade brought and settled charges against Ji-Neng Tsai, a nonmember, for entering non bona fide orders between July 13, 2015, and April 11, 2016, in the CBOT Oats and Rough Rice markets prior to market opening with the intent to ascertain the depth of the order book. CBOT claimed that the non bona fide transactions resulted in fluctuations in the publicly displayed Indicative Opening Price. According to CBOT, Mr. Tsai did not cooperate with its investigation. CBOT fined Mr. Tsai US $50,000 and banned him from trading on all CME Group exchanges beginning immediately through one year after the date he pays his fine in full.

For further information

Broker-Dealer Hit With US $250,000 SEC Fine for Purported Failure to Supervise Salesman’s Alleged Pump and Dump Scheme:

CFTC Asks Appeals Court to “End the Confusion” Regarding Clarity of Law Regarding Actual Delivery and Fraud-Based Manipulation:

CFTC Settles Charges With Non-US Trading Platform and Its CEO for Allegedly Engaging in Margined Bitcoin Transactions With Retail Clients Contrary to Law:

Clearing and Settlement Institution Recommends Guiding Principles for Processing of Digital Securities:

Colorado Authorizers Issuer Registration Exemption for Certain ICOs:

Global Bank Standard Setter Issues Guidance for Banks Obtaining Cryptocurrency Exposure:

NFA Proposes More Supervision of Member’s Commodity Interest Activities:

Outgoing CFTC Chair Promises Workable Position Limit Proposal Before Departure; Pending New CFTC Head Says Agency Must Continue to Promote Digital Innovation:

SEC Chairman Concurs With Division Head That a Cryptoasset’s Regulatory Classification May Morph Over Time:

SEC Settles Charges Against 79 Investment Advisers for Inadequate Disclosure of Differently Priced Mutual Fund Share Classes:

SEC Staff Curious How Custody Rule Applies to Cryptoassets While Canadian Regulators Seek Help Understanding Digital Assets Trading Platforms:

Use of Allegedly Deceptive Promotional Material Results in NFA Bar of CPO and Firm’s Sole AP:



The information in this article is for informational purposes only and is derived from sources believed to be reliable as of March 16, 2019. 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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