Bridging the Week by Gary DeWaal: December 9 to 13, and December 16, 2019 (Evaluating New Virtual Currencies; Articulating Elements of Supervision)

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Published Date: December 15, 2019

The New York State Department of Financial Services proposed a self-certification regime for the approval of new digital coins by licensed virtual currency firms similar to the process applied by the Commodity Futures Trading Commission for new products by registered markets. Some fine tuning is likely required, but this is a welcome, principles-based measure that puts the burden on licensees to develop robust procedures to evaluate new virtual currencies. Separately, ICE Futures U.S. proposed to require certain core elements of a mandatory program of supervision by all firms accessing its markets – whether registered with the CFTC or not, or whether a member of IFUS or not. As a result, the following matters are covered in this week’s edition of Bridging the Week:

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As proposed, DFS will maintain a list on its website of all virtual currencies approved for transactions by licensed firms. Any licensee may transact in these digital assets without the prior approval of DFS, provided such cryptocurrencies have not been subject to any modification, division or change after their posting on DFS’s website. Virtual currencies proposed for initial inclusion on DFS’s website are bitcoin, bitcoin cash, ether, ether classic, litecoin, ripple, Paxos Standard and Gemini dollar.

A licensee desiring to transact in new digital coins would first have to adopt a coin listing or adoption policy (“listing policy”) that outlines all steps the firm would take to review and approve potential new virtual currencies not listed on DFS’s website. After having its policy approved by DFS, the licensee would be able to self-certify any new virtual currency and upon prior notice to DFS, transact in such coins without the agency’s prior consent.

Licensees without an approved listing policy would be required to seek DFS’s prior approval to transaction in new digital currencies as is currently the case. All licensees would be required to advise DFS of all digital coins they transact in no less than on a quarterly basis.

Virtual currency listing policies should be designed in light of each firm’s specific business model, operations, customers, geographies of operations, service providers and the specific characteristics of each cryptocurrency being evaluated. In its listing policy, each licensee should address its governance around approval; risks associated with a new coin; and ongoing monitoring to ensure transacting in the digital asset by the firm, after approval, “remains prudent.”

DFS will accept comments on its proposal through January 27, 2020.

(Click here for background on NY BitLicense requirements 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. Click here for additional information on the 2018 augmentation of requirements for persons conducting a NY virtual currency business in the article “NYS Financial Services Regulator Ups the Obligations of State-Licensed Virtual Currency Entities” in the February 11, 2018 edition of Bridging the Week.)

In other legal and regulatory developments regarding cryptoassets:

In papers filed last week, the NY AG disputed defendants’ arguments and claimed their opposition was solely “an extraordinary effort to halt an ongoing investigation … into potential securities and commodities fraud.” The New York AG claimed that defendants’ arguments rest on a “fundamental misconception” that they can halt a pending investigation based on their objections “to what they think [the AG] will claim in a future lawsuit.” However, said the AG, the purpose of the relevant provision of the Martin Act is to enable the AG to uncover facts to support a later claim.

In April 2019, the NY AG obtained an ex parte order from a New York State court prohibiting defendants from accessing, loaning or encumbering in any way US dollar reserves supporting tether digital coins. The NY AG applied for such order without giving respondents notice or an opportunity to object, claiming such emergency action was necessary because of the potential danger of respondents compromising tether’s supporting balances to help fund Bitfinex’s operations. (Click here for background in the article “NY Attorney General Sues Stablecoin Issuer and Related Companies for Purportedly Misusing Tethered Fiat Currency Without Customer Disclosure” in the April 28, 2019 edition of Bridging the Week.)

My View and Legal Weeds: Generally, the DFS’s proposed process for licensed virtual currency firms to list new digital tokens will enable such entities to meet customer demand to transact in such cryptocurrencies more expeditiously subject to robust protections. This is a good development and will put the burden on each licensee to develop a robust framework to analyze new coins, as opposed to making the DFS the arbiter of digital coins’ features. Hopefully, in order to help DFS make a good proposal better, commentators will encourage the agency to flush out more precise details of its proposal, including how much time in advance a licensee must file a notice of intent to transact in a new virtual currency; what is the distinction between a self-certification filing and prior notice; and what authority, if any, might DFS have to preclude transacting in a new coin even after any notice is filed.

That being said, DFS’s proposal echoes the long-standing authority of Commodity Futures Trading Commission designated contract markets to list new products solely by filing a self-certification with the Commission. Typically, a DCM seeking to list a new product must file by no later than the close of the business day prior to the first business day of the proposed initial trading a submission with certain enumerated elements, including a certification that the product complies with applicable law and CFTC regulations; among other things, the product must not be readily susceptible to manipulation. (Click here to access CFTC Rule 40.2 (regarding filing) and here for CFTC rule 38.200 (regarding manipulation); click here to access general background regarding the CFTC’s DCM self-certification process.) Under the CFTC regime, swap execution facilities are also authorized to self-certify new products on one-day prior notice (see CFTC Rule 40.2, above). 

On December 1, 2017, three DCMs – the Chicago Mercantile Exchange, the CBOE Futures Exchange and the Cantor Exchange – self-certified with the CFTC cash-settled derivatives contracts based on Bitcoin.

Contemporaneously with the three exchanges’ self-certifications, the CFTC issued a press release noting that it had “extensive discussions” with each of the DCMs regarding their proposed new contracts. Then CFTC Chairman J. Christopher Giancarlo said each of the facilities “agreed to significant enhancements to protect customers and maintain orderly markets.” The CFTC separately noted in a “Backgrounder” also issued on December 1 that its staff had considered the potential risk of default of the three exchanges’ derivatives contracts on the regulated clearinghouses clearing the products. However, said the CFTC, “[b]ased on analysis of different stress scenarios, staff estimates that any potential impact will not be significant to a DCO.” The CFTC also said that CME had modified its proposed margining in response to discussions with Commission staff.

(Click here for further background on the December 1, 2017 self-certification of three bitcoin derivatives contracts in the article “Three CFTC-Regulated Exchanges Self-Certify Bitcoin Derivatives Contracts” in the December 3, 2017 edition of Bridging the Week.)

As an example of how different sized firms might have different acceptable procedures, IFUS noted that a proprietary firm of five traders might conduct monitoring manually; however, a firm of 50 traders “may require an automated solution.” As a general rule, IFUS noted that “[t]he expectation is that larger firms and firms acting as intermediaries will have more sophisticated and extensive resources dedicated to their supervisory programs.”

IFUS’s amended rule 4.01 and guidance are scheduled to be effective January 1, 2020, unless the Commodity Futures Trading Commission intervenes. These measures will apply to all persons trading on IFUS whether registered with the CFTC or not, or members of IFUS or not. IFUS may bring disciplinary actions against any firm solely for violating its supervision rule; a violation of another substantive provision is not required.

Compliance Weeds: Although the CFTC imposes on registrants a general duty of supervision (click here to access CFTC Rule 166.3), the Commission has principally articulated its expectation of supervision through enforcement actions and the CFTC wields “failure to supervise” very broadly and often as a stand-alone violation.

In September 2017, for example, 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. 

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.

(Click here for background on the Tillage and Logista cases in the article “Two Commodity Pool Operators Charged by CFTC with Failure to Supervise” in the October 1, 2017 edition of Bridging the Week.)

Likewise, CME Group also imposes on parties accessing its exchanges a duty to supervise their employees and agents. (Click here to access CME Group Rule 432.W in Advisory RA1620-5/January 3, 2017.) However, CME Group also has mostly articulated its expectations of supervision in disciplinary actions. 

In an October 2017 disciplinary action against Arab Global Commodities DMCC, for example, the Commodity Exchange, Inc. claimed the firm failed to supervise one of its traders that engaged in spoofing transactions because it did not have an anti-spoofing policy; did not train its traders or managers regarding US prohibitions against spoofing; did not monitor for spoofing; and did not detect its trader’s purported spoofing. (Click here for background in the article “Proprietary Trading Firm Charged by CFTC with Spoofing Based Solely on the Alleged Wrongful Trading of One Employee" in the October 15, 2017 edition of Bridging the Week.) 

The National Futures Association has more detailed expectations regarding supervision, particularly related to the oversight of branch offices and guaranteed introducing brokers, and certain discrete topics, such as the handling of discretionary accounts and communications with the public. (Click here for background regarding the NFA’s expectations regarding registrants’ branch offices and guaranteed introducing brokers in the article “NFA Proposes Overhaul of Requirements for Supervision of Branch Offices and Guaranteed IBs” in the June 9, 2019 edition of Bridging the Week, and here regarding NFA’s general and some of its specific expectation regarding supervision in NFA Regulatory Requirements brochure (October 2019) at pages 20 - 23.)

In all cases, including IFUS’s new proposed requirements, adequate supervision likely requires at least four principal elements whether mandated expressly or in fact:

  1. implementation and maintenance of relevant policies and procedures (these should be revised and reviewed regularly to update in response to changed requirements);

  2. at least annual training (training should also occur ad hoc in connection with material new requirements or following evidence of a specific need);

  3. monitoring and follow-up (evidence of these reviews should be maintained electronically or in writing); and

  4. appropriate action when violations are identified (these actions should also be documented).

In 1978, the CFTC declined to articulate specific mandatory requirements of supervision. (Click here to access the relevant Federal Register publication at pg. 31889 (July 24, 1978).)

More Briefly:

Under the CFTC’s proposal, there would be three alternative capital approaches: a bank-based capital approach, a net liquid assets capital approach, and a tangible net worth capital approach for SDs. 

The CFTC requested revised comments on its 2016 proposal in light of “significant changes” to the swaps market since that time, and the Securities and Exchange Commission’s finalization of capital, margin and segregation requirements for security-based swap dealers.

In his dissent, Mr. Berkovitz argued that the re-opening for comments of the CFTC’s prior capital proposal is more in the nature of an “advanced rule-making” because it was not structured as a proposal that could lead to a final rule. This is because there are more than 140 questions asked, and no new rule text or amendments to the prior proposal. Mr. Berkovitz said that the questions appear designed mostly to encourage change “that only weaken what the Commission had previously proposed.” Mr. Behnam said that if the Commission seeks to modify its prior proposal through the solicitation of answers to questions it should have simply issued a new proposal. According to Mr. Behnam, “[a]sking further questions, without a clear signal as to where the Commission is going, at the minimum risks further slowing this nearly ten-year effort to finalize a capital rule by adding an unnecessary step.”

Separately, the Commission finalized the proposed deletion of most of its own regulations related to the creation, amendment and repeal of rules. The CFTC proposed this route in light of the already existing application of the Administrative Procedure Act to the CFTC’s rule-making process. (Click here for background in the article "CFTC Adopts Final Rule for Position Limits on Security Futures and Amendments to Volcker Rule" in the September 22, 2019 edition of Bridging the Week.) 

For further information:

Bitfinex Entities and NYS AG Express Different Views Regarding Legitimacy of AG’s Tether Investigation:

Broker-Dealer to Pay US $4 Million for Alleged Improper Handling of ADRs:

ICE Futures U.S. Proposes Formal Requirements of Supervision and Ancillary Guidance:

International Central Banks Organization Calls for Harsh Capital Treatment for Banks Holding Cryptoassets’ Exposure:

NY DFS Proposes Self-Certification Process for Licensed Cryptocurrency Firms to Transact in New Virtual Currencies:

Over Dissent of Two Commissioners, CFTC Re-proposes Re-proposed SWAP Dealer Capital Rules:

SEC Charges Individual and His Company With Fraud in Connection With Purported Illegal ICO:

The information in this article is for informational purposes only and is derived from sources believed to be reliable as of December 14, 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 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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