On July 24, 2017, the Commodity Futures Trading Commission (“CFTC”) approved the application of the first registered derivatives clearing organization (“DCO”) in virtual currency (including cryptocurrency) swaps.1 With the approval, LedgerX will act as a clearing house for derivatives contracts settling in virtual currency. The CFTC’s approval comes at a time of increasing demand for investments in virtual currencies (e.g., bitcoin or ether) and initial coin offerings (“ICOs”).
LedgerX will make it easier for investment funds to clear trades in virtual currency derivatives, allowing an investment adviser to hedge a fund’s investments in virtual currencies, which are known to be volatile. However, an investment adviser that places a fund’s assets in such derivatives should be mindful of the CFTC’s regulatory requirements for investments in virtual currency derivatives when making investment decisions.
Background
The Enforcement Division of the CFTC first outlined its position with respect to virtual currencies in In re Coinflip, an enforcement action against an operator of a bitcoin option contract exchange for violations of the Commodity Exchange Act (“CEA”).2 The CFTC alleged that Coinflip had violated the CEA because the broad definition of “commodity” under the CEA includes bitcoin and other virtual currencies and therefore Coinflip should have registered as a DCO or swap execution facility.3 The CFTC’s Enforcement Division again took the position that virtual currencies are commodities in two subsequent enforcement actions against operators of virtual currency derivative exchanges for violations of the CEA.4 These enforcement actions together with the approval of LedgerX’s DCO application make it clear that the CFTC intends to treat derivatives in bitcoin and other virtual or cryptocurrencies the same way it treats derivatives of traditional currencies.5
Legal Considerations
Because the CFTC treats derivatives contracts in bitcoin and other virtual currencies as commodity interests, investment advisers should consider the effect that such investments may have on their status as a commodity pool operator (“CPO”) or commodity trading advisor (“CTA”).
Under the CEA, the operator of a fund that conducts trading in commodity interests may have to register as a CPO6 and certain persons who advise others on the trading of commodity interests may have to register as a CTA.7 Advisers that are required to register as a CPO or CTA are subject to additional recordkeeping, reporting and disclosure requirements. The CEA and rules thereunder provide various exemptions, including a de minimis exemption from registration as a CPO8 and provide an exemption from registration as a CTA for certain registered investment advisers.9
Conclusion
The CFTC considers virtual currency derivatives contracts to be commodity interests. Investment advisers should treat them as they would any other commodity interest and consider whether investments in such derivatives rise to a level that would require registration, or the claiming of an exemption, as a CPO or CTA.
We will continue to monitor any developments regarding the CFTC’s treatment of derivatives in virtual currency. If you have any questions regarding virtual currency derivatives or other issues in connection with virtual or cryptocurrencies, please speak with your Seward & Kissel contact attorney.
______________________________________________________
1 In re the Application of LedgerX, LLC, (July 24, 2017)
2 In re Coinflip, Inc., CFTC No. 15-29 (Sept. 17, 2015)
3 The CFTC cited Board of Trade of City of Chicago v. SEC, 677 F.2d 1137, 1142 (7th Cir. 1982), in which the court discussed the definition of commodity under the CEA, which was “meant to encompass futures markets that were expected to be expanded to cover non-traditional goods and services.”
4 In re TeraExchange LLC, CFTC No. 15-33 (Sept. 24, 2015); In re BFXNA Inc., CFTC No. 16-19 (June 2, 2016)
5 Notably, in In re Coinflip, the CFTC distinguished bitcoin and other virtual currencies from “real currencies”: “Bitcoin is a ‘virtual currency,’ defined here as a digital representation of value that functions as a medium of exchange, a unit of account, and/or a store of value, but does not have legal tender status in any jurisdiction. Bitcoin and other virtual currencies are distinct from ‘real’ currencies, which are the coin and paper money of the United States or another country that are designated as legal tender, circulate, and are customarily used and accepted as a medium of exchange in the country of issuance.”
6 7 U.S.C. § 1a(10-11).
7 7 U.S.C. § 1a(12).
8 The de minimis exemptions of Rule 4.13 (for private funds) and Rule 4.5 (for registered funds) are similar and generally require (in addition to other requirements) either that (i) the initial margin, premiums and required security deposit for commodity interests do not exceed 5% of the liquidation value of the portfolio; or (ii) the net notional value of positions in commodity interests not exceed 100% of the liquidation value of the portfolio. 17 CFR § 4.13(3); 17 CFR § 4.5.
9 7 U.S.C. § 6m(3).
______________________________________________________
If you have any questions regarding the matters covered in this memo, please contact any of the partners and counsel listed below or your primary attorney in Seward & Kissel’s Investment Management Group
