October 1, 2015
Authored by: Bryan Cave Leighton Paisner
On September 17, 2015, the CFTC entered into a settlement with Coinflip, Inc. d/b/a Derivabit and Francisco Riordan. As part of the settlement with Coinflip, the CFTC entered an Order which included findings and the imposition of remedial sanctions. The CFTC found that Coinflip operated an “options trading platform that connected buyers and sellers of standardized Bitcoin options and futures contracts.” By doing so, the company had violated the Commodities Exchange Act by operating a facility for trading options or processing swaps without being registered with the CFTC as a Swap Execution Facility or a designated contract market.
Coinflip advertised Derivabit as a “risk management platform . . . that connects buyers and sellers of standardized Bitcoin options and futures contracts.” Coinflip listed put and call options contracts as eligible for trading on the Derivabit platform. These contracts listed Bitcoin as the asset underlying the option and denominated the strike and delivery prices in US Dollars. Customers could place orders by registering as a user and depositing Bitcoin into an account in their name. The option contracts were settled using Bitcoin at a spot rate determined by a third-party Bitcoin currency exchange. Users could post bids or offers for the options contracts. Coinflip confirmed the bids or offers through the website.
The case is interesting because for the first time the CFTC publicly stated that Bitcoin and other virtual currencies are “commodities” subject to CFTC enforcement actions:
Section 1a(9) of the Act defines “commodity” to include, among other things, “all services, rights and interests in which contracts for future delivery are presently or in the future dealt in.” . . . The definition of “commodity” is broad. . . . .Bitcoin and other virtual currencies are encompassed in the definition and properly defined as commodities.
To regular observers of the CFTC, the Coinflip decision was not surprising. In May 2013, then Commissioner Chilton noted “[i]n essence, we’re talking about a type of shadow currency, and there is more than a colourable argument to be made that derivative products relating to Bitcoin fall squarely in our jurisdiction.”
More recently, CFTC Chairman Timothy Massad, on December 10, 2014, noted in his testimony to Congress that:
The CFTC’s jurisdiction with respect to virtual currencies will depend on the facts and circumstances pertaining to any particular activity in question. While the CFTC does not have policies and procedures specific to virtual currencies like Bitcoin, the agency’s authority extends to futures and swaps contracts in any commodity. The CEA defines the term commodity very broadly so that in addition to traditional agricultural commodities, metals, and energy, the CFTC has oversight of derivatives contracts related to Treasury securities, interest rate indices, stock market indices, currencies, electricity, and heating degree days, to name just a few underlying products.
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As with all new developments, we must remain vigilant to ensure market integrity, and will continue to evaluate these new contracts over time
There are nevertheless complaints that this latest ruling creates undue confusion. After all, the IRS has indicated that Bitcoin is “property,” FinCEN has determined that it is “currency, funds or value that substitutes for currency” and now the CFTC has declared it to be a commodity.
However, as noted by Chairman Massad, the treatment of Bitcoin and other digital currencies will depend on “facts and circumstances.” The Coinflip decision rested on the fact that the business was trading options and derivatives based on Bitcoin through a facility that should have been registered as a Swap Execution Facility. The CFTC did not suggest that all Bitcoin enterprises would be subject to CFTC supervision.
In a January 2015 interview by Coindesk of outgoing CFTC Commissioner Mark Wetjen, Wetjen stressed the limited nature of the CFTC’s jurisdiction. For example, a finding that Bitcoin is a commodity would not impact Bitcoin exchanges:
The CFTC. . . does not have extensive oversight over Bitcoin exchanges that do not offer derivatives contracts. “Where market participants are simply buying and selling Bitcoin on an exchange, we wouldn’t have oversight responsibilities for those exchanges,” . . .
. . . .
In an instance where there are manipulative or fraudulent activities in the cash market, that is the type of case where the definition of a commodity comes into play and we can use that authority to prosecute bad behavior in the cash market,” Wetjen clarified.
Nevertheless, as one more federal enforcement action targets Bitcoin and potentially other digital currency businesses, the Coinflip decision is a stark reminder that digital currency entrepreneurs must move forward with care.
Digital currency businesses should consider if their business requires licensing or registration in order to be conducted legally in US dollars. Are they operating a platform or a contract market that could be deemed a designated contract market or a Swap Execution Facility. They should be mindful that they are not free of CFTC jurisdiction just because they are dealing in digital currencies – – this distinction will not shield you from liability. Federal regulators including the CFTC, the SEC, FinCEN, and the IRS have made it clear that they intend to exercise their jurisdiction over digital currency businesses that violate the law.
Any firm that is planning to trade in or develop a platform to facilitate the trading of virtual currencies should proceed with caution. Similarly, anyone looking to invest in a collective investment vehicle that focuses on virtual currencies should make sure the vehicle is properly structured to comply with the securities laws. Due to the lack of clearly defined guidance with respect to the authority of the SEC, the CFTC, FinCEN and state regulators to supervise virtual currencies, it is important that you engage experienced counsel to assist you in navigating the regulatory requirements that may apply to any business you are building.