Back to Drawing Board for CFTC Cryptocurrency Guidance?

By Lydia Beyoud

The nation’s top derivatives regulator may have to rethink the direction it takes in regulating cryptocurrency trading after a federal judge this month dismissed an enforcement action against a precious metals dealer.

The Commodity Futures Trading Commission’s case against Monex, which lacks the name recognition of Bitcoin, may have flown under the radar for much of the cryptocurrency community. But the case is likely to have a significant impact on the industry, as well as the agency’s broader enforcement authority.

“I think initially people lost the significance of this case because it had to deal with precious metals, but this case is all about cryptocurrencies,” Gary DeWaal, special counsel at Katten Muchin Rosenman LLP in New York, told Bloomberg Law.

The CFTC issued proposed guidance in December exempting retail cryptocurrency trading from direct regulatory oversight, under certain circumstances. A key part of the guidance would extend an exemption from registration and regulation as a commodity future to retail crypto transactions involving a margined, leveraged, or financed transaction, so long as the commodity purchased is delivered to the buyer within 28 days.

However, the U.S. District Court for the Central District of California’s May 1 opinion in CFTC v. Monex may call into question whether the CFTC can pursue that exemption for virtual currencies, or whether it needs to reconsider how it defines “actual delivery” of them.

That’s because Judge James V. Selna found that the CFTC’s reasoning in its enforcement complaint against Monex would effectively eliminate the actual delivery exemption for retail commodities transactions. He also said it would contravene the CFTC’s 2013 final interpretation of the meaning of “actual delivery.”

The CFTC typically considers who has control to determine whether actual delivery of a commodity has been met within the 28-day window. But in his opinion, Selna said that doesn’t work in the context of leveraged transactions.

“No one’s lending money without taking a lien,” DeWaal said. “To create a safe harbor for lending money but effectively not allowing it to be exercised, that is a problem. [The judge] looked at that and said that doesn’t make sense.”

In the Monex case, the CFTC alleged the gold dealer committed fraud and failed to deliver control over purchased gold and other metals to buyers within 28 days of execution, in part because it held the precious metals in independent depositories while waiting for the buyer to pay the dealer back for the financing used to purchase the metals.

“The Court can conceive of no plausible leveraged retail transaction of fungible commodities that would not involve at least some of the same alleged practices,” Selna said. Adopting the CFTC’s reasoning in that case would eliminate the actual delivery exemption for retail commodities transactions, he said.

Although Selna dismissed the case, it’s possible the CFTC may seek an appeal. A CFTC spokeswoman declined to comment on whether the agency would seek an appeal.

Regulating Digital Assets

The court’s reasoning and interpretation of the Commodity Exchange Act and its legislative history “put the narrow interpretation for what constitutes actual delivery into question,” Kari Larsen, counsel with Reed Smith LLP in New York, told Bloomberg Law.

Many cryptocurrency transactions take place on exchanges. However, others involve a financed, margined, or leveraged transaction between a dealer and buyer, with the latter hoping the cryptocurrency will increase in value sufficient to cover the amount borrowed from the dealer. That could take longer than 28 days, and a dealer is unlikely to transfer control of the virtual currency commodity to the purchaser without some sort of lien or security.

Two examples in the proposed guidance would require a dealer not to retain an interest in a virtual currency to gain the actual delivery exemption.

“This requirement would appear inconsistent with the Court’s decision in Monex, in which the Court held that the fact that Monex continued to have a security interest in the metals purchased on margin did not negate the ‘actual delivery’ that was made to customers,” Jason Grimes, an associate at Covington & Burling LLP in Washington, told Bloomberg Law by email.

The inconsistency may cause the CFTC to revisit that requirement before issuing its final guidance, Grimes said. However, “it is unclear whether the CFTC will take the decision into consideration given the guidance may come out soon,” he added.

Asset-Backed Token Application

If the CFTC tries to narrowly construe “actual delivery” in the cryptocurrency space, the Monex opinion could give groups a basis to challenge that construction, said Larsen, co-lead of Reed Smith’s global fintech practice.

“I do think that they’re going to have to go back a little bit, not necessarily to the drawing board, but really consider whatever proposal they’re planning on issuing” for actual delivery of virtual currencies, Larsen said.

The CFTC will have to continue to think through the actual delivery question as the use of distributed ledger drives other technology innovations, as well.

“With more and more assets being tokenized, this is going to be an issue for more than just cryptocurrencies,” Larsen said.

Enforcement Reach

The Monex decision may also affect the CFTC’s broader enforcement authority. With a change in reading of a single word, Selna called into doubt a major enforcement authority the CFTC has wielded for nearly eight years.

Selna determined the legislative history of the 2010 Dodd-Frank Act should be read as only allowing the CFTC to bring antifraud enforcement cases in connection with charges of market manipulation, but not as a stand-alone charge. Market manipulation can be much harder to prove.

“What you have here now is you have a judge who has basically read an ‘or’ as an ‘and’ and said it now has to be fraud-based manipulation only” to bring an enforcement action, said DeWaal, a former CFTC Enforcement Division attorney and specialist in cryptocurrency legal issues.

“It’s a dramatic viewpoint” that is inconsistent with the way the CFTC has previously applied the law, he said.

Although the decision is not binding outside the Central District of California, “as a matter of influence, people will certainly take notice” for future CFTC enforcement actions related to fraud, DeWaal said.

The decision may cause the swaps and futures regulator to modify their enforcement tactics, he said. “My guess is they’ll plead their cases to include the magic words ‘fraud-based manipulation’ going forward,” DeWaal said of the CFTC.

The case is CFTC v. Monex Credit Co. , C.D. Cal., 8:17-cv-01868-JVS-DFM, order issued 5/1/18 .

To contact the reporter on this story: Lydia Beyoud in Washington at lbeyoud@bloomberglaw.com

To contact the editor responsible for this story: Michael Ferullo at mferullo@bloomberglaw.com

For More Information

Text of the order is at http://src.bna.com/yFt.

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