Do We Have a Comprehensive Regulatory Framework for Virtual Currencies? It’s All in the Future(s)

Paul J. Devlin

By Paul J. Devlin

Paul J. Devlin is a partner at Richards Kibbe & Orbe LLP, where he represents institutions and individuals in high-stakes investigations, regulatory enforcement actions, white-collar cases and litigations, especially those raising market integrity questions and other important systemic issues for the financial markets. He is based in the firm’s New York office.

Today, there are over 1,500 different virtual (or crypto) currencies with an approximate market capitalization of $300 billion. While the underlying blockchain technology has immense promise, serious problems including fraud, computer hacking, illicit darknet transactions, money laundering, irrational investor exuberance, and extreme price volatility have cast a long shadow over virtual currencies. Clearly virtual currencies will be regulated, but how and by which regulators is not yet settled. The Securities and Exchange Commission and the Commodity Futures Trading Commission are both staking strong claims to this virtual Wild West. To date, the SEC has focused on initial coin offerings, or “ICOs,” while the CFTC has targeted non-ICO virtual currencies traded in cash or spot markets, as well as related derivatives markets. The SEC’s approach seems clear and consistent with precedent. For its part, the CFTC has left more open questions than answers.

This division of regulatory labor between the SEC and CFTC appears to be reasonable because ICOs are capital raisings while non-ICO virtual currencies like bitcoin behave, at least at present, more like a store of value or a medium of exchange. The SEC contends that ICOs are presumptively securities transactions, and therefore subject to the full panoply of the securities laws. The CFTC, on the other hand, asserts that virtual currencies are commodities under the Commodity Exchange Act (“CEA”), and are therefore within the CFTC’s anti-fraud and anti-manipulation enforcement jurisdiction. Together, these agencies hope to cover the virtual currency universe to ensure that all transactions are subject to the jurisdiction of at least one regulator.

These are early days, however, and the courts have not yet weighed in decisively on this proposed distribution of regulatory power. The SEC’s approach, while firmly rooted in well-established legal principles, potentially leaves vast swaths of virtual currencies outside its mandate. Notwithstanding the recent decision in CFTC v. McDonnell, ___ F. Supp. 3d ___, 2018 BL 76558 (E.D.N.Y. Mar. 6, 2018), which decided that virtual currencies are commodities under the CEA, there are real doubts about whether the CFTC’s enforcement jurisdiction is currently broad enough to take up the slack. Unlike the SEC, which has comprehensive regulatory power over securities, the CFTC has traditionally been a futures regulator with a limited role over spot and cash commodity markets. As discussed in more detail below, it may be that the CFTC’s jurisdiction is actually restricted to only those virtual currencies for which futures contracts exist. At present, only bitcoin futures contracts are traded. The absence of futures markets for any of the other non-ICO virtual currencies potentially undermines their status as CEA commodities.

I. The Spectrum of Virtual Currencies and Virtual Currency Transactions

The term “virtual currency” is frequently a misnomer. There is an array of digital products built on blockchain technology (a distributed peer-to-peer electronic ledger that verifies transactions through cryptography and by network consensus). Virtual currencies are created, acquired, and used in wildly divergent ways. Some believe that virtual currencies are like digital gold. Others argue that they are electronic currencies to be used in transactions, while still others advocate that they are, at least sometimes, securities. Much depends on individual facts and circumstances of the particular technology and transaction under consideration. An acquisition of a virtual currency through an ICO transaction is very different from earning bitcoin by “mining” (described below) or buying it online.

In a typical ICO, an entity seeking capital will issue virtual currency (often called virtual coins or tokens) in return for fiat currency or another virtual currency. While ICO tokens generally do not convey a formal equity interest in the issuer, they often grant rights to share in profits, or to access the enterprise’s goods and services. ICO participants may also hope to reap capital gains from secondary trading of virtual coins.

But not all virtual currencies are created in ICOs. For example, bitcoin, the most well-known virtual currency, is produced by “mining.” “Mining” is the process by which transactions are verified and added to the blockchain, something that demands substantial computing power. In return for these network services, an algorithm grants miners new bitcoin, which they can then hold, trade, or use to buy things. Though new bitcoin enters the market through the mining process, many people just buy existing bitcoin through online trading platforms. Some also receive bitcoin as payment for the sale of property or in return for services. And while many virtual currencies utilize a mining methodology, not all do so.

II. Some, But Not All, Virtual Currencies Are “Securities.”

Last year, the SEC’s Enforcement Division issued a report on an ICO by a virtual organization called DAO. Report of Investigation: The DAO, Exchange Act Release No. 81207 (July 25, 2017) (“ DAO”). In this ICO, virtual tokens were sold in exchange for “ether,” a virtual currency based on the Ethereum Blockchain. The plan was to use the ether to fund certain projects. DAO token holders hoped to share in the profits from some of the funded projects. While the token holders had some voting rights over projects, they were substantially reliant on the managerial efforts of others to turn a profit.

The SEC’s jurisdiction in DAO depended on the tokens being a “security.” Under the securities laws, it is well settled that the definition of a “security” is a matter of substance and economic reality over form. Following the venerable authority of SEC v. W.J. Howey & Co., 328 U.S. 293 (1946), the SEC concluded that the virtual tokens in DAO were unregistered securities because (i) an investment was made (ii) with a reasonable expectation of profits (iii) derived from the managerial efforts of others. DAO represents the relatively straightforward application of well-established principles to new technologies and products.

Clearly not every virtual currency will be a security. It is possible to envisage ICO coins that are harder to characterize than those in DAO. Beyond that, it is hard to see how non-ICO virtual currencies like bitcoin are securities. For instance, bitcoin holders do not in any real sense depend on the managerial efforts of others. But if non-ICO virtual currencies are not securities, are they then commodities?

III. Are Virtual Currencies Commodities?

Historically, the CFTC has been a futures and derivatives regulator, and not a general regulator of the spot or cash commodities markets. The CFTC can – and does – insist that futures markets are subject to the whole spectrum of its regulation, including registration requirements. With respect to spot and cash markets, though, the CFTC is restricted to anti-fraud and anti-manipulation enforcement jurisdiction where there is a “contract of any sale of any commodity in interstate commerce[.]” 7 U.S.C. § 9(1); 17 C.F.R. §§ 180.1 and 180.2. “The CFTC does not have regulatory authority over a simple quick cash sale or spot transactions that do not involve fraud or manipulation.” McDonnell, 2018 BL 76558, at *13.

Just as the SEC needed to find that it was dealing with a “security” in DAO, a “commodity” is the touchstone for CFTC enforcement jurisdiction under the CEA. If “commodity” is analyzed using economic arguments similar to those common in securities cases, there would be some good arguments for classifying non-ICO virtual currencies as commodities. Bitcoin, for instance, appears to be a “‘good[]’ exchanged in a market for uniform quality and value.” McDonnell, 2018 BL 76558, at *14. The problem is that, while expansive and flexible in its own way, the CEA’s drafters have diverged from the securities laws in an important respect.

A layman’s or an economist’s commodity is not always synonymous with a statutory commodity under the CEA. In addition to traditional agricultural commodities not relevant here, a “commodity” under the CEA includes “all other goods and articles . . . and all services, rights, and interests . . . in which contracts for future delivery are presently or in the future dealt in.” 7 U.S.C. § 1a(9) (emphasis added). In other words, a CEA commodity is defined simply as anything for which futures markets exist. See United States v. Brooks, 681 F.3d 678, 694 (5th Cir. 2012) (whether natural gas is a statutory commodity “turns on whether it is a good ‘in which contracts for future delivery are presently or in the future dealt with.’”). The CFTC’s spot enforcement jurisdiction is generally derivative of its futures oversight function. This is why something like natural gas would arguably not be a CEA commodity without natural gas futures markets, and why certain benchmarks such as the VIX index, which has linked futures products, may be a commodity even though it would not traditionally be so considered.

This definition presents a conundrum for the CFTC’s regulation of virtual currencies. Virtual currencies have seen a rapid expansion in spot markets unaccompanied by related futures trading. The CFTC has been asserting jurisdiction over virtual currencies since 2015, but the first bitcoin futures contracts were launched only recently in December 2017 by the CME and CBOE. See CFTC Statement on Self-Certification of Bitcoin Products by CME, CFE, and Cantor Exchange, Release No. 7654-17 (Dec. 1, 2017). There are not yet futures markets for any other virtual currencies.

A. The CFTC Steals a March on the Bitcoin Enforcement Journey.

It is instructive to review the history of the CFTC’s virtual currency enforcement jurisdiction because the CFTC’s pronouncements have been incorporated wholesale into McDonnell. For years, the CFTC has claimed enforcement jurisdiction over virtual currencies in an increasingly assertive fashion.

In 2014, the then-CFTC Chair told the Senate Agriculture Committee that “the CFTC’s jurisdiction with respect to virtual currencies will depend on the facts and circumstances pertaining to any particular activity in question[,]” though he foreshadowed CFTC oversight of derivatives contracts tied to virtual currencies. The Commodity Futures Commission: Effective Enforcement and the Future of Derivatives Regulation Before the S. Comm. on Agric., Nutrition and Forestry , 113th Cong. 55 (2014) (prepared written statement of Timothy Massad, CFTC Chair).

The CFTC first staked its claim that “Bitcoin and other virtual currencies” are statutory commodities in a 2015 settlement order. In re Coinflip, Inc., CFTC. No. 15-29, 2015 BL 301227 (Sept. 17, 2015). Two other settlement orders followed shortly thereafter reiterating this position: In re TeraExchange LLC, CFTC No. 15-33, 2015 BL 310738 (Sept. 24, 2015), and In re BFXNA Inc., CFTC No. 16-19, 2016 BL 176656 (June 2, 2016) (“ Bitfinex”). Then, in October 2017, the CFTC published a primer on virtual currencies which restated the CFTC’s view that “Bitcoin and other virtual currencies are properly defined as commodities[.]” U.S. Commodity Futures Trading Commission, A CFTC Primer of Virtual Currencies 11 (2017),

The problem with the CFTC’s claims that all virtual currencies are commodities is their conclusory nature. The extent of the reasoning in Coinflip is the following: “Section 1(a)(9) of the Act defines ‘commodity’ to include, among other things, ‘all services, rights, and interests in which contracts of 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.” Coinflip, 2015 BL 301227, at *2 (citations omitted). Coinflip does not explain why the CFTC deemed bitcoin to be a commodity, or why this position automatically applies to other virtual currencies.

There is little dispute that virtual currencies are goods, articles, services or rights or interests of some sort. That part of the CEA definition is sufficiently broad. But what the CFTC failed to do in Coinflip and its progeny is to identify the related “contracts for future delivery” that are required under the CEA’s definition of “commodity,” perhaps because no such contracts existed at the time.

B. McDonnell: Bitcoin Futures Contracts Transform All Other Virtual Currencies into Commodities

This brings us back to McDonnell. The McDonnell opinion was issued on a preliminary injunction motion in a CFTC enforcement action against pro se defendants. Customers paid defendants (in either U.S. dollars or in virtual currency) in return for promises of staggering returns. Defendants allegedly did not provide the promised services, nor pay the promised returns, and misappropriated the real and virtual currency transferred to them. McDonnell, 2018 BL 76558, at *2.

In granting the preliminary injunction to the CFTC, the court essentially followed the CFTC’s lead in Coinflip, TeraExchange, and Bitfinex. Like the CFTC, the court failed to explicitly say why virtual currencies are statutory commodities. Nonetheless, the reasons for the court’s decision can be teased out. The court stated correctly that “[w]here a futures market exists for a good, service, right, or interest, it may be regulated by the CFTC as a commodity, without regard to whether the dispute involves futures contracts.” McDonnell, 2018 BL 76558, at *13. In an earlier part of the opinion, the court posited that “[l]egitimization and regulation of virtual currencies has followed from the CFTC’s allowance of futures trading on certified exchanges.” Id. at *7. While the court did not link these two statements explicitly, a reasonable reading of the opinion is that the CFTC has enforcement jurisdiction over all virtual currencies because there are bitcoin futures. Read this way, McDonnell ratifies the relevant parts of Coinflip and TeraExchange, and Bitfinex, because bitcoin futures markets now exist.

The broader question is: Does the new futures market for bitcoin mean that all virtual currencies are now commodities? Is “litecoin” a commodity? Is “ripple”? No futures markets yet exist for these virtual currencies, therefore claims that these and all other virtual currencies are also commodities seem to deserve some skepticism. Does the CFTC have jurisdiction over alleged manipulation in tea sales, for which no futures markets exist, because there are coffee futures? Does the CFTC have enforcement jurisdiction over the metal lithium (which does not yet have a futures contract) because gold futures are traded? Or are virtual currencies more like natural gas, which is a commodity even where the natural gas is located at a hub that does not underlie a futures contract? See Brooks, 681 F.3d at 695 (“[I]t would be peculiar that natural gas at another hub is not a commodity, but suddenly becomes a commodity solely on the basis that it passes through Henry Hub, and ceases to be a commodity once it moves onto some other locale . . . the actual nature of the ‘good’ does not change.”). Most commodity lawyers would pause before answering these questions. It may be that these analogies to tea, lithium, and natural gas are apposite or inapposite to virtual currency regulation. But that is hard to know because the CFTC and the courts have yet to even ask the question.

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