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LabCFTC Issues Primer on CFTC Regulation of Virtual Currencies
Practical Law Legal Update w-011-0695 (Approx. 7 pages)
LabCFTC Issues Primer on CFTC Regulation of Virtual Currencies
by Practical Law Finance
| Published on 26 Oct 2017 • USA (National/Federal) |
The CFTC's LabCFTC released a primer on virtual currencies that sets out the CFTC's position regarding its oversight of these instruments and provides an educational overview of virtual currencies such as bitcoin.
On October 17, 2017, the CFTC's LabCFTC released a primer on virtual currencies that:
- Describes the role of the CFTC in the regulation of virtual currencies, including the scope of the CFTC's authority as well as examples of permitted and prohibited activities involving virtual currencies (see CFTC Oversight of Virtual Currencies).
- Provides an overview of virtual currencies and examples of potential uses and risks of virtual currencies (see Uses and Risks of Virtual Currencies).
The primer is intended to be the first in a series of LabCFTC primers on financial technology (fintech) innovation. The CFTC also issued a press release on the primer.
The CFTC launched LabCFTC in May 2017 to encourage fintech innovation in markets subject to CFTC oversight and to aid the CFTC's engagement with new fintech solutions and innovation opportunities (see Legal Update, CFTC Launches LabCFTC Fintech Initiative).
CFTC Oversight of Virtual Currencies
The CFTC describes virtual currency using a definition from IRS Notice 2014-21 (IRS notice), which provides guidance on tax principles applicable to transactions using virtual currencies. The IRS notice defines virtual currency generally as a digital medium of exchange that operates like currency but does not have legal tender status in the US. Convertible virtual currency is virtual currency that has an equivalent value in real currency. Bitcoin is an example of a convertible virtual currency.
According to the CFTC, bitcoin and other virtual currencies may be commodities under the Commodities Exchange Act (CEA) depending on their particular facts and circumstances (see Legal Update, CFTC: Bitcoin a “Commodity” Subject to Dodd-Frank Swaps Rules). The primer notes that the SEC recently released an investigative report determining that sales of digital assets by virtual organizations using blockchain or distributed ledger technology (DLT) are securities (see Legal Update, SEC Issues Investigative Report Concluding Virtual Assets May Be Securities). The primer states the CFTC's position that there is no inconsistency between the SEC's report and the CFTC's determination.
The primer provides an overview of the CFTC's oversight of virtual currencies, which is implicated when either:
- A virtual currency is used in a derivatives contract; or
- There is an instance of fraud or manipulation involving virtual-currency trading.
The primer lists examples of both permitted and prohibited activities involving virtual currencies.
Permitted activities. Examples of permitted activities involving virtual currencies include:
- The CFTC-registered swap execution facility (SEF) TeraExchange, LLC, entering into the virtual currency market in 2014.
- The designated contract market (DCM) North American Derivatives Exchange Inc. (NADEX), listing binary option contracts based on the Tera Bitcoin Price Index.
- The CFTC-registered SEF and derivatives clearing organization (DCO) LedgerX, LLC planning to list digital currency options (see Legal Update, CFTC Registers Digital Currency Trading Platform as Derivatives Clearinghouse).
Prohibited activities. Examples of prohibited activities involving virtual currencies include:
- Price manipulation.
- Pre-arranged trading in an exchange-traded virtual-currency swap.
- A virtual-currency futures or option contract or swap that is traded on an unregistered US trading platform.
- Off-exchange financed commodity transactions.
Uses and Risks of Virtual Currencies
The primer provides a general overview of virtual currencies and their uses and risks in financial markets. The primer's overview describes:
- Virtual currencies such as bitcoin that are built on blockchain or DLT technologies.
- The differences between private and public ledger systems.
- Potential uses for virtual currencies, which include storing value, trading, use for payment and settlement of transactions, and transferring money.
In addition, according to the primer, potential applications of blockchain and DLT (see Article, Expert Q&A on Blockchain Technology in Banking and Financial Services) include:
- Trading platforms, regulatory reporting, know your customer (KYC) compliance, and repurchase agreements (repos) for financial institutions.
- General records management, real property deeds and title transfers, and regulatory reporting and oversight for governments.
- Smart contracts, resource sharing agreements, and digital identity for cross-industry uses (see Practice Note, Smart Contracts: Best Practices).
The primer also details certain risks of virtual currencies as including:
- Operational risk, since some virtual-currency platforms are not subject to regulation and lack adequate system safeguards to provide customer protection.
- Speculative risk, since the virtual-currency marketplace is highly volatile.
- Cybersecurity risk, since digital wallets may be vulnerable to hackers and some virtual-currency platforms may mix customer assets in shared accounts, which affects currency withdrawal.
- Fraud and manipulation risk, since some unregistered virtual-currency platforms may be unable to protect customers from market abuses. There is also the risk of Ponzi and other fraudulent schemes.