On Friday, December 15, 2017, the Commodity Futures Trading Commission (CFTC) issued a proposed interpretation of the term “actual delivery” for purposes of determining whether certain virtual currency transaction could be deemed “retail commodity transactions” subject to the CFTC’s jurisdiction under the Commodity Exchange Act (CEA).[1]

Background

This new proposed interpretation builds on the CFTC’s 2015 Coinflip enforcement action, where it first asserted that virtual currencies should be treated as “commodities” under the CEA.[2]  This conclusion had the effect of placing derivatives involving virtual currency in the United States exclusively within the regulatory jurisdiction of the CFTC, whether as swaps, options or, most recently, futures.[3]  In contrast, the CFTC’s jurisdiction over pure “spot” transactions is limited to general anti-fraud and anti-manipulation authority.

However, an important exception to this framework is the CFTC’s jurisdiction over “retail commodity transactions.”  Those transactions include commodity transactions entered into, or offered to, a retail counterparty on a leveraged, margined or financed basis.[4]  If so, these transactions are treated as “futures” subject to the CFTC’s jurisdiction.

The CEA provides an exception from the retail commodity transaction definition if the contract of sale results in “actual delivery” within 28 days, even if it involves leverage, margin or financing.[5]  In guidance that predated the classification of virtual currencies as commodities, the CFTC noted that it would “employ a functional approach” to the interpretation of “actual delivery,” focusing on transfer of title and possession of the commodity to the purchaser or a depository acting on the purchaser’s behalf.[6]  Notably, the CFTC’s prior guidance held that mere “book entries” would not be sufficient to demonstrate actual delivery.

The application of this “actual delivery” standard to virtual currencies became a live issue with the CFTC’s 2016 Bitfinex enforcement action.[7]  In that case, the CFTC focused on the following factors: (1) purchasers’ bitcoin was initially held in an omnibus account, (2) Bitfinex exclusively held the private keys, and (3) Bitfinex did not transfer possession and control to purchasers until all liens were satisfied.  In the Bitfinex case, the CFTC concluded that “actual delivery” did not occur for bitcoin held in the omnibus account and the CFTC had jurisdiction over the transactions.

Proposed Interpretation

The CFTC’s proposed interpretation was issued in response to requests for guidance in the wake of the Bitfinex case and specifically addresses the meaning of the actual delivery exception in the context of virtual currency transactions.  The CFTC noted that it will continue to apply the “functional approach” adopted in its prior guidance and, in the specific context of virtual currencies, that “actual delivery” will only occur where:

(1)  A customer [has] the ability to: (i) Take possession and control of the entire quantity of the commodity, whether it was purchased on margin, or using leverage, or any other financing arrangement, and (ii) use it freely in commerce (both within and away from any particular platform) no later than 28 days from the date of the transaction; and

(2)  The offeror and counterparty seller (including any of their respective affiliates or other persons acting in concert with the offeror or counterparty seller on a similar basis) [do not retain] any interest in or control over any of the commodity purchased on margin, leverage, or other financing arrangement at the expiration of 28 days from the date of the transaction.  (footnotes omitted)

The CFTC further clarified that “actual delivery” of virtual currency cannot be satisfied where the offering party (including, for example, the virtual currency exchange), counterparty seller, or any of their agents retain any interest or control over the virtual currency at the conclusion of 28 days.  The CFTC noted that “physical settlement” in the virtual currency is required, not merely a cash or virtual currency settlement that covers the transferred virtual currency’s value.

In examples illustrating this interpretation, the CFTC stated that actual delivery would occur where virtual currency is transferred to a purchaser’s own digital wallet on the public blockchain or to a depository (such as a third-party wallet or other storage system) acting as agent for the purchaser, so long as the seller transfers title and neither it, the offeror nor persons acting in concert with them retain any control or title to, or liens over, the virtual currency.  For actual delivery to be effective, the purchaser’s wallet may not be affiliated with the counterparty seller, but the CFTC left open the possibility that the purchaser’s depository could be affiliated with a third-party offeror, such as an exchange, so long as that offeror did not act as intermediary (e.g., a matching platform that receives virtual currency from the seller before delivering it to the purchaser) or otherwise in concert with the seller.  By contrast, actual delivery could not occur by mere book entry without corresponding delivery and transfer of title, or where a contract is rolled, offset against, netted out or settled via cash or other virtual currency.

Final Thoughts

  • Effect on Existing Business Models. It is unclear whether the CFTC’s proposed interpretation is consistent with the commercial realities of virtual currency markets as currently structured.  It remains to be seen whether the proposed CFTC interpretation, along with the prior decisions, will require changes to some existing business models for virtual currency transactions and wallets.
  • Role of Depositories. The CFTC raises questions about the role of depositories, how they should be regulated, and their relationship with retail commodity offerors.  Resolving these questions will be critical to the continued development of the virtual currency market, given the significant limitations that otherwise apply to retail commodity transactions.
  • CFTC Exemptions? In its request for comment, the CFTC noted that it has exemptive authority to exempt retail commodity transactions from the exchange trading and related registration requirements applicable to futures, even if actual delivery is not satisfied.  The CFTC then specifically asked whether to establish a distinct registration and compliance regime for retail commodity transactions in virtual currency.  Market participants will want to consider the nature and feasibility of such a regime, which might allow for more flexible custody structures than the CFTC’s proposed interpretation.
  • Implications for State Regulation.  The CFTC’s proposed interpretation could have ramifications beyond the scope of the CFTC’s jurisdiction.  A number of states have adopted a version of the Model State Commodity Code.  These codes generally prohibit all commodity contracts that do not meet certain specified exemptions, including exemptions for transactions conducted by banks, trust companies or certain entities or persons subject to CFTC or Securities and Exchange Commission regulation.  Unless the transaction is subject to one of these exemptions or results in “physical delivery” of the commodity within 28 days, the commodity contract is prohibited.  While there are material differences in the language of the CEA and the Code, it is certainly not impossible that the CFTC’s “actual delivery” interpretation could be adopted by relevant state authorities in interpreting their “physical delivery” standards as applied to virtual currencies.  Unlike the CEA, the Code applies to all spot commodity transactions, including where no leverage, margin or financing is involved.  Consequently, the CFTC’s interpretation of the “actual delivery” standard may be even more critical for virtual currency markets operating in states that have adopted the Code or similar commodities laws.

[1] Retail Commodity Transactions Involving Virtual Currency, 82 Fed. Reg. 60,335 (Dec. 20, 2017), available at http://www.cftc.gov/idc/groups/public/@lrfederalregister/documents/file/2017-27421a.pdf.

[2] See In the Matter of Coinflip, Inc., d/b/a Derivabit, and Francisco Riordan, CFTC Docket No. 15-29 (2015), available at http://www.cftc.gov/idc/groups/public/@lrenforcementactions/documents/legalpleading/enfcoinfliprorder09172015.pdf.

[3] See Bitcoin’s Futures:  CME and Other Exchanges Self-Certify Bitcoin Futures and Options with the CFTC, available at https://www.clearyfintechupdate.com/2017/12/bitcoins-future-cme-exchanges-self-certify-bitcoin-futures-options-cftc/.

[4] CEA Section 2(c)(2)(D).  For this purpose, a “retail” counterparty is one that does not qualify as an “eligible contract participant” or “eligible commercial entity.”  In most instances, an individual must have more than $10 million invested on a discretionary basis to qualify as a non-retail counterparty.

[5] CEA Section 2(c)(2)(D)(ii)(III)(aa).

[6] See Retail Commodity Transactions Under Commodity Exchange Act, 78 Fed. Reg. 52,426 (Aug 23, 2013).

[7] In the Matter of BFXNA Inc. d/b/a Bitfinex, CFTC Docket No. 16-19 (2016), available at http://www.cftc.gov/idc/groups/public/@lrenforcementactions/documents/legalpleading/enfbfxnaorder060216.pdf.