{"id":4306,"date":"2016-12-03T16:05:22","date_gmt":"2016-12-03T21:05:22","guid":{"rendered":"http:\/\/journals.law.harvard.edu\/hblr\/?p=4306"},"modified":"2016-12-07T10:02:52","modified_gmt":"2016-12-07T15:02:52","slug":"bitcoin-and-virtual-currencies-welcome-to-your-regulator","status":"publish","type":"post","link":"https:\/\/journals.law.harvard.edu\/hblr\/bitcoin-and-virtual-currencies-welcome-to-your-regulator\/","title":{"rendered":"Bitcoin and Virtual Currencies: Welcome to Your Regulator"},"content":{"rendered":"

Download PDF<\/a><\/p>\n

Matthew Kluchenek\u2020<\/sup><\/a><\/p>\n

I.\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0<\/strong>Introduction<\/strong><\/p>\n

Among all the U.S. regulators interested in regulating Bitcoin and virtual currencies, the Commodity Futures Trading Commission (CFTC) is determined to be at the forefront. Since the announcement by CFTC Chairman Timothy Massad in late 2014 that Bitcoin derivatives should fall within the scope of the CFTC\u2019s jurisdiction,[1]<\/sup><\/a> the CFTC has been aggressive in addressing not only wrongful conduct involving Bitcoin derivatives, but also wrongful conduct involving certain spot Bitcoin transactions.<\/p>\n

The CFTC\u2019s actions are a clarion call for market participants to understand the broad breadth of the CFTC\u2019s jurisdiction, and to take notice of the requirements that may apply both to derivatives and to certain physical transactions involving Bitcoin and other virtual currencies.<\/p>\n

II. \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0Scope of CFTC\u2019s Jurisdiction<\/strong><\/p>\n

The U.S. Commodity Exchange Act (CEA),[2]<\/sup><\/a> as amended by Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the Dodd-Frank Act),[3]<\/sup><\/a> regulates transactions in \u201ccommodity interests.\u201d[4]<\/sup><\/a> The CFTC, an independent federal agency, is charged with administering the CEA and has exclusive jurisdiction over transactions involving commodity interests.[5]<\/sup><\/a> Throughout the history of the CFTC, and particularly with respect to the Dodd-Frank Act, Congress has ceded broad power to the CFTC to interpret and promulgate rules regarding commodity interest products, transactions, and market participants.[6]<\/sup><\/a><\/p>\n

As a general matter, the CFTC\u2019s jurisdiction flows from the definition of a \u201ccommodity\u201d under the CEA.[7]<\/sup><\/a> At bottom, if a \u201ccommodity\u201d is not involved in a contract, agreement, or transaction, the CFTC lacks the statutory basis to regulate the contract, agreement, or transaction.[8]<\/sup><\/a> The definition of a \u201ccommodity,\u201d however, is exceedingly broad under the CEA. The definition delineates a laundry list of agricultural products, but also sweeps in \u201call services, rights, and interests (except motion picture box office receipts, or any index, measure, value or data related to such receipts) in which contracts for future delivery are presently or in the future dealt in.\u201d[9]<\/sup><\/a> As a result, almost anything except onions[10]<\/sup><\/a> and movie box office receipts[11]<\/sup><\/a> can constitute a \u201ccommodity\u201d under the definition, including bottles of wine, baseball cards, reference rates, indices, mathematical permutations, services, intangibles, and contingencies that would not seemingly fall within the traditional view of a commodity.[12]<\/sup><\/a><\/p>\n

If, however, a commodity is involved, then the CFTC may only assert jurisdiction if a \u201ccommodity interest\u201d is based on the commodity.[13]<\/sup>[<\/a> A \u201ccommodity interest\u201d refers to the types of instruments that are subject to the CFTC\u2019s regulation, which are: (i) futures contracts, (ii) options on futures contracts, (iii) swaps, (iv) leveraged retail foreign exchange contracts, (v) leveraged retail commodity transactions, and (vi) certain other leveraged products.[14]<\/sup><\/a> Importantly, the CFTC\u2019s jurisdiction is thus not\u2014as many assume\u2014limited to \u201cderivatives,\u201d but rather also extends to certain spot, or physical market, transactions.<\/p>\n

As a result, in seeking to assert jurisdiction over a contract, agreement, or transaction involving a commodity, the CFTC\u2019s jurisdictional hook is premised upon whether a commodity interest is involved. If so, and assuming that no exclusions or exemptions apply, the CFTC has a basis to assert regulatory authority.<\/p>\n

III. \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 Bitcoin as a \u201cCommodity\u201d under the Commodity Exchange Act<\/strong><\/p>\n

In the context of Bitcoin (and other virtual currencies), the threshold issue is whether Bitcoin is a \u201ccommodity.\u201d If Bitcoin is a commodity, then the CFTC may regulate commodity interests based on the commodity. If Bitcoin is not a commodity, then the CFTC lacks the authority to so regulate.<\/p>\n

In December 2014, CFTC Chairman Timothy Massad telegraphed the CFTC\u2019s intent to regulate Bitcoin derivatives<\/em>, stating that \u201cderivatives contracts based on a virtual currency represent one area within [the Commission\u2019s] responsibilit[ies].\u201d[15]<\/sup><\/a> Little elucidation was given. However, in September 2015, the CFTC took a significant step in asserting jurisdiction when it issued an order determining that \u201cBitcoin and other virtual currencies are encompassed in the definition and properly defined as commodities.\u201d[16]<\/sup><\/a><\/p>\n

The CFTC\u2019s determination did not arise out of a rulemaking or an interpretation, but rather via an enforcement action against an online Bitcoin trading platform called \u201cDerivabit,\u201d which was owned by Coinflip, Inc.[17]<\/sup><\/a> Coinflip operated the trading platform, which was designed for risk management purposes, in an effort to bring together buyers and sellers of Bitcoin option contracts.[18]<\/sup><\/a> Coinflip was not registered with the CFTC.<\/p>\n

In making the pronouncement that Bitcoin is a commodity, the CFTC effectively determined that Bitcoin is not a currency. According to the CFTC, \u201cBitcoin and other virtual currencies are distinct from \u2018real\u2019 currencies, which are the coin and paper money of the United States or another country that are designated as legal tender, circulate, and are customarily used and accepted as a medium of exchange in the country of issuance.\u201d[19]<\/sup><\/a><\/p>\n

Importantly, the CFTC\u2019s determination is not limited to Bitcoin, but extends to \u201cother virtual currencies,\u201d which the CFTC broadly defines as \u201ca digital representation of value that functions as a medium of exchange, a unit of account, or a store of value, but does not have legal tender status in any jurisdiction.\u201d[20]<\/sup><\/a> Thus, the definition of \u201cvirtual currency\u201d could also engulf Litecoin and Dogecoin, among others yet to be created.<\/p>\n

Based on its determination that Bitcoin is a commodity, the CFTC applied the CEA\u2019s provisions to the Derivabit trading platform, finding that Coinflip unlawfully offered commodity options by operating a facility for the trading of such options without being registered as a designated contract market (that is, a futures exchange) or a swap execution facility (SEF).[21]<\/sup><\/a> Importantly, because Coinflip offered commodity options, which are derivatives, the CFTC had an ostensibly clear basis to assert jurisdiction once the agency determined that Bitcoin is a commodity.[22]<\/sup><\/a><\/p>\n

Just one week after the Coinflip settlement, and armed with its determination that Bitcoin is a commodity, the CFTC brought its second Bitcoin-related enforcement action, this time against TeraExchange, LLC (Tera), an SEF.[23]<\/sup><\/a> In the action, the CFTC alleged that Tera failed to enforce its prohibition on wash trades by facilitating the prearrangement of a single Bitcoin swap transaction.[24]<\/sup><\/a><\/p>\n

As with the Coinflip matter, the CFTC\u2019s enforcement action against Tera involved a derivative\u2014that is, here, swaps based on Bitcoin. The presence of the swap, coupled with Tera\u2019s provisional registration with the CFTC as an SEF, provided the CFTC with an unambiguous pathway to assert jurisdiction. Soon thereafter, however, the CFTC\u2019s path would take a different, and more aggressive, turn.<\/p>\n

IV. \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 The CFTC\u2019s Enforcement Action Against Bitfinex<\/strong><\/p>\n

In June 2016, the CFTC filed charges against a Hong Kong-based company called Bitfinex, which operates an online platform for trading in cryptocurrencies, including Bitcoin.[25]<\/sup><\/a> Unlike Coinflip and Tera, however, Bitfinex did not list or permit the trading of derivatives, such as futures, options, or swaps.[26]<\/sup><\/a> Rather, Bitfinex merely facilitated spot<\/em> transactions in cryptocurrencies.[27]<\/sup><\/a> Generally, a \u201cspot\u201d transaction is the everyday transaction of buying and selling a good, much like one does when purchasing an item on eBay. Payment is made for the item, and the item is promptly delivered to the buyer. The CFTC is generally not authorized to regulate spot transactions.[28]<\/sup><\/a> However, by adding a couple of characteristics to an otherwise vanilla spot transaction, the transaction can be transformed into a commodity interest transaction subject to the full panoply of provisions under the CEA.<\/p>\n

The basis for the CFTC\u2019s authority to regulate certain spot transactions derives from the jurisdictional hook that the agency has used so successfully to prosecute retail precious metals transactions[29]<\/sup><\/a>\u2014the so-called \u201cretail commodity transaction\u201d provision under the CEA.[30]<\/sup><\/a> The retail commodity transaction provision is a relatively short provision set forth in CEA section 2(c)(2)(D). It provides:<\/p>\n

(D) Retail commodity transactions<\/p>\n

(i) Applicability[.] Except as provided in clause (ii), this subparagraph shall apply to any agreement, contract, or transaction in any commodity that is\u2014<\/p>\n

(I) entered into with, or offered to (even if not entered into with), a person that is not an eligible contract participant or eligible commercial entity; and<\/p>\n

(II) entered into, or offered (even if not entered into), on a leveraged or margined basis, or financed by the offeror, the counterparty, or a person acting in concert with the offeror or counterparty on a similar basis.[31]<\/sup><\/a><\/p>\n

The elements of a retail commodity transaction are thus threefold\u2014the agreement, contract, or transaction must:<\/p>\n

(1) \u00a0involve a commodity;<\/p>\n

(2) \u00a0be entered into with, or offered to, a person that is not an eligible contract participant (ECP);[32]<\/sup><\/a> and<\/p>\n

(3) \u00a0be entered into, or offered, on a leveraged, margined or financed basis.[33]<\/sup><\/a><\/p>\n

All three elements must be present for there to be a retail commodity transaction. Any person that deals in commodities subject to the retail commodity transaction provision is required to be registered with the CFTC as a futures commission merchant (FCM).[34]<\/sup><\/a><\/p>\n

While a retail commodity transaction is a form of commodity interest, such a transaction is fundamentally different from a derivatives transaction, the latter of which derives its value from an underlying commodity and contains an element of futurity. Critically, where a derivative is not involved, market participants are often caught off-guard with respect to the broad scope of the CFTC\u2019s jurisdiction.<\/p>\n

Like so many requirements under the CEA, however, there are exceptions to the retail commodity transaction provision. One such exception involves the timely \u201cactual delivery\u201d of a commodity to the buyer.[35]<\/sup><\/a> If a seller offers to enter, or enters into, a commodity transaction with a non-ECP on a leveraged basis, the transaction will not fall under the retail commodity transaction provision if the seller actually delivers the commodity to the buyer within 28 days of the date that the contract is entered into.[36]<\/sup><\/a> The meaning of \u201cactual delivery\u201d has been the subject of extensive interpretation by the CFTC.[37]<\/sup><\/a><\/p>\n

In determining that Bitfinex violated the CEA, the CFTC\u2019s order found that the transactions executed on the Bitfinex platform fell within the purview of the retail commodity transaction provision, and that no \u201cactual delivery\u201d occurred. According to the CFTC:<\/p>\n