CFTC Issues Guidance on Listing Virtual Currency Derivatives

Last week, the Market Oversight and Clearing and Risk Divisions of the Commodity Futures Trading Commission (“CFTC” or “Commission”) issued Staff Advisory No. 18-14 regarding virtual currency derivative product listings. The advisory serves as guidance to exchanges and clearinghouses in the context of listing derivative contracts based on virtual currency under Commission Regulations 40.2 (self-certification) or 40.3 (voluntary submission for Commission review and approval) in order to promote effectiveness and efficiency in the emerging area virtual currency derivatives.

Specifically, the advisory clarifies CFTC priorities and expectations for virtual currency derivatives listed on a designated contract market (“DCM”) or swap execution facility (“SEF”) or cleared by a derivatives clearing organization (“DCO”­) with regard to enhanced market surveillance, coordination with CFTC staff, large trader reporting, stakeholder outreach, and DCO risk management. The Commission notes that this latest effort at providing regulatory clarity is not a “compliance checklist,” and the extent of its relevance depends on the terms and conditions of each virtual currency contract.

Enhanced Market Surveillance: DCMs and SEFs are responsible for having an oversight program designed to ensure listed contracts are not readily susceptible to manipulation and to detect and prevent manipulation, price distortion, and disruptions of the delivery or cash-settlement process. To increase visibility into underlying spot markets and manage risks related to the trading of listed virtual currency derivatives, the Commission advises having an information sharing arrangement in place with the underlying spot markets that may contribute to the cash-settlement price in order to provide the derivatives exchanges access to a broader range of trade data, including trader identity, prices, volumes, times, and quotes.

The Commission also advises a heightened level of real-time monitoring that involves continuous monitoring of relevant data feeds (particularly around settlement) and making inquiries where appropriate in the event of identified anomalies or disproportionate moves in spot markets.

Coordination with CFTC Staff: The Commission expects exchanges to regularly discuss virtual currency derivatives contracts surveillance issues with CFTC staff and to provide information upon request, including data related to the settlement process referenced by the derivatives contract.

Large Trader Reporting: The Commission may raise or lower reporting levels in specific markets under the Commission’s Large Trader Reporting System. Exchanges can set the reporting level of contracts in a particular commodity at a lower level than specified in CFTC regulations, but the Commission recommends setting the large trader reporting threshold for any virtual currency derivative contract at five bitcoin (or the equivalent) to facilitate surveillance.

Stakeholder Outreach: The Commission expects exchanges to take extra care to engage meaningfully with stakeholders due to the novel and evolving nature of virtual currency contracts and concerns related to price volatility and lack of transparency. The effort should include soliciting comments on a broad array of topics related to the listing that go beyond the terms and conditions and manipulation susceptibility from members as well as other relevant stakeholders that go beyond those interested in trading the contract (e.g., clearing members and futures commission merchants (“FCMs”). When submitting a virtual currency derivative contract listing, an exchange should provide as much information as possible, including explanations of substantive opposing views and how the exchange has addressed them.

DCO Risk Management: CFTC staff will request and review from the identified DCO: (1) proposed initial margin requirements to assess whether they are commensurate with the risks; (2) ability of proposed margin requirements to adequately cover potential future exposures to clearing members based on an appropriate historic time period (and may require adjustments); (3) information related to the governance process for approving the proposed contract(s), including explanation of views of approving clearing members and the response to dissenting reviews; (4) adherence to internal governance procedures for new contract approval; and (5) any other information relevant to the clearing of the proposed contract.

Exchanges and clearinghouses are currently evaluating new crypto products, and these guidelines setting forth the Commission’s expectations with regard to that process will help streamline the new contract listing procedures. It also emphasizes a current priority for the CFTC, which is to obtain more information regarding the crypto spot markets, which they hope to accomplish via the registered platforms. Market participants are looking forward to seeing a wider variety of crypto derivative products, and hopefully this guidance will speed that process.

The Chain Gang – FTC’s New Blockchain Working Group May be Good News for Marketers

One of the greatest developments for marketers in 2018 is likely to be the proliferation of new and innovative applications on the blockchain in the context of marketing and promotion, particularly in connection with loyalty programs, ad fraud mitigation, and ongoing CRM activities that combine brand affinity and peer-to-peer influencing.  The potential magnitude of the changes that the promotion marketing industry could see in the next 12 months, especially in the loyalty area, is simultaneously thrilling and daunting.  The technological challenges of simply understanding the blockchain is hard enough.  In addition, cryptocurrency fraud and money laundering concerns have delayed public acceptance of blockchain-based promotional activities.

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Massachusetts Enforces While Arizona Provides Flexibility to Fintech

This week, the Massachusetts Secretary of State ordered five companies, 18Moons, Across Platforms, Mattervest, Pink Ribbon, and Sparko, to cease and desist from engaging in initial coin offering (“ICO) campaigns as part of an ongoing government investigation of token sales.  The companies allegedly offered and sold unregistered securities in violation of the Massachusetts Uniform Securities Act (Chapter 110A of Massachusetts’ General Laws) and corresponding regulations.  The orders, among other things, (1) prohibit the companies from selling unregistered or non-exempt securities in Massachusetts until they are in compliance, including filing a Form U-2 Consent to Service of Process; (2) require the companies to provide the Enforcement Section with written notice of securities offerings prior to making future offers or sales; and (3) mandate rescission of sales to investors that purchased the tokens at issue prior to the order date, pursuant to specified terms.  The Enforcement Section may take further actions if the companies fail to comply, including re-instituting investigations.

The announcement of the Massachusetts enforcement actions was announced five days after Arizona announced becoming the first U.S. state to enact a fintech regulatory “sandbox.” The Arizona Governor signed House Bill 2434 into law on March 23, which aims to foster innovation by allowing companies to launch and test innovative products under limited conditions in the Arizona market outside of the scope of potentially burdensome and costly regulatory requirements.  The Office of the Arizona Attorney General will administer the sandbox program and will likely begin accepting applications for entry in late 2018, which will require detailed descriptions of the product or service and a to-be-determined fee.  Approved participants will have one year to test their product or service on Arizona residents, with the possibility of a year-long extension before July 2028, when the program ends.  Other limits include caps on the numbers of individuals who may participate in each agreement, the amount of loans that may be issued, and those related to financial transactions under Arizona law.  The sandbox participants also will be subject to the Arizona Consumer Fraud Act.  Notably, a reciprocity provision allows the Attorney General to provide sandbox participants the opportunity to participate in similar programs that other jurisdictions may develop in time.

Blockchain Backed International Dispute Resolution

Startups often are at the forefront of creating unique solutions with the ability to have a tremendous impact on various industries. The Miami Blockchain Group, a legal technology startup, has created a novel blockchain application specifically for the international dispute resolution community. The Smart Arbitration & Mediation Blockchain Application, SAMBA, debuted at the 2018 Global Legal Institute for Peace Conference at the University of São Paulo on March 14.

Recent news about blockchain has focused primarily on cryptocurrencies and crypto tokens, such as financial regulator statements regarding whether initial coin offerings could constitute securities. Here we see a use for the technology in a completely different industry, and a traditionally conservative one with respect to technology. As we have described in our paper Blockchain – Distributed ledger technology and designing the future, a blockchain, also known as distributed ledger technology (DLT), is a digital record, or ledger, of transactions. Blockchain is unlike a traditional ledger however and is stored collectively by all the participants on its network. Each transaction is stored with others in a unit of data called a block and those blocks securely link to one another, forming a “chain” of records going all the way back to the very beginning of the ledger.

SAMBA intends to utilize a blockchain to eliminate the need for couriers, hard copies and mailing. The application gives claimants the ability to use a blockchain portal, held by an arbitral institution, to file requests for arbitration. Documents can be drafted within the portal, finalized, and submitted directly to the tribunal. Additionally, claimants will have the option to conduct electronic discovery by way of a drop box, allowing for hearings to become virtual. Claimants will also be able to view their final award on portal.

SAMBA is likely to positively impact the international dispute resolution process. The legal industry certainly will be watching for the success of this initiative.  We will be eagerly watching for additional blockchain backed applications introduced in other areas of the legal industry that will hopefully drive efficiency, transparency and trust amongst legal professionals.

Berkeley to Use Blockchain for Tokenized Bonds

The City of Berkeley, California will be the first U.S. city to explore blockchain-based financing to tackle social issues such as affordable housing.  Mayor Jesse Arreguin and Councilmember Ben Bartlett are collaborating with the UC Berkeley Blockchain Lab and San Francisco-based financial startup Neighborly for the Berkeley Blockchain Initiative (“BBI”) to develop a tokenized municipal bond.  According to Forbes, Berkeley had a similar idea twenty years ago with a local currency called “Berkeley Bucks.”  This time, Neighborly explains, “[t]he initiative will explore how to harness the power of blockchain and cryptocurrencies to democratize access to public finance and improve social outcomes.”[1]

Termed an “initial community offering” rather than an initial coin offering (“ICO”), municipal bonds will be divided into micro-bonds and sold as a token as a new source of capital that will enable more Berkeley residents to invest directly in their community through various projects at low denominations.  According to Coindesk, Councilmember Bartlett claims the offering will be less risky than an ICO because the tokens will be backed by an underlying bond. Residents will be able to choose specific social impact projects of interest compared to the traditional nature of a single bond that may be raising funds for multiple municipal projects.  Councilmember Bartlett believes “[b]lockchain’s benefits, such as security, efficiency, transparency and speed, are not only applicable, but much needed at the government level to deliver better and more streamlined services to the people who need it most.”

Details on what this new token will be named and whether it will be issued on a private or public blockchain are up in the air, but the plan is to keep the initiative local to Berkeley.  Issuing tokenized micro-bonds through blockchain will fund smaller ventures like purchasing an ambulance at first, but the City of Berkeley envisions the model will eventually fund affordable housing projects and could potentially give the homeless population access to other goods and services in the future.

This project may be a signal that tokenized public finance models could become mainstream in the near future.  Local investors may like the flexibility that these municipal tokens allow in investing in smaller investments in specific projects the investors support.  Bonds issued by states, cities, and municipalities are exempt from the registration requirements and certain of the reporting requirements under the federal securities laws.  Nevertheless, these products are subject to the Securities and Exchange Commission’s (“SEC”) antifraud rules and therefore it is important that issuers make appropriate risk disclosures with respect to the crypto market and nature of the tokens to investors.

Issuers also should carefully weigh the risk of special treatment by the SEC.  The agency may more carefully scrutinize bonds issued as crypto tokens out of concern that the issuer chose to issue crypto token bonds rather than traditional bonds to garner attention or to capitalize on the euphoria associated with crypto investments.  This offering will test the waters for new security token issuances amid an environment where the SEC is scrutinizing a broad swath of so-called “utility” tokens for being unregistered securities.

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[1] The statement can be found at neighborly.com/.

The End of the Cryptocurrency Carney-val?

In a speech given on Friday 2nd March, the governor of the Bank of England, Mark Carney, said that cryptocurrencies are “failing” as a form of money. Mr.Carney also stated that cryptocurrency should fall under the “regulatory tent” and argued that “the time has come to hold the crypto asset ecosystem to the same standards as the rest of the financial system”. The governor of the Bank of England is the latest prominent figure to speak out on the cryptocurrency market – and he has made his views clear.

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Hong Kong Securities Commission Launches Inquiry Into Seven Crypto Exchanges

On February 9, 2018, the Hong Kong Securities and Futures Commission (“SFC”) released a statement which, among other things, informs the marketplace that the SFC sent letters to seven Hong Kong cryptocurrency exchanges warning against listing instruments that qualify as “securities” under the Securities and Futures Ordinance (“SFO”) without a required license.[1]  Additionally, the SFC sent letters to seven crypto token issuers inquiring about compliance with the securities laws.

In response to the letters, most cryptocurrency exchanges and initial coin offering (“ICO”) crypto token issuers either confirmed compliance or immediately took remedial measures,  according to the SFC statement.

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Securities Class Action Lawsuits Continue to Test the “Utility” Token Sale Model

On January 30, 2018, dissatisfied crypto token purchasers filed a class action lawsuit against Paragon Coin, Inc. (“Paragon”) and founders Jessica VerSteeg and Egor Lavrov, alleging that the Paragon initial coin offering (“ICO”) violated the federal securities laws.[1]  This lawsuit follows those filed by plaintiffs against Centra, Tezos, ATBCoin, BitConnect, and Xunlei in connection with their ICOs in recent months.  One of the more high profile class action defendants is BitConnect, which is defending two class action lawsuits alleging that it sold unregistered securities and operated a Ponzi scheme.[2]  BitConnect allegedly led purchasers to believe that they would receive a 3,000% return on their investment over the course of a year.

The Securities and Exchange Commission (“SEC”) has brought a number of enforcement actions against companies and individuals for selling crypto tokens to the public without registering the sale with the SEC and for engaging in securities fraud.  All such actions have either settled outside of court or remain pending.  Now, the private plaintiffs’ bar is moving in as well and filing claims.  As these cases make their way through the courts, federal judges may soon be faced with the challenging task of running numerous  novel “utility” token products through the rigors of the Howey test analysis to determine if such products must be offered in compliance with the securities laws.[3]

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Beyond SegWit2X

Bitcoin’s Blocksize Debate: Behind the scenes of Bitcoin’s (BTC) success, a debate continues about whether to expand the leading cryptocurrency’s blocksize from 1MB to 2MB. On one side, the “Big Blockers” want to increase Bitcoin’s blocksize, allowing the cryptocurrency to realize its potential as a cash alternative and compete with traditional payment systems. On the other side, the “Decentralists” worry that increasing Bitcoin’s blocksize will create barriers to entry for miners, compromising Bitcoin’s security and welcoming government regulations that would jeopardize its censor-free qualities. A group of developers tried to settle the issue in November 2017 by increasing Bitcoin’s blocksize to 2MB with an update dubbed “SegWit2X,” but the proposal failed, proving too controversial. This post examines SegWit2X, the greater blocksize debate, and the important ramifications this debate has for Bitcoin’s future.

Please read the full client alert at reedsmith.com.

SEC Scrutinizes Pumping of Blockchain-Related Securities

The U.S. Securities and Exchange Commission (“SEC”) is continuing to increase its scrutiny of companies that might be taking advantage of investor excitement for blockchain and cryptocurrency (ICO) deals to inflate their share prices and raise funds.  On January 8, 2018, the SEC suspended trading in the securities of Hong Kong-based UBI Blockchain Internet, Ltd. (“UBI Blockchain”) through at least January 22, 2018.[1]  This action follows the SEC’s suspension of trading in the securities of The Crypto Company announced in December 2017[2] and three other blockchain-related companies in the summer of 2017.[3]

JA Energy changed its name to UBI Blockchain and announced its plans to use blockchain technology to track food and drug products in 2016.[4]  Securities in the company surged from $0.55 a share in February 2017 to $115 per share before the SEC suspended trading.  The SEC’s suspension notice explains that it issued the suspension due to questions regarding the accuracy of statements in SEC filings pertaining to UBI Blockchain’s business operations and the “recent, unusual and unexplained market activity in the company’s Class A common stock.”

The SEC also recently suspended trading in securities of The Crypto Company, which engages in consulting on blockchain technology and manages a portfolio of digital assets.[5]  Securities in The Crypto Company were trading at around $0.05 a share in September 2017, when their value began to climb and eventually reached $642 in December before the SEC suspended trading.  The SEC issued the suspension due to “concerns regarding the accuracy and adequacy of information in the marketplace about, among other things, the compensation paid for promotion of the company, and statements in Commission filings about the plans of the company’s insiders to sell their shares of The Crypto Company’s common stock.”

UBI Blockchain and The Crypto Company are not alone.  In recent months, an iced tea company, a cigar manufacturer, and a sports-bra company incorporated blockchain into their corporate names or business plans and saw meteoric rises in their share prices.[6]

It is important that public companies who announce a shift to a blockchain strategy or develop a business model around blockchain give careful thought to the required and appropriate SEC disclosure and reporting criteria.  The failure to do so could lead to unwanted suspension of trading, SEC enforcement actions, and shareholder actions.

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[1] The suspension notice is available here.

[2] The notice is available here.

[3] A Reed Smith client alert on these suspensions is available here.

[4] A related article is available here.

[5] As described on the company’s website.

[6] A related article is available here.

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