Nine years after Satoshi Nakamoto circulated his whitepaper and introduced the world to bitcoin, regulated bitcoin derivatives are about to be introduced in the United States. CME Group recently announced that it will begin to offer bitcoin futures based on the CME CF Bitcoin Reference Rate later this year and the Chicago Board Options Exchange has announced it will begin listing bitcoin futures contracts in Q1 2018. Ahead of any futures contract launch, U.S. Commodity Futures Trading Commission (“CFTC”) Chairman J. Christopher Giancarlo revealed that he does not feel that any new laws or regulations are necessary to accommodate the new bitcoin futures products or digital assets generally.
On October 30, 2017, the U.S. Securities and Exchange Commission (“SEC”) filed a complaint in federal court against a day trader for allegedly committing fraud and market manipulation during which the trader utilized a digital currency exchange in a supposed attempt to cover his tracks. The SEC claims that defendant’s associate obtained unauthorized access to other people’s brokerage accounts and caused them to enter unauthorized trade orders at artificial prices. Many of these orders then executed, directly or indirectly, against the defendant’s orders. The defendant then allegedly transferred a share of the profits to his associate. Notably, the defendant transferred the proceeds, which were denominated in U.S. dollars, to a digital currency company that converted the dollars to bitcoin and transmitted them to the defendant’s associate.
While the connection to cryptocurrency seems mostly incidental here, this is the type of press that sullies the reputation of digital assets. In this case, the defendant could have simply transferred dollars offshore or tried other methods of obscuring the transfers without comment, but the connection to bitcoin will likely give this case more press than it deserves. The digital currency industry continues to encourage discussion on self-regulation efforts intended to address perceived risks and governance issues raised by cases such as this and combat reputational concerns.
The SEC’s complaint is available here.
On October 18, the Consumer Financial Protection Bureau (“CFPB” or “Bureau”) entered into the long simmering debate over consumer-authorized data sharing. This debate pits mainstream financial institutions, which are typically reticent to share customer data with third parties, against data aggregators and other fintechs. Those newer companies provide services directly to consumers—or to enhance the consumer experience—and rely on data from mainstream institutions in order to do so. Both sides are grappling with complex issues surrounding consumer information, including who owns consumers’ financial data as well as how it can be used, shared, and kept secure. The CFPB released a set of nine consumer protection principles to address those and other issues and “help safeguard consumer interests as the consumer-authorized aggregation services market develops.” Read the full report on our sister site, the Technology Law Dispatch.
On October 17, 2017, the U.S. Commodity Futures Trading Commission’s (“CFTC”) LabCFTC released a primer on virtual currencies, available here. The primer is an “education tool” that provides an overview of the virtual currency landscape and is “not intended to describe the official policy or position of the CFTC, or to limit the CFTC’s current or future positions or actions.” While the document is largely unrevealing, everyone in the initial coin offering (“ICO”) market should carefully review the risk factors outlined in the document to ensure that they are incorporated into their whitepapers and offering materials.
September 28, 2017
Two months after its Investor Bulletin stating that U.S. securities laws may apply to digital token sales, the Securities Exchange Commission (“SEC”) announced Monday two new initiatives to address cyber-based threats and protect retail investors. The SEC’s press release outlined the creation of the Cyber Unit (“Unit”) and the Retail Strategy Task Force (“RSTF”).
According to the press release, the Unit has been in the planning stages for months, and will focus the Enforcement Division’s substantial cyber-related expertise on targeting cyber-related misconduct, including:
- Market manipulation schemes involving false information spread through electronic and social media
- Hacking to obtain material nonpublic information
- Violations involving distributed ledger technology and initial coin offerings
- Misconduct perpetrated using the dark web
- Intrusions into retail brokerage accounts
- Cyber-related threats to trading platforms and other critical market infrastructure
The Unit seeks to implement an internal cybersecurity risk profile and create a cybersecurity working group in order to enhance the SEC’s ability to detect and investigate cyber threats. The Unit will coordinate information sharing, risk monitoring, and incident response efforts within the SEC. The Unit will be led by Robert A. Cohen, the former co-chief of the SEC’s Market Abuse Unit.Additionally, the RSTF has been established to “develop proactive, targeted initiatives to identify misconduct impacting retail investors.” Using lessons learned from previous cases involving fraud targeting retail investors, along with leveraging data analytics and technology, the RSTF intends to identify large-scale misconduct affecting retail investors.While the stated objective of the RSTF does not specifically mention distributed ledger technology or initial coin offerings, the proliferation of such offerings is likely to draw the attention of the RSTF, specifically for those coins or tokens that would be deemed investment contracts under the “Howey Test,” and that may be considered “securities” for regulatory purposes.
We expect the regulatory scrutiny to continue to increase within the crypto token markets. When considering undertaking an initial coin offering or investing in a crypto token or coin, it is important to conduct appropriate due diligence. Please review Reed Smith’s Client Alerts regarding the jurisdiction of the SEC over initial coin offerings (https://www.reedsmith.com/en/perspectives/2017/07/sec-exercises-jurisdiction-over-initial-coin-offerings), and the CFTC’s enforcement action over fraudulent bitcoin trading (https://sites-reedsmith.vuture.net/24/721/september-2017/cftc-brings-enforcement-action-involving-a-fraudulent-bitcoin-robo-trader.asp?sid=100a3126-a5b4-4296-9f6b-3a4c0ce13649).
On August 3, 2017, the International Swaps and Derivatives Association (“ISDA”) released a whitepaper that considers whether derivative contracts could operate on a blockchain (the “Whitepaper”). The Whitepaper, titled “Smart Contracts and Distributed Ledger – A Legal Perspective,” concludes that many of the provisions of the ISDA Master Agreement and related documentation can be translated into conditional logic and coded into “smart contracts.” While we are still in the early days of distributed ledger technology (“DLT”) and smart contracts, the Whitepaper represents a significant first step towards integrating blockchain into the derivatives market from the leading provider of swaps documentation.
Building on its 2016 whitepaper entitled “The Future of Derivatives Processing and Market Infrastructure”, ISDA explains in this Whitepaper that “[d]erivatives are fertile territory for the application of smart contracts and DLT because their main payments and deliveries are heavily dependent on conditional logic.” It proposes the use of a blockchain to store electronic ISDA Master Agreements. The agreements would contain conditional logic triggers programmed by smart contract code, which would facilitate the automation of certain provisions within swaps documentation. For example, the Whitepaper lists certain “operational” ISDA definitions that embed some form of conditional logic (namely, that upon the occurrence of a specified event at a specified time, a determinative action is required), for example the cash settlement of options transactions.
Moreover, the ISDA Definitions booklets could be translated into “a more formal representation that would be tractable by computers” to allow cross-references. Regulators would then be provided with direct access to the data stored on the blockchain. The Whitepaper qualifies that a “consistent, non-ambiguous language” would need to be developed for the drafting of smart legal contracts that lawyers could understand and utilize on a global basis.
The Whitepaper acknowledges that certain “non-operational” aspects of the ISDA documentation, for example clauses predicated on good faith or reasonability, are not suited for translation into formal logic. However, the Whitepaper also proposes that certain subjective provisions could be replaced with determinations by third-party oracles. For example, a third-party oracle could be relied upon to determine if a credit event has occurred with respect to a credit derivatives transaction. If the third-party oracle makes such a determination, then the relevant smart contract provisions would be initiated.
ISDA has also commissioned e-contract opinions from a number of jurisdictions to determine whether ISDA documentation can be executed electronically with e-signatures. In relation to the ISDA netting opinions however, the Whitepaper distinguishes between smart contracts on one hand, and legal contracts on the other. The application of smart contract technology should therefore have little impact on the veracity of the ISDA netting opinions as the opinions apply to the legal contracts that the smart technology sits above, rather than displaces. This is important and illustrates that conditional logic can be over-applied. e.g., to automatically make credit and relationship choices (for example to close-out all outstanding transactions upon the occurrence of an Event of Default where this is not required for the effectiveness of close-out netting or desired under the circumstances).
Moving ISDA documentation to the blockchain could facilitate automated compliance with both the Commodity Futures Trading Commission’s (“CFTC”) swap data reporting and margin requirements in the USA, and European Market Infrastructure Regulation (“EMIR”) reporting requirements in the EU. Day-to-day compliance with the regulations could theoretically be embedded into smart contracts. For example, bank accounts or virtual currency wallets could be linked to the smart contract and automatically exchange variation margin as required. Similarly, the smart contract could be designed to automatically submit swap continuation data and other reports to a swap data repository upon the occurrence of a life cycle event, providing regulators with direct and unencumbered access. Moreover, counterparties would have all of their swap documentation and confirmations stored on the permissioned, private distributed ledger, reducing the volume of records required to be maintained. This would make it much easier for swap counterparties to comply with some of the more onerous requirements imposed by the Dodd-Frank Act, for example.
ISDA’s publication represents another milestone in the ever-growing recognition of the usefulness and ramifications of DLT and smart contracts (see our client alert on Arizona and Nevada’s enactment of bills addressing smart contract enforcement here). With influential bodies such as ISDA standing up and taking note, conditional logic states that this trend is set to continue.
If you have any questions regarding the Whitepaper, please contact Kari S. Larsen, email@example.com, Brett Hillis, firstname.lastname@example.org, Michael S. Selig, email@example.com, or Alex Murawa, firstname.lastname@example.org.
 In its simplest form, a smart contract is a “set of promises, specified in digital form, including protocols within which the parties perform on these promises”, Nick Szabo, Smart Contracts: Building Blocks for Digital Markets, 1996.
 See sections 8.1 and 8.2 ISDA 2002 Equity Derivative Definitions.
 The Whitepaper notes that under the 2014 ISDA Credit Derivatives Definitions, a determination by the Credit Derivatives Determinations Committee that a credit event has occurred would result in an automatic triggering in many cases, subject to certain conditions.
On June 13, 2017, the Illinois Department of Financial and Professional Regulation (“IDFPR”) released guidance outlining its policies with respect to the treatment of digital currencies under the Illinois Transmitters of Money Act (“TOMA”). The guidance document offers a clear distinction between traditional currencies, which it considers “money,” and digital currencies, which it states are not. The guidance will be welcomed by Illinois residents who use and accept digital currencies in commercial transactions.
On May 17, 2017, Commodity Futures Trading Commission (“CFTC”) Acting Chairman J. Christopher Giancarlo announced an “important step forward” in bringing the CFTC’s regulations into the “digital world of the 21st century.” The CFTC’s new FinTech initiative, LabCFTC, will facilitate cooperation between the CFTC and FinTech innovators.
Acting Chairman Giancarlo stated that the primary aims of the initiative are: (1) to provide greater regulatory certainty to the industry; and (2) to identify and utilize emerging technologies that can better enable the CFTC to regulate the commodities markets. Given the breadth of the “commodity” definition, numerous potential FinTech initiatives, such as those related to clearing, digital currencies, transaction settlement, etc., may fall under CFTC jurisdiction. Often the regulations are new and potentially costly and burdensome for FinTech startups, so any guidance and certainty from the CFTC should be very welcomed by the industry.
The initiative’s two core components are GuidePoint and CFTC 2.0. GuidePoint will provide a direct point of contact to FinTech innovators to engage with the CFTC, discuss compliance issues, and obtain guidance. GuidePoint will have its own suite in the CFTC’s New York office. Acting Chairman Giancarlo clarified that CFTC will not be entering the business of providing legal advice to market participants but it will help innovators better understand relevant regulations and the CFTC’s policies. LabCFTC will not have its own independent decision making authority, but can offer some guidance to industry members. The CFTC website will have a new portal that persons can use to reach out with such questions and concerns. CFTC 2.0 is a FinTech/RegTech innovation lab that will better enable the CFTC to understand new financial technologies and identify useful applications.
In a speech announcing the initiative, Acting Chairman Giancarlo expressed his hope that “LabCFTC and its engagement with technology innovators will assist the CFTC in prioritizing efforts to modernize its regulatory mission.”
If you have any questions regarding LabCFTC or wish to contact the CFTC via GuidePoint, please contact Kari S. Larsen (email@example.com) or Michael S. Selig (firstname.lastname@example.org).
On April 26, 2017, the Conference of State Bank Supervisors (“CSBS”), the trade association that represents state banking regulators, initiated a lawsuit against the Office of the Comptroller of the Currency (“OCC”) in the U.S. District Court for the District of Columbia. The lawsuit seeks declaratory and injunctive relief to prevent the OCC from moving forward with its proposal for granting special-purpose national bank charters to fintech companies.
Following the trend of regulators across the globe, the United Nations Office for Project Services’ (“UNOPS”) issued a request for information regarding the application of blockchain technologies on April 24, 2017. The UNOPS has formed a blockchain group within the United Nations to analyze the possible applicability of blockchain technologies to the international assistance area. The Request for Information explains that the UNOPS seeks “information widely from the industry of blockchain space and to identify potential partners / suppliers for the future work in the area of international, humanitarian, development or peacekeeping assistance.”