October 24, 2020
by Elizabeth Lan Davis, Brian M. Walsh

Introduction

In response to market participants’ request for guidance on how the customer protection provisions of the Commodity Exchange Act (“Act”) and the Regulations (“Regulations”) of the Commodity Futures Trading Commission  (“CFTC”) apply to virtual currencies deposited by futures customers or cleared swaps customers with futures commission merchants (“FCMs”), the CFTC’s Division of Swap Dealer and Intermediary Oversight (“DSIO”) issued an advisory on October 21, 2020 (“Advisory”) regarding the holding of virtual currency in segregated accounts.  The Advisory provides FCMs with its views on accepting and holding customer virtual currency assets.  The Advisory also sets forth guidance on practices to consider in developing and maintaining risk management programs in accordance with Regulation 1.11 when holding virtual currency as customer funds.  With the issuance of this Advisory, FCMs holding virtual currencies as customer funds should consider themselves on notice of these requirements and should immediately incorporate these requirements into their risk management programs.    

Custodian Safeguards

Citing reports of incidents where virtual currencies have been lost or misappropriated due to the custodian’s failure to effectively safeguard assets or digital keys, hacking of systems designed to hold virtual currencies, and other forms of theft, the Advisory notes that virtual currencies present additional custodian risk beyond what currently exists for banks and trust companies.  As such, FCMs holding virtual currency as customer funds must adhere to the following seven requirements:

Virtual Currencies Must Be Held in a Depository

Virtual currency held as customer funds by an FCM must be deposited only with a bank, trust company, another FCM, or a clearing organization that clears virtual currency futures, options on futures, or cleared swap contracts (“Depository”).  While FCMs are not expected to hold customers’ virtual currencies directly, any FCM that wishes to hold virtual currencies directly will have to demonstrate to DSIO how the FCM satisfies the Commission’s segregation requirements, including retaining the appropriate possession, control, and safeguarding of the virtual currencies.  Regulation 1.20 provides the requirements for how futures customer funds are segregated and separately accounted for.

Account Name Must Identify Customer Funds

FCMs must deposit virtual currency held as customer funds with a Depository under an account name that clearly identifies the funds as customer funds and shows that the funds are segregated as required by Regulations 1.20, 22.2, and 22.6.  FCMs are required to obtain the appropriate written acknowledgment letter from each Depository holding customer funds in accordance with Regulation 22.5.  See generally 17 C.F.R. §§ 1.20, 22.2(b)(1), (f)(4), and (g), 22.5, and 22.6.  

Virtual Currency Immediately Available for Withdrawal

Virtual currency must be available for withdrawal from a Depository upon the FCM’s demand so that delivery pursuant to the terms of the contracts to which the virtual currency relates will be made without delay.  This treatment mirrors the requirements of bank or trust companies pursuant to Regulation 1.20(h).  

FCM Segregation Statements Must Report the FMV of Virtual Currencies in U.S. Dollars Using Reasoned Judgment

FCMs’ daily and month-end segregation statements must report customer’s virtual currencies at fair market value in U.S. dollars on Line 1.B. (“Net ledger balance—Securities (at market)”) and on Line 12 (“Segregated funds on hand”).  The total fair market value of customer virtual currency held at a bank or custodian, at a derivatives clearing organization (“DCO”), or another FCM must be reported as supplemental information.  The Advisory provides clarity in stating that the reported fair market value must reflect the FCMs reasoned judgment based on spot market or other appropriate market transactions.  See 17 C.F.R. § 22.2(g).

Virtual Currencies Not Used for Offsets

FCMs may not offset a debit or deficit in a futures customer’s or cleared swaps customer’s account by the value of any virtual currency held in the respective customer’s account when computing its daily and month-end segregation requirement.  An FCM may be required to deposit its own funds into segregation to cover any debit or deficit.  See 17 C.F.R. § 22.2(g).

Virtual Currencies Must be Kept in Segregated Accounts

FCMs may not deposit its own virtual currencies in futures customer or cleared swaps customer segregated accounts for any reason, including to meet targeted or residual interest requirements.  See also 17 C.F.R. § 1.20(e).

Segregated Customer Funds Not to be Invested in Virtual Currency

FCMs may not invest any segregated futures customer or segregated cleared swap customer funds in virtual currency to be held on behalf of customers.  This requirement reflects the Commission’s concern over the volatility of virtual currencies.

Risk Management Policies and Procedures

Regulation 1.11(c) mandates that each FCM “shall establish, maintain, and enforce a system of risk management policies and procedures designed to monitor and manage the risks associated with the activities of the futures commission merchant as such.”  In designing and maintaining its risk management programs, FCMs that accept virtual currency as customer funds should ensure that it can establish that its risk management program incorporates the following five points set forth in the Advisory in addition to the elements already required by Regulation 1.11(e).

Segregated Accounts

An FCM should limit the acceptance of virtual currency into segregated and cleared swaps segregated accounts as follows:

    1. The particular type of virtual currency (e.g., bitcoin or ether) relates solely to customer trading of futures (or options on such futures) or cleared swaps contracts that provide for the physical delivery of that virtual currency, provided that the virtual currency is intended to margin, guarantee, or secure such customer trading and has been formally determined to be an acceptable form of collateral for those contracts by the relevant designated clearing organization;
    1. The amount of virtual currency accepted reasonably relates to the customer’s level of trading in those contracts during each calendar quarter, with the reasonable relationship to be determined by the FCM and the determination to be documented in the books and records of the FCM pursuant to its risk management program policies and procedures.

Virtual Currency May Not Provide Margin Value

All virtual currency accepted by an FCM should not provide margin value to any contracts other than those identified above; provided, however, an FCM would be entitled to use any virtual currency held in a customer’s trading account to cover the customer’s default resulting from losses on virtual currency or non-virtual currency futures or cleared swap transactions, as applicable.

Notice and Return of Virtual Currency When Trading Has Ceased

If a customer has stopped trading the contracts to which the virtual currency relates and therefore there is no related open futures position, an FCM that holds virtual currency for a customer should contact the customer and initiate the return of that virtual currency with notice.  The return of the virtual currency should be completed within a reasonable time frame.  DSIO has determined that a “reasonable time frame” should not exceed 30 days after the customer has ceased trading for a period of 90 days (i.e., the return should be effected within a total of 120 days from the cessation of trading).  However, the Advisory does not explain how DSIO reached the conclusion that this specified time frame is reasonable. 

Timeline for Withdrawal of Virtual Currency from a Depository

Each withdrawal of virtual currency from a Depository upon demand by the FCM in order to liquidate customer accounts or return customer funds should be completed within a time that is technologically and operationally possible, but should not exceed one day, unless the procedures of the Depository specify additional time as part of its controls related to transfers of virtual currency.

Notice to Customers of FCM’s Intent to Accept Virtual Currency

Before accepting any virtual currency into segregation, an FCM should provide 45 days prior written notice to all futures and cleared swaps customers that the FCM will begin accepting virtual currency as of a specified date.

Practical Takeaways

The guidance reflects a major step forward toward the acceptance of virtual currencies, but strikes a reasonable balance in recognizing the unique risks represented by the asset class. However, FCMs accepting virtual currencies from their customers should take heed of the Advisory immediately.  The Advisory inevitably will be cited by the CFTC as putting FCMs on notice of these additional requirements when handling virtual currencies held by their customers, and FCMs will be expected to comply with this guidance.  The Advisory warns that DSIO may examine any FCM that accepts and holds virtual currency assets to ascertain compliance with Regulation 1.11(c), and that DSIO may instruct any FCM, at any time, to cease receipt of virtual currency from its customers until such time as any non-compliance with the Act and regulations is remediated.  Finally, the Advisory warns that the guidance does not limit DSIO’s ability to refer an FCM to the CFTC’s Division of Enforcement for a potential investigation relating to the FCM’s practices involving virtual currencies, specific transactions involving virtual currencies or related contracts, or for any other reason.  Coming on the heels of the Bitmex complaint and DOJ's cryptocurrency enforcement framework, this Advisory is yet another sign of heightened and increased regulatory scrutiny of virtual currencies.  

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