May 23, 2018
by Elizabeth Lan Davis

The latest step in the CFTC’s efforts to regulate virtual currency raises compliance and enforcement issues for market participants.  The Advisory with Respect to Virtual Currency Derivative Product Listings issued by the Division of Market Oversight and the Division of Clearing and Risk on May 21, 2018,[1] provides guidance to exchanges and clearinghouses regarding virtual currency derivatives to be listed on a designated contract market or swap execution facility, or to be cleared by a derivatives clearing organization.  The advisory highlights the following key areas requiring particular attention in listing a new virtual currency derivatives contract pursuant to the Commission’s Regulation 40.2 or 40.3: 
(1) enhanced market surveillance; (2) close coordination with the CFTC’s surveillance group; (3) large trader reporting; (4) outreach to members and market participants; and (5) DCO’s risk management.  Entities already listing or clearing virtual currency derivatives, as well as those considering doing so, should be cognizant of the compliance and enforcement implications from the advisory.

As a practical matter, the Director of the Division of Enforcement now oversees the Commission’s market surveillance function, which is no longer housed within the Division of Market Oversight.  Consequently, information and data obtained by the CFTC’s surveillance group will likely trigger and support enforcement investigations in the virtual currency space.  Indeed, the advisory notes that this information is expected to be shared with Commission staff regularly.

In terms of its substance, the advisory appears to augment the Commission’s information-gathering abilities in the virtual currency realm, perhaps in response to recent resource and technological constraints at the Commission.  Exchanges offering virtual currency derivatives are expected to provide trade data and information about the underlying spot markets that comprise the cash settlement price, and not just data concerning the derivatives contract itself.  The advisory also places a “heightened” level of real-time monitoring for manipulative trading activities, disorderly trading, and system anomalies.  Consequently, exchanges should consider adopting information-sharing arrangements that provide access to trade data on relevant spot markets.  When observing unusual trading behavior, the advisory provides that the exchanges are expected to engage in “appropriate” inquiries, including obtaining spot market trader-level data.  Thus, exchanges will likely have to obtain and provide trade data for the underlying spot market data in addition to the virtual currency derivative contract itself, as week as inquire about suspicious trading activity. 

The advisory also spotlights the role that clearing members, futures commission merchants, and foreign brokers fulfill in supplying information, potentially for enforcement purposes, through the large trader reports submitted under Part 17 of the Commission’s Regulations.  The advisory acknowledges the difficulty in getting information about trading in the virtual currency spot markets and reflects the Commission’s view that the existing large trader reporting regime may be instrumental in identifying traders who may be engaging in manipulative activity.  While the reporting level is still subject to further rulemaking, the advisory recommends setting the large trader reporting threshold at five bitcoin or its equivalent in other virtual currencies.  To avoid potential reporting problems, reporting firms already submitting large trader reports to the Commission should consider taking steps to incorporate into those reports reportable positions in virtual currency derivatives contracts consistent with the other information required to be reported pursuant to 17 C.F.R. §17.00 (2017).

This advisory is another step forward for the Commission in trying to regulate the virtual currency markets.  As a source of information and trade data in both the virtual currency spot and derivatives markets, exchanges, and reporting firms should expect that this information will lead to and support enforcement investigations.  Moreover, given the expectations set forth in the advisory, exchanges and reporting firms should be cognizant that that the guidelines may lead to potential supervision and compliance issues if this information is not accurately and timely provided to the CFTC’s Division of Enforcement.

 

About Blockchain Law Center

Blockchain technology utilizes a distributed digital ledger to record and track information, and can be leveraged to gain transparency and certainty in transactions ranging from cryptocurrency to supply chain tracking.  This blog provides information on the legal developments surrounding implementation of blockchain technology, with an initial focus on the financial services sector.