Following the high-profile market disruptions caused by the “flash crash” of May 6, 2010, and the “Knightmare” in August 2012, when a coding error in Knight Capital’s trading software resulted in the firm suffering $460 million in losses over the course of 45 minutes, the CFTC sought to determine existing industry practices around automated trading in the futures markets and to evaluate the need for additional regulations. To this end, in 2013, the CFTC published an extensive Concept Release and sought industry feedback on over 120 questions regarding risk controls and system safeguards around automated trading. Market participants applauded the CFTC’s efforts to foster an open discussion on industry best practices, and the industry devoted significant time and resources to drafting thoughtful responses to the Commission’s questions, with over 50 response letters filed.
Yesterday, the CFTC’s Division of Enforcement formally issued new guidance regarding the Division’s decisions to recommend the imposition of civil monetary penalties. According to the CFTC, “[t]he guidance memorializes the existing practice within the Division,” but “has now been incorporated into the Division’s Enforcement Manual.” CFTC, CFTC Division of Enforcement Issues Civil Monetary Guidance.
In a Consent Order entered on August 15, Kraft Foods Group, Inc, and its subsidiary Mondelez Global LLC agreed to pay $16 million to settle the CFTC’s complaint alleging the firms manipulated the December 2011 wheat futures markets. The settlement was thought to have ended the litigation, begun in 2015, however, shortly after the entry of the Consent Order, the firms filed a motion seeking contempt sanctions against the CFTC and Commissioners Berkovitz and Behnam. Kraft’s emergency motion alleges the Commission’s statements, and individual Commissioner statements filed concurrently with the Consent Order violated the terms of the settlement.
The Consent Order contained two unusual aspects. First it contained no factual findings or conclusions of law. Second, it contained a clause limiting the parties’ ability to speak publicly on the litigation.
Under the Consent Agreement, both parties agreed to refrain from making any public statements, other than to refer to the terms of the settlement. The CFTC issued a press release outlining the initial claims brought against the firms, and touting the $16 million fine as “approximately three times the defendants’ alleged gain.” The CFTC simultaneously released two other statements regarding the Consent Order, one from the Commission itself, and a joint statement by Commissioners Berkovitz and Behnam.
In their release, the Commissioners stated that the “consent order only limits statements of the Commission as a collective body. Individual Commissioners, speaking in their own capacities, retain their right and ability to speak fully and truthfully about this matter.” The statement goes on to “explain to Congress and the public the basis for the sanctions obtained, as well as the rationale for entering into a settlement agreement rather than pursuing litigation.”
In their motion for contempt, filed last Friday, Kraft argued that the three statements by the CFTC were willful violations of the Consent Order. According to their memorandum in support of the motion, the three statements were released simultaneously in an orchestrated effort to violate the Consent Order, arguing that even if only the CFTC were bound by the Consent Order the Commission violated it “when it endorsed the statements of its Commissioners by identifying them in the CFTC’s official press release, linking to them, and posting them prominently on the CFTC’s webpage announcing the settlement.” Kraft further argued that not only did the violation of the Consent Order harm Kraft, but allowing Commissioners to speak publicly on issues the Commission is prohibited by the Consent Order from discussing will harm future litigants. “There will be no reason for future parties to agree to settlements if the Commissioners – the only parties with the power to bind the CFTC to an agreement in the first place – may simply disregard the agreement without consequence.”
The Commission has since voluntarily removed the press release, Commission statement, and Commissioners’ statement from its website. Judge Blakely has ordered Commissioners Behnam and Berkovitz to appear before the court in person at an evidentiary hearing scheduled for September 12, 2019.
In a recent announcement, the CFTC indicated it would not appeal its district court loss in CFTC v. DRW, stating, “After careful consideration of the issues, as well as discussion with agency staff and Commissioners, Chairman Giancarlo has decided the agency will not appeal the district court’s decision.”
In 2013, the CFTC filed a complaint against principal trading firm DRW Investments, LLC (“DRW”) and its principal, alleging price manipulation of a various interest rate swaps futures contract in 2011, specifically the IDEX Three-Month Interest Rate Swap Future (the “Three-Month Contract”). The CFTC alleged that DRW’s bidding practices in the Three-Month Contract created artificial daily settlement prices. The Commission based this assertion primarily upon the fact that the bids in question were higher than the corresponding rates in the contemporaneous over the counter (“OTC”) swap market. DRW argued its bids were not only a truer indication of the fair value of the future, but contributed to a more accurate valuation. Cleared futures contracts are marked to market daily with a corresponding exchange in variation margin payments, while uncleared OTC swaps generally do not involve such margin payments. DRW identified this difference and entered bids to reflect the variance.
District court Judge Richard Sullivan agreed with DRW, writing in his November 30, 2018 opinion, “there can be no dispute that a cleared interest rate swap contract is economically distinguishable from, and therefore not equivalent to, an uncleared interest rate swap, even when the two contracts otherwise have the same price point, duration, and notional amount.” CFTC v. Wilson, No. 13 Civ. 7884.
Judge Sullivan’s comprehensive opinion was notable in its criticism of the CFTC’s case, stating the CFTC provided “no evidence or explanation that … settlement prices were artificially high.” Id. The intent to affect market prices, on its own, is insufficient to show manipulation, a market participant must intend to cause, or cause in fact, an artificial price. Rather than being manipulative, DRW’s trading activity was simply a result of the firm’s understanding that the Three-Month Contract was not the economic equivalent of an OTC Swap. According to Judge Sullivan, “the so-called price distortion decried by the CFTC was simply a more accurate assessment of the fair market value of the… contract.”
While the CFTC’s statement announcing its decision not to appeal was brief, it also stressed the Commission’s intention continue the vigorous enforcement of its anti-manipulation rules, and litigate cases when necessary.
In an effort to increase awareness and attention by regulated entities, the CFTC’s divisions of Market Oversight (DMO), Swap Dealer & Intermediary Oversight (DSIO), and Clearing & Risk (DCR) announced their 2019 examination priorities. This marks the first time that the agency has published division examination priorities, and Chairman Giancarolo commended CFTC leadership and staff for their work in bringing additional transparency into the CFTC’s agenda.
Tasked with oversight of trade execution facilities, DMO focuses its examination priorities on designated contract markets (DCMs) and swap execution facilities (SEFs). DMO’s Compliance Branch conducts examinations of DCMs to monitor their compliance with the Commodity Exchange Act and CFTC regulations. Throughout 2018 the Compliance Branch completed a review of 11 DCM’s self-regulatory operations. Based on this review, and feedback from the DCM staff, the division identified the following topics for in-depth examination in 2019:
- cryptocurrency surveillance practices;
- surveillance for disruptive trading (including DCMs’ rules, surveillance practices, investigations, and disciplinary cases);
- trade surveillance practices (selected elements);
- block trade surveillance practices;
- market surveillance practices (selected elements);
- real-time market monitoring practices;
- practices around market maker and trading incentive programs; and
- DCMs’ relationships with and services received from regulatory service providers.
While SEFs will not be subject to 2019 examinations, given the pending regulatory changes to Part 37 rules, DMO’s Compliance Branch will conduct regulatory consultations with a number of SEFs and begin designing a SEF examination program.
According to the DMO, most of the nation’s registered DCM’s can expect to undergo at least one examination during the course of 2019. Additionally, the CFTC anticipates regular communication with DCM’s, including quarterly calls with large and medium volume DCM’s, and bi-annual calls for smaller exchanges. These calls will further the Compliance Branch’s goals of effective communication with regulated entities. Finally, the Compliance Branch will seek to identify industry best practices through comparative examinations of DCM’s. DMO will look to share these model practices with other DCM’s, to the extent it will not violate each DCM’s confidentiality.
Responsible for overseeing the registration and compliance of intermediaries, swap dealers, and major swap participants, DSIO will focus its 2019 examination priorities on the protection of customer funds. The DSIO exams will continue to monitor the activities of CFTC registrations through the review of, notices, risk management programs, financial statement filings, risk exposure reports, risk assessment reports, and chief compliance officer annual reports. In 2019, CFTC-registered intermediaries can expect the DSIO to additionally focus on:
- withdrawal of residual interest from customer accounts;
- accepted forms of non-cash margin;
- compliance with segregation requirements;
- FCM use of customer depositories;
- FCM customer account documentation; and
- SD/MSP relationships with third-party vendors.
DCR is responsible for the oversight of derivative clearing organizations (DCOs), including those that have been designated as systemically important by the Financial Stability Oversight Council, and performs examinations of systemically important DCOs in consultation with the Board of Governors of the Federal Reserve.
DCR’s primary goal of the examination process is to determine areas of weakness or non-compliance in activities that are critical to safe and efficient clearing. The scope and methodology for the examinations are risk-based, and tailored to individual DCOs and the products they clear. Examinations will look to assess the resilience and maturity of DCOs by reviewing its financial resources, risk management, system safeguards and cyber-security policies, practices and procedures.
Earlier this month, the U.S. Securities and Exchange Commission and the U.S. Commodity Futures Trading Commission issued their annual reports about their Divisions of Enforcement results for fiscal year 2018. Analyzing these reports is a helpful way for us to learn from the recent historical enforcement efforts by both financial regulatory agencies. Also, both reports provide guidance about the divisions’ objectives and initiatives for the upcoming fiscal year and beyond. Below we explore and summarize the important topics covered in both reports.
The SEC issued its FY2018 Annual Report earlier this month. The last several pages categorize and list every action filed by SEC Enforcement during FY2018; this provides a useful reference tool. In addition, this report continues to evolve and provide more information than in years past. Not surprisingly, the report highlights SEC Chairman Jay Clayton’s direction to SEC Enforcement to focus on “Main Street” investors. Thus, it was no surprise to see SEC Enforcement’s Share Class Selection Disclosure Initiative touted as a success.
If focusing on Main Street is Chairman Clayton’s top priority for SEC Enforcement, then policing cyber-related misconduct is the Chairman’s priority “1B.” In its Annual Report, SEC Enforcement specifically advised:
Since the formation of the Cyber Unit at the end of FY 2017, the Division’s focus on cyber- related misconduct has steadily increased. In FY 2018, the Commission brought 20 standalone cases, including those cases involving ICOs and digital assets. At the end of the fiscal year, the Division had more than 225 cyber-related investigations ongoing. Thanks to the work of the Unit and other staff focusing on these issues, in FY 2018 the SEC’s enforcement efforts impacted a number of areas where the federal securities laws intersect with cyber issues (emphasis added).
Regarding SEC Enforcement’s results, while the SEC seemingly tried to temper the increased results from last year and asked readers to avoid focusing on quantitative results, one thing that has become clear during Chairman Clayton’s tenure is that he has apparently not slowed down SEC Enforcement. Regarding the quantitative results, the SEC brought a diverse mix of 821 enforcement actions, including 490 standalone actions, and returned $794 million to harmed investors. A significant number of the SEC’s standalone cases concerned investment advisory issues, securities offerings, and issuer reporting/accounting and auditing, collectively comprising approximately 63 percent of the overall number of standalone actions. The SEC also continued to bring actions relating to market manipulation, insider trading, and broker-dealer misconduct, with each comprising approximately 10 percent of the overall number of standalone actions, as well as other areas. The agency also obtained judgments and orders totaling more than $3.945 billion in disgorgement and penalties.
The report also outlined the five core principles that serve to guide SEC Enforcement’s work. From here, we garner a glimpse into their focus and efforts going forward. These principles are:
- Focus on the Main Street investor;
- Focus on individual accountability;
- Keep pace with technological change;
- Impose remedies that most effectively further enforcement goals; and
- Constantly assess the allocation of resources.
In concluding our discussion of the SEC Enforcement’s efforts and looking forward, with the continuing focus on the advisory and brokerage industries, we should expect SEC Enforcement to continue to focus its efforts and resources on the investment advisers and broker-dealers who serve Main Street.
Before turning to the CFTC, it is worth noting that both the SEC and the CFTC highlight the increased use of specialized proprietary tools they have developed to review data and bring enforcement actions. The SEC specifically stated that it “has continued to leverage its own technology to accomplish its enforcement goals.” These goals include using proprietary tools to conduct data analysis to identify and pursue a wide variety of misconduct, including insider trading, “cherry-picking” schemes, and the sale of unsuitable investment products or programs to retail investors. The CFTC highlighted its realignment of the Market Surveillance Unit, moving it from the Division of Market Oversight to the Division of Enforcement. Building and utilizing sophisticated analytical tools, the Market Surveillance Unit reviews data for instances of fraud, manipulation, and disruption. Moving the unit to the Division of Enforcement “reflects the data-centric approach the Division pursued during the last Fiscal Year, and expects to continue going forward.” Thus, the SEC and the CFTC will continue to increasingly employ sophisticated data analytics to pursue their enforcement objectives.
Turning to CFTC Enforcement, much like the SEC, CFTC Enforcement now provides much greater detail in its FY2018 Annual Report than in previous editions. Similar to the SEC’s results, quantitatively, CFTC Enforcement’s efforts in FY 2018 reflect significant increases. The number of enforcement actions filed increased year over year from 49 to 83 and monetary sanctions also increased from $413 million to $950 million. CFTC Enforcement explained in the report a number of key initiatives started or continued during FY 2018, including cooperation and self-reporting, the use of data analytics, and the development of a set of specialized task forces focused on four substantive areas — spoofing and manipulative trading, virtual currency, insider trading and protection of confidential information, and the Bank Secrecy Act.
Regarding the “Spoofing and Manipulative Trading” task force, the CFTC Enforcement Director provided additional information on this task force in a speech the day before the release of the FY2018 Annual Report:
Spoofing and Manipulative Trading: A little more than a decade ago, our markets moved from in-person trading in the pit, to computer-based trading in an electronic order book. The advent of the electronic order book brought with it significant benefits to our markets—it increased information available, reduced friction in trading, and significantly enhanced the price discovery process. But at the same time, this technological development has presented new opportunities for bad actors. Just as the electronic order book increases information available to traders, it creates the possibility that false information injected into the order book could trick them into trading to benefit a bad actor.
Efforts to manipulate the electronic order book—which can include spoofing—are particularly pernicious examples of bad actors seeking to gain an unlawful advantage through the abuse of technology. These efforts to manipulate the order book, if left unchecked, drive traders away from our markets, reducing the liquidity needed for these markets to flourish. And this misconduct harms businesses, large and small, that use our markets to hedge their risks in order to provide the stable prices that all Americans enjoy. The Spoofing Task Force works to preserve the integrity of these markets.
The CFTC’s efforts to detect market manipulation generally and spoofing in particular, however, were not limited to the creation of a task force. The FY2018 report identified 83 total actions filed, 26 (approximately 31 percent) of which were manipulation-based. This was a number second only to retail fraud (30 actions filed). While supervision is not discussed specifically as an initiative or a particular priority, CFTC Enforcement’s FY2018 Annual Report also identified 6 “Supervision” cases. Here is the breakdown by category:
From this table, it is a little unclear how the CFTC’s spoofing supervision cases were categorized and quantified in its FY2018 Annual Report. Regardless, based on the increased focus on supervision in this area— as previously reported—we can expect CFTC Enforcement to continue to investigate and bring charges for spoofing and related supervisory violations well into the future.
Finally, the CFTC Enforcement’s FY2018 Annual Report emphasizes its efforts to significantly ramp up its “coordination with our law enforcement and regulatory partners—in particular the criminal authorities.” These efforts included the announcement of the parallel actions involving spoofing and manipulative conduct filed together with the Department of Justice in January 2018. In those filings, the Commission charged three financial institutions and six individuals with manipulative conduct and spoofing. While the early 2018 joint filing was significant, the Commission’s coordination with criminal authorities was not limited to this filing. Joint filings with criminal counterparts were up significantly and may signal more to come:
“The definition of ‘commodity’ is broad. Bitcoin and other virtual currencies are encompassed in the definition and properly defined as commodities.” (In re Coinflip, Inc., CFTC No. 15-29 (Sept. 17, 2015)). This has been the view of the Commodity Futures Trading Commission (CFTC) since at least 2015, and the courts increasingly appear to be affirming the Commission’s assertion of jurisdiction over the virtual currency market.
The U.S. District Court for the District of Massachusetts is the latest court to rule that virtual currencies are commodities, and subject to CFTC jurisdiction. (See CFTC v. My Big Coin Pay, Inc, 1:18-CV-10011-RWZ). In My Big Coin, the district court entered an order holding that the CFTC has the power to prosecute fraud involving virtual currency, even in instances where there is no futures contract over the relevant virtual currency.
A “commodity” as defined in the Commodities Exchange Act (CEA) includes a list of enumerated agricultural products, “and all other goods and articles… and all services, rights, and interests… in which contracts for future delivery are presently or in the future dealt in.” 7 U.S.C §1a(9).
The defendants argued that a commodity under this definition required the specific item at issue be the subject of a futures contract. The only existing futures are on Bitcoin (CME’s BTC and CBOE’s XBT), no other virtual currency currently underlies a futures contract. Because contracts for future delivery were not “dealt in” the virtual currency at issue, My Big Coin (MBC), defendants argued MBC could not be a commodity under the CEA. The court rejected the defendant’s argument, holding that the “CEA only requires the existence of futures trading within a certain class… to be considered commodities.”
This holding is consistent with an earlier decision in the Eastern District of New York, where the court found virtual currencies fell “well-within” the definition of commodity, and can therefore be regulated by the CFTC. (See CFTC v. McDonnell, 287 F. Supp. 3d 213 (E.D.N.Y. 2018)).
McDonnell is distinguishable from My Big Coin, in that McDonnel involved alleged fraud in connection with Bitcoin, a virtual currency with an existing futures market. This distinction was apparently not relevant to the court in My Big Coin. It ruled that if futures contracts exist within a certain class of commodities (such as virtual currency), then all items within that class are considered commodities under the CEA.
“[MBC] is a virtual currency and it is undisputed that there is futures trading in virtual currencies (specifically involving Bitcoin). That is sufficient…to allege that [MBC] is a ‘commodity’ under the Act.” (See My Big Coin, 1:18-CV-10011-RWZ).
It is important to note the court also rejected Defendant’s argument that the CFTC’s anti-fraud authority under Section 6(c)(1) of the CEA extended only to fraudulent market manipulation, holding that the “broad language in the statute” “explicitly prohibit[s] fraud even in the absence of market manipulation.”
Section 6(c) of the CEA, and the ancillary CFTC rule 180.1, prohibit the use of any manipulative or deceptive device or contrivance in connection with transactions involving commodities in interstate commerce. 17 C.F.R. §180(a)(1)-(3). The CFTC has looked to assert this authority not only over instances of fraud in the cash commodity market that manipulates the derivatives market, but also in instances of fraud where no market manipulation, or even a relevant futures market, exists.
This finding again was consistent with the McDonnell court, which faced a similar argument. Not all courts who have decided this issue, however, are in agreement. In May this year a US District Court for the Central District of California found that “the CEA unambiguously forecloses the application of 6(c)(1) in the absence of actual or potential market manipulation. (CFTC v Monex, SACV 17-01868 JVS). This decision is being appealed by the CFTC.
The rulings in My Big Coin and McDonnell are particularly broad, and extend CFTC jurisdiction not only over all virtual currencies, but over all fraud in such virtual currencies, regardless of any impact or manipulation on a futures contract. The CFTC, however, is not the only regulator looking to assert or extend its enforcement rights over virtual currency market participants. There have been a series of recent enforcement actions announced by the CFTC, SEC and FINRA.
First, the SEC entered an order finding that Crypto Asset Management LP (CAM) offered a fund that operated as an unregistered investment company while falsely marketing it as the “first regulated crypto asset fund in the United States.” According to the SEC’s order, hedge fund CAM raised more than $3.6 million over a four-month period in late 2017 while falsely claiming that it was regulated by the SEC and had filed a registration statement with the agency. By engaging in an unregistered non-exempt public offering and investing more than 40 percent of the fund’s assets in digital asset securities, CAM caused the fund to operate as an unregistered investment company.
Second, the SEC settled charges against another firm and its owners for violations of the Securities Exchange Act. Specifically, the Commission found a platform that brokered both secondary purchases of virtual currencies and sales of ICOs was improperly operating as an unregistered broker/dealer. This was the SEC’s first case charging unregistered broker-dealers for selling digital tokens after the SEC issued The DAO Report in 2017 cautioning that those who offer and sell digital securities must comply with the federal securities laws.
Additionally, the SEC and CFTC filed charges in separate complaints against a virtual currency dealer based in the Marshall Islands and its Austrian based CEO for various federal regulatory violations, including: failure to properly register as a security-based swaps dealer, failure to properly register as a FCM, and failure to properly maintain adequate anti-money laundering procedures.
Finally, FINRA announced charges against an individual for selling virtual currency that was not properly registered as a security. These charges followed FINRA’s recent request for member firms to voluntarily disclose their virtual currency activities (see previous remarks here). FINRA asked firms to not only disclose their activity, but the outside virtual currency business activities of their associated persons.
The recent caselaw and regulatory actions continue the trend towards more regulatory oversight of the virtual currency market. While the McDonnell and My Big Coin holdings appear far-reaching, they (along with the enforcement actions of other regulators) have provided some clarity to the market participants.
The National Futures Association (“NFA”) recently proposed an interpretive notice updating disclosure requirements for its members engaged in virtual currency (i.e. cryptocurrency) activities. Self-Regulatory Organizations are increasingly interested in their members’ activities in the emerging virtual currency market, with the NFA’s notice following on the heels of a FINRA Regulatory Notice encouraging its members to self-report their virtual currency activities. (See here for detail on FINRA’s notice).
The apparent catalyst for the NFA’s recent proposal was the launch of bitcoin futures by the CME and CBOE Futures Exchange in December 2017. Concerned that the growth of the market has attracted investors that may not fully appreciate the substantial risk of loss that may rise from trading virtual currencies, and the NFA’s limited regulatory oversight authority, the NFA developed the enhanced disclosure requirements for members.
According to the NFA’s interpretive notice, virtual currencies and virtual currency derivatives have a variety of unique and potentially significant risks. These risks include price volatility, valuation and liquidity sourcing issues as a result of the decentralized and opaque spot market, unregulated intermediaries and custodians, an uncertain regulatory landscape, and security of assets due to nascent technology. The proposed disclosures are intended to educate and warn customers of these unique risks.
As outlined, a member would have different disclosure requirements based upon its registration status, and virtual currency activities.
Futures Commission Merchants (“FCM”) and Introducing Brokers (“IB”)
Under the notice, FCMs and IBs engaged in virtual currency derivatives activities must provide both the NFA’s Investor Advisory Futures on Virtual Currencies Including Bitcoin, and the CFTC’s Customer Advisory Understanding the Risk of Virtual Currency Trading to any customer that is engaged, or intends to engage in, virtual currency derivative trading with or through the FCM or IB.
FCMs and IBs engaging in activities with customers or counterparties involving spot virtual currencies must provide customers and counterparties the standardized disclosure language outlined in the notice.
Commodity Pool Operators (“CPO”) and Commodity Trading Advisors (“CTA”)
CPOs and CTAs are required to draft and provide robust disclosures related to the risks of virtual currencies and virtual currency derivatives. To help ensure this, the notice provides guidelines of risks that a CPO/CTA must address, but the NFA cautions that the guidelines are not exhaustive, and members should tailor their disclosures to address the specific risks associated with the particular activity they intend to engage in.
For a CPO/CTA engaged in virtual currency transactions, it must provide not only standardized language outlined in the notice, but additional disclosures in their offering documents or promotional materials that address the following areas:
- Unique features of virtual currencies
- Price volatility
- Valuation and liquidity
- Opaque spot market
- Virtual currency exchanges, intermediaries and custodians
- Regulatory landscape
- Transaction fees
Finally, any CPO/CTA engaged in any manner in activities with customers or counterparties involving spot virtual currencies not outlined in the notice must provide an additional standardized risk disclosure.
The guidance will take effect in 10 days unless the CFTC initiates a review. The full text of the proposed interpretive notice can be found here.
UPDATE: The NFA has set October 31, 2018 as an effective date for the disclosure requirements outlined in its interpretive notice for members engaged in virtual currency actives. To ensure members understand their updated obligations, the NFA indicated in its Notice to Members announcing the effective date that it will be providing member education on the new requirements prior to October 31st.