NFA Proposes Enhanced Disclosure Requirements for Members Engaging in Virtual Currency Activities

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
  • Cybersecurity
  • Opaque spot market
  • Virtual currency exchanges, intermediaries and custodians
  • Regulatory landscape
  • Technology
  • 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.

SEC says Bitcoin and Ether are not Securities

“I believe every ICO I’ve seen is a security and we have jurisdiction and our federal securities laws apply.” Clayton, J., Testimony, Sen. Banking, Housing and Urban Affairs Committee (Feb. 6, 2018). This was SEC Chairman Jay Clayton’s testimony on February 6, 2018 to the Senate Banking Committee in a hearing on the SEC oversight of virtual currencies. The Chair’s sentiments in February were in line with the SEC’s historic approach to asserting jurisdiction over the nascent cryptocurrency marketplace. Beginning as early as 2013, the SEC began issuing investor alerts asserting the Commission’s jurisdiction over cryptocurrencies that functioned as securities. SEC Investor Alert, Ponzi Schemes Using Virtual Currencies, July 1, 2013. This early assertion of jurisdiction has been confirmed through the SEC’s position in the DAO Report, and reinforced through multiple SEC enforcement actions.

Four months after the Chair’s comments before the Senate Banking Committee, there are signs that the SEC is refining its opinion on the extent of its jurisdiction. Last week, Chairman Clayton stated that Bitcoin and cryptocurrencies like Bitcoin are not securities. See link here. This in itself is not particularly progressive. Bitcoin has widely been considered only an asset used as a store of value or method of payment, and it was never subject to an ICO. The CFTC has already claimed Bitcoin as a commodity, and even called it a currency (though in a twist of regulatory nuance it is not a “foreign” currency). See In re Coinflip, Inc., CFTC No. 15-29 (Sept. 17, 2015), See In re BFXNA Inc., d/b/a Bitfinex, CFTC No. 16-19 (Jun. 2, 2016). Nevertheless Clayton’s recent comments are some of the most concrete “no action” language the market has heard from the SEC regarding cryptocurrencies.

Last week, there was even more interesting news. William Hinman, the Director of the Division of Corporation Finance, in prepared remarks stated that “based on my understanding of the present state of Ether, the Ethereum network and its decentralized structure, current offers and sales of Ether are not securities transactions.” Full speech available here. Behind Bitcoin, Ether is the next largest traded cryptocurrency by volume (see market cap statistics here), and many other cryptocurrencies utilize the Etherium structure and employ Ether as a method of payment or investment. With Clayton and Hinman’s comments the SEC is providing the market some needed clarity on the Commission’s jurisdictional limits. As expected, the market reacted positively to news, with Ether’s price rising 10% intra-day, and Bitcoin rising 6%.

Hinman’s speech is significant for another reason. Ether started out as an ICO. Development of the Etherium network was funded by participants purchasing Ether. Over time, however, Ether’s characteristics have changed; it is produced exclusively through mining efforts, and the network it operates on is decentralized. Ether has essentially morphed into a method of payment more akin to Bitcoin. Hinman addresses this change in his speech, and concedes that coins can change over time from an ICO to a currency. He specifically emphasizes “that the analysis of whether something is a security is not static and does not strictly inhere to the instrument.”

It is uncertain how the SEC would seek to regulate a security that, over time, transforms into a currency or from a currency into a security, but this concession from the Commission is important for the crypto space as it provides some needed guidance to the marketplace.