By Andrew P. Cross, Laurie Rosini, and Thomas Ahmadifar
On December 15, 2017, the U.S. Commodity Futures Trading Commission (the “CFTC”) issued a proposed interpretation of the term “actual delivery” as used in the provision of the Commodity Exchange Act (the “CEA”) that grants the CFTC explicit authority to oversee the marketplace for “retail commodity transactions.” This is the second blog posting in a multi-part series (read Part 1 here) that will explore the regulation of retail commodity transactions and the CFTC’s recent proposed interpretation (the “Proposed Interpretation”), the issuance of which we believe represents a potentially significant milestone in the regulation of virtual currency transactions. We continue our series with an examination of the Proposed Interpretation and its examples for what may constitute “actual delivery” of virtual currency.
Retail Commodity Transactions under Section 2(c)(2)(D)
As we explain in greater detail in Part 1, the CFTC has exclusive jurisdiction over the marketplace for “retail commodity transactions,” arrangements that Section 2(c)(2)(D) of the CEA describes as an agreement, contract, or transaction that is offered or entered into by a party:
- On a leveraged or margined basis, or financed by the offeror, the counterparty, or a person acting in concert with the offeror or counterparty on a similar basis; and
- To or with persons who do not qualify as either an eligible contract participant (“ECP”) or an eligible commercial entity (“ECE”).
If an agreement, contract, or transaction constitutes a “retail commodity transaction” under Section 2(c)(2)(D), then it is subject to other key components of the CEA, such as Sections 4(a) (prohibiting the off-exchange trading of futures transactions by U.S. persons unless the transaction is conducted on or subject to the rules of a designated contract market), 4(b) (permitting foreign boards of trade registered with the CFTC with the ability to provide direct access to U.S. persons), and 4b (prohibiting fraudulent conduct in connection with any contract of sale of any commodity in interstate commerce).
However, as described in Part 1, Section 2(c)(2)(D) does provide for a few exceptions from CFTC oversight for retail commodity transactions. In particular, Section 2(c)(2)(D)(ii)(III)(aa) excepts a contract of sale that “results in actual delivery within 28 days . . . ” (Emphasis added). Thus, a contract that would otherwise be considered a “retail commodity transaction” under Section 2(c)(2)(D)(i), will not subject to CFTC oversight if it results in actual delivery within 28 days.
The CFTC’s 2013 Guidance on “Actual Delivery”
In 2013, the CFTC issued an interpretation (the “2013 Guidance”) of the actual delivery exception in the context of certain physical commodity transactions to provide guidance on whether “actual delivery” of a commodity has occurred. In the 2013 Guidance, the CFTC explained that it would take a functional approach to evaluating actual delivery and provided a list of relevant factors it would consider, such as ownership, possession, title, among others. The only satisfactory examples of actual delivery involved transfer of title and possession of the commodity to the purchaser or a depository acting on the purchaser’s behalf. Shortly after the 2013 Guidance, the Eleventh Circuit Court of Appeals reinforced the Guidance when it held that actual delivery denotes an immediate transfer of possession and control (see CFTC v. Hunter Wise Commodities, LLC, 749 F.3d 967 (11th Cir. 2014)).
The Proposed Interpretation for Retail Commodity Transactions Involving Virtual Currency
Margined, leveraged or financed transactions involving virtual currency entered into by retail investors are regulated by the CFTC as “retail commodity transactions.” When a centralized virtual currency exchange or trading platform (“Platform”) offers margin trading, or facilitates margined, leveraged or financed virtual currency transactions on behalf of its retail investors, the Platform is subjected to CFTC oversight unless there is “actual delivery” of the purchased virtual currency within 28 days of the transaction.
A Functional Approach to “Actual Delivery” of Virtual Currency
While the 2013 Guidance helped to provide an explanation for “actual delivery,” as noted in Part 1, by the CFTC’s own admission, it is not particularly well-suited to virtual currency transactions. Nonetheless, the CFTC stated that it will continue to follow the spirit of the 2013 Guidance in interpreting “actual delivery”. In this regard, the CFTC stated that it will “employ a functional approach and examine how the agreement, contract, or transaction is marketed, managed, and performed, instead of relying solely on language used by the parties in the agreement, contract, or transaction.”
By taking a functional approach, the CFTC makes clear that a mere contractual arrangement between the Platform and the purchaser, granting the purchaser all rights and interest in the virtual currency, does not meet the requirements of actual delivery in the absence of a transfer of title and possession to the virtual currency. Specifically, there must be a transfer of title and possession of the virtual currency to the purchaser, or to a depository acting on the purchaser’s behalf, for the transaction to qualify for the 28-day “actual delivery” exemption. In addition, the CFTC makes clear that actual delivery will not have occurred if the transaction is “rolled, offset against, netted out, or settled in cash or virtual currency (other than the purchased virtual currency)” between the purchaser and the Platform or counterparty seller.
Specifically, the Proposed Interpretation states that actual delivery, in the context of virtual currency, requires that:
- there be a record on the relevant public distributed ledger network or blockchain of the transfer of the entire quantity of the virtual currency to the purchaser’s blockchain wallet;
- the purchaser be able to freely use the virtual currency (both within and away from any particular Platform);
- neither the counterparty seller nor the Platform retains any interest in or control over the transferred virtual currency; and
- the counterparty seller has transferred title to the purchaser, which may be reflected by linking the purchaser with proof of ownership of the wallet into which the virtual currency is transferred.
Implications of the Proposed Interpretation on Industry Participants
These requirements run counter to the manner in which most Platforms currently operate. In order to facilitate trading, Platforms offer “custodial” wallets – whereby customer funds are held in omnibus wallets controlled by the Platform, with ownership of the virtual currency recorded on an internal ledger. Transactions conducted on such Platforms occur “off-chain,” and so do not result in a record on the relevant public blockchain. Instead, the funds remain in public blockchain wallets controlled by the Platform, with corresponding book entries recorded on the Platform’s internal proprietary ledger. Under the Proposed Interpretation, and as previously articulated by the CFTC in the Bitfinex settlement order, such arrangements would not appear to qualify as “actual delivery.” (See In re BFXNA INC. d/b/a/ BITFINEX, CFTC Docket No. 16-19 (June 2, 2016) in which the CFTC found that actual delivery did not occur because Bitfinex held the purchased bitcoin in wallets that it owned and controlled).
The CFTC does not elaborate on what constitutes “an interest in or control over” the virtual currency by the counterparty seller or Platform—thus the implication for Platforms that provide multi-signature wallets remains unclear. However, the Proposed Interpretation indicates that the CFTC may look into whether the seller or Platform retains “any ability to access or withdraw any quantity of the virtual currency from the purchaser’s account or wallet.” This falls short of other definitions of “control” put forth by the industry in which “control” requires a unilateral ability to access or withdraw the funds. (See National Conference Of Commissioners On Uniform State Laws, Uniform Regulation of Virtual Currency Businesses Act, Section 102, (July, 2017)).
To comply with “actual delivery” under the Proposed Interpretation, Platforms could decouple exchange and trading services from custodial services. One way to achieve this is by transferring the purchased virtual currency to the purchaser’s wallet maintained by a “depository” that (i) is not owned, controlled, or operated by the Platform or counterparty seller, and (ii) that has entered into an agreement with the purchaser to hold the virtual currency on the purchaser’s behalf as its agent. The CFTC acknowledges that a Platform may associate with a depository, provided that the relationship between the purchaser and the depository is independent of any asserted interests or liens by the Platform or counterparty seller.
Examples of Actual Delivery in the Proposed Interpretation
The Proposed Interpretation provides the following non-exclusive examples to illustrate the above requirements:
Example 1: Actual delivery will have occurred if, within 28 days of entering into a transaction:
- The relevant distributed ledger network or blockchain of the virtual currency has been updated to reflect that the entire quantity of the virtual currency (including any portion of the purchase made using leverage, margin, or financing) has been transferred from the seller’s blockchain wallet to the buyer’s blockchain wallet;
- The seller no longer has control over the virtual currency; and
- The seller has transferred title of the virtual currency to the buyer.
The above must still be true if a Platform or other third-party acts as an intermediary.
Example 2: Actual delivery will have occurred if, within 28 days of entering into a transaction:
- The seller has delivered the entire quantity of the virtual currency purchased (including any portion of the purchase made using leverage, margin, or financing) to the buyer’s wallet;
- The seller has transferred title of the virtual currency to the buyer;
- The buyer has full control over the virtual currency (i.e. the buyer could immediately remove the entire purchase amount from his or her wallet); and
- There are no liens on the virtual currency relating to the leverage, margin, or financing used in the purchase that will last beyond 28 days of the purchase.
Example 3: Actual delivery will not have occurred if the seller has not delivered the entire quantity of the virtual currency (including any portion of the purchase made using leverage, margin, or financing) within 28 days, even if the seller makes a book entry purporting to show that delivery has been made.
Example 4: Actual delivery will not have occurred if there has only been a cash settlement (or other type of transaction such as being rolled, offset, or netted out in cash) within 28 days. Physical delivery of the virtual currency itself is required for actual delivery.
Where the Proposed Interpretation Goes from Here
In the Proposed Interpretation, the CFTC raised several hypothetical questions, and invited the public to comment on its Proposed Interpretation. Comments are due 90 days after the Proposed Interpretation is published in the Federal Register, which should occur before the end of the year (and most likely during the week of December 17th).
In the meantime, check back here for Part 3, where we will provide observations in respect of some “practical” considerations relating to custodial and transactional practices in the existing retail commodity markets, particularly in light of the specific questions raised by the CFTC.