This post is the fourth in a series that outlines key considerations for investment funds and their advisers regarding the application of the U.S. commodity laws to cryptocurrency derivatives.  This post is intended to be a primer on the topic and is not legal advice.  You should consult with your counsel regarding the application of the U.S. Commodity laws to your particular facts and circumstances.

In this Part 4, we discuss the commodity interests that are likely to be of greatest interest to crypto funds and advisers: futures contracts, swaps and retail commodity transactions.

At the outset, a sincere thanks goes out to Conor O’Hanlon and Michael Selig for their invaluable assistance and time spent thinking through many of the issues that are at this heart of this post and, more generally, this series.

Background: Mandatory Intermediation of Derivatives Trading (…And That’s What Its All About)

The intermediation of derivatives trading is a concept that is fundamental to the substantive regulation of commodity interests under the CEA.  For example, only certain market participants, known as “eligible contract participants” (or “ECPs”), are permitted to enter into privately negotiated, bi-lateral transactions that involve commodity interests.  Or, put differently, the CEA and related CFTC regulations require non-ECPs to enter into commodity interest transactions, including derivatives, through a regulated intermediary (i.e., a futures commission merchant) and over a regulated exchange (i.e., a futures exchange).  In addition, the CEA mandates that certain types of commodity interests (e.g., certain interest rate swaps) be executed through a central trading facility (i.e., a swap execution facility or futures exchange), notwithstanding the fact that both parties to the trade may qualify as ECPs.

As a threshold observation, this bedrock regulatory principle (i.e., mandatory intermediation) can be viewed as being at odds with the disintermediation that underlies distributed ledger technology, generally, and the use of smart contract technology for financial transactions, in particular.  We may explore aspects of this possible incongruity between regulation and technology in a later post.  But, for purposes of this post, it is sufficient for us to observe that the principle of what we refer to as “mandatory intermediation” is enshrined in the text of the CEA and the CFTC’s regulations.  Therefore, we believe that an understanding of this principle is central to the proper understanding of the regulation of commodity interests under the CEA.

Who – or what – is an ECP? 

This is a logical “next question,” given the prominent role of the ECP concept in the architecture of the CEA and related CFTC regulations.

As a purely legal matter, an ECP is a market participant that satisfies the applicable criteria established by the definition of the term “eligible contract participant” in section 1a(18) of the CEA and CFTC Regulation 1.3.

More practically speaking, cryptocurrency funds and advisers can think of the ECP concept as being similar to the accredited investor concept under the U.S. securities laws.  Although, for certain investors the dollar thresholds to qualify as an ECP may be higher than the thresholds required to qualify as an accredited investor.

• An investment fund must have $5 million in total assets in order to qualify as an ECP (assuming that the fund does not trade certain foreign exchange forwards or derivatives enumerated in the CEA and has not been established to evade the requirements of the CEA, including those that apply to commodity interest transactions).
• The total asset test for other types of entities can be as high as $10 million in total assets, while natural persons must possess “amounts invested on a discretionary basis” of $10 million.  (In addition, a lower dollar threshold may apply to an entity or a natural person that satisfies certain risk management standards established by the relevant provisions of the laws.)

There are other ways to qualify as an ECP, although we focused on these examples since they are most likely to be of interest to cryptocurrency funds and advisers.

Futures (Technically, “Contracts of Sale of a Commodity for Future Delivery”)

As noted in Part 1 of this series, the CEA uses the phrase “contract of sale of a commodity for future delivery” to describe what most market participants call a “futures contract”.  Futures contracts can be entered into by ECPs and non-ECPs alike, provided that the purchaser or seller of the futures contract accesses the market through a regulated market intermediary known as a futures commission merchant or “FCM” (or perhaps qualifies as some other type of regulated market participant).

Any fund or adviser seeking to trade a crypto futures contract will need to open an account and enter into a futures customer agreement with an FCM.  Futures are traded over an exchange, known as a designated contract market (for purposes of this post, we use the more colloquial term, “futures exchange”).  An FCM has “privileges” that allow its customers (e.g., the fund) to access the futures exchange for trading purposes.  Additionally, all exchange-traded futures contracts are cleared through a derivatives clearing organization (or “DCO”), which is often said to become the “buyer to every seller and the seller to every buyer”.  While that statement is somewhat of an oversimplification of a complicated market structure, it is largely accurate in conveying the idea that the DCO effectively establishes a centralized risk sharing framework for the futures markets that is intended to ensure that parties to futures contracts can perform their obligations under that contract.  It is for this reason that an FCM can be thought of as the “front line credit officer” for the broader derivatives markets and, as a result, many funds and advisers spend time negotiating provisions in futures customer agreements that relate to liens, termination and set-off rights, and collateral (or margin) requirements.

Swaps (Among Other Things)

The current iteration of the term “swap” was added to as section 1a(47) of the CEA in 2010, as part of the Dodd-Frank Act’s overhaul to the U.S. financial markets.  Section 2(e) of the CEA makes it unlawful for a non-ECP to enter into a swap, unless it is entered into over a futures exchange.

The definition of a swap under the CEA is very broad (and rightfully the subject of a post of its own), since any “agreement, contract or transaction” could be a swap if it:

• Requires a payment or delivery to be made by one party to the arrangement based upon the change in the value of an asset without conveying a direct or indirect ownership interest in that asset;
• Is an option of any kind on any asset other than a security; or
• Requires that a payment or delivery be made based upon the occurrence, non-occurrence or the extent of the occurrence of an event with a potential, financial, economic, or commercial consequence.

Considerable attention and effort has been made by a wide range of derivatives market participants to understand the scope of this definition in a variety of industries and applications.  Nevertheless, the analysis of whether a particular agreement, contract or transaction may be an inadvertent swap remains a nuanced and complex exercise, especially in the context of whether a particular crypto investment or product may constitute an inadvertent swap.

At present, different types of swaps (such as non-deliverable forwards and options) are available for trading by crypto funds and their advisers.  These transactions constitute “orthodox swaps” (see Part 3, for additional information as to the meaning of this term), since they are intended to be traded and regulated as derivatives.  Although, liquidity in these products does not seem to be as deep as with other derivatives, most likely due to the novelty of the cryptocurrencies relative to traditional asset classes like interest rates and fiat currencies.

Retail Commodity Transactions

Section 2(c)(2)(D) of the CEA defines a retail commodity transaction 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 an ECP (or a sub-category of ECP known as an “eligible commercial entity,” the discussion of which is beyond the scope of this posting).

If both parties to a transaction are ECPs, then the transaction is NOT a retail commodity transaction (although, depending upon facts and circumstances, that transaction may constitute a swap).  If one of the parties to the transaction is not an ECP and the transaction involves leverage, margin or financing , then this category of commodity interest is likely to be relevant or, at a minimum, should be analyzed to determine whether it is relevant.

Section 2(c)(2)(D) of the CEA effectively makes it unlawful for a retail commodity transaction to be entered into, unless it is entered into over a CFTC-regulated exchange and through CFTC-regulated intermediaries.   To our knowledge, no such regulated exchanges or intermediaries offer trading that involves the use of borrowed funds or property to purchase or sell crypto (i.e., “buying on margin” or “short sales” of crypto, respectively), or what can be described as “debt-based” or “financed” retail commodity transactions.  (As more fully developed below, we distinguish such retail commodity transactions from those that involve leverage.)

One notable exception from the regulation of a transaction as a retail commodity transaction can be found in section 2(c)(2)(d)(ii), which exempts a transaction that settles by “actual delivery” of the commodity within 28 days.  The CFTC is in the process of considering the issuance of guidance regarding what constitutes “actual delivery” of a crypto for purposes of this carve-out from retail commodity regulation.

Some Final Thoughts:  Leverage, Margin or Financing 

The concepts of “leverage, margin, and financing” are not well-developed for purposes of the retail commodity transaction definition or the CEA more generally.  It would seem that a transaction that involves the use of borrowed funds or property to purchase or sell crypto (i.e., “buying on margin” or “short sales” of crypto, respectively) implicates the retail commodity transaction analysis.  (For more information on this aspect of the retail commodity transaction definition, please our 2016 posting Making Sense of the CFTC’s Enforcement Order and Settlement with Bitfinex.)

The CFTC appears to be of the view that indebtedness in the traditional sense (i.e., the use of borrowed money) is not required in order for a transaction to constitute a retail commodity transaction, based upon a recent enforcement action filed by the CFTC in the U.S. District Court for the District of Columbia (CFTC v. 1Pool Ltd. and Patrick Brunner, Case 1:18-cv-2243, filed Sept. 27, 2018 (“1Pool Ltd.“) .  In particular, 1Pool Ltd. involved a particular type of derivative known as a “contract for differences” or “CFD,” which the CFTC defined in that action as “[A]n agreement to exchange the difference in value of an underlying asset between the time at which the CFD trading position…is established and the time at which it is terminated.” Paragraph 25 of 1Pool Ltd.

The case did not make any mention of any sort of loan, borrowing, or other debt-based financing arrangement, so it is reasonably to assume that the economic leverage involved in many derivatives is a type of “leverage” for purposes of the retail commodity transaction definition.

Notably, in 2012, the CFTC stated that, that “CFDs…fall within the swap definition.” Further Definition of “Swap,” “Security-Based Swap,” “Security-Based Swap Agreement’; Mixed Swaps; Security-Based Swap Agreement Recordkeeping; Final Rule, 77 Fed. Reg. 48208, 48260 (Aug. 13, 2012).  It appears that 1Pool Ltd. supplements the CFTC’s 2012 view of CFDs, which now also seem to fall within the retail commodity transaction category of commodity interest.

Interestingly, the Securities and Exchange Commission filed a parallel action against the same defendant in which it characterized CFDs as security-based swaps.  As a matter of statutory construction, a security-based swap is a “type” of a swap, which further supports the understanding that CFDs appear to be swaps and retail commodity transactions.  Perhaps more about this on another day…

Good day.  Good for something…we hope. DR2