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This post builds upon an idea presented in Part 4 of current series of posts on considerations for investment funds and advisers related to cryptocurrency derivatives.

In particular, this post provides additional perspectives on the relationship of leverage, margin, and financing to two commodity interests: “retail commodity transactions” and a “swaps”.  We decided to present these comments separate from the current multi-part series on cryptocurrency derivatives, since the topic may appeal to a broader audience than funds and advisers.

This post was co-authored with Michael Selig, an associate attorney in the New York office of Perkins Coie.

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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.

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This post is the third 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 Part 1, we focused on the status of cryptocurrencies as commodities and how that status relates to the jurisdiction of the U.S. Commodity Futures Trading Commission (the “CFTC”). In Part 2, we provided an overview of the regulation of commodities and the commodity markets under the Commodity Exchange Act (the “CEA”), explaining in particular that while the authority to prevent fraud and manipulation may apply to any transaction in interstate commerce that involves a commodity, the CFTC’s “substantive regulation” applies only if a transaction involves a “commodity interest“.

Here, in Part 3, we explain why the concept of a commodity interest can be described as a “linchpin” to the substantive regulation  of CPOs and CTAs.

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This post is the second 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 posting 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 Part 1, we focused on the status of cryptocurrencies as commodities and how that status relates to the jurisdiction of the U.S. Commodity Futures Trading Commission (the “CFTC”). Here, in Part 2, we provide an overview of the regulation of commodities and the commodity markets under the Commodity Exchange Act (the “CEA”).

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In this multi-part posting, we outline key considerations for investment funds and their advisers regarding the application of the U.S commodity laws to cryptocurrency derivatives.  This posting 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.

First, a few words about our use of the word “cryptocurrency”… In this series of postings, we use the word cryptocurrency (and often the term “crypto”) to refer to traditional virtual currencies, like BTC and ETH, as well as tokens related to a particular software product development initiative (i.e., “coins” sold in an initial coin offering or “ICO”).  We recognize that there are different classifications of cryptos among different groups of market participants; however, when we say “crypto,” we mean cryptocurrency in the broadest sense (inclusive of virtual currencies and tokens).

Having dealt with the initial definitional matter, we now turn to the substance of this Part 1 – Cryptos are Commodities (Except When They Are Not).

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For those of you who have been following along thus far, the U.S. Securities and Exchange Commission (“SEC”) and the SEC’s Division of Trading and Markets (“SEC Staff”) have been wrestling since December 2017 with whether to approve or disapprove exchange-traded funds (“ETFs”) that invest in bitcoin futures contracts.  On August 22, 2018, the SEC Staff decided to reject three proposals that included a total of nine bitcoin futures ETFs, possibly.  Just one day later, the SEC issued stays of all three rejections and elected to review the SEC Staff’s decisions.  With no clear decision, it is worth looking at the reasons for the SEC Staff’s rejection of the three proposals, particularly in light of the SEC’s recent split decision on the rejection of a bitcoin ETF (the “Bitcoin ETF”).

The three rejection orders came against two proposals by NYSE Arca, Inc. (“NYSE Arca”) and one by Cboe BZX Exchange, Inc. (“Cboe BZX”).  The ETFs themselves would predominantly hold bitcoin futures contracts in lieu of holding “physical” bitcoin.  The result would create exposure to the price fluctuations of bitcoin, but the futures-based ETFs would seek to invest in a more “traditional” asset (i.e., a futures contract) that is traded on established futures markets such as the Chicago Mercantile Exchange (“CME”) and Cboe Options Exchange, Inc. (“Cboe”).…
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On July 26, 2018, the U.S. Securities and Exchange Commission (“SEC” or “Commission”) issued an order disapproving a proposed rule change that would have allowed for a bitcoin exchange-traded product (“ETP”) (the “Order”).  However, the Order was not unanimous amongst the SEC’s Commissioners.  Commissioner Hester M. Peirce issued a stand-alone dissent against the Order, arguing that the SEC mischaracterized their worries with the ETP and that the Commission was teetering on stifling the innovation of new investment products in the United States (in this context-bitcoin).

The Order Satisfies the Securities Exchange Act of 1934

First, Commissioner Peirce disagreed with the Commission and argued that the proposal for a rule change to allow for the bitcoin ETP (the “Proposal”) satisfies certain requirements of the Securities Exchange Act of 1934 (the “Exchange Act”).  The Exchange Act requires the SEC to evaluate whether the rules of a national securities exchange (such as Bats BZX Exchange, Inc. (“BZX”)) are designed to prevent fraud and protect investors.  Commissioner Pierce argued that the SEC erroneously focuses on the characteristics underlying the spot market for bitcoin rather than whether the rules of BZX are designed to prevent fraud and protect investors.  For Commissioner Pierce, BZX and its rules could adequately play the role of watch dog over the underlying bitcoin spot markets.…
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On July 26, 2018, the U.S. Securities and Exchange Commission (“SEC” or “Commission”) issued an order, by a 3-1 vote, disapproving a proposed rule change (the “Proposal”) that would have allowed for a bitcoin exchange-traded product (“ETP”) (the “Order”).  In the Order, the SEC re-asserted many of its prior concerns and reasons for denying the same proposal for a bitcoin ETP back in March 2017.…
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On March 23, 2018, the U.S. Securities and Exchange Commission (“SEC”) issued an order instituting proceedings to determine whether it will approve or disapprove a proposal for Bitcoin futures exchange-traded funds (“ETFs”) (the “Order”).  In December 2017, NYSE Arca, Inc. filed a rule change proposal to allow for the creation of ETFs that invest in Bitcoin futures contracts and potentially other Bitcoin related investments.  In January 2018, the SEC extended its review of the proposal, and with the Order, it now has instituted formal review proceedings and is seeking public comment.  …
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According to recent data provided by CBOE and CME Group, the volatility and total volume of bitcoin futures in 2018 have been in a gradual decline.  As displayed in the chart below, the Cboe bitcoin futures contract (XBT) volatility for the lead month declined in each month to begin 2018.  In addition, according to data as of a May 22, 2018 trading date, the trading volume for CME bitcoin futures contracts (BTC) in prospective lead months is also low, with as few as 5 trades for September 2018 contracts.  There have been a few instances of volume surges such as in late April when the average daily volume of XBT rose to 8800 in the single-most active session of the CBOE Global Market, according to CBOE.  However, as shown in the final chart below with data from CME Group as of May 22, 2018, the daily exchange volume of bitcoin futures contracts has remained below 6000 for the last month with one exception.…
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