The long-awaited guidance clarifies the application of the “actual delivery” exception to leveraged virtual currency transactions with retail purchasers.
Earlier this year, the US Commodity Futures Trading Commission (CFTC) approved final interpretive guidance (Guidance) concerning retail commodity transactions involving certain digital assets. The Guidance clarifies the CFTC’s views regarding the “actual delivery” exception to Section 2(c)(2)(D) of the Commodity Exchange Act (CEA) in the context of virtual currencies, and is intended for exchanges, trading platforms, custodians, and other market participants transacting in virtual currencies that are considered commodities (such as Bitcoin and Ether) and traded via leverage, margin, or other financing provided by the seller, trading platform, or other third party.
The Guidance has a long history, as it was originally proposed in December 2017, and the public comment period ended on March 20, 2018. The Guidance finally became effective on June 24, 2020. However, as previously maintained by CFTC Chairman Tarbert in a statement in support of the guidance, the CFTC will “forbear from initiating enforcement actions addressing aspects of the [G]uidance that were not plainly evident from prior CFTC guidance, enforcement actions, and case law” for 90 days in order to decrease the risk of market disruption.
All of a sudden, September 22, 2020, became a very important date for the crypto trading world.
“Actual Delivery” Exception Under the CEA: Background and Guidance
Commodity transactions with retail purchasers that are transacted using leverage, margin, or other financing arrangement (Retail Leveraged Commodity Transactions) are regulated as futures contracts which would require on-exchange trading and broker registration requirements under Section 2(c)(2)(D) of the CEA (Retail Commodity Rules), unless an exception applies. The Retail Commodity Rules exempt Retail Leveraged Commodity Transactions from such regulatory requirements if “actual delivery” of the underlying commodity occurs within 28 days from the date of the transaction.
The Guidance sets forth two primary factors that indicate “actual delivery” of Retail Leveraged Commodity Transactions in the context of virtual currency transactions:
- No later than 28 days from the date of the Retail Leveraged Commodity Transaction, and at all times thereafter, a purchaser must secure both possession and control of the entire quantity of the commodity (i.e., virtual currency), whether it was purchased on margin, or using leverage, or any other financing arrangement
- The ability to use the entire quantity of the commodity freely in commerce (away from any particular execution venue) the offeror and counterparty seller (including any of their respective affiliates or other persons acting in concert with the offeror or counterparty seller on a similar basis) may not retain any interest in, legal right to, or control over any of the commodity (i.e., virtual currency) purchased on margin, using leverage, or other financing arrangement at the expiration of 28 days from the date of the transaction.
Specifically, the interpretation is limited to Retail Leveraged Commodity Transactions in virtual currency. Virtual currency is defined broadly in the Guidance; the CFTC does not create a bright-line definition given the evolving nature of digital assets and their respective underlying blockchain or distributed ledger technology. The Guidance describes virtual currency as:
[A]ny digital representation of value … that functions as a medium of exchange, and any other digital unit of account that is used as a form of a currency (i.e., transferred from one party to another as a medium of exchange); [that] may be manifested through units, tokens, or coins, among other things; and [that] may be distributed by way of digital “smart contracts,” among other structures.
Of the various digital assets available, the CFTC has confirmed that Bitcoin and Ether are virtual currencies for purposes of the Guidance.
What the Guidance Means for Crypto Platforms and Brokers
The Guidance takes a functional approach to the interpretation of “actual delivery” by proposing a central tenet: a purchaser must secure possession and control over the virtual currency and the ability to use it freely in commerce within 28 days from the date of the transaction.
Rather than venture into defining what transfer of title may mean in the context of digital assets or rely on possession of a particular key or blockchain address, the CFTC looks to principles of possession and control to establish the principle markers of “actual delivery.”
Further, and importantly, the CFTC states that it interprets the term “offeror” broadly and that the term could capture “any persons presenting, soliciting, or otherwise facilitating ‘retail commodity transactions’, including by way of a participation interest in a foundation, consensus or other collective that controls operational decisions on the protocol, or any other persons with an ability to assert control over the protocol” that offers such transactions. This position effectively puts crypto exchanges, execution venues, decentralized trading platforms, and the collective group of persons who are able to exert control on the platform on notice that they could be held accountable for Retail Leveraged Commodity Transactions in virtual currency that are transacted on their platforms or exchanges.
Through a series of examples set forth in the Guidance, the CFTC clarified what it would consider meaningful possession and control in order to constitute “actual delivery” of a virtual currency in a Retail Leveraged Commodity Transaction. The key takeaways are as follows:
- Keys and Blockchain Addresses. A transfer of virtual currency reflected on a public ledger, from the counterparty seller’s blockchain address (or, if relevant, any intermediary or execution venue) to the purchaser’s blockchain address over which the purchaser maintains sole possession and control would be considered actual delivery. However, the CFTC declined to consider further whether a purchaser’s possession of a particular key or blockchain address was dispositive of possession and control; rather, the Guidance focuses on whether the purchaser has achieved “a meaningful degree of possession and control.”
- Liens. The virtual currency must be free of any liens, interest, or legal rights (including the right to force a sale) of the offeror, counterparty seller, or any persons acting in concert with the offeror and counterparty seller that would prevent or make it impractical for the purchaser to use the virtual currency freely as a medium of exchange.
- Depository. Delivery to depositories may constitute actual delivery.
- To this end, the depository cannot be affiliated, controlled, or operated by the seller, and such depository must enter into an agreement with the purchaser to hold virtual currency as agent for the purchaser without regard to any interest of the offeror, counterparty seller, or persons acting in concert with the offeror or counterparty seller.
- The purchaser must be able to have full control of the virtual currency held in a depository, including the ability to use the full amount freely, or transfer it to another depository of the purchaser’s choosing. The virtual currency must also be free of any liens, interest, or legal rights of the offeror, counterparty seller, or any other person, as set forth above.
- Regarding any offeror-depository affiliation (e.g., an affiliated depository to an execution venue), the CFTC has clarified that — in order for such affiliation to not be disqualifying — such affiliated depository should be:
- A financial institution
- A separate line of business from the offeror not subject to control of the offeror
- A separate legal entity from the offeror and execution venue
- Predominantly operated for the purpose of providing custodial services
- Appropriately licensed as a custodian in the relevant jurisdiction, as applicable
- Contractually authorized as an agent of the purchaser and offeror of cold storage options
- Execution Venue as Seller. The offeror’s ability to take the opposite side of a Retail Leveraged Commodity Transaction raises concerns regarding conflicts of interest and may create situations in which actual delivery fails to occur. As a result, the CFTC will consider such activity as a factor weighing against demonstration of actual delivery.
- Book Entry Transfers. Actual delivery does not occur as a result of a book-entry transfer, regardless of whether the agreement between the purchaser and offeror or counterparty seller creates an enforceable obligation to deliver the virtual currency to the purchaser.
- Netting, Rolling of Offset. Actual delivery does not occur if — within 28 days of entering into a Retail Leveraged Commodity Transaction — such transaction is rolled, offset against, netted out, or settled in cash or virtual currency other than the purchased virtual currency, between (i) the purchaser and (ii) the offeror, counterparty seller, or any persons acting in concert with such offeror or counterparty seller.
The Guidance comes at a much-needed moment in digital asset trading, as markets continue to develop and the products available to the retail sector continue to broaden.
Given the expanding retail sector of digital asset trading, crypto exchanges and brokers should work closely with counsel on the introduction of leverage or margin to their digital asset trading platforms. Any such margin trading will require careful management and structuring in order to comply with applicable regulatory requirements.