LedgerX and CBOE: The CFTC's Trojan Horse in an SEC Turf War

Benjamin Sauter and David McGill of Kobre & Kim LLP are civil litigators and criminal and regulatory defense attorneys. They are also part of the Digital Currency & Ledger Defense Coalition, a group of over 50 lawyers dedicated to protecting US blockchain innovators.

In this opinion piece, Sauter and McGill examine how a new class of cryptocurrency-based financial products could impact the balance of power between US regulators.

There is more than meets the eye to recent announcements that LedgerX and CBOE will soon be offering digital currency derivatives in the U.S.

In addition to delivering new financial products to the public, these initiatives may also usher the U.S. Commodity Futures Trading Commission (CFTC) into the underlying digital currency markets. If so, this would be a regime change in how cryptocurrency trading is regulated, particularly with respect to manipulative or disruptive trading practices.

In light of recent reports of rampant "spoofing" and "wash trading" in some markets, the CFTC may be called upon to rule with an iron fist.

At the same time, the recent announcement that the U.S. Securities and Exchange Commission (SEC) will consider many (if not all) new currency offerings as "securities" portends a looming game of thrones for regulatory dominance in these markets.

The Westeros of digital currency trading

Currently, the CFTC is "beyond the wall" of the digital currency markets.

This is because, as a general matter, the CFTC regulates the trading of commodity derivatives (for example, wheat futures and options), not the trading of underlying commodities themselves (for example, wheat).

The CFTC has designated bitcoin and other virtual currencies as "commodities," thereby removing them from the ordinary scope of what the the CFTC regulates. As readers may recall, the CFTC's lack of oversight in this area, and the possibility of unregulated manipulation in the digital currency markets, was a key reason why the SEC recently denied a bid by investors Cameron and Tyler Winklevoss for approval of an exchange-traded bitcoin ETF.

There are two primary exceptions to the rule that the CFTC does not oversee commodities trading:

First, as brandished in the CFTC's enforcement action against Bitfinex in June 2016, an obscure provision of the Dodd-Frank Wall Street Reform and Consumer Protection Act gives the CFTC jurisdiction over commodities trading when: (a) the trading is done on a leveraged or margined basis, and (b) the commodity is not actually delivered to the customer within 28 days.

Due to a quirk in how Bitfinex held the private keys for customer bitcoins, the CFTC found that these conditions were met and, therefore, that Bitfinex should have been registered with the CFTC. Bitfinex agreed to settle the matter, so the CFTC’s interpretation remains untested and open to dispute in court.

In any event, the CFTC's enforcement action was largely hollow because digital currency exchanges now appear to be sidestepping this jurisdictional provision by ensuring "actual delivery" of customer private keys. Thus, this provision is unlikely to sustain meaningful regulation by the CFTC of the digital currency markets.

Second, the CFTC has brought enforcement actions for manipulative trading in underlying commodity markets (such as silver) when that trading also affects derivatives markets subject to CFTC oversight.

Again, this basis for the CFTC's jurisdiction is open to dispute in court, but it is clear that the CFTC believes it has this authority. By extension, one could expect the CFTC to assert some degree of authority over digital currency trading to the extent that trading impacts digital currency derivatives markets.

The CFTC's gambit

To date, there have been no digital currency derivatives markets in the U.S. to speak of, and thus no opening for the CFTC to break through the jurisdictional wall separating it from the underlying digital currency markets. (Recall that the CFTC tried to shut down derivatives trading on Derivabit and TerraExchange in 2015.)

This is why the CFTC's recent approval of LedgerX and anticipated approval of CBOE for digital currency derivatives trading is so significant.

With digital currency derivatives trading set to begin, the CFTC may well have found the jurisdictional allies it needs to breach the wall. At a minimum, one can expect the CFTC to assert authority over trading practices on the underlying digital currency markets that provide reference prices for the newly approved derivatives products.

But because the digital currency markets and related derivatives markets are all linked through arbitrage, there may be no natural stopping point once the CFTC crosses the threshold. That could mean a new regulator sitting on the digital throne.

Wars to come

Not to be outdone, the SEC has also been busy plotting its own run at the throne.

The SEC's recently published "Report of Investigation" on The DAO and Slock.it signals that new coin offerings may be deemed "securities" subject to SEC oversight.

A key implication of this finding is that the secondary trading of these securities would fall under the SEC's Section 10(b) anti-fraud mandate – including its prohibitions on market manipulation and insider trading. In other words, the SEC appears to have just carved for itself a large slice of the underlying digital currency markets, at least with respect to newly issued digital currencies.

Given that the CFTC has already found digital currencies to constitute "commodities" within the meaning of the Commodity Exchange Act, there is tension between these two regulatory campaigns.

Which agency would regulate the secondary trading of a new coin offering that serves as a reference price for a derivatives contract?

This regulatory conflict is not unique to digital currencies, and the SEC and the CFTC may end up sharing power as they do with other single-security futures products. But security futures products are subject to an arcane set of rules and joint-registration requirements that are sure to chill the digital currency trading environment.

Prepare for a long winter

Regardless of whether the SEC, the CFTC or both ultimately assert power over trading in the digital currency markets, recent developments suggest that a new regime is coming. Digital currency traders in the U.S. and abroad should prepare for a long winter of uncertainty and, ultimately, regulatory scrutiny of trading practices.

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