Commentaries

Bridging the Weeks by Gary DeWaal: November 20 – December 1 and December 4, 2017 (Bitcoin, EFRPs, Wash Sales, Spoofing)

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Published Date: December 03, 2017

After a week of significant volatility, Bitcoin moved a step closer to mainstream acceptance as three exchanges regulated by the Commodity Futures Trading Commission self-certified on December 1 new cash-settled derivatives contracts tied to prices on spot Bitcoin markets. The CFTC declined to stop the self-certifications despite acknowledging, “there are concerns about the price volatility and trade practices of participants in these markets.” According to the Commission, the three exchanges agreed to “significant enhancements” in their original proposals to address the concerns. Separately, CME Group exchanges brought and resolved disciplinary actions involving claims of wrongful trading practices. As a result, the following matters are covered in this week’s edition of Bridging the Weeks:

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Briefly:

CME and CFE proposed to offer margined futures contracts related to the price of Bitcoin, while Cantor said it would list fully collateralized binary options based on the price of the same virtual currency. Only CME announced an intended launch date – December 17 for trade date December 18.

Contemporaneously with the three exchanges' self-certifications, the CFTC issued a press release noting that it had “extensive discussions” with each of the DCMs regarding their proposed new contracts. CFTC Chairman J. Christopher Giancarlo said each of the facilities “agreed to significant enhancements to protect customers and maintain orderly markets.” The CFTC separately noted in a “Backgrounder” also issued on December 1 that its staff had considered the potential risk of default of the three exchanges derivatives contracts on the regulated clearinghouses (DCOs) clearing the products. However, said the CFTC, “[b]ased on analysis of different stress scenarios, staff estimates that any potential impact will not be significant to a DCO.” The CFTC also said that CME had modified its proposed margining in response to discussions with Commission staff. CME observed that, if it had begun trading its Bitcoin futures contract as of December 1, it would have assessed an initial margin requirement of 35 percent of the contract’s notional value.

CME – which plans to self-clear its own Bitcoin futures contracts – will use its proprietary CF Bitcoin Reference Rate for final settlement. The BRR is derived from Bitcoin/US Dollar transactions on selected spot exchanges. Currently, there are four constituent spot exchanges – Bitstamp, GDAX, itBIT and Kraken; however, two more – Bitfinex and OkCoin – may be added later if they satisfy all BRR requirements. (Click here for details regarding CME Bitcoin futures contracts.)

CBOE Bitcoin futures contracts will settle to the auction price of Bitcoin in US dollars on the Gemini Exchange – another spot exchange that trades Bitcoin. (Click here for details regarding CBOE Bitcoin futures contracts.) CBOE Bitcoin futures contracts will be cleared by the Options Clearing Corporation.

Cantor Bitcoin binary options – a form of swap contract – will settle to the Cantor Exchange Cash Market Reference Price, which represents the value of Bitcoin in US dollars at the time of a contract’s expiration. The CECM Reference Price will be determined by Cantor “in its sole and absolute discretion” using publicly available Bitcoin prices from a variety of sources including “widely followed” cryptocurrency spot exchanges and “aggregates, composites or indexes of Bitcoin cash prices,” as well as bids, offers and transactions in the expiring and non-expiring contract months traded on Cantor. Cantor Bitcoin binary options will be cleared through an affiliated DCO – the Cantor Clearinghouse. (Click here for details regarding Cantor’s Bitcoin binary options.)

In its Backgrounder, the CFTC noted its belief that “responsible innovation is market-enhancing.”

In 2014, TeraExchange LLC – a CFTC-regulated swap execution facility (SEF) – began trading non-deliverable Bitcoin forward contracts based on the Tera Bitcoin Price Index. In July 2017, the CFTC approved LedgerX as a SEF and DCO for fully collateralized digital currency swaps. Unlike with CME, CFE and Cantor’s proposed derivatives contracts, LedgerX’s swap contracts may result in settlement in Bitcoin. (Click here for details in the article “LedgerX Approved by CFTC as First Derivatives Clearing Organization for Fully Collateralized Swap Contracts Potentially Settling in Bitcoin” in the July 30, 2017 edition of Bridging the Week.)

According to Coinbase, the price of Bitcoin rose from $9,386/Bitcoin to $11,235/Bitcoin  a 19.7 percent increase – from November 27 through December 3, including a midweek drop from $11,290/Bitcoin to $9,398/Bitcoin – a 16.8 percent decline  between November 29 and November 30 (click here for details).

Separately,

Helpful to Getting the Business Done: As a result of these developments, soon there will be three principal ways for US-based hedgers and speculators to gain exposure to Bitcoin:

My View: When DCMs self-certify a new derivatives contract, they must confirm that the contract is not “readily susceptible to manipulation.” This requirement derives from CFTC Core Principle 3 for DCMs (click here to access CFTC Rule 38.200). Although acknowledging “concerns” about the price volatility and trading practices of participants on the spot markets underlying the new CME, CFE and Cantor Bitcoin derivatives contracts which the CFTC conceded were “largely unregulated,” the Commission accepted the self-certification by the three exchanges that each of their proposed new Bitcoin derivatives contracts complied with Core Principle 3. According to the CFTC, “We expect that the futures exchanges … will be monitoring the trading activity on the relevant cash platforms for potential impacts on futures contracts’ price discovery process, including potential market manipulation and market dislocations due to flash rallies and crashes and trading outages.”

In March 2017, the Securities and Exchange Commission declined to approve a rule change to the Bats BZX Exchange to list and trade shares of the Winklevoss Trust – which proposed to hold Bitcoin as an asset and track the price of Bitcoin as traded on the Gemini Exchange – the same exchange on whose prices the CBOE Bitcoin futures contract will be based. In denying Bats BZX’s application, the SEC concluded that the exchange’s proposal did not support a finding that “the significant markets for Bitcoin or derivatives on Bitcoin are regulated markets with which the [Bats BZX Exchange] can enter into [a] surveillance-sharing agreement.” The SEC implied concern regarding the integrity of prices of Bitcoin traded on the Gemini Exchange. (Click here to access the SEC's BZX Order.) Within the last few months, two additional Bitcoin-related exchange-traded funds withdrew their applications to the SEC for qualification, apparently because the SEC’s view on ETFs based on prices on spot Bitcoin exchanges has not changed. (Click here for background regarding REX Shares LLC’s and Grayscale Investments LLC’s investment trusts in the article “Singapore Regulator Joins Other Regulators in Warning Initial Coin Offerings May Impact Local Laws,” in the October 8, 2017 edition of Bridging the Week.)

Potentially, the CFTC’s acceptance of the self-certifications of CME, CFE and Cantor will spur a rethink by the SEC of its views regarding the regulation of trading on at least certain spot Bitcoin exchanges. It seems incongruous that the CFTC could take comfort in the three exchanges’ oversight of activities on at least a few spot Bitcoin exchanges, but that the SEC may still have material concerns.

At some point soon, it would also be helpful for the CFTC and SEC to develop a common approach to distributed ledger entries (DLEs) like Bitcoin and Ether. Although the CFTC has determined that Bitcoin is a virtual currency and is properly regulated as a commodity under applicable law, the SEC has separately determined that initial coin offerings may constitute securities requiring registration or an exemption from registration, as well as being subject to other requirements under securities laws and SEC rules. However, in the end, ICOs often result in the same type of DLEs that function as a medium of exchange or unit of account just like the DLEs the CFTC regards as commodities. Moreover, some of these DLEs may be chameleon-like, having principal characteristics of securities at initial creation and principal characteristics of a virtual currency later on. Different approaches to the same type of technology could impede its development and cause regulatory and legal headaches. (Click here for background regarding the SEC’s approach to ICOs in the article “SEC Warns That Digital Tokens May Be Securities” in the August 3 Advisory by Katten Muchin Rosenman LLP.)

In two disciplinary actions – one involving Image Securities and the other its employee Ramakant Gaund – the Chicago Mercantile Exchange alleged that, from December 1, 2014, through March 31, 2015, the firm, through its employee, engaged in multiple matching buy and sell orders to move positions between different accounts of the firm to “manage” margin calls. The exchange charged that these transactions constituted impermissible wash trades. To resolve these matters, Image agreed to pay a fine of US $85,000 while Mr. Gaund consented to pay a fine of US $10,000 and be subject to a five-business day all CME Group exchanges trading suspension. CME claimed that Image failed to supervise its employee. The exchange also charged Image with permitting one employee to enter trades on its Globex trading platform using a different employee’s Tag 50 user ID. Both Image and Mr. Gaund were nonmembers.

Robert Overholt agreed to pay a fine of US $25,000 and serve a 30-day all CME Group exchanges trading suspension for allegedly entering orders involving Live Cattle futures contracts without intent to execute the orders. This conduct purportedly occurred on “multiple occasions” from October 12, 2015, through December 8, 2015. Typically, said CME, Mr. Overholt would place a large order on one side of the market to induce execution of a small order on the other side, and then cancel the large order after the small order was executed. The exchange claimed that the orders placed without an intent for execution constituted a violation of its disruptive practices rule (click here to access CME Group Rule 575.A).

Finally, Citigroup Global Australia, Pty LTD and AMP Capital Investors Limited – in two separate disciplinary actions – agreed to resolve allegations by the Chicago Board of Trade that on April 15, 2015, the firms executed two EFRP transactions “that were contingent upon each other, wherein each position was established and offset without the incurrence of material market risk.” Each firm agreed to pay a fine of US $15,000 to resolve their disciplinary action. Transitory EFRPs (including contingent EFRPs) are not authorized under CME Group guidance (click here to access CME MRAN RA1716-5 (October 18, 2017), Q/A 13).

Compliance Weeds: Under applicable law, a person is prohibited from entering into or offering to enter into transactions that are “commonly known” as wash sales. (Click here to access Commodity Exchange Act Sec. 4c(a)(2)(A)(i), 7 USC Sec. 6c(a)(2)(A)(i).) For the CFTC to show that a wash sale has occurred it must demonstrate that a wash result occurred (e.g., a purchase and sale of the same delivery month of the identical futures contract (or option strike price) at the same price), and that the wash result was intended. Intent can be demonstrated by specific prearrangement or inferred through conduct. CME Group arguably has a broader view of wash sales and wash trades. For CME Group, a person is forbidden to place or accept buy and sell orders for the same product and month (or option strike price) “where the person reasonably should know that the purpose of the orders is to avoid taking a market position exposed to market risk.” (Click here to access CME Group Rule 534 and here for the applicable CME Group Market Regulation Advisory Notice.) On CME Group exchanges, buy and sell orders for different accounts with common beneficial owners can be deemed wash sales. ICE Futures U.S. has equivalent prohibitions. (Click here to access the applicable IFUS guidance.) Firms with multiple traders that independently place orders manually or through automated trading systems may, on occasion, have offsetting trades inadvertently match. Provided such matching is de minimis, CME Group and IFUS typically will not consider such transactions as wash trades. However, firms are expected to have policies to minimize such matching. (See relevant CME Group MRAN, Q/A 13; IFUS Guidance Q/A 12.)

More briefly:

For further information:

CME Group Disciplinary Actions Charge Wrongful EFRPs, Wash Sales and Spoofing:

CFTC Reports a Decline in Enforcement Actions and Sanctions:
http://www.cftc.gov/PressRoom/PressReleases/pr7650-17

FINRA Fines Broker-Dealer $1.25 Million for Not Adequately Screening Its Employees:
http://www.finra.org/sites/default/files/jp_morgan_awc_112117.pdf

FINRA Provides AML Guidance to Members:
http://www.finra.org/sites/default/files/notice_doc_file_ref/Regulatory-Notice-17-40.pdf

ICE Canada Extends Supervisory Obligations to All Market Participants:
https://www.theice.com/publicdocs/futures_canada/member_notices/2017_11_30_Supervision_Rules.pdf

NFA Proposes to Augment Supervisory Obligations of Certain Members Regarding APs Electronic Communications With Customers:
https://www.nfa.futures.org/news/PDF/CFTC/proposedamendmentstonfainterpretivenoticecr2-9enhancedsupervisoryrequirements.pdf

Three CFTC-Regulated Exchanges Self-Certify Bitcoin Derivative Contracts:
http://www.cftc.gov/PressRoom/PressReleases/pr7654-17#PrRoWMBL
http://www.cftc.gov/idc/groups/public/@newsroom/documents/file/bitcoin_factsheet120117.pdf

DFS/Bitflyer:
http://www.dfs.ny.gov/about/press/pr1711281.htm

World Exchanges Organization Says Regulatory Coordination Key to Financial Markets Health:
https://www.world-exchanges.org/home/index.php/news/world-exchange-news/the-world-federation-of-exchanges-publishes-position-paper-on-international-regulatory-dissonance

The information in this article is for informational purposes only and is derived from sources believed to be reliable as of December 2, 2017. No representation or warranty is made regarding the accuracy of any statement or information in this article. Also, the information in this article is not intended as a substitute for legal counsel, and is not intended to create, and receipt of it does not constitute, a lawyer-client relationship. The impact of the law for any particular situation depends on a variety of factors; therefore, readers of this article should not act upon any information in the article without seeking professional legal counsel. Katten Muchin Rosenman LLP may represent one or more entities mentioned in this article. Quotations attributable to speeches are from published remarks and may not reflect statements actually made.

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ABOUT GARY DEWAAL

Gary DeWaal

Gary DeWaal is currently Special Counsel with Katten Muchin Rosenman LLP in its New York office focusing on financial services regulatory matters. He provides advisory services and assists with investigations and litigation.


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