CFTC Releases Guidance for Acceptance of Virtual Currency
The United States Commodity Futures Trading Commission ("CFTC")’s Division of Swap Dealer and Intermediary Oversight released guidance on October 21, 2020 for futures commission merchants ("FCMs") accepting virtual currencies as customer funds and reporting on these currencies. It also provided guidance on holding and reporting virtual currency in connection with physically delivered swaps. The full text of the Advisory can be accessed here.
The Advisory does not address virtual currency held by FCMs on behalf of customers who trade in foreign markets, or virtual currency held by the FCM itself for its proprietary or house accounts.
The CFTC issued the guidance considering two provisions of the Commodity Exchange Act ("ACT"): Sections 4d(a)(2) and 4d(f) (4d(a)(2); the Bankruptcy Code; and CFTC Regulations 1.11. Section 4d(a)(2) governs the segregation and handling of customer funds to be used for margin or to purchase futures, and 4d(f) is concerned with the same issues but for customers engaging in swap transactions. Regulations 1.11 concern an FCM’s risk management policy and in this Advisory it is discussed for establishing and maintaining risk management programs for the acceptance of virtual currency.
How is Virtual Currency Defined?
The Advisory defines virtual currency as any digital representation of value such as cryptocurrency, tokens, or “other assets.” These virtual currencies can be held by FCMs in segregated accounts as long as the twelve enumerated points mentioned in the Advisory are adhered to.
Among the twelve points enumerated in the Advisory are: that FCMs must deposit virtual currency held for customers with a Depository and receive acknowledgment of the deposit in conformity with CFTC Rule 1.20; that the virtual currency deposited has some relation to the customer’s trading and margin requirements, and the type of entities at which virtual currencies can be deposited.
Typically, large amounts of virtual currencies are stored with entities called custodians. Custodians are institutions which store digital currencies for third parties. This is an extremely important role because hacking and the loss of private keys represent a significant risk with virtual currency.
What Risks Are Discussed in the CFTC Advisory?
This risk is discussed in the CFTC Advisory, which characterizes the storage of virtual currencies as riskier than other assets, presenting, “a degree of custodian risk that is beyond what is currently present with depositories, such as banks and trust companies.” As such, an FCM accepting a virtual currency and holding it as segregated customer funds is deemed to create additional risks for other FCM customers. This is in part because custodians are generally not the subject of federal or state regulations, and also private keys can get lost or stolen and systems containing digital keys can get hacked.
Existing custodians are entities like Anchorage, BitGo Inc, Paxos, Gemini and Coinbase. Though some larger Wall Street names like Fidelity have gotten involved in what is considered a rapidly growing, multi-billion dollar industry. In order to address theft and hacking, custodians store private keys and digital assets in what is termed, “cold storage,” meaning as hardware or in paper wallets inside the equivalent of bank vaults.
The CFTC Advisory requires that FCMs deposit virtual currency, “with a bank, trust, or another FCM, or with a clearing organization that clears virtual currency futures, options on futures, or cleared swap contracts.” What the CFTC defines as a Depository.
The Advisory ends with the warning that notwithstanding the guidance issued within it, the Division of Swap Dealer and Intermediary Oversight is always free to refer an “FCM to the Division of Enforcement for potential investigation relating to the FCM’s practices involving virtual currencies or related contracts, or for any other reason.”
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