NY Attorney General Releases Report on Cryptocurrency Exchanges, Federal District Court Agrees with CFTC That Virtual Currencies are Commodities under the CEA, and CFTC and SEC Bring Action and Charge against Crypto Swap Dealer

New York Attorney General Issues Virtual Markets Integrity Initiative Report

On September 18, 2018, the New York State Office of the Attorney General (the “OAG”) issued the Virtual Markets Integrity Initiative Report (the “Report”), which presents information collected by the OAG from nine virtual asset trading platforms, often referred to as “exchanges.” Of the thirteen exchanges contacted, four declined to respond;¹ the information provided by the nine responding exchanged formed of the Report. The nine exchanges are based in the United States and abroad, and the responses were on a voluntary basis. The Report identified three broad areas of concern: (1) lack of protection from abusive trading practices, (2) pervasive conflicts of interest, and (3) limited protection of customer funds.

• Lack of Protection from abusive trading practices: The Report found that the exchanges lack robust real-time and historical market surveillance capabilities to identify and stop suspicious trading patterns. According to the Report, few exchanges seriously restrict or even monitor the operation of automated algorithmic trading on their venues. Indeed, certain exchanges disclaim any responsibility for stopping traders from artificially affecting prices. The Report concluded that these factors, coupled with the concentration of virtual currency in the hands of a relatively small number of major traders, leave the exchanges highly susceptible for abuse.
• Pervasive conflict of interest: The Report found that exchanges often engage in several lines of business that would be restricted or carefully monitored in a traditional trading environment. Exchanges often serve as venues of exchange, as traditional broker-dealers, as proprietary traders, as owners of large virtual currency and in some cases, as issuers of virtual currencies listed on their own and other exchanges. The employees of an exchange often hold virtual currency and trade on their own or competing exchanges. The Report concluded that these factors introduce substantive potential conflicts between the interests of the exchanges, the exchange’s insiders and the exchange’s customers.
• Limited protection of customer funds: According to the Report, generally accepted methods for auditing virtual assets do not exist and some exchanges do not claim to do any independent auditing of their virtual currency holdings at all. This lack of auditing makes it difficult or impossible to confirm whether exchanges are responsibly holding their customers’ virtual assets as claimed. Furthermore, some exchanges do not insure against any virtual asset losses, and those that do may not have the scope and sufficiency necessary to cover virtual asset losses.

Federal District Court Rules Agrees with CFTC That Virtual Currencies are Commodities under the CEA

On September 26, 2018, the United States District Court in Massachusetts denied the defendants’ motion to dismiss in a closely watched fraud case, CFTC v. My Big Coin Pay, Inc., et al. In the case, the Commodities Futures Trading Commission (the “CFTC”) alleges that the defendant engaged in a fraudulent “virtual currency scheme” in violation of the Commodity Exchange Act (the “CEA”) and a CFTC implementing regulation banning fraud and manipulation in connection with the sale of a commodity related to the sale of a virtual currency named “My Big Coin” (“MBC”).

“Commodity” is a defined under the CEA, and the definition includes a list of 30 specific agricultural products “and all other goods and services…in which contracts for future delivery are presently or in the future dealt in.”²

In the motion to dismiss, the defendants argued, among other things, that the allegedly fraudulent virtual currency involved in the scheme was not a “commodity” within the meaning of the CEA because MBC is neither a tangible good nor does futures trading of MBC exist.

In her Memorandum of Decision, U.S. District Judge Rya W. Zobel determined that Congress intended for the CFTC to regulate a swath of products that should be considered generally, not by individual good. She concluded that well-known cryptocurrency Bitcoin meets the legal standard of a commodity under the CEA, and therefore so do other virtual currencies like MBC. The court further reviewed existing caselaw³ and concluded that, for purposes of determining whether something is a commodity under the definition set forth in the CEA, it is only required that futures trading exists within a certain class (e.g. “natural gas”) in order for all items within that class (e.g. “West Coast” natural gas) to be considered commodities.⁴ Therefore, since for purposes of the motion to dismiss the court had to accept the CFTC’s assertion that MBC is a virtual currency, and it is undisputed that there is futures trading in virtual currencies (specifically involving Bitcoin), it was “sufficient, especially at the pleading stage, for plaintiff to allege that My Big Coin is a ‘commodity’ under the Act.”⁵

CFTC and SEC Bring Action and Charge against Crypto Swap Dealer

On September 27, 2018, CFTC filed a civil enforcement action in the U.S. District Court for the District of Columbia against 1pool Ltd. (“1pool”), a crypto swap dealer organized in the Marshall Islands and its CEO and owner, Patrick Brunner of Austria (collectively “Defendants”).⁶ CFTC’s Complaint charges the Defendants with engaging in unlawful retail commodity transactions, failing to register as a Futures Commission Merchant (“FCM”), and supervisory violations for failing to implement procedures to prevent money laundering as required under federal laws and regulations. Investors could open accounts by simply providing an email address and a user name – no additional information was required – and could only fund their account using bitcoins.

1pool engaged in commodity transactions in the form of “contracts for difference” (“CFDs”) that had as underlying assets commodities such as gold and West Texas Intermediate crude oil. A CFD is generally an agreement to exchange the difference in value of an underlying asset between the time at which the CFD trading position is established and the time at which it is terminated. The Complaint alleges that the Defendants did not conduct these transactions on or subject to the rules of any board of trade that has been designated or registered by the CFTC as a contract market, as required by the CEA. The Complaint further alleges that 1pool, through Brunner and its other employees and agents, acted as an FCM by soliciting or accepting orders for retail commodity transactions, acted as a counterparty to these transactions, and in connection with these activities, accepted money, securities, or property (or extended credit in lieu thereof) in the form of bitcoin to margin any resulting trades or contracts that result or may result therefrom. This may be the first instance in which the CFTC has charged any crypto dealer with failure to register as FCM.

On the same day, the Securities and Exchange Commission (“SEC”) also filed charges against 1pool Ltd. and its CEO in U.S. District Court for the District of Columbia for allegedly violating the federal securities laws in connection with security-based swaps funded with bitcoins.7 The SEC alleged that 1pool Ltd., and its CEO failed to transact its security-based swaps on a registered national exchange, and failed to properly register as a security-based swaps dealer. 1pool Ltd. and its CEO solicited investors from the United States to buy and sell security-based swaps disregarding the discretionary investment thresholds requirement under the federal securities laws. Also, similar to charges filed by CFTC, SEC alleged that 1pool Ltd., and its CEO violated federal laws by failing to implement anti-money laundering and supervisory features.

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¹ Nine of the thirteen platforms participated in the Initiative: Bitfinex (operated by iFinex Inc.), bitFlyer USA, Inc., Bitstamp, Ltd., Bittrex, Inc., Coinbase, Inc., Gemini Trust Company, itBit (operated by Paxos Trust Company), Poloniex (owned by Circle Internet Financial Limited), and Tidex (operated by Elite Way Developments LLP). The OAG separately invited HBUS – a platform that calls itself the U.S. “strategic partner” of Huobi Inc. – to respond, as the platform opened for trading in July 2018. HBUS elected to do so, and its responses are included in the Report. Four platforms – Binance Limited, Gate.io (operated by Gate Technology Incorporated), Huobi Global Limited, and Kraken (operated by Payward, Inc.) – claimed they do not allow trading from New York and declined to participate.

² See 7 U.S.C. § 1a(9).

³ See, e.g., United States v. Brooks, 681 F.3d 678 (5th Cir. 2012); United States v. Futch, 278 F. App’x 387, 395 (5th Cir. 2008); United States v. Valencia, No. CR.A. H-03-024, 2003 WL 23174749, at *8 (S.D. Tex. Aug. 25, 2003), order vacated in part on reconsideration, No. CRIM.A. H-03-024, 2003 WL 23675402 (S.D. Tex. Nov. 13, 2003), rev’d and remanded on other grounds, 394 F.3d 352 (5th Cir. 2004).

⁴ CFTC v. My Big Coin Pay, Inc., No. 18-10077-RWZ, 2018 U.S. Dist. LEXIS 164932 (D. Mass. Sep. 26, 2018).

⁵ Id.

⁶ See https://www.cftc.gov/PressRoom/PressReleases/7809-18, last visited on September 28, 2018.

⁷ See https://www.sec.gov/news/press-release/2018-218, last visited on September 28, 2018.