New York regulators continued an aggressive approach against certain entities engaged in virtual currency businesses when the state's Attorney General’s office obtained an ex parte order precluding companies associated with a very popular international cryptocurrency exchange and stablecoin from utilizing fiat currency reserves backing the stablecoin to help fund operations of the exchange. The NY AG alleged that the respondents had previously engaged in such activities without disclosure to customers. Separately, the Department of Justice determined not to retry a purported programmer to the “Flash Crash” spoofer following the mistrial declared by the judge overseeing the criminal trial of the programmer earlier this month. As a result, the following matters are covered in this week’s edition of Bridging the Week:

• NY Attorney General Sues Stablecoin Issuer and Related Companies for Purportedly Misusing Tethered Fiat Currency Without Customer Disclosure (includes Memory Lane); 

• Department of Justice Declines to Retry Alleged Programmer for Flash Crash Spoofer (includes My View); 

• Follow-up – Subject of CFTC Foreign Corrupt Practices Probe Self-Discloses (includes Legal Weeds); and more.

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Briefly:

• NY Attorney General Sues Stablecoin Issuer and Related Companies for Purportedly Misusing Tethered Fiat Currency Without Customer Disclosure: The Office of the Attorney General for the State of New York obtained an ex parte order from a New York State court prohibiting companies associated with the management of the cryptoasset exchange Bitfinex as well as the stablecoin tether from accessing, loaning or encumbering in any way US dollar reserves supporting tether digital coins. The NY AG claimed that the same individuals ultimately own and operate all the companies.

The NY AG had applied for such order without giving respondents notice or having an opportunity to object, claiming such emergency action was necessary because of the potential danger of respondents compromising tether’s supporting balances to help fund Bitfinex's operations.

Stablecoins backed by fiat currency such as tether are a type of virtual currency that are intended to be supported 1:1 by the relevant fiat currency or cash equivalents held in escrow, typically at a bank or other financial institution (e.g., US $1,000 of US dollar stablecoins should be backed by at least US $1,000 of fiat currency or cash equivalents held in a bank or other financial institution in a segregated account solely to support the stablecoins).

According to papers filed by the NY AG, by mid-2018 Bitfinex experienced “extreme difficulty” satisfying clients’ requests to withdraw money from their trading accounts because a payment processor, Crypto Capital Corp. (a Panamanian entity) – where it maintained customer and proprietary funds –, failed to process customer withdrawal requests and would not or could not remit any funds to the cryptoasset exchange. Specifically, as alleged by the NY AG, Bitfinex was unable to retrieve US $851 million from Crypto Capital because the payment processor claimed that the “funds [had been] seized by governmental authorities in Portugal, Poland and the United States.” The NY AG claimed that Bitfinex did not believe Crypto Capital’s explanation. In October 2018, said the NY AG, Bitfinex publicly denied rumors of difficulty meeting customer withdrawal requests despite public rumors to the contrary.

In response, charged the NY AG, executives of Bitfinex and the company managing tether (“Tether”) agreed for Tether to provide Bitfinex a line of credit of up to US $900 million sourced from the US dollar reserves supporting the tether stablecoin in order to help meet Bitfinex’s customers’ withdrawal demands. However, this arrangement, asserted the NY AG, was made without disclosure to tether holders. To date, claimed the NY AG, Bitfinex has already borrowed US $700 million from Tether utilizing tether supporting balances.

The court’s order also required respondents to safeguard certain records, and provide certain documents to the NY AG. Other than requesting the specific relief granted in the court’s order, the NY AG did not seek to interfere in any manner with Bitfinex’s or Tether’s day-to-day operations.

In a press release issued on April 26, Bitfinex said that the NY AG’s filings “were written in bad faith and are riddled with false assertions … Both Bitfinex and Tether are financially strong – full stop.” Bitfinex expressly denied the NY AG’s allegations that it did not believe Crypto Capital’s explanation regarding the US $851 million, saying “that these Crypto Capital amounts are not lost but have been, in fact, seized and safeguarded. We are and have been actively working to exercise our rights and remedies and [sic] get those funds released.” (Click here to access the full Bitfinex press release.)

A court hearing on this matter is scheduled for May 3, 2019.

Earlier this month, the New York Department of Financial Services cancelled Bittrex Inc.’s temporary authority to conduct a virtual currency business in New York, denied its application to obtain a BitLicense, and explained its actions in a letter to Bittrex that the agency publicly disseminated. Bittrex and Bitfinex are not related entities. (Click here for background in the article “New York State Department of Financial Services Revokes Crypto Exchange’s Safe Harbor to Operate Without BitLicense” in the April 14, 2016 edition of Bridging the Week.) Last year the NY AG issued a report claiming that cryptoasset trading facilities often (1) engage in several lines of business that may pose conflicts of interest; (2) have not implemented “serious efforts to impede abusive trading activity”; and (3) have “limited or illusory” protection for customer positions. It also claimed that at least three cryptoasset exchanges were operating in New York without an appropriate license. Bitfinex was one of nine cryptoasset exchanges that voluntarily participated in NY AG’s information request that resulted in the agency’s report. (Click here for more details in the article “NY Attorney General Says Investors Risk Abusive Trading and More on Crypto Platforms” in the September 23, 2018 edition of Bridging the Week.)

In other legal and regulatory developments regarding cryptoassets:

• Public Sniping Continues – Denied NY BitLicense Applicant Claims NY DFS Information Regarding Supposed North Korean Accounts Was Wrong: The public sparring between Bittrex and the NY DFS following DFS’s April 10, 2019 denial of Bittrex for a NY BitLicense continued last week when the firm claimed on Twitter that the New York State agency was wrong to accuse it of opening two accounts for North Korean persons. In fact, claimed Bittrex, the firm had investigated and learned in October 2017 that both accounts were for South Korean residents who had incorrectly selected North Korea in a country dropdown menu. The DFS in its April 18, 2019 commentary on a CoinDesk blog had cited Bittrex accounts opened on behalf of residents of North Korea and Iran as examples of the firm’s purported “customer due diligence failures.” Bittrex did not address DFS’s allegations about the Iranian accounts in its Twitter response. (Click here for background on the public sparring between DFS and Bittrex in the article “Thrilla in Manhattan – NY Regulator and Declined BitLicense Applicant Engage in Extraordinary Public Brawl in Media Blog” in the April 21, 2019 edition of Bridging the Week.)

• France to Implement Voluntary Regime for Issuers of Cryptoassets for Fundraising: Legislation approved by the French National Assembly on April 11 would empower the Autorité des marchés financiers – the French financial services regulator – to offer a “visa” to issuers of digital tokens that would not otherwise constitute financial instruments (e.g., securities or derivatives) to raise funds from France on a voluntary basis. As proposed, issuers of qualified digital assets would have to be incorporated in France; provide an information document to all investors describing the company, the token offering and the project to be financed; establish a system “for monitoring and safeguarding the assets raised during the offer”; and comply with anti-money laundering and terrorist financing rules. Companies that do not obtain a visa could still conduct initial coin offerings in France, but could not do so through general solicitation activity. 

The approved legislation would also permit digital assets service providers to be voluntarily licensed and supervised by AMF. However, this proposed regime would not apply to service providers who provide digital assets custody services to third parties or purchase or sell digital assets in exchange for fiat currency; these persons are subject to mandatory registration with AMF. Additionally, the new legislation expressly authorizes two types of funds to invest in digital assets – professional specialized investment funds subject to applicable liquidity and valuation requirements and professional private equity investment funds subject to a 20 percent limit.

The legislation passed by the National Assembly must be formally enacted into law before becoming effective.

• Two Non-US Persons Indicted for Alleged Online Cryptoasset Fraud: The United States Attorney’s Office for the District of Oregon indicted Onwuemerie Ogor Gift and Kelvin Usifoh – two non-US nationals – for wire fraud and conspiracy to commit wire fraud for engaging in an online scheme to defraud individuals of bitcoin. According to the US Attorney’s Office, from December 2017 through June 2018, the defendants allegedly induced three persons, including one Oregon resident, to transfer 50 bitcoins in aggregate to them for investment purposes; however, the defendants are charged with misappropriating the bitcoin for their own use.

• FINRA Joins CFTC and SEC in Creating Fintech Hub: The Financial Industry Regulatory Authority established an Office of Financial Innovation to serve as a central point of coordination for novel fintech issues by member firms. The office appears designed to fulfill a similar purpose as LabCFTC at the Commodity Futures Trading Commission (click here for more details) and the Strategic Hub for Innovation and Financial Technology (FinHub) at the Securities and Exchange Commission (click here for background).​

Memory Lane: Bitfinex was involved in one of the first enforcement actions by the CFTC involving spot virtual currencies. In June 2016, Bitfinex agreed to settle charges brought by the Commission that, from approximately April 2013 through at least February 2016, it allegedly engaged in prohibited, off-exchange commodity transactions with retail clients and failed to register as a futures commission merchant, as required. According to the CFTC, during the relevant time period, Bitfinex “operated an online platform for exchange and trading cryptocurrencies, mainly Bitcoins.” The CFTC said that Bitfinex’s platform allowed users that were not eligible contract participants to borrow funds to purchase bitcoins from other platform users. Bitfinex agreed to pay a fine of US $75,000 to resolve the CFTC’s charges and to cease and desist from future violations. (Click here for more details in the article “Bitcoin Exchange Sanctioned by CFTC for Not Being Registered” in the June 5, 2016 edition of Bridging the Week.)

The CFTC’s first enforcement action involving spot virtual currencies was in September 2015 against Coinflip, Inc. and Francisco Riordan, its founder and chief executive officer, for operating a trading facility for bitcoin options – Derivabit – without it being registered as a swap execution facility or a designated contract market. According to the CFTC, because bitcoin and other virtual currencies are “properly” defined as “commodities” under applicable law, all trading facilities for commodity options on bitcoin must be registered with it as a SEF or a DCM. Coinflip was not so registered. To settle this matter, Coinflip and Mr. Riordan agreed to cease and desist from violating applicable law. No financial penalty was required as part of the settlement. (Click here for more background in the article “CFTC Says Virtual Currencies Are a 'Commodity' Under Federal Law, Files Charges Against Coinflip for Operating an Unregistered Bitcoin Options Trading Platform” in the September 20, 2015 edition of Bridging the Week.)

• Department of Justice Declines to Retry Alleged Programmer for Flash Crash Spoofer: The Department of Justice determined not to re-prosecute Jitesh Thakkar, an alleged programmer for purported flash crash spoofer Navinder Sarao. This decision followed the declaration of a mistrial on April 9, 2019, by the judge who presided over the criminal trial of Mr. Thakkar. Previously, the judge – The Hon. Robert Gettleman of the United States District Court for the Northern District of Illinois – acquitted Mr. Thakkar of the criminal charge of conspiracy to commit spoofing. The jury hearing Mr. Thakkar’s case voted 10- 2 against convicting him of two counts of aiding and abetting spoofing. (Click here for more background in the article “Mistrial Declared in Prosecution of Purported Programmer for Alleged Flash Crash Spoofer” in the April 14, 2019 edition of Bridging the Week.)

My View: Mr. Sarao pleaded guilty in November 2016 to criminal charges brought against him by the DoJ for engaging in manipulative conduct through spoofing-type activity involving E-mini S&P futures contracts traded on the Chicago Mercantile Exchange between April 2010 and April 2015, including illicit trading that contributed to the May 6, 2010, “Flash Crash.” On the same day, the CFTC announced that Mr. Sarao settled civil charges it had brought against him and Nav Sarao Futures Limited PLC, a company he controlled, related to the same essential conduct. (Click here for additional details in the article “Alleged Flash Crash Spoofer Pleads Guilty to Criminal Charges and Agrees to Resolve CFTC Civil Complaint by Paying Over $38.6 Million in Penalties” in the November 13, 2016 edition of Bridging the Week.)

Mr. Thakkar was initially named in a criminal action by the DoJ and a civil action by the CFTC in January 2018, for purportedly developing “back-of-the-book” software that was allegedly used by Mr. Sarao to effectuate his spoofing activities. In court papers, Mr. Thakkar claimed that he never was told by Mr. Sarao the purpose of his software request, but in any case, he did not develop the actual software; he assigned the task to other programmers at his company – Edge Financial Technologies, Inc.

Mr. Thakkar’s CFTC action was stayed in December 2018 pending resolution of Mr. Thakkar’s criminal case. Although the standard of proof the CFTC would have to satisfy to gain a judgment against Mr. Thakkar in its enforcement action is less than what the DoJ required in its criminal case (a preponderance of the evidence vs. beyond reasonable doubt), the Commission should exercise its discretion and voluntarily drop its enforcement action against Mr. Thakkar. Unless the CFTC has a smoking gun it did not make available to the DoJ, it does not appear that there is compelling evidence that Mr. Thakkar was aware that software developed by his firm would be used by Mr. Sarao for illicit purposes.

It should not be case that a software developer or provider can be held liable for the illicit use of the software absent express knowledge of the user’s illicit intent. Simply being aware that that software could potentially be used for an illegal purpose should not be enough to warrant prosecution by the CFTC let alone by the DoJ. Otherwise, the potential for regulatory liability will chill if not freeze trading software development.

More Briefly:

• CFTC Proposes Rule Amendments to Enhance Swap Data Quality: The Commodity Futures Trading Commission proposed the first of three sets of rule amendments designed to enhance the accuracy of swaps data reported to and maintained by swap data repositories. The initial proposed rule amendments would, among other things, require each SDR to implement procedures reasonably designed to verify the accuracy of swap data it receives from swap execution facilities, designated contract markets, reporting counterparties or third-party service providers, and to require reporting counterparties to verify the accuracy of their reporting in accordance with an SDR’s procedures. The rule amendments would also heighten the CFTC’s general oversight of swap data reporting and SDRs. The CFTC is proposing three sets of rule amendments in response to comments received to its July 2017 Roadmap to Achieve High Quality Swap Data (click here to access). The objective of the first set of rules is to achieve the operations review goals of the Roadmap, mainly to: (1) confirm the accuracy of swap data; (2) improve the “clarity and consistency” of SDR regulations; and (3) heighten the CFTC’s oversight of SDRs. 

Although Commissioner Dawn Stump voted in favor of issuing the first round of rule amendments for public comment, she questioned whether the recommendations were a “solution in search of a problem.” Commissioner Rostin Behnam also voted in favor of authorizing the proposal but objected to language in the recommended rule amendments that would require SDR chief compliance officers to take “reasonable steps” to resolve any conflict of interest at the SDR. Mr. Behnam claimed this language is inconsistent with statutory language that expressly requires the CCO to “resolve any conflicts of interest that may arise” and may undermine CCOs authority within the SDR. 

Comments to the CFTC’s proposed rule amendments will technically be accepted for only 75 days following their publication in the Federal Register; however, the CFTC will reopen the comment period on these rule amendments proposals when it publishes its other two sets of related proposed rule amendments to allow market participants to comment on all SDR proposed rule amendments together.

• NYSE ARCA Participant Settles Disciplinary Action for US $450,000 for Purported Breakdown of Risk Management Controls Related to Market Access; CME Group Exchanges Sanction Multiple Traders Too: Maxim Group LLC agreed to pay a fine of US $450,000 to NYSE ARCA, Inc. to settle disciplinary charges that from December 1, 2016, through December 19, 2018, it allegedly failed to comply fully with Regulation Market Access by the Securities and Exchange Commission. (Click here to access an overview of Reg MAR published by the Financial Industry Regulatory Authority.) According to NYSE ARCA, during this time Maxim Group – an SEC-registered broker-dealer and a NYSE Equities Trading Permit Holder – failed to enforce a system of risk management controls required by Reg MAR related to credit limits; erroneous orders; post-trade reviews; and annual reviews, and did not have adequate supervisory procedures reasonably designed to ensure compliance with the relevant regulation. According to NYSE ARCA, during the relevant time, Maxim Group did not apply credit limits to any of its institutional customers. Although none of these customers were granted direct or sponsored access by Maxim Group, Reg MAR requirements apply to any market access. NYSE ARCA also claimed that the firm did not conduct spoofing or layering reviews as part of post-trade surveillance during the relevant time.

Separately, Merrill Lynch Commodities Inc. agreed to pay a fine of US $75,000 to settle a disciplinary proceeding by the New York Mercantile Exchange. A NYMEX business conduct committee charged that during one trade date, September 24, 2018, the firm maintained positions in excess of its hedge exemption in October 2018 Henry Hub Natural Gas futures. In accepting the firm’s settlement, the NYMEX BCC noted that Merrill Lynch had two other position limit violations during the prior two years. Arches Asset Management LLC also resolved allegations of position limit violations on the Chicago Board of Trade by settling two disciplinary actions for fines totaling US $55,000 and disgorgement of $966.

Finally, Hongfeng Wang (Hongfeng) settled disciplinary actions by the Commodity Exchange, Inc. and NYMEX claiming that from May 10 to 12, 2017, traders he employed executed trades between accounts he owned, without waiting at least five seconds between the placement of an order on one side of the market, and an order on the other side. The exchanges charged Hongfeng with impermissible wash trades and engaging in prearranged and noncompetitive trades. To resolve this matter, Hongfeng agreed to pay a total fine to both exchanges of US $30,000 and serve a six-month all CME Group-exchange access prohibition.

Follow-up:

• Subject of CFTC Foreign Corrupt Practices Probe Self-Discloses: Last month the Division of Enforcement of the Commodity Futures Trading Commission publicized a new initiative aimed at encouraging non-CFTC registrants to voluntarily self-report violations of the Commodity Exchange Act – the principle law overseen by the CFTC – involving foreign corrupt practices. According to the Division, it would recommended to the Commission a resolution of their wrongdoing “with no civil penalty, absent aggravating circumstances involving the nature of the offender or the seriousness of the offense” for non-registrants who self-reported such violations, fully cooperated with the CFTC, and remediated their violations. At the time it was unclear what might have prompted the unexpected introduction of this new policy more than 40 years after the adoption of the Foreign Corrupt Practices Act in 1977 – three years after the authorization of the CFTC. 

Last week, the motivation may have become clearer when Glencore – one of the largest international firms involved with natural resources and the marketing of more than 90 commodities – announced it had been advised by the Commission it was subject to an investigation into whether it or its subsidiaries violated the CEA in connection with corrupt practices involving commodities. Previously, one Glencore group company was served with a subpoena by the US Department of Justice for documents and other records regarding its compliance with the FCPA in connection with the Group’s business in Nigeria, the Congo and Venezuela from 2007 through 2018. (Click here for background regarding the Department of Justice inquiry; click here for background regarding the Division’s new initiative.)

Legal Weeds: Last year, the CFTC determined not to bring an enforcement action at all against Deutsche Bank after the Commission brought and settled charges against one of its traders for purportedly mismarking his swap trading portfolio to disguise trading losses. The CFTC said it determined not to bring an enforcement action against Deutsche Bank in connection with this matter because of its “timely, voluntary self-disclosure” of the incident, full cooperation, and “proactive remediation efforts.” (Click here for more in the article “Ex-Bank Trader Fined US $350,000 and Banned From All CFTC Overseen Markets for Allegedly Concealing Swaps Trading Losses; Bank That Self-Reported, Cooperated and Remediated Receives Letter Closing Investigation” in the November 11, 2018 edition of Bridging the Week.)

This development occurred following a 2017 speech by James McDonald, CFTC Director of the Division of Enforcement, that potential wrongdoers who voluntarily self-report their violations, fully cooperate in any subsequent CFTC investigation, and fix the cause of their wrongdoing to prevent a reoccurrence will receive “substantial benefits” in the form of significantly lesser sanctions in any enforcement proceeding and “in truly extraordinary circumstances,” no prosecution at all. (Click here for background in the article “New Math: Come Forward + Come Clean + Remediate = Substantial Settlement Benefits Says CFTC Enforcement Chief” in the October 1, 2017 edition of Bridging the Week.) Contemporaneously with his speech, the CFTC’s DOE released a formal Updated Advisory on Self Reporting and Full Cooperation that memorialized and expanded the elements of Mr. McDonald’s presentation (click here to access).

Upon discovery of any potential wrongdoing impacting the Commodity Exchange Act or CFTC regulations, market participants must evaluate whether to self-report to the CFTC and if so, when. No matter what the potential benefit of obtaining cooperation credit, it’s important to materially understand the scope of any potential violation before self-reporting. Even where reporting may be mandatory, it’s best to ensure that an actual predicate for reporting has actually or most likely occurred. (Click here to access a National Futures Association-prepared summary of mandatory CFTC reporting obligations for future commission merchants, and here for independent introducing brokers.)

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