The United Kingdom’s Financial Conduct Authority proposed to ban the marketing and sale in or from the UK to retail persons of derivatives and exchange-traded notes based on cryptocurrencies and utility digital tokens, including futures on bitcoin currently authorized for trading in the United States. Separately, the US Commodity Futures Trading Commission and the Chicago Board of Trade sanctioned a Hong Kong-based hedge fund for a one-day position limits violation. Among its penalties, the fund agreed to pay back losses it mitigated by liquidating its positions in excess of federal limits. As a result, the following matters are covered in this week’s edition of Bridging the Week:

• UK Financial Regulator Proposes to Ban Crypto-Derivative Sales to Retail Clients; US Congressional Committee Recommends Facebook Libra Moratorium
• CFTC and CBOT Both Fine HK-Based Hedge Fund for Position Limits Violation; IFUS Settles with Spoofer; and more.

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• UK Financial Regulator Proposes to Ban Crypto-Derivative Sales to Retail Clients; US Congressional Committee Recommends Facebook Libra Moratorium: The United Kingdom’s Financial Conduct Authority proposed to ban the sale, marketing and distribution in or from the UK to retail persons of all derivatives and exchange-traded notes referencing unregulated cryptoassets that can be widely exchanged on cryptoasset platforms or other forums. 

Generally, the proposed ban would include derivatives and ETNs based on cryptocurrencies and so-called “utility tokens” to the extent they are created on public blockchains and are readily transferable. The ban would not include derivatives or ETNs referencing security tokens; digital tokens that are unregulated but not widely transferrable (e.g., tokens used on a private blockchain); or tokens that constitute e-money and are subject to the FCA’s Electronic Money regulations (e.g., potentially stablecoins). Futures, options and contracts for differences are types of derivatives that would be included in the proposed ban.

The proposed ban would also not extend to professional clients or eligible counterparties as defined under the FCA’s client categorization rules. (Click here to access The FCA’s Conduct of Business Sourcebook, §3.5.1 regarding professional clients and §3.6.1 regarding eligible counterparties.)

The FCA’s prohibition would apply to affected products sold, distributed or marketed in or from the UK to retail clients and sales to UK clients from the European Economic Area, even where the clients seek such products proactively. However, it appears that retail clients would be authorized to obtain affected products proactively from non-EEA sources. The proposed ban would also prevent UK brokers from selling to UK retail clients affected products that might be traded abroad lawfully (e.g., bitcoin futures currently authorized for trading in the United States on Commodity Futures Trading Commission-designated contract markets).

The FCA claimed that it was proposing its ban because of (1) the complexity of the affected cryptoassets and “the lack of transparency around their valuation”; (2) “the prevalence of market abuse and financial crime in the secondary market for cryptoassets (e.g. cyber theft)”; (3) retail customers’ apparent “lack of knowledge and understanding” regarding affected cryptoassets; and (4) particular characteristics of the relevant derivatives and ETNs, including leverage “and volatility of the underlying assets.”

The FCA presented various statistical analyses it claimed supported its concerns. According to the FCA, some of these observations demonstrate that affected cryptoasset markets “are not driven by external factors such as usage or technological developments, but instead are driven by speculation akin to gambling.”

The FCA acknowledged that, if adopted, its proposal might encourage retail clients to invest directly in unregulated tokens, or for impacted authorized (i.e., registered) firms, to encourage “retail clients to ‘opt-up’ to professional client status or move their accounts to affiliated non-UK entities.” FCA expects that adoption of its proposal would potentially avoid consumer losses between GB £75 million and GB £234.3 million.

The FCA claimed it considered but rejected recommending the use of mandatory risk disclosures as an alternative to a ban. The FCA said this is because “consumers are unlikely to follow advice from authoritative sources.” Moreover, “[t]he continued offer of [affected] products by firms with FCA authorisations may also perpetuate a false sense of safety.”

The FCA will accept comments on its proposal through October 3, 2019.

Unrelatedly, Congresswoman Maxine Waters, Chairwoman of the United States House Committee on Financial Services, and various subcommittee chairpersons requested that Facebook and its partners “immediately” consent to a moratorium on the development and introduction of Libra, its proposed cryptocurrency, and associated initiatives.

Last month, Facebook published a white paper describing Libra, whose stated goal is to create a secure, scalable blockchain and global virtual currency to help individuals currently outside the financial system benefit from an efficient payment system and to help reduce payment transaction costs for others. (Click here for details in the My View commentary to the article “Global AML Standards Setter Says Countries Should Require Virtual Asset Service Providers to Obtain and Transmit Certain Information Regarding Senders and Recipients for All Virtual Asset Transfers” in the June 23, 2019 edition of Bridging the Week.)

A moratorium is warranted, wrote Ms. Waters, because Libra “raises serious privacy, trading, national security, and monetary policy concerns for not only Facebook’s over 2 billion users, but also for investors, consumers, and the broader global economy.” Ms. Waters indicated that during the moratorium, the House Committee on Financial Services would hold hearings on cryptocurrencies generally and “explore legislative solutions.”

Regardless of Facebook’s response to the moratorium call, a hearing regarding the Libra proposal is scheduled by the House Committee on Financial Services for July 17.

In other legal and regulatory matters involving cryptoassets:

• CFTC Approves New Clearing House as First Derivatives Clearing Organization for Fully Collateralized, Deliverable Virtual Currency Futures: The CFTC approved Eris Clearing LLC as the first derivatives clearing organization authorized to clear fully collateralized virtual currency futures contracts that may be settled by the making or taking of delivery of cryptocurrencies. In 2011, the CFTC approved Eris Exchange LLC, Eris Clearing’s indirect parent company, as a designated contract market. Marketed together as “ErisX,” Eris Clearing anticipates offering the clearing of digital asset futures contracts traded on Eris Exchange beginning later in 2019. ErisX began offering spot virtual currency contracts earlier this year.

Among conditions for its DCO registration, Eris Clearing must obtain and endeavor to maintain “to the extent commercially reasonable” insurance for the theft or loss of participant cryptocurrency collateral; must disclose to any potential clearing member material risks associated with the clearing of fully collateralized virtual currency futures; and, within three years of its DCO Order, must have an independent certified public accountant review its internal controls and provide the accountant’s report to the CFTC. Eris Clearing must also have an independent CPA audit its virtual currency balances annually, and must provide to the CFTC any audit report of internal controls it may obtain from any third-party service provider used in connection with the custody or storage of cryptocurrencies for clearing members. Eris Clearing was required to demonstrate compliance with 17 core principles under applicable law to obtain its DCO status, including establishing standards and procedures to protect members’ and participants’ funds, implementing and maintaining "adequate and appropriate" risk management capabilities and system safeguards. (Click here for background on these core principles.)

Contemporaneously with its receipt of DCO status, Eris Clearing also received certain no-action relief from the CFTC’s Division of Clearing and Risk from various requirements ordinarily required by DCOs that clear margined products. Staff concluded that Eris Clearing would not be obligated to perform these requirements because of its fully collateralized clearing model.

• Bitfinex Repays US $100 Million of US $700 Million Tether Loan Subject of NY AG Lawsuit: The cryptocurrency exchange Bitfinex announced that it repaid US $100 million of its outstanding loan facility to Tether, the company managing the tether stablecoin. 

Previously, 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 Bitfinex and 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 both Bitfinex and Tether, as well as their related companies.

Among other things, charged the NY AG, executives of Bitfinex and Tether agreed for Tether to provide Bitfinex a line of credit of up to US $900 million sourced from the US dollar reserves supporting tether in order to help meet Bitfinex’s customers’ withdrawal demands. However, this arrangement, asserted the NY AG, was made without disclosure to tether holders. At the time of its lawsuit, claimed the NY AG, Bitfinex had borrowed US $700 million from Tether utilizing tether supporting balances. 

(Click here for background on the NY AG’s lawsuit against Bitfinex and Tether in the article “NY Court Upholds Restriction on Stablecoin Transferring Tethered Funds to Affiliated International Exchange but Limits Time Period of Prohibition” in the May 19, 2019 edition of Bridging the Week.)

My View: On December 12, 1980, a small start-up company, Apple Computer Inc., launched an initial public offering where it raised less than US $100 million through the sale of 4.6 million shares priced at US $22. Investors throughout the United States were able to participate in this IPO; however individual investors of one state – Massachusetts  – were famously barred from participating. This was because the state’s regulators said Apple was too risky an enterprise for its citizens to invest in and banned the IPO under regulations designed to eradicate “highfliers that don’t have solid earnings foundations.” Last Friday, Apple closed at over US $204/share (after multiple share splits throughout its history) and the company’s market capitalization hovered between US $900 billion and $1 trillion. (Click here for a representative article describing Apple’s IPO and Massachusetts’s ban.)

In retrospect, Massachusetts clearly got it wrong. Its fear of Apple was grounded in a lack of understanding. Its prevention of Massachusetts individual residents to participate in this IPO was a misguided application of the doctrine of in loco parentis (in place of the parents) and in retrospect, it did not know better at all than ordinary citizens.

It appears equally condescending for the FCA to propose banning derivatives based on cryptocurrencies for the entire class of “retail persons” solely because it believes that such persons, generically, cannot possibly understand the risks of the product. This particularly appears to be the case when the FCA concedes that its ban may not be entirely effective either in precluding retail persons from obtaining access to derivatives through non-UK based sellers or preventing retail persons from purchasing spot cryptocurrencies directly.

I have no view on whether any individual cryptocurrency will be around in its current form in 5, 10 or more years, let alone whether the price of any particular virtual currency will rise or fall. No one can dispute that the prices of cryptocurrencies have been highly volatile. Moreover, it is more than likely that additional virtual currencies will be lost through external hacks and internal fraud at intermediaries if not through design flaws of some cryptocurrencies themselves.

Notwithstanding, if the FCA is concerned about the integrity of cryptocurrencies and derivatives based on them, it should draft clearer disclosures and develop and impose appropriate standards on the marketers and sellers of such products rather than banning access by retail persons outright. This is the approach the CFTC has taken in the US in recently approving DCMs, DCOs and swap execution facilities to trade and clear virtual currency derivatives, and of the National Futures Association, in mandating disclosures to all customers by futures commission merchants and introducing brokers that engage in virtual currency transactions. (Click here for details regarding the NFA Advisory in the article “National Futures Association Proposes Interpretive Notice Requiring FCM, IB, CTA and CPO Disclosures Regarding Virtual Currency Activity” in the July 27, 2018 edition of Between Bridges. The effective date of the NFA Notice was October 31, 2018.) The FCA might even consider suitability standards that could require sellers to preclude certain individual retail purchasers who fail to satisfy certain minimum standards. But make these prohibitions individual-focused and not across an entire class.

Banning derivatives for a generic group of purchasers (and sellers) – all retail persons – regardless of individual suitability is wrong. This is especially the case where, from the outset, other alternatives exist to acquire cryptoasset exposure that retail persons desiring exposure can pursue. It is far better for a regulator to establish standards for derivatives on cryptocurrencies that can assist all investors and recognizes differences in individual capabilities.

Hopefully, the FCA gets it better for retail persons in 2019 than Massachusetts got it for its individual citizens who wanted to participate in the Apple IPO in 1980. 

• CFTC and CBOT Both Fine HK-Based Hedge Fund for Position Limits Violation; IFUS Settles with Spoofer: The Commodity Futures Trading Commission and the Chicago Board of Trade brought and settled enforcement actions against Elephas Investment Management Limited, a Hong Kong-based hedge fund, for violating the spot month speculative federal position limit for wheat futures on one day in 2017. (Click here to access CFTC Rule 150.2.) To settle this matter, Elephas agreed to pay a fine of US $160,000 to the CFTC, and US $50,000 to the CBOT. Elephas also agreed to pay the CBOT US $166,590 – an amount CBOT claimed the firm saved in reduced losses.

According to the CBOT, on November 29, 2017, Elephas held a futures equivalent net long position of 1,680 December Soft Red Wheat Futures Contracts – in excess of 1,080 contracts over the spot month position limit of 600 contracts. After Elephas was required to take delivery of a large portion of its December long positions and was assigned 1,185 wheat certificates, the firm rolled its remaining spot month futures contracts and entered into short positions to re-tender its certificates – effectively liquidating all its spot positions, including its violative positions. It did this by selling 1680 lots of a December 2017/March 2018 wheat futures spread. The CBOT and CFTC claimed these transactions contributed to a reduction of a loss of US $168,590 the company otherwise would have incurred as a result of violating position limits

Unrelatedly, Craig Cowell agreed to a permanent suspension from all access to ICE Futures U.S. markets to resolve an enforcement action brought against him by the exchange. IFUS charged that from October 2016 through November 2017, Mr. Cowell engaged in a pattern of placing what appeared to be a smaller order on one side of the market (using an iceberg order) while placing visibly larger orders on the opposite side of the market. The larger orders gave the appearance of false market depth and helped the execution of Mr. Cowell’s smaller orders. Mr. Cowell cancelled his larger orders as soon as his small order was executed. As a result, claimed IFUS, Mr. Cowell did not appear to have entered orders with the intent of execution. Mr. Cowell principally engaged in his purported spoofing conduct in Coffee C, Sugar No. 11 and Cocoa futures contracts.

Mr. Cowell previously was summarily suspended from access to all IFUS markets for the same offense in August 2018. (Click here for details in the article “COMEX and NYMEX Non-Member Settles Disciplinary Actions for Allegedly Operating Trading System Designed to Mislead Market Participants by Spoofing” in the August 12, 2018 edition of Bridging the Week.)

Legal Weeds/My View:In November 2013, the CFTC proposed new rules related to derivatives speculative position limits, addressing absolute levels for 28 so-called “core referenced futures contracts” involving various agricultural commodities, energy products and metals. These limits were proposed to apply on a futures equivalent basis across all referenced contracts (e.g., related futures, options and swaps). The proposed rules also addressed what constituted bona fide hedging positions. The recommended rules were meant to replace final position limits rules adopted by the CFTC in 2011 that were vacated by a US District Court during September 2012. (Click here for details regarding the CFTC’s 2013 proposed position limit rules in the article “CFTC Proposes Revised Position Limit Rules” published on November 12, 2013 by Katten Muchin Rosenman LLP.)

In May 2016, the CFTC proposed some modifications and additions to its 2013 proposed regulations and guidance related to speculative position limits in order to potentially authorize relevant derivatives exchanges to recognize certain derivatives positions as constituting non-enumerated bona fide hedges or enumerated anticipatory hedges. The CFTC also proposed to grant derivatives exchanges authority to recognize certain spread positions as justifying an exemption from speculative position limits. (Click here for background in the article “CFTC Proposes to Authorize Exchanges to Grant Physical Commodity Users Non-Enumerated Hedging Exemptions and Other Relief Related to Speculative Position Limits” in the May 27, 2016 edition of Between Bridges.)

In December 2016, the CFTC re-proposed its position limits rules. Compared to its November 2013 proposed rules, the Commission’s most recent proposals: (1) reduced the number of core referenced contracts subject to express oversight by the Commission for position limits purposes from 28 to 25; (2) revised spot month, single and all-months position limits on the 25 referenced contracts; (3) defined bona fide hedging to more closely parallel the definition in existing law and to address many concerns raised in response to the CFTC’s 2013 proposal; and (4) authorized persons to apply for non-enumerated hedging exemptions from qualified exchanges, even for referenced contracts. (Click here for details in the article “CFTC Adopts Final Rules Related to Aggregation of Positions and Owned Entity Exemption; Re-Proposes Position Limits Rules” in the December 11, 2016 edition of Bridging the Week.)

In March 2019, J. Christopher Giancarlo, Chairman of the CFTC, announced that prior to leaving the Commission this summer, he intended to propose a new “workable” position limits rule that, among other things, would address anticipatory hedging. He offered no other contents of the proposed new rule other than to suggest it “must be responsive to the public comments and ensure that regulatory barriers do not stand in the way of long-standing hedging practices of American farmers, ranchers, producers and manufacturers, who depend on our markets.” (Click here to access Mr. Giancarlo’s speech before FIA.) It now appears that no new proposed position limits rule will be issued by the CFTC prior to Mr. Giancarlo’s departure on July 15. 

The CFTC has struggled mightily for about a decade to develop a “just right” position limits regime to reflect what different persons regard as less than precise requirements under the Dodd Frank Wall Street Reform and Consumer Protection Act. If anything, this delay should reinforce the old adage, “if it ain’t broke, don’t fix it.” The current balance between the CFTC and exchanges in overseeing an effective position limits regime has now worked for a very long time. Extend and adapt this regime to swaps, extend the regime to a few more commodities, and let’s move on.

In any case, the challenge to get it right now passes to new CFTC chairman, Heath Tarbert. Welcome aboard!

More Briefly:

• Goodbye SPAN, Hello HVaR; CME Clearing House to Phase In New Margin Calculation Methodology: The Clearing House Division of the Chicago Mercantile Exchange proposed to adopt a new framework to calculate initial margin requirements for CME-cleared products – a filtered historical value at risk methodology termed “HVaR.” 

HVaR will calculate the maximum potential loss that could be incurred by a portfolio (and thus, determine initial margin requirements) by (1) reviewing the actual losses that would have been incurred by the portfolio during a given period of time; and (2) adjusting the historical data to adjust for the conditions existing during the given period (e.g., high volatility) and the market conditions currently in effect. 

In a submission to the Commodity Futures Trading Commission, CME Group said that HVaR will be a “single, unified framework capable of supporting all CME futures and options (as well as swaps and cash products, if desired)”, and will be able to capture liquidity and concentration risks “beyond the risks posed by changes in the market value of positions.”

Ultimately, HVaR will replace the Standard Portfolio Analysis of Rate framework (“SPAN”) that has been used to calculated initial margin requirements since 1988.

CME Group proposes to apply its new framework to all CME-cleared products other than interest rate swaps and over-the-counter foreign exchange swaps. Initially, CME Group will apply its new framework to 150 major energy futures and options products and extend its new framework to other products over time. When rolling out HVaR, CME plans to run both SPAN and HVaR in a parallel production for at least six months. 

• FINRA Sanctions Member for Not Reviewing Trading Alerts that Identified Excessive Trading by Banned Salesperson: Summit Brokerage Services, Inc. – a broker-dealer registered with the Securities and Exchange Commission and a member of the Financial Industry Regulatory Authority – agreed to pay sanctions of US $880,000 to FINRA to resolve charges that it failed to adequately detect and prevent excessive trading by a former salesperson who subsequently was banned by FINRA.

According to FINRA, from January 2012 through March 2017, Summit’s procedures required it to review trade alerts from clearing brokers to evaluate its registered representatives’ trading activity. However, claimed FINRA, during this time, the firm’s compliance principals did not review such alerts related to turnover and cost-to-equity ratios; instead, they solely conducted manual reviews of trade blotters to detect for potential excessive trading. 

Moreover, during the relevant time, the review process did not detect that one salesperson – solely identified by FINRA as “CJ” – had excessively traded 14 accounts, including one for a retired customer with a net worth of less than US $500,000, who paid more than US $61,000 in commissions and had a cost-to-equity ratio in excess of 27%. CJ recommended 267 trades for this customer over a three-year period during the relevant time.

All told, claimed FINRA, accounts traded by CJ generated more than 150 alerts for potentially excessive turnover rates and cost-to-equity ratios during the relevant time, none of which were reviewed by Summit compliance principals. FINRA calculated that the 14 accounts paid US $651,405 in commissions and realized losses in excess of US $300,000.

(In 2017, a former Summit registered representative with the initials “CJ” – Christopher Jorgensen – was banned by FINRA after determining not to appear before FINRA for required on-the-record testimony. (Click here to access FINRA’s relevant Letter of Acceptance, Waiver and Consent.))

FINRA also charged that, from January 2015 through March 2018, Summit failed to supervise the distribution of consolidated reports of customer assets held away from the firm at other brokers.

To resolve this matter, Summit agreed to pay a fine of US $325,000 and restitution to customers totaling US $558,296.

• Reduced Margin Requirements for Security-Based Futures Proposed by SEC; CFTC View Pending: The Securities and Exchange Commission proposed amendments to a regulation that would lower the margin requirement for unhedged security futures from 20% to 15%. Additionally, the SEC proposed conforming revisions to its margin offset table to enable exchanges to set margin less than 20% for customers holding security futures and one or more related securities and futures. The SEC argued that such lower level of margin is defensible because there are exchange-traded options based on an equity security or narrow-based index where the required margin is 15% or less.

In March 2001, the Board of Governors of the Federal Reserve Board delegated its authority over security futures margin jointly to both the SEC and the Commodity Futures Trading Commission. In response, in 2002, the SEC and CFTC adopted their current margin requirements for brokers to collect from customers trading security futures. Because of the SEC’s and CFTC’s joint oversight of security futures, the SEC’s proposed amendment to its related margin requirements will not be published in the Federal Register until after an equivalent amendment is proposed by the CFTC – expected to happen on July 11. (Click here for information regarding a CFTC open meeting scheduled for July 11.)

SEC Commissioner Robert Jackson declined to support the SEC’s proposal because of the SEC’s failure to consider alternatives to its proposal and for not conducting a “serious economic analysis” of whether reduced margin might increase price discovery.

• Investment Advisor and Principal Sanctioned by SEC for Failure to Disclose Conflicts: The Securities and Exchange Commission assessed sanctions in excess of US $1.3 million against Fieldstone Financial Management Group LLC, an investment advisor, and Kristofor Behn, its principal, for failing to disclose material conflicts of interest in connection with their recommendation to clients to purchase promissory notes of Aequitas Management LLC. Specifically, charged the SEC, the defendants failed to disclose that Fieldstone had received a US $1.5 million loan from Aequitas to help pay down personal debt of Mr. Behn, and had access to a US $2 million line of credit under terms that incentivized defendants to recommend investments in Aequitas. The SEC said that the defendants also solicited one client to invest US $1 million in Aequitas without disclosing that Mr. Behn intended to use most of the proceeds for personal purposes. 

Prior to soliciting clients to invest in Aequitas, defendants provided them an email discussing a “strategic affiliation” between Fieldstone and Aequitas. However, claimed the SEC, this email did not discuss Mr. Behn’s personal benefit from the US $1.5 million loan or his incentives to sell Aequitas’ notes.

To resolve the SEC’s complaint, defendants also agreed to disgorgement, including interest, of $1.047 million and a fine of US $275,000. Mr. Behn also agreed to be permanently barred from association with most types of SEC registrants.

In 2016, the SEC brought an enforcement action against Aequitas, four of its affiliates and three of its senior executives for soliciting funds from investors while, at the time, failing to disclose the firm’s failing financial situation, and repayment of prior investors’ redemptions and interest payments through funds raised by new investors. (Click here to access the relevant SEC complaint.)