The recent and rapid proliferation of cryptocurrency¹ transactions involving retail or “Main Street” customers has left some — including many cryptocurrency platforms serving retail customers — grappling conceptually with the answer to a fundamental question: what constitutes “actual delivery” of cryptocurrency in the eyes of the U.S. Commodity Futures Trading Commission (CFTC) for purposes of the “actual delivery exemption” from registration with the CFTC?
In December 2017, in response to requests for guidance, the CFTC issued a proposed interpretation of “actual delivery” in the cryptocurrency retail commodity transaction context. The public has until March 20, 2018 to provide comments to the CFTC’s Proposed Interpretation. This article discusses; (a) the CFTC’s current Proposed Interpretation; (b) why the Proposed Interpretation matters to the cryptocurrency industry, and (c) some practical related questions that arguably remain to be explored.
Retail Commodity Transactions
Under section 2(c)(2)(D) of the Commodity Exchange Act (CEA), it is unlawful for a person (including an entity) to enter into, or to offer to enter into, a transaction in any commodity with a retail customer (i.e., someone who is not an eligible contract participant or eligible commercial entity as defined in the CEA), if such transaction is entered into with the retail customer on a leveraged, margined, or financed basis, with certain exceptions, unless the person transacting with the retail customer is registered with the CFTC in an appropriate capacity. This type of transaction is sometimes referred to as a “retail commodity transaction.”
Cryptocurrency Retail Commodity Transactions
The CFTC has repeatedly established that virtual currency is a commodity within the meaning of section 1a(9) of the CEA². In general, a cryptocurrency platform that offers cryptocurrencies (i.e., commodities) to retail investors on a leveraged, margined, or financed basis (a “cryptocurrency retail commodity transaction”) falls within the jurisdiction of the CEA and would be required, among other things, to register with the CFTC as a licensed domestic futures exchange or a foreign board of trade, unless such platform qualified for an exemption from registration.
Although many cryptocurrency platforms³ currently serve retail customers4, many such platforms have not registered with the CFTC. Instead, a number of such platforms rely on a statutory exemption from such CEA registration requirements that sometimes is referred to as the “actual delivery exemption.” To qualify for the “actual delivery exemption,” a contract of sale for cryptocurrency needs to result in “actual delivery” of the purchased cryptocurrency to the retail customer within 28 days after the consummation of the transaction5.
Consistent with past CFTC guidance interpreting the meaning of the term “actual delivery” in section 2(c)(2)(D) of the CEA, the CFTC’s Proposed Interpretation of “actual delivery” in the context of cryptocurrency retail commodity transactions distinguishes between the transfer of title and possession of the cryptocurrency — which would satisfy the requirements of “actual delivery” — from mere book entry transfers with respect to the ownership of such cryptocurrency, which would not satisfy “actual delivery” requirements.
Meaning of “Actual Delivery”
But what does “actual delivery” really mean in the cryptocurrency context, and how does one know with certainty that — and when — “actual delivery” has been achieved?
Traditional Economy Definition
With respect to the traditional economy, the CFTC defined the meaning of “actual delivery” in 2013, when the CFTC issued a final interpretation (the “2013 Final Interpretation”)6. The 2013 Final Interpretation provided that “actual delivery” is the transfer of title and possession of the commodity to the purchaser as distinguished from mere book-entry of a transfer (which is not “actual delivery”)7.
In the 2014 case CFTC v. Hunter Wise Commodities, LLC,8 the U.S. Court of Appeals for the Eleventh Circuit reinforced the 2013 Final Interpretation and held that “actual delivery” of a commodity is the transfer of possession and control of such commodity whereby the buyer has real and immediate possession thereof, as opposed to merely constructive delivery. In that case, the Court of Appeals noted further that Congress used the modifier “actual,” which must be given meaning as other than simply “delivery” without such modifier.
Prior Cryptocurrency Guidance
Similarly, in its 2016 enforcement action against Bitfinex,9 the CFTC was not satisfied that Bitfinex met the requirements of providing “actual delivery” of Bitcoin to retail purchasers, because Bitfinex did not actually deliver the purchased Bitcoins to retail customers. Instead, Bitfinex held the Bitcoins in deposit wallets that Bitfinex (not the retail customers) owned and controlled.
The CFTC’s December 2017 Proposed Interpretation specifies that “actual delivery” in the cryptocurrency context requires the applicable retail customer to have the ability to (a) take possession and control of the entire quantity of purchased cryptocurrency and (b) use such purchased cryptocurrency freely in commerce. In addition, the cryptocurrency platform must not retain any interest or control over the cryptocurrency purchased by the retail customer. Sham delivery or cash settlement of cryptocurrency, and other offset mechanisms that may be exercised by the cryptocurrency platform with respect to purchased cryptocurrency, will not qualify as “actual delivery” of purchased cryptocurrency to the applicable retail customers.
On the other hand, the Proposed Interpretation also states that the “actual delivery” requirement is satisfied where the transfer of cryptocurrency is recorded on the applicable cryptocurrency blockchain. The Proposed Interpretation includes a number of non-exclusive examples illustrating the meaning of “actual delivery” in this context.
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In general, the requirements of the Proposed Interpretation are not consistent with the current operations of many cryptocurrency platforms serving retail customers, and it remains to be seen what impact the Proposed Interpretation, if adopted as proposed, will have. Some initial observations and areas for further analysis and exploration include:
Private Keys. From a practical perspective, it is unclear what the ideal way is for a cryptocurrency platform to satisfy the “actual delivery” exemption’s possession and control requirements. The Proposed Interpretation raises the question of whether this should be satisfied by way of possession of a private key.10 Currently, many retail cryptocurrency platforms do not provide customers with private keys, and, in certain cases, there arguably may be some good reasons for that. For instance, from a custody perspective, it may not always be secure for retail customers to store their own private keys, and they may not know how to do so.
Multi-signature Authentication. The Proposed Interpretation leaves open the issue of whether multi-signature authentication (i.e., requiring more than one signature to authorize a cryptocurrency transaction) would satisfy the “actual delivery” exemption’s possession and control requirements.11
“Actual Delivery” Period. The CFTC seeks public comments as to whether a shorter “actual delivery” period under the CEA would be appropriate in the cryptocurrency context, in particular, whether such period should be shortened to a two-day period from the current 28-day period. While the CFTC has the authority under the CEA to lengthen the “actual delivery” period beyond 28 days, it does not have the authority to shorten the “actual delivery” period (absent Congressional action). If the “actual delivery” period is reduced to a two-day period, some cryptocurrency platforms may have technical difficulties satisfying the “actual delivery” requirements within the shortened time frame.
Leverage, Margin, and Financing. If they find it too challenging to comply with the requirements of the “actual delivery” exemption, cryptocurrency platforms potentially may avoid the requirements of the CEA by not providing leverage, margin, or other financing to their retail customers. Query whether as a policy matter that is a result that the CFTC and retail customers would prefer.
The CFTC is requesting comments from the public until March 20, 2018. This is a potentially important opportunity for the cryptocurrency industry to engage actively with the CFTC and to provide valuable perspectives regarding what “actual delivery” means for cryptocurrency retail commodity transactions.
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Joshua Ashley Klayman Chairs the Wall Street Blockchain Alliance’s Legal Working Group and frequently speaks and publishes about Blockchain technology, smart contracts, cryptocurrency and tokens sales (initial coin offerings), among other topics. Klayman’s clients have included investment banks, other financial institutions and issuers (including token sale issuers); private equity, venture and hedge funds and their portfolio companies; major publicly traded organizations and emerging companies. Klayman regularly represents lenders and borrowers in leveraged finance transactions involving senior, mezzanine and subordinated debt and equity offerings and co-investments, as well as in general lending matters. In her corporate practice, Klayman represents public and private organizations in a broad array of commercial transactions (including mergers and acquisitions, as well as royalty purchase and licensing transactions) and corporate governance matters.
Julian Hammar – focuses on futures, derivatives and commodities, energy regulatory, corporate and securities matters. Hammar is a leading expert on the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act). Hammar previously served as special counsel at an Am Law 50 firm and as the assistant general counsel at the Commodity Futures Trading Commission (CFTC), Office of the General Counsel. His most recent work at the CFTC included drafting regulations to further define key terms including “swap,” “security-based swap” and “security-based swap agreement,” under the Dodd-Frank Act.
Shiukay Hung practices in tax law and Blockchain + Smart Contracts. He has a broad-based transaction-oriented practice focused on U.S. federal and international income tax matters. Hung advises on the tax aspects of sophisticated capital markets transactions (including ICOs), financial instruments (including structured products and derivatives), cryptocurrencies, REITs, real estate finance and equity transactions, credit facilities, mergers and acquisitions, representations and warranty insurance, and private equity transactions (including sovereign wealth funds).
Anna Pinedo has concentrated her practice on securities and derivatives. She represents issuers, investment banks / financial intermediaries, and investors in financing transactions, including public offerings and private placements of equity and debt securities, as well as structured notes and other hybrid and structured products. Pinedo works closely with financial institutions to create and structure innovative financing techniques, including new securities distribution methodologies and financial products. Pinedo has particular financing expertise in certain industries, including working with technology-based companies, telecommunications companies, healthcare companies, financial institutions, REITs and consumer finance companies.