CFTC: Division of Swap Dealer and Intermediary Oversight Director Joshua B. Sterling: We Support “Responsible” Innovation in Digital Asset Products, and Pooled Investment Vehicles

Joshua B. Sterling, the Commodity Futures Trading Commission (CFTC), Director of the Division of Swap Dealer and Intermediary Oversight (Division), or DSIO, confirmed on February 10, 2020, that it recognizes that the US Commodities and Futures Commission (CFTC)-licensed companies are “often at the forefront in product innovation.”  

The DSIO director acknowledged that this had been the case during CFTC’s history as a major federal regulator, and it still holds true today with the introduction of many new types of products and services in the crypto-asset sector.

The Division says it actively supports the CFTC’s objective of supporting “responsible” innovation and improving the regulatory experience of industry participants, which includes DSIO’s registrants.  

Sterling noted that the organization works cooperatively with its colleagues who are part of the agency, which includes the LabCFTC team. The DSIO aims to stay well-informed about new product launches and how they “intersect with its rule sets for swap dealers, futures commission merchants, commodity pool operators (CPOs), and other registrant categories.” 

Sterling says the DSIO encourages all opportunities to meet with registrants and other market participants to hold productive discussions about their product ideas so that it can serve as a ready guide on important issues and considerations. The DSIO has extensive experience working with innovators and pioneers in several different industries.

The DSIO can be helpful to CPOs and other fund managers that are looking into whether and how best to “offer pooled investment vehicles that trade futures, swaps, and other commodity interests that reference digital assets like Bitcoin and stablecoins.”  

The Division explains that vehicles that will do so are “considered commodity pools under the Commodity Exchange Act and CFTC regulations.”  

Sterling clarifies:

“As such, the operators of those vehicles are considered CPOs and must generally register with the CFTC and comply with certain disclosure, recordkeeping, and reporting requirements in the CFTC’s Part 4 regulations.”  

He continues:

“Certain exemptions and exclusions from those requirements are available, in whole and in part, depending upon the composition of a given commodity pool’s portfolio, its investor base, and the manner in which the pool markets itself.”

A company that’s trying to determine whether to introduce a particular commodity pool should look into whether it needs to register as a CPO to do so and, what the exact requirements will be for that pool. 

A CPO that is looking into whether to introduce a commodity pool that trades different commodity interests and securities may have to determine whether that pool is also an “investment company” required to register accordingly with the US Securities and Exchange Commission (SEC) under the Investment Company Act of 1940 (1940 Act) “absent an available exemption or exclusion.”  

The Division director explains that this type of determination is “highly fact-specific, and it will inform a variety of considerations for how the CPO proceeds with an offering of the pool’s interests.” 

The considerations include determining whether a particular commodity pool needs to provide relevant disclosure documents to the National Futures Association (NFA) so the agency can review them “before it can be used to solicit investments.”

Commodity pools registered as investment firms under the 1940 Act need not turn in documents for review. Registered CPOs operating pools registered as investment firms are subject to the antifraud provision of the Commodity Exchange Act when they try to offer those pools to investors.  

Regardless of whether a commodity pool is an investment firm,  the Commodity Exchange Act clarifies that the “offer and sale of the pool’s interests will be subject to the federal securities laws.”

Sterling adds:

“The CFTC’s regulations governing commodity pool disclosures contain many important provisions that focus on risks, return characteristics, and associated expenses that are unique to commodity interest trading strategies.”

He further notes:

“This is true regardless of the asset referenced by a futures contract, swap, or other commodity interest – including Bitcoin and other digital assets.” 

Disclosures that are subject to such requirements illustrate several key points that may be apply to commodity pool investors, such as:

  • Strategy Disclosure.  A futures contract doesn’t have “intrinsic” worth and will expire after a fixed period of time. A futures contract may not pay “current income or a dividend; nor does it provide any other basis of return.” Because of this, it could “mischaracterize a pool’s investment strategy to state, without sufficient explanatory context, that the pool “invests” in futures contracts.”
  • Risk Disclosure.  A futures contract transfers “the risk of future price movements from one party to another.  For every gain in futures trading, there is an equal and offsetting loss…whether a futures trade is profitable for one party depends on the price paid, value received, or cost of delivery under the related futures contract is favorable to that party.”  “This is true regardless of the underlying asset, whether tangible or intangible in nature.  It is important for a fund that trades futures or other commodity interests to describe carefully, in connection with the presentation of its strategy, precisely how those instruments present opportunities for gain or loss,” the Division director noted.
  • Expense Disclosure.  Commodity pool disclosure documents must have line-item disclosures regarding fees and expenses involved in commodity interest trading.
  • Principal Disclosures.  Since trading futures and other commodity interests is a specialized area, a commodity pool needs to present relevant background on the nature of business and educational qualification of personnel who are “principals” of the pool’s CPO, or commodity trading advisor. This information is needed to assist investors in assessing their qualification of the personnel involved to manage the pool’s main trading strategy.
  • Discussion of Commodity Brokers and Trading Counterparties.  Since commodity interest transactions are highly leveraged, a commodity pool needs to share material information regarding its commodity brokers and trading counterparties.

These types of disclosures are subject to review by NFA, although not for commodity pools registered as investment companies under the 1940 Act.

The Division says it continues to be supportive of “responsible” innovation in US financial markets, particularly when motivated by its registrants.  The Division says it is prepared to help innovators and pioneers with their products and services. This may include pooled investment vehicles that aim to gain exposure to digital assets.  

The Division concludes:

“We want to do our part to help market participants ensure that these innovations can develop in a practical way that is consistent with the law.  This offer of assistance extends to products – like whether publicly- or privately-offered – that may not be subject to specific CFTC disclosure requirements and disclosure document review by NFA.”

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