CFTC Sues Digital Asset Exchange for Illegal Trading with U.S. Customers
Commentary by Steven Lofchie
The CFTC sued a centralized digital asset exchange for dealing in off-exchange commodity derivatives without proper registration or compliance with U.S. regulations.
In a Complaint filed in the U.S. District Court for the Southern District of New York, the CFTC alleged that the exchange offered and executed commodity derivatives, including trading of futures, swaps, and leveraged, margined, or financed retail commodity transactions, to and for people in the United States. The CFTC charged the exchange with failing to implement required know-your-customer ("KYC") compliance procedures. While the exchange claimed to have implemented KYC procedures, the CFTC alleged that "those procedures were a sham and did not... prevent U.S. customers from trading commodity interests and... derivatives on the platform." As a result, the CFTC alleged that the exchange failed (i) to impose IP address restrictions to prevent U.S customers from trading commodity interests and (ii) to account for commonly used technology such as virtual private networks that could potentially circumvent IP address restrictions.
The CFTC claimed that the exchange violated CEA Sections 4(a) ("Excessive Speculation"), 4d ("Dealing by unregistered futures commission merchants or introducing brokers prohibited"), 5h(a)(1) ("Swap execution facilities") and CFTC Regulations 37.3(a)(1) ("Requirements and procedures for registration"), 166.3 ("Supervision), and 42.2 ("Compliance with Bank Secrecy Act").
The CFTC is seeking (i) disgorgement, (ii) civil monetary penalties, (iii) permanent trading and registration bans and (iv) a permanent injunction against further violations of the CEA and CFTC regulations.
Commentary
Here are excerpts from pages 16-17 of the Ku-Coin enforcement action (though I reversed the order of the excerpts for clarity).
KuCoin describes its leveraged tokens as “unit share[s] of a leveraged fund.” KuCoin is the manager of these “leveraged funds” and the creator of the leveraged tokens. In that capacity, KuCoin finances and oversees the leverage of the fund and charges management fees that vary according to market conditions. Customers may buy and sell KuCoin’s leveraged tokens in either primary or secondary market transactions.
KuCoin’s BTC3L token seeks to mimic a 3x leveraged long position in BTC, which means that if the price of BTC increases or decreases by 1%, the net value of BTC3L will increase or decrease by 3%. Conversely, BTC3S is a token that seeks to mimic a 3x leverage short position in BTC, which means that if the price of BTC increases or decrease by 1%, the net value of BTC3S will decrease or increase by 3%.
From an economic perspective, there really is not that much difference between a swap with 3x leverage and investment in a fund with 3x leverage. Nor is the legal difference that significant: Ku-Coin's defense to the leveraged tokens being illegal swaps would be that they were shares sold in an illegal unregistered securities offering.
On the one hand, one has to commend Commissioner Pham for thinking through jurisdictional issues, and suggesting that her agency may be stretching its jurisdiction. On the other hand, the product would be illegal whichever agency has jurisdiction.
The larger problem is that all of our regulatory efforts with respect to crypto assets are about defining jurisdiction, and none are about considering whether there might be a workable regulatory scheme.