September 26, 2022

Commodity Trading Software Operator Fined for Operating as Unregistered DCM/FCM

Steven Lofchie Commentary by Steven Lofchie

The CFTC sanctioned a digital asset commodity trading platform for failing to register with the CFTC as either a designated contract market ("DCM") or a futures commission merchant ("FCM") and offering trading in CFTC-regulated products to retail investors.

In the Order, the CFTC found that the firm provided retail investors - who did not qualify as eligible contract participants and therefore could not enter into swaps - with the ability to enter into leveraged or margined retail commodity transactions that did not result in actual delivery within 28 days. The firm marketed a blockchain-based software protocol to allow trading in contracts, the value of which was determined by changes in the price difference between two digital assets.

Additionally, the CFTC found that the firm marketed noncompliance with CFTC regulations by advertising a superior trading experience predicated on its refusal to follow know-your-customer, AML and other required protocols. The firm further claimed that it did not take custody of user assets and offered high levels of liquidity at all times. The firm offered its software service to customers anywhere in the world without taking proper steps to screen for U.S. residents (or other non-eligible contract participants) or establishing a proper customer identification program. The firm later transferred control of the protocol to an affiliated decentralized autonomous organization ("DAO") in an attempt to "insulate the [protocol] from regulatory oversight and accountability for compliance with U.S. law[,]" with no changes to its operational methodology. The CFTC also charged the DAO with similar violations.

As a result, the CFTC determined that the firm violated CEA Section 4(a) ("Regulation of futures trading and foreign transactions") and Section 4d(a)(1) ("Dealing by unregistered futures commission merchants or introducing brokers prohibited"), as well as CFTC Rule 42.2 ("Compliance with Bank Secrecy Act"). To settle the charges, the firm agreed to (i) cease and desist, (ii) pay a civil monetary penalty of $250,000 and (iii) initiate undertakings to ensure future compliance with CFTC regulations.

CFTC Commissioner Summer K. Mersinger dissented, arguing that the decision "arbitrarily decide[s] who is accountable for those violations based on an unsupported legal theory amounting to regulation by enforcement while federal and state policy is developing."

Commentary

At a time when U.S. regulators are clearly pursuing enforcement actions against digital assets, it is really not prudent to publicly market a product to retail investors in illegal off-exchange swaps and proclaim one of the product's advantages is that it allows evasion of AML regulations. It only compounds the idiocy to announce that one is converting the operation of the protocol to a DAO so as to avoid regulatory obligations.

In situations such as this (where there is obvious misconduct), U.S. regulators' pursuit of the misconduct seems to cast doubt on the viability of DAOs as a corporate structure. This action ought not to be read to conclude that a DAO is not a feasible structure where the DAO is established for legitimate reasons; i.e., to operate a protocol the primary benefits of which are something other than evasion of U.S. law.

There will certainly come a time when an interesting case is tried as to who has liability for the conduct of a DAO. This is not it.

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