Digital Assets, Actual Delivery & Control

Every new asset type results in a free-for-all between the various agencies in the US that control regulation and enforcement over instruments or assets that appear in the marketplace. Ostensibly, regulators exist for the protection of investors, by overseeing markets in such a way that fraud is rooted out and consumers protected. The argument for multiple agency regulation in the US, that eventually has to be clarified in courts is decentralization of power as well as competition between the agencies to provide rational oversight of the marketplace without stifling innovation.

Add to this alphabet soup the ingredients cooked up at the state level; especially from states that have an unusual degree of control over financial matters in the US. New York has unusual influence, since a huge percentage of financial transactions for the US flow through the state. Hence the power exerted by regulations like the BitLicense.

The existence of multiple regulatory bodies and the lack of regulatory clarity stands in the way of groundbreaking progress in the United States. Inventions and ideas from the healthy ecosystem of private and public individuals and firms in the US end up being taken up by countries that are forward looking in regulation and innovation. In the US and elsewhere the enterprises that leverage the lack of clarity thrive in a twilight zone, like the social media and e-commerce giants. Outdated anti-trust and privacy laws are leveraged to endanger users’ privacy, security and ultimately democracy itself.

A recent exhibit for this type of regulatory opacity and confusion is the CFTC interpretive guidance on whether “actual delivery” for has occurred for certain types of digital assets that serve as a medium of exchange, colloquially known as ‘‘virtual currencies.’’ published in the federal register of June 24, 2020. Before examining this guidance further, let us begin at the beginning, the 1936 Commodities Exchange Act.

Anything other than onions

The precedence for bitcoin and other digital assets as commodities comes from the 1974 amendment of the definition of commodity from the 1936 Commodities Exchange Act (CEA). The definition of “commodity” includes “all other goods and articles, except onions * * *, and all services, rights, and interests in which contracts for future delivery are presently or in the future dealt in * * *.” Quoted in a 1982 ruling from the 7th circuit dealing with GNMA options which goes on to say “By this amendment, literally anything other than onions could become a “commodity” and thereby subject to CFTC regulation simply by its futures being traded on some exchange.” How about that for clarity on the term commodity?

Anything other than onions traded as derivatives are not commodities, maybe the derivatives are commodities, but not the original instrument. The SEC and other regulators control trading of various instruments, even though derivatives for these instruments trade on many exchanges. The existence of such regulation puts paid to the argument above. The 1982 ruling was on the trading of GNMA options. At first, it states that GNMA are “securities and commodities”. Then it goes on to clarify that definitely the options are commodities and hence under the purview of the CFTC. However, it discreetly draws a veil on whether GNMAs themselves are securities or not.

The case for bitcoin and other crypto-currency trading being regulated by the CFTC is a result of this 1982 ruling. CFTC brought action against Coinflip in 2015 for trading unregulated bitcoin options and futures. But then proceed to use the “anything but onions” argument to assert that bitcoin is a commodity.

The CFTC asserts that bitcoin regulation and any other crypto-currency regulation is within their remit. This could include any industrial tokens based on commodities. In the case of tokens based on actual commodities, it is easy to see the connection.

With such beginnings and its interpretation by circuit courts, it is easy to see why confusion reigns over the regulation of digital assets.

There are two or three salient points made in the interpretive guidance by the CFTC over actual delivery of digital assets commonly called “virtual currencies”. The term digital asset is used in the guidance interchangeably with the qualified term digital asset used as a medium of exchange.

We are on the verge of the establishment of a digital market that represents all kinds of digital assets. These include twins of real world assets, existing securities and other instruments like bonds. Guidance does not refer to digital assets that are not qualified as participating as a medium of exchange.

The second point is that actual delivery does not take place unless the buyer has complete control of the asset to be used in commerce, without being limited in any way by the seller or the seller’s agent. This is a functional definition and quite in line with reason. The third point, that actual delivery must take place within 28 days is probably based on actual delivery of physical commodities. Having a 28 day actual delivery deadline for a virtual currency seems unduly long, if not absurd.

Clarity, actual protection of consumers, dynamic guidance based on actual data and products, seem to be a long way away. Unless these conditions exist, a vibrant market for digital assets and new products are beyond our grasp. LabCFTC, although called a lab does not appear to have any facilities for running experiments. That is to be expected when the head of the lab is an attorney, not a technologist, nor do technologists appear to have much of a voice in most regulatory agencies.

Labs controlled and setup by regulators with technically adept participants are needed for real change. These should be part of the FED, FINRA, SEC, CFTC etc. Results from the labs should be inputs into regulatory guidance. Ideally, a team consisting of business experts, developers, performance professionals, testers, cyber security experts, regulators, deployment specialists and economists should be driving the experiments. The experiments should be run with copies of real world data if possible, mimicking real world conditions.

These are trying times, however current developments have revealed the limits of received wisdom and regulatory regimes patched together with precedent over time. It is time to leverage these lessons and prepare collaboratively with all the tools at our disposal.

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