LawFlash

NFA Proposes Interpretive Notice Mandating New Virtual Currency Disclosures

August 01, 2018

The National Futures Association’s proposed virtual currency disclosure requirements would be applicable to futures commission merchant, introducing broker, commodity pool operator, and commodity trading advisor member firms. In its interpretive notice, NFA expressed concerns about whether customers fully understand the valuation issues, lack of regulatory oversight, and substantial risk of loss associated with virtual currencies.

The National Futures Association (NFA) has proposed new disclosures applicable to futures commission merchants (FCMs), introducing brokers (IBs), commodity pool operators (CPOs), and commodity trading advisors (CTAs) that could require firms to repaper existing disclosure documents, offering documents, and promotional materials. NFA’s concerns regarding CPO and CTA member firms’ activities in virtual currencies arise out of several issues unique to those instruments. For example, virtual currency derivatives may experience significant price volatility with the potential for their initial margin requirements to increase without warning. Additionally, FCMs and designated contract markets may impose rules that limit market participants’ ability to exit positions during periods of high volatility. FCMs may require additional margin, impose position limits, or prohibit naked shorting or give-in transactions with regard to virtual currency derivatives. These and other features unique to virtual currency derivatives motivated NFA’s decision to require the new disclosures.

In addition, it is clear from the interpretive notice that NFA is concerned that market participants may not fully understand the nature of virtual currencies and virtual currency derivatives, the substantial risk of loss that may arise from trading these products, or the limitations of NFA’s regulatory authority over spot market virtual currencies (primarily due to a lack of a centralized pricing source and limited price discovery). NFA recognizes that the requirements contained in the interpretive notice may need to evolve over time in order to keep pace with advancements in the virtual currency space, explicitly stating that the interpretive notice may be supplemented in the future.

One of the new prescribed disclosures relates to the lack of NFA’s regulatory oversight over spot virtual currency products and virtual currency exchanges, custodians, or markets. The prescribed disclosure, applicable to FCMs, IBs, and CPOs and CTAs (for spot market virtual currency activities not including investments in a pool or managed account program), reads as follows:

[NAME OF NFA MEMBER] IS A MEMBER OF NFA AND IS SUBJECT TO NFA'S REGULATORY OVERSIGHT AND EXAMINATIONS. HOWEVER, YOU SHOULD BE AWARE THAT NFA DOES NOT HAVE REGULATORY OVERSIGHT AUTHORITY OVER UNDERLYING OR SPOT VIRTUAL CURRENCY PRODUCTS OR TRANSACTIONS OR VIRTUAL CURRENCY EXCHANGES, CUSTODIANS OR MARKETS.[1]


CPOs and CTAs would be subject to a different prescribed disclosure when they engage in an underlying spot virtual currency transaction in a pool, exempt pool (i.e., a pool offered pursuant to CFTC Regulation 4.7), or managed account program. The prescribed disclosure includes the language regarding lack of NFA oversight authority, discussed above, along with certain risks central to virtual currencies. The prescribed disclosure for these types of pools (whether exempt or nonexempt) and managed accounts must be included in disclosure documents and offering documents and be prominently displayed in promotional materials related to CPOs’ and CTAs’ activities in virtual currencies at or before the time the CPO or CTA engages in such activity. The disclosure reads as follows:

[NAME OF NFA MEMBER] IS A MEMBER OF NFA AND IS SUBJECT TO NFA'S REGULATORY OVERSIGHT AND EXAMINATIONS. [NAME OF NFA MEMBER] HAS ENGAGED OR MAY ENGAGE IN UNDERLYING OR SPOT VIRTUAL CURRENCY TRANSACTIONS IN A [COMMODITY POOL OR MANAGED ACCOUNT PROGRAM]. ALTHOUGH NFA HAS JURISDICTION OVER [NAME OF NFA MEMBER] AND ITS [COMMODITY POOL OR MANAGED ACCOUNT PROGRAM], YOU SHOULD BE AWARE THAT NFA DOES NOT HAVE REGULATORY OVERSIGHT AUTHORITY FOR UNDERLYING OR SPOT MARKET VIRTUAL CURRENCY PRODUCTS OR TRANSACTIONS OR VIRTUAL CURRENCY EXCHANGES, CUSTODIANS OR MARKETS. YOU SHOULD ALSO BE AWARE THAT GIVEN CERTAIN MATERIAL CHARACTERISTICS OF THESE PRODUCTS, INCLUDING LACK OF A CENTRALIZED PRICING SOURCE AND THE OPAQUE NATURE OF THE VIRTUAL CURRENCY MARKET, THERE CURRENTLY IS NO SOUND OR ACCEPTABLE PRACTICE FOR NFA TO ADEQUATELY VERIFY THE OWNERSHIP AND CONTROL OF A VIRTUAL CURRENCY OR THE VALUATION ATTRIBUTED TO A VIRTUAL CURRENCY BY [NAME OF NFA MEMBER].[2]

Risk Disclosure Topics for Pool and Managed Account Programs

It is our experience that CPOs and CTAs that are engaged in underlying or spot virtual currency transactions in pools and account programs already include risk disclosures about virtual currency products in offering memoranda. However, NFA has now made the inclusion of such risk disclosures a requirement and provides a nonexhaustive list of the types of disclosures that a CPO or CTA should consider including, as applicable, in its disclosure documents, offering documents, and promotional materials. As such, CPOs and CTAs should include these disclosures to the extent they do not already do so and, to the extent they do, augment and increase the visibility of existing disclosures. NFA explains that the guidelines with respect to virtual currency disclosure contained in the interpretive notice are nonexhaustive, there is not a one-size-fits-all approach, and a CPO or CTA may need to address other topics relevant to trading virtual currencies as appropriate to the activities undertaken on behalf of the pool or managed account. NFA does not prescribe specific language for these disclosures, which include the following:

  • Unique Features of Virtual Currencies
    • Virtual currencies are not legal tender in the United States and therefore have questionable intrinsic value.
    • Price is often based on an agreement by the parties to the transaction.
  • Price Volatility
    • Price is based on perceived value and is subject to changes in sentiment.
    • In some cases, virtual currencies experience daily volatility of 20% or greater.
  • Valuation and Liquidity
    • Virtual currencies are traded both privately and through virtual currency exchanges, meaning there is no centralized pricing source.
    • CPOs and CTAs must tailor their policies and procedures used to value virtual currency products to consider the liquidity and volatility of these markets.
    • Specifically, CPOs and CTAs should explain to customers (1) the valuation and liquidity risks involved and (2) the valuation procedures used.
  • Cybersecurity
    • “Wallets” and spot exchanges are susceptible to hacking.
    • Publicly distributed ledgers may not be immutable.
    • Even minor cybersecurity events can bring about immediate and irreversible losses for participants.
  • Opaque Spot Market
    • Unlike banks or brokerage accounts, virtual currency exchanges and custodians holding virtual currency do not always identify the owner, creating asset verification challenges and an increased potential for manipulation/fraud.
  • Virtual Currency Exchanges, Intermediaries, and Custodians
    • Entities that facilitate virtual currency transactions are new and largely unregulated.
    • The lack of regulatory oversight as well as the dangers attendant to the opaque spot market create the risk that a virtual currency exchange may not hold enough virtual currency to satisfy its obligations at a particular time, and such inability may not be readily apparent.
    • Virtual currency exchanges may have higher operational risk than regulated exchanges.
  • Regulatory Landscape
    • Currently, no federal regulatory oversight for virtual currency exchanges exists in the United States.
      • However, some of these exchanges may be regulated by state regulators.
      • The CFTC currently regulates virtual currency derivatives.
      • The Securities and Exchange Commission (SEC) has stated that many ICOs constitute securities offerings subject to the federal securities laws.
      • Jurisdictions could adopt laws in the future that would affect virtual currency networks, issuers, prices, and the acceptance of such networks.
  • Technology
    • Owners of virtual currencies cannot access, use, or transfer them without a unique private key, the loss, theft, or destruction of which may be irreversible.
    • If a virtual currency exchange doesn’t allow customers to participate in a fork that creates a new product, there could be an adverse impact on those customers.
  • Transaction Fees
    • Many virtual currency transactions engage a third-party “miner” who accepts a fee. These fees are subject to market dynamics and could increase substantially.
    • Custodians involved in virtual currency transactions may charge higher fees than custodians in other financial markets.

Other Disclosure Requirements for FCMs and IBs

In addition to the disclosure above, FCMs and IBs will be required to provide to any customer that engages in a virtual currency derivative transaction with or through that FCM or IB the NFA Investor Advisory, Futures on Virtual Currencies Including Bitcoin, and the CFTC Customer Advisory, Understand the Risk of Virtual Currency Trading.

This requirement will apply retroactively, requiring an FCM or IB to provide these advisories to customers who engaged in a virtual currency transaction before the issuance of the NFA interpretive notice within 30 days of the date of the interpretive notice. Otherwise, the disclosure and advisories must be provided at or before the time the customer first engages in a virtual currency transaction (with regard to all customers). For introduced accounts, either the FCM or the IB may provide the advisories and disclosure to customers.

The requirements for delivery of these advisories and the prescribed disclosure differ between eligible contract participants (ECPs)[3] and retail clients. An FCM or IB may provide the advisories and disclosure to ECPs through its website. However, for retail clients, the advisories and prescribed disclosure must be delivered either in writing, or if electronically, in a prominent manner ensured to capture the customer’s attention. Delivery via email containing links to the FCM’s or IB’s website is acceptable, but merely posting the advisories and disclosure language on the website of the FCM or IB would be insufficient. The FCM or IB will need to affirmatively direct the customer to the advisories and prescribed disclosure.

Practical Implications

Beyond the practical burden of repapering offering documents and promotional materials, it remains to be seen whether the new disclosure requirements will raise additional concerns for those who are also subject to the SEC’s oversight and compliance with the federal securities laws. To date, the SEC has not permitted a fund registered under the Investment Company Act and/or the Securities Act of 1933 to offer interests in either physical or derivatives-based virtual currency pools. As a result, only privately offered funds are able to offer these strategies currently. The new disclosure requirements could potentially expose these funds to greater liability under the federal securities laws for shortcomings in the adequacy or completeness of such disclosures. While it is unclear whether the SEC will take action similar to that taken by NFA, public statements by the SEC and its staff to date make it clear that the SEC shares many of NFA’s concerns about whether customers fully understand the valuation issues, lack of regulatory oversight, and substantial risk of loss associated with virtual currencies. Moreover, NFA reminded its members to consider Compliance Rule 2-29 (prohibiting misleading or deceptive promotional materials) when communicating to the public about virtual currencies.

Contacts

If you have any questions or would like more information on the issues discussed in this LawFlash, please contact any of the following Morgan Lewis lawyers:

Boston
Steven M. Giordano
Stephen C. Tirrell
Katherine Dobson

Chicago
Michael M. Philipp
Sarah V. Riddell

Miami
Ethan W. Johnson

New York
Brendan R. Kalb
Jennifer L. Klass
Alexander Starr

San Francisco
Mary M. Dunbar

Washington, DC
Laura E. Flores
Christopher D. Menconi
David A. Sirignano
Joshua B. Sterling



 

[1] NFA Compliance Rule 2-22 prohibits a CPO or CTA from, among other things, stating or implying that such party’s activities have been sponsored, recommended, or approved by NFA.

[2] As indicated in the interpretive notice, any failure to follow the disclosure guidelines may (1) be treated as a violation of NFA Compliance Rule 2-29 and (2) be deemed to be conduct inconsistent with a CPO’s or CTA’s obligations under NFA Compliance Rule 2-4, which requires member firms to observe high standards of commercial honor and just and equitable principles of trade.

[3] Section 1a(18) of the CEA (7 U.S.C. § 1a(18)); 17 C.F.R. § 1.3.