April 24, 2019
by Katherine Cooper

            The Bible’s Book of Genesis tells the story of how Jacob persuaded his older, first-born, brother, Esau, to exchange his first-born birthright for a bowl of stew.  Needless to say, the famished Esau made a bad deal.  Last fall, the SEC hinted that it may be on the verge of making a similar bad deal with its younger sister agency, the CFTC.  To exorcise the specter of Bitcoin-related securities trading in the U.S. securities markets, the SEC has implied that it is willing to cede jurisdiction over commodity-linked exchange-traded notes to the CFTC on the basis that such instruments are “commodity swaps” rather than securities.  After all, if exchange-traded notes linked to commodities are “commodity swaps,” then they cannot trade on the U.S. securities markets.

            The biblical-like saga of the SEC’s diffident approach to Bitcoin began in March 2017 when the SEC staff rejected the first proposal to list a Bitcoin-backed exchange-traded fund.  The SEC has since rejected several other applications to list Bitcoin-backed ETFs.  In January 2018, the SEC told other fund sponsors essentially not to bother applying to list a Bitcoin-backed ETF, and warned mutual fund companies not to launch a crypto-based mutual fund or otherwise find “loopholes” through which a crypto-backed security could be offered in the U.S.[1] 

            In the late summer of 2018, however, some intrepid market participants, pursuant to the “dealer exemption” in Section 4(a)(3) of the Securities Act,[2] “imported” into the U.S. Bitcoin-and Ether-tracking certificates issued in Sweden (the “Certificates”) and offered them for sale in the U.S. securities over-the-counter markets.  The Certificates are designed to track the price of Bitcoin or Ether.[3]  The Certificates were issued by a special purpose vehicle, XBT, whose sole purpose is to issue the Certificates and hedge the risk generated by the Certificates.[4]  A buyer of the Certificate pays the full notional amount of the Bitcoin or Ether that the Certificate represents.  For example, if the Certificate represents one Bitcoin and the price of Bitcoin is $3,000, the buyer pays $3,000.  After purchasing the Certificates, either from XBT or in the secondary market, the holder is not required to make any further payments.[5]  Under the prospectus, the holder has the right to redeem the Certificates at a price based on the then-current price of Bitcoin or Ether, less fees and expenses. 

            The SEC seemed displeased with the dealers’ clever use of the dealer exemption.  Apparently, this was one of the “loopholes” the SEC had warned market participants against using.  On September 9, 2018, the SEC issued an order of suspension of trading in the Certificates.[6] The SEC explained that it took this action due to “a lack of current, consistent and accurate information” regarding the Certificates.  The order notes that some materials submitted to enable the trading of the products in the United States characterized them as “Exchange Traded Funds” while others called them “Exchange Traded Notes.”  In ordering the trading suspension, the SEC invoked Section 12(k) of the Exchange Act[7] which authorizes the SEC to suspend the trading of securities in the United States for up to 10 business days.

            At the end of the ten-day suspension, the SEC Divisions of Trading and Markets and Corporation Finance (collectively, the “Divisions”) issued a Statement on Order of Suspension of Trading of Certain Bitcoin/Ether Tracking Certificates.[8]  In part, the Divisions said

Market participants seeking to quote, trade or facilitate transactions in the Certificates are cautioned to analyze the legal and regulatory implications and consequences of doing so, including under the federal securities laws and the Commodity Exchange Act (“CEA”) . . . . The payout of the Certificates is described as calculated with reference to Bitcoin/Ether prices in relation to USD, which “causes a so-called synthetic exposure” to Bitcoin/Ether and USD. SEC staff is consulting with Commodity Futures Trading Commission (“CFTC”) staff with respect to the regulatory considerations applicable to the Certificates under the CEA. Under the comprehensive framework for regulating swaps and security-based swaps established in Title VII of the Dodd-Frank Act, the CFTC is given regulatory authority over swaps and the SEC is given regulatory authority over security-based swaps.[9]

Within a span of ten days, the SEC took the position that the Certificates were securities which gave the agency the authority to suspend trading in them and then took the position that they could be commodity swaps.

            CEA Section 1a(47)(iii) defines the term “swap” in pertinent part to mean:

any agreement, contract or transaction . . . that provides on an executory basis for the exchange, on a fixed or contingent basis, of 1 or more payments based on the value or level of 1 or more interest or other rates, currencies, commodities, securities, instruments of indebtedness, indices, quantitative measures, or other financial or economic interests or property of any kind, or any interest therein or based on the value thereof, and that transfers, as between the parties to the transaction, in whole or in part, the financial risk associated with a future change in any such value or level without also conveying a current or future direct or indirect ownership interest in an asset (including any enterprise or investment pool) or liability that incorporates the financial risk so transferred . . . .[10]

We understand that the Divisions’ position was that the Certificates could be “swaps” because the holder’s purchase of the Certificate and the holder’s later redemption of the Certificate constituted “an exchange of payments” that gave the holder “a synthetic exposure” to the price of Bitcoin.

            The SEC staff’s argument fundamentally misunderstands what Congress meant by the phrase “exchange of 1 or more payments.”  CFTC economists describe commodity swaps as follows:

[A] commodity swap is a legally binding agreement where two counterparties agree to ‘swap’ cash flows, for example, at regular intervals over a specified period (e.g., for one year). One of the cash flows (also known as legs) is based on a floating price that is tied to the price of a commodity, and the other cash flow, or leg, is usually based on an agreed upon fixed price. . . . These cash flows are generally also based on a fixed amount of the commodity (e.g., 1 million barrels of oil) which is known as the notional.[11]

 

A swap’s exchanges of cash flows are at specified points in time in the future.[12]  Because traders price swaps as a series of cash-settled forward contracts, it is absolutely essential that the dates on which the cash flows are to be swapped are known when the swap is entered into.  In contrast, the Certificates have no maturity date and can be put to the issuer by the holder or called by the issuer at any point in time in the future. If someone bought a Certificate and held it for a year, the payment on day one of the full notional value of the Certificate and then the receipt of a payment of the full notional value on day 365 is simply not “an exchange of payments.” 

            Typically, the notional amount of a commodity swap is not exchanged between the parties.[13] In buying the Certificate at issue or any ETN, the buyer pays the seller the full notional amount of the quantity of the underlying virtual currency or commodity.

            In fact, the staff’s argument is contrary to earlier SEC definitions of the term “swap:” “Derivative swaps are a particular type of derivative ‘in which two counterparties agree to exchange or ‘swap’ payments with each other as a result of such things as changes in a stock price, interest rate or commodity price’.”[14] 

            Why this matters is that there are many ETNs trading on the U.S. securities markets.  The “ETF Screener & Database” on ETF.com[15] lists 54 commodity-tracking ETNs with notional assets under management of over $3.6 trillion.[16]  These ETNs track the price of either a specific commodity (e.g., cotton), or baskets of like commodities (e.g., grains), commodity indices (e.g., the Dow Jones-AIG Commodity Index) or a combination of one or more of the foregoing along with a strategy (e.g., Velocity Shares 3X Inverse Silver).  Typically, ETNs are viewed as one of the most accessible products for retail investors to gain exposure to the commodity asset class.[17]  A retail investor can buy a commodity-tracking ETN through his or her securities account through which they own stocks and bonds.  For retail investors, opening a futures account can be a challenging process and most are not familiar with how to trade futures.  Over-the-counter commodity swaps are completely out of reach for retail investors since only eligible contract participants can trade swaps over-the-counter.

            If the SEC’s position is that the Swedish Certificates are really swaps, then all commodity-tracking ETNs would be swaps.  If all commodity-tracking ETNs are swaps, then they could not be traded on either the national securities exchanges or through the over-the-counter securities market.  Moreover, they could only be traded on CFTC-designated contract markets (“DCMs”) or swap execution facilities. Although retail investors can buy and sell swaps listed on DCMs,[18] forcing retail investors to open futures accounts would be a challenge for many and significantly reduce retail investors’ access to the performance of the commodity asset class. 

            Is the SEC’s “not in my neighborhood” approach to the Bitcoin- and Ether-linked securities giving the CFTC jurisdiction over a $3.6 trillion market currently regulated by the SEC?  If so, it seems about as bad a deal that Esau made with Jacob to trade his birthright for a bowl of stew.

 

[1] D. Michaels & A. Loder, SEC Pours Cold Water on Prospect of Bitcoin ETFs (WSJ Jan. 19, 2018) available at: https://www.wsj.com/articles/sec-rejects-idea-of-bitcoin-etfs-1516323558

[2] Section 4(a)(3) permits a dealer to offer an unregistered security for sale, as long as the dealer does not sell the security prior to forty days after the first date the security was offered to the public.  15 U.S.C. § 77d(a)(3)(A).

[3] Base Prospectus for the Bitcoin Tracker Certificates, Bitcoin Cash Tracker Certificates, Ethereum Tracker Certificates, Ethereum Classic Tracker Certificates, Litecoin Tracker Certificates, Ripple Tracker Certificates, Neo Tracker Certificates and Basket Certificates under the Issuance Programme of XBT Provider at 6 (May 17, 2018) (unofficial English translation of original Swedish prospectus) (“XBT Prospectus”) available at: https://xbtprovider.com/assets/documents/2018-prospectus-(unofficial--english-language--translation).pdf

[4] Id.

[5] Id.

[6] In re Certain Bitcoin/Ether Tracking Certificates, File No. 500-1 (SEC Sept. 9, 2018) available at: https://www.sec.gov/litigation/suspensions/2018/34-84063-o.pdf

[7] 15 U.S.C. § 78l(k).

[8] Statement on Order of Suspension of Trading of Certain Bitcoin/Ether Tracking Certificates (SEC Sept. 20, 2018) (emphasis added) available at: https://www.sec.gov/news/public-statement/suspension-trading-certain-bitcoinether-tracking-certificates

[9] Id.

[10] 7 U.S.C. § 1a(47)(A)(iii).

[11] S. Mixon, E. Onur & L. Riggs, Exploring Commodity Trading Activity: An Integrated Analysis of Swaps and Futures 4 (CFTC Nov. 2016) available at: https://www.cftc.gov/sites/default/files/idc/groups/public/@economicanalysis/documents/file/oce_wtiswapsfutures.pdf

[12] R. Heckinger, Chap. 1 Understanding Derivatives: Markets and Infrastructure at 4 (Federal Reserve Bank of Chicago rev’d 2013) (“swaps are OTC agreements to exchange cash flows at regular intervals over an agreed period according to terms agreed on today”) available at: https://www.chicagofed.org/publications/understanding-derivatives/index

[13] FINCAD, Resources, Types of Swaps (“Usually only the payment streams, not the principal, are exchanged”) available at: http://www.fincad.com/resources/resource-library/wiki/types-swaps

[14] SIFMA v. CFTC, 67 F. Supp. 3d 373, 385 (D.D.C. 2014) quoting The Regulatory Regime for Security-Based Swaps, (SEC 2012) available at: http://www.sec.gov/swaps-chart/swaps-chart.pdf

[16] M. Kennedy, List of Exchange Traded Notes (ETNs) (The Balance Oct. 28, 2017) available at: https://www.thebalance.com/list-of-etns-1214798

[17] D. DeFrancesco, CBOE’s CEO Says There’s 1 Pain Point That’s Keeping Out Wall Street’s Billions from the Growth of Bitcoin (Bus. Insider Jan. 18, 2019) available at: https://www.businessinsider.com/cboes-ceo-lack-of-exchange-traded-note-keeping-out-bitcoin-growth-2019-1?IR=T

[18] CEA § 2(e); 7 U.S.C. § 2(e) (“It shall be unlawful for any person other than an eligible contract participant, to enter into a swap unless the swap is entered into on, or subject to the rules of, a board of trade designated as a contract market under [CEA] Section 5”).

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