The CFTC issues stringent guidelines for FCMs seeking to custody digital assets in connection with physically delivered futures contracts or swaps.
The US Commodity Futures Trading Commission’s (CFTC’s) Division of Swap Dealer and Intermediary Oversight (DSIO) issued CFTC Staff Letter No. 20-34 (the Advisory) on October 21, 2020, clarifying its views on the acceptance, holding, and reporting of virtual currency (e.g., bitcoin or ether) in segregated accounts by futures commission merchants (FCMs) and the development of appropriate risk management programs in relation thereto.
Specifically, the Advisory relates to virtual currencies deposited by customers with FCMs in connection with physically delivered futures contracts or swaps. Due to the “custodian risk” associated with holding virtual currency as segregated funds, the Advisory lays out specific guidance for FCMs on virtual asset acceptance and custody, and their responsibility to implement appropriate policies, procedures, and oversight programs. The Advisory does not address virtual currency held by FCMs on behalf of customers trading derivatives on markets outside of the US, or virtual currency held by FCMs on their own behalf, including in a proprietary account.
Separately, and of note, according to an October 27, 2020 directive by CFTC Chairman Heath Tarbert on the use of staff letters and guidance, advisories “communicate staff’s expectation regarding how regulated parties may comply with a particular requirement, or inform regulated parties about staff’s regulatory priorities.” They are not, according to the directive, binding on the CFTC, other divisions of the CFTC (such as the CFTC’s Division of Enforcement), or the public. Indeed, the Advisory warns that it in no way limits the DSIO’s ability to refer an FCM to the Division of Enforcement for any reason, including potential investigation of practices regarding virtual currencies. However, market participants should be on notice to the extent that the Advisory provides insight into how the DSIO intends to examine FCM adherence to the regulations regarding custody of customer assets.
Highlights From the Advisory
Under longstanding customer protection requirements, an FCM is required to safeguard customer assets by segregating all money, securities, and assets deposited by customers from the FCM’s own funds and accounts. An FCM’s receipt of virtual currencies from a customer and the holding of such virtual currencies give rise to unique risks, including custodian risk associated with the fact that virtual currency custodians “are typically not subject to a system of comprehensive federal or state regulation and oversight, which includes safeguarding of these novel assets … .” To mitigate such risk, the Advisory states that FCMs must adhere to the following guidelines when holding virtual currency as customer funds:
- Virtual currency held as customer funds by an FCM must be deposited only with a bank, trust company, another FCM, or clearing organization that clears virtual currency derivatives such as futures, options on futures, or cleared swap contracts (a Depository).
- A Depository account with a customer’s virtual currency must be held under an account name that clearly indicates that the funds are segregated and identifies the funds as customer funds.
- An FCM must obtain the appropriate written acknowledgment letter from each Depository holding customer funds as virtual currency.
- The funds held in a Depository account must be available for withdrawal upon the FCM’s request, so that there is no delay in delivery of such funds pursuant to the terms of the contracts to which the virtual currency relates.
- The FCM is required to prepare daily and month-end segregation statements, including to report total fair market value of customer virtual currency held at a custodian. Fair market value must be reported in US dollars and must reflect the FCM’s “reasoned judgment” based on spot market or other appropriate market transactions.
- An FCM may not offset a debit or deficit in a futures customer’s or cleared swaps customer’s account by the value of any virtual currency held in the respective customer’s account. An FCM may be required to deposit its own funds into segregation to cover any such debit or deficit.
- An FCM may not deposit its own virtual currencies in futures customer’s or cleared swaps customer’s segregated accounts for any reason, including in order to meet targeted or residual interest requirements.
- An FCM may not invest any other segregated futures customer or segregated cleared swap customer funds in virtual currencies
Risk Management Is Critical
An FCM is required to establish, maintain, and enforce a system of risk management policies and procedures that are reasonably designed to ensure that customer funds are separately accounted for and segregated or secured as belonging to customers.
The Advisory provides guidance addressing the unique risks posed by the custody of virtual assets, such as the loss or misappropriation of digital keys, illicit commingling of accounts, exit scams, and theft of assets by remote hackers. According to the Advisory, an FCM that accepts virtual currencies as customer funds should adhere to the following guidelines when designing and maintaining its risk management program:
- The virtual currency deposited into segregated accounts must relate solely to customer trading of futures (or options on such futures), or cleared swaps contracts that provide for the physical delivery of that virtual currency.
- The virtual currency accepted must be intended to margin, guarantee, or secure the contracts related to such customer trading (unless the FCM would be entitled to use any virtual currency held in a customer’s trading account to cover the customer’s default resulting from losses on virtual currency or non-virtual currency futures or cleared swap transactions).
- The relevant designated organization must have formally determined that the virtual currency is an acceptable form of collateral for those contracts.
- The FCM must determine that the amount of virtual currency reasonably relates to the customer’s level of trading in those contracts during each calendar quarter. Such determination must be documented in the FCM’s books and records pursuant to its risk management program policies and procedures.
- If a customer has ceased trading the contracts to which the virtual currency relates, an FCM should notify the customer and initiate a return of the virtual currency within a reasonable time frame (not to exceed 30 days after the customer has ceased trading for a period of 90 days).
- Withdrawals from a Depository upon demand by the FCM in order to liquidate customer accounts or return customer funds should be completed within a timeframe that is technologically and operationally possible, but should not exceed one day, unless the Depository’s procedures specify additional time as part of its controls related to virtual currency transfers.
- As part of the disclosures required under CFTC Rule 1.55 (Public disclosures by futures commission merchants), an FCM should provide 45 days prior written notice to all futures and cleared swaps customers that the FCM will begin accepting virtual currency as of a specified date. The FCM should thereafter include as part of its disclosures the total amount of customer activity in virtual currency being supported by the deposit of actual virtual currency by customer origin.