Over the last year, the CFTC continued to align itself with other, more frequently-lauded enforcement agencies like the U.S. Department of Justice (DOJ) and U.S. Securities and Exchange Commission (SEC). Among other undertakings, the CFTC implemented new rules aimed at protecting and incentivizing whistleblowers (see CFTC Strengthens Anti-Retaliation Protections for Whistleblowers and Enhances the Award Claims Review Process, May 22, 2017); restructured the market surveillance unit so that it reports directly to the Director of Enforcement (see Testimony of J. Christopher Giancarlo, Chairman U.S. Commodity Futures Trading Commission before the House Committee on Agriculture, Oct. 11, 2017); and issued new cooperation and self-reporting advisories in line with other agencies such as the DOJ, which recently formalized its cooperation-centered Foreign Corrupt Practices Act enforcement policy (id.).
But the CFTC also closed out its fiscal year having brought only 49 enforcement actions, nearly 30 percent fewer actions than in FY2016, and obtaining orders totaling approximately $412 million in restitution, disgorgement and penalties, amounting to only one-third of the $1.29 billion garnered in FY2016. See Commodity Futures Trading Commission Fiscal Year 2017 Agency Financial Report. The low numbers, however, are not all that surprising given the current administration’s focus on regulatory minimalism and CFTC Chairman Christopher Giancarlo’s parallel mission to “right-size” the agency’s regulatory footprint. See Remarks of Acting Chairman J. Christopher Giancarlo at 42nd Annual International Futures Industry Conference in Boca Raton, FL, “CFTC: A New Direction Forward,” March 15, 2017. Early last year, Giancarlo launched Project KISS, for “Keep It Simple, Stupid,” which directs CFTC staff to review agency rules and apply them in simpler ways. See CFTC Requests Public Input on Simplifying Rule, May 3, 2017. The project’s announcement came on the heels of an executive order issued by President Trump calling on federal agencies to find ways to ease regulatory burdens on the U.S. economy.
For the CFTC, perhaps the method for easing those burdens lies in its other FY2017 initiative: getting in step with the ever-evolving, technology-centric markets it polices. As recently as November, Giancarlo reaffirmed to a FinTech-focused audience that the CFTC’s mission is to formulate policy around market innovations and use technology to become a more effective and efficient regulator. See Remarks of Chairman J. Christopher Giancarlo at Singapore FinTech Festival, Nov. 15, 2017. To that end, the CFTC launched LabCFTC, a New York-based FinTech initiative tasked with making it easier to align CFTC rules with today’s technologies; or, as Giancarlo put it, combatting the CFTC’s status as “an analog regulator of rapidly digitizing global markets.” Id.
In discussing the LabCFTC initiative, Giancarlo explained that its goal echoed that of hockey legend Wayne Gretzky, who once stated that instead of skating to where the puck was, he skated to where the puck was going. In that same vein, this article discusses the technology-driven trends we anticipate seeing in the CFTC’s 2018 enforcement efforts in the three traditional brackets of CFTC actions: (1) trading, (2) Futures Commission Merchants (FCMs), and (3) off-exchange activity. In each of these spaces, we expect to see technological advancements as both the genesis of misconduct as well as the vehicle through which the CFTC will address it.
Earning its reputation as the enforcement buzz word of 2017, spoofing is a common form of market manipulation and an attractive target for financial enforcement agencies. See Q&A—Interpretive Guidance and Policy Statement on Disruptive Practices. Spoofing is most often executed via complex computer algorithms that rapidly display and then cancel bids or orders so that the spoofer may advantageously buy low and sell high, or vice versa. Id. Although there have been cases brought against “manual” spoofers, the majority of CFTC and Exchange enforcement actions against spoofers involve automated spoofing. See IMPACT ANALYSIS: Nasdaq publishes white paper, suggestions for detecting spoofing, July 5, 2017, Reuters. Cf. CFTC Orders New York Trader Simon Posen to Pay a $635,000 Civil Monetary Penalty and Permanently Bans Him from Trading in CFTC-Regulated Markets for Spoofing in the Gold, Silver, Copper, and Crude Oil Futures Markets, July 26, 2017 (trader “manually placed orders to buy and sell gold, silver, copper, and crude oil futures contracts with the intent to cancel these orders before execution (spoof orders)”). During FY2017, the CFTC brought nine actions involving spoofing, imposing $27.35 million in aggregate penalties and permanent trading and registration bans. See Commodity Futures Trading Commission Fiscal Year 2017 Agency Financial Report. Only one of these actions stemmed from self-reporting, whereas the remainder resulted from market regulation efforts. See CFTC Finds that The Bank of Tokyo-Mitsubishi UFJ, Ltd. Engaged in Spoofing of Treasury Futures and Eurodollar Futures, Aug. 7, 2017; see also id. Detecting spoofing requires reviewing the market context, an individual’s trading activity patterns, and other pertinent facts and circumstances. But advancements in technology and automation have armed would-be spoofers with stealthier methods of manipulation, making the increasingly electronic marketplace more difficult to surveil. Automated trading now constitutes up to 70 percent of regulated futures markets and foreign exchange spot markets, and Giancarlo predicts it will continue to dominate with “new and innovative developments far into the future”—which means CFTC’s surveillance abilities must follow suit. See Remarks of Chairman J. Christopher Giancarlo at Singapore FinTech Festival; see also Address of CFTC Commissioner J. Christopher Giancarlo to the American Enterprise Institute, “21st Century Markets Need 21st Century Regulation,” Sept. 21, 2016.
In implementing a new “big data” platform, the CFTC recognized this growing need to collect and analyze large amounts of data so that it may swiftly take appropriate regulatory action. See Commodity Futures Trading Commission Fiscal Year 2017 Agency Financial Report. The new platform allows CFTC staff to analyze billions of market transactions in a fraction of the time necessary under older systems. For instance, the big data platform now completes a query used to identify spoofing activity in futures market data in approximately seven minutes, instead of the 20 plus hours previously required. Id. The CFTC has also made organizational changes that reflect its desire to employ technology to more quickly and effectively detect and prosecute spoofing. The realignment of the market surveillance unit to sit within the Division of Enforcement was applauded by Giancarlo as a step towards strengthening the agency’s prosecution of violations like spoofing. See Remarks of Acting Chairman J. Christopher Giancarlo at 42nd Annual International Futures Industry Conference in Boca Raton, FL, “CFTC: A New Direction Forward,” March 15, 2017.
Futures Commission Merchants: Virtual Currencies
Easily the most ubiquitous FinTech innovation of late, the development of virtual currencies—digital representations of value functioning as mediums of exchange, units of accounts, and/or a storage of value—has regulators straining to catch up. See A CFTC Primer on Virtual Currencies, Oct. 17 2017. Virtual currencies are not guaranteed by the central bank or any state body, and therefore pose high risks in terms of price volatility, platform instability, and cyber-threats, including theft, hacking, and loss. See Customer Advisory: Understand the Risks of Virtual Currency Trading, Dec. 15, 2017. Yet believers remain undeterred: Despite plummeting 45 percent in December, the value of popular virtual currency bitcoin more than doubled that same month (see Bitcoin Price: Digital currency had big swings in 2017, Dec. 29, 2017, USA Today), increasing more than 1,900 percent at one point in 2017 and soaring from below $1,000 to almost $20,000 on the CoinDesk Bitcoin Price Index. See From $900 to $20,000: Bitcoin’s Historic 2017 Price Run Revisited, Dec. 29, 2017. Estimates report that the market capitalization of the asset class briefly crossed $600 billion late last year, increasing nearly 3,300 percent in less than one year. See Cryptocurrencies are now worth a grand total of $600 billion—and climbing, Business Insider, Dec. 21, 2017.
But virtual currencies’ novelty poses extraordinary challenges for the CFTC, whose jurisdiction is implicated when a virtual currency is used in a derivatives contract, or if there is fraud or manipulation involving a virtual currency traded in interstate commerce. See A CFTC Primer on Virtual Currencies, Oct. 17 2017; Customer Advisory: Understand the Risks of Virtual Currency Trading, Dec. 15, 2017. As Giancarlo has observed, “virtual currencies are unlike any commodity that the CFTC has dealt with in the past.” See CFTC Statement on Self-Certification of Bitcoin Products by CME, CFE and Cantor Exchange, Dec. 1, 2017. In its first regulatory action targeting virtual currency fraud, in September 2017 the CFTC charged a New York corporation and its CEO and head trader with fraud, misappropriation, and issuing false account statements in connection with a two-year bitcoin Ponzi scheme. Allegedly, the scheme fraudulently raised more than $600,000 for supposed placement in a pooled commodity fund that purportedly operated a high-frequency, algorithmic trading strategy executed by a computer trading program named “Jigsaw.” See CFTC Charges Nicholas Gelfman and Gelfman Blueprint, Inc. with Fraudulent Solicitation, Misappropriation, and Issuing False Account Statements in Bitcoin Ponzi Scheme, Sept. 21, 2017. In connection with the charges, CFTC Director of Enforcement James McDonald credited the exemplary work of LabCFTC as demonstrating the CFTC’s “continued commitment to facilitating market-enhancing FinTech innovation” and “acting aggressively and assertively to root out fraud and bad actors in these areas.” Id.
Cryptocurrency concerns will undoubtedly remain on the CFTC’s agenda in 2018, as the market only continues to grow. In July of last year, the CFTC granted LedgerX registration to clear and custody cryptocurrencies, making it the first U.S. federally-regulated virtual currency derivatives platform and clearinghouse. See Commodity Futures Trading Commission Fiscal Year 2017 Agency Financial Report. In December 2017, both the CME Group Inc. and Cboe Global Markets Inc. launched bitcoin futures contracts, traded under product codes BTC and XBT, respectively, and Nasdaq, Inc. plans to launch its own bitcoin futures in the first half of this year. See Nasdaq Plans to Launch Bitcoin Futures in First Half 2018, Nov. 29, 2017, The Wall Street Journal.
Off-Exchange Activity: Commodity Based Binary Options
The accessibility—and opacity—of the Internet provides an easy opportunity to take advantage of unsophisticated investors eager to enter the market. Binary options, often referred to as “all-or-nothing options,” are one such example. Binary options’ payout depends entirely on the outcome of a yes/no proposition related to whether the price of a particular asset will rise above or fall below a certain amount at a specified date and time. See CFTC Fraud Advisories, Binary Options. Unlike other options, a binary option does not give the holder the right to purchase or sell the underlying asset. Id. Rather, upon expiration, the holder will receive a pre-determined amount of cash or nothing at all. Id.
The CFTC’s jurisdiction encompasses binary options when the transaction involves commodities like foreign currencies, metals, or agricultural products. Any entity soliciting, offering, or accepting offers to enter into commodity-based binary options transactions with U.S. citizens are doing so illegally unless the transactions are conducted on a designated contract market, with limited exceptions. Id. Accordingly, the CFTC maintains a Registration Deficient List (the RED List), which identifies unregistered foreign entities believed to be illegally soliciting and accepting funds from U.S. residents to trade in binary options. See CFTC Publishes List of Foreign Entities that Illegally Solicit U.S. Residents to Trade Foreign Currency and Binary Options, Sept. 9, 2015. In 2017, the CFTC nearly quadrupled the number of entities on the RED List when it added a total of 92 names. See CFTC Adds 21 Names to Its List of Foreign Entities that Illegally Solicit U.S. Residents to Trade Binary Options and Forex, Dec. 15, 2017; see also CFTC Adds 71 Names to Its List of Foreign Entities that Illegally Solicit U.S. Residents to Trade Binary Options and Forex, April 25, 2017.
Much of the binary options market operates through Internet-based trading platforms that do not comply with regulatory requirements. As demonstrated by the CFTC’s recent enforcement actions, the pattern is often the same: entities drive potential customers to their websites offering commodity-based binary options, accept customer money, and, rather than trading binary options on customers’ behalf, illicitly use the funds for their own expenditure. See, e.g., CFTC Charges California Resident Jason B. Scharf, His Worldwide Web of Companies, and Florida-Based Affiliate Marketers Michael Shah and Zilmil, Inc. with $16 Million Binary Options Fraud Scheme, July 18, 2017; Federal Court Orders Relief Defendants Westward International Ltd. and Coucarin Holdings Ltd. to Disgorge Ill-Gotten Funds Totaling More than $1.77 Million in CFTC Binary Options Fraud Action, April 6, 2017; and Federal Court in Florida Orders Neil Pecker and His Company, Vision Financial Partners, LLC, to Pay More than $6.5 Million in Restitution and a Civil Monetary Penalty in CFTC Binary Options Fraud Action, March 21, 2017. For example, last year, the CFTC charged several individuals and entities for operating a set of binary options websites through which over $16 million was allegedly illicitly solicited and misappropriated from over 8,000 customers. See CFTC Charges California Resident Jason B. Scharf, His Worldwide Web of Companies, and Florida-Based Affiliate Marketers Michael Shah and Zilmil, Inc. with $16 Million Binary Options Fraud Scheme, July 18, 2017. The massive scheme attracted potential customers through fraudulent advertising campaigns, including one with the tagline: “The Most Profitable Click You Will Ever Make.” Id. The money customers used to fund their trading accounts was then routed through foreign corporations and overseas accounts in order to pay the business and personal expenses of the charged individuals. Id.
In addition to traditional enforcement, and as promulgated in LabCFTC’s goals, the CFTC has collaborated with tech giants to address binary options fraud at its source. For example, CFTC educated the Apple and Google app stores about binary options fraud and identified RED List entities that were selling apps on their platforms. See Commodity Futures Trading Commission Fiscal Year 2017 Agency Financial Report. These efforts led both stores to remove apps that violated their terms and conditions and, in June 2017, Apple voluntarily ceased accepting binary options apps completely. Id.
The CFTC has recognized that it must modernize the ways in which it detects and addresses misconduct in order to keep up with the rapidly advancing, technology-centric markets it is tasked with overseeing. The CFTC’s sharp focus on technology is a move designed to understand where the puck is going, and we expect this technology driven approach to continue to shape CFTC enforcement throughout 2018.
Zack Brez and Allison Lullo are partners, and Giselle Sedano is an associate, at Kirkland & Ellis.
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