It’s a tough position. On the one hand the CFTC really does not want to do anything that will disrupt a burgeoning market.
On the other hand, as a regulator, they are in the unfortunate position of reconciling laws and regulations that could never, not on their best day, ever imagine something like virtual currency.
Here’s what’s happening. The CFTC has requests for comments out regarding “Retail Transactions Involving Virtual Currency”.[1]
For the CFTC, this is all about the “Actual Delivery Exception.” In a nutshell, so long as an exchange facilitates a “physical delivery’ of virtual currency within 28 days of sale, the exchange avoids having to register with the CFTC as a regulated exchange (e.g., DCM).[2]
So what’s all the fuss about? The CFTC senses there is something not quite right about some elements of how exchanges are using this exception. It begins to engender some deep questions about the nature of virtual currency under US law. So, I’m going to try and unpack some of the challenges that have been brought up while keeping the legalese to a minimum.
If you want to use the Actual Delivery Exception, what does it require? The CFTC’s 2013 interpretation requires full physical delivery of ownership, possession, title and physical location within 28 days.[3] For the exception, it does not matter what the contract terms say. The CFTC has even said they will go outside the four corners of any agreement to determine if actual delivery has been made.
Those words ownership and title? That’s that’s the source of the problem. It’s a little Waterloo because we have to look hard at where things like Bitcoin rub up against US law…and we might not like the outcome.
Off-Chain Transfers
The first area of concern is transfers on an exchange that are not processed on the blockchain. The problem is this: Sending something like bitcoin to the blockchain to process a transfer is slow and expensive. It’s a real fly in the ointment. With the surge in popularity, coin processing costs have gone from .10 cents to about $28.[4] So the exchanges stepped up. They allow users to transfer from one on exchange account to another at little to no cost. Why is this a problem? It’s not on the blockchain.
If the assumption is that an on-block transfer is the indisputable thing proving ownership, an account to account transfer that does not go through the blockchain is “less ownership”. But is it enough ownership to meet the Exception? An account to account transfer could be as little as an accounting entry at the exchange. If the exchange goes bankrupt, what happens? On it’s face it seems to fall short of the title requirements. My take is that it tends more toward “constructive delivery” than actual delivery.
Omnibus Accounts
A lot of exchanges have set up what are commonly called omnibus accounts. This is where the exchange, itself, owns the virtual coins on the blockchain and then customers are allocated a pro rata share of those coins. Again, if you assume that an on-chain transfer is dispositive of ownership, it becomes really tough to meet the title and ownership requirements of the Actual Delivery Exception. The exchange is the owner, per the blockchain. There is also something contextually about virtual currency omnibus accounts. They really start to look like custody accounts. There is not enough digital ink here to discuss custody in detail, but the takeaway is this: custody accounts have formidable requirements, fiduciary duties, and independent operations. Even commodity warehouses that hold other commodities have a litany of rules and also entirely external to the exchange. At the end of the day, I have a feeling that omnibus accounts might be allowed in the future given the right construct, but again tend toward “constructive delivery” and not actual delivery.
Title
Under the CFTC interpretation, actual delivery requires transfer of title. So, can you have title to virtual currency? A little background: In the U.S., title is different than possession. Title is more. It’s not just having possession of something, but also the “bundle of rights” that gives the owner the ability to defend their ownership.[5] On a blockchain,when someone has the cryptographic keys, they can be said to have dominion over the coins. Strong enough that it could be called title? Maybe. There is a good example in the CFTC comments.[6] Imagine a lawsuit over a thumb drive with virtual currency on it. Party A has possession of the thumb drive. But, Party B has the cryptographic keys. Who owns the virtual coins? In the absence of any other facts, its Party B. They are the ones who have dominion and likely the best defensible position.
But here is the twist. Most blockchains are anonymous (or pseudo-anonymous). Can you anonymously have title to something? It seems somewhat axiomatic that it’s very difficult, if not impossible, to exercise your “bundle of rights” as an anonymous entity. But does that mean your bundle of rights does not exist? This could come out two ways. First is you don’t have title until you identify yourself to defend your rights. Or, you always had title to the coins, but that the title is unenforceable until you identify yourself. For the Actual Delivery Exception, the result is the same. In order to use the exception exchanges are going to have to step up their KYC (know your counterparty) operations. Signing up to an exchange as Joe Anonymous is unlikely to cut it anymore.
Clear Title
Strap in. This one gets complicated, but it’s worth it.[7]
Virtual currency has a major ownership flaw under US law. Did you see how Allianz came out and said they didn’t believe in the value of virtual currency?[8] This is what they are talking about.
Let’s assume I am a wheat dealer. Let’s further assume that a retail buyer purchased my wheat and I immediately physically delivered to a customer. But there is a catch. The wheat I sent has a lien on it. In other words, I delivered a CFTC recognized commodity with an encumbered title. Would the delivery of encumbered wheat meet the CFTC’s Actual Delivery Exception? It’s difficult to see how the Commission would accept encumbered wheat under the title and ownership requirements contained the CFTC 2013 Guidance.[9]
So let’s look at virtual currency. Can virtual currency be encumbered? Yes, and here is a simple way it can happen. Let’s say Dell sells 500 computers to a company on credit. Dell places a lien on the computers perfecting their credit interest in the computers. But then the company decides to sell all computers in exchange for Bitcoin.
Because most states have adopted it, scenarios like this are governed by the Secured Transactions section of the Uniform Commercial Code. Under the UCC, a virtual coin is most likely something called a “General Intangible.” As such, in the scenario above, Dell now has an automatic interest in the Bitcoins. If the company sold those Bitcoins, the lien will keep following the coins, transfer after transfer. It’s very possible for the lien to keep following subsequent transfers, again and again, for a long time.[10]
Because the virtual currency market is anonymous (or at least pseudo-anonymous) there is just no way to know whether you are receiving clear title. It’s not at all a stretch for an innocent buyer of virtual currency to receive encumbered coins. This leaves you, as an exchange purchaser, exposed to losing coins.
If there is no way to know whether clear title is being transferred, can it meet the Actual Delivery Exception? It is doubtful. Title under actual delivery means clear title. If this is the case, then it will be difficult for the CFTC to allow any coin transfer to use the Actual Delivery Exception. The risk is simply too high that the virtual coins are encumbered; or, there is not way a buyer can know if the coins have clear title. The result is virtual currency exchanges in the U.S. will likely have to register with the CFTC as Designated Contract Markets (DCMs).
But There is Hope
The CFTC requested comment about possibly creating a “Virtual Currency Depository.” The concept outlined by the CFTC is in a very early phase and is somewhat vague. But, there is a valid reasoning behind the concept.
A depository could change the stripes of virtual currency from a UCC “general intangible” to a “financial asset.” This does not have the same lien following problem. But this requires the parties to transfer to a “securities intermediary” or a depository.[11] The other way to go might be by calling the intermediary a title clearing organization. As such, virtual currency transfers could fall under the “commodity contract” regime.[12] But there is A LOT of work to do in terms of how this kind of depository would actually work.
My personal feeling is to setup a simple Title Clearing Organization. This entity accepts ownership details from wallets and facilitates KYC procedures. Likewise, a TCO has the ability to search public blockchains. This will ensure wallets do not contain virtual currency downstream with known encumbered accounts, those involved in theft, and money laundering. A depository would also create a place where owners can warrant and/or insure the coins in their account. Think about this. If a good search of the blockchain has been done the risk of being downstream of a “bad wallet” goes down substantially. Why not allow sellers to warrant the coins? In other words, the coins might not have clear title, but the seller has warranted them against the risk. Hard to say how the CFTC might come out on this, but a warranted coin is far closer to the intent of the Actual Delivery Exception.
Conclusions
Here’s the thing. For virtual currency to become mainstream, where national retailers and institutions readily exchange virtual currency, the title issue has to be cured. Some may really not like the content here. But the challenges discussed here are exactly what happens when new technology collides with old laws that never imagined something like Bitcoin.
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[1] http://www.cftc.gov/sites/default/files/idc/groups/public/@lrfederalregister/documents/file/2017-27421a.pdf
[2] CEA section 2(c)(2)(D)(ii)(III)(aa) and 2013 guidance here: https://www.gpo.gov/fdsys/pkg/FR-2013-08-23/pdf/2013-20617.pdf
[3] See the 2013 guidance above.
[4] https://arstechnica.com/tech-policy/2017/12/bitcoin-fees-rising-high/
[5] G.S. Rasmussen &; Assocs., Inc. v. Kalitta Flying Serv., Inc., 958 F.2d 896, 899 (9th Cir. 1992) at 903.
[6] See Tupper comments, 17 CFR Part 1 Retail Commodity Transactions Involving Virtual Currency
[7] If you find this section interesting, the deep dive is: Jeanne L. Schroeder, “Bitcoin and the Uniform Commercial Code.” University of Miami Business Law Review (June 1, 2016). https://repository.law.miami.edu/umblr/vol24/iss3/3/
[8] https://www.bloomberg.com/news/articles/2018-03-14/bitcoin-is-worthless-bubble-may-pop-soon-allianz-global-says
[9] http://www.cftc.gov/idc/groups/public/@newsroom/documents/file/federalregister121517.pdf
[10] Jeanne L. Schroeder, Bitcoin and the Uniform Commercial Code, 24 U. Miami Bus. L. Rev. 1 (2016) , pp.31-43.
[11] UCC (8-102(a)(9)(iii) in which the indirect holder has a “securities entitlement” (8-102(a)(17)
[12] The depository could, theoretically fall under the definition of a clearing agency under UCC (9-102(a)(17)(B))
