Unhedged: Pham Dissents, IB vs CTA & Uniswap
This blast is more geared toward lawyers and compliance professionals, but below are some notable CFTC enforcement actions. As we’ve mentioned before, when you see a Commissioner dissenting, it's often a good indicator that the action is worth a closer look. Commissioner Pham is raising some great point.
While I don’t doubt the validity of decisions—whether they include a dissent or not—any dissent often reflects a political viewpoint or leaning. However, politics aside, I believe a dissent signals a missed opportunity or a failure to compromise on the part of the CFTC. Whether the fault lies with the majority, the dissenter, or both, the result is often that the market misses out on clearer guidance. In short, the marketplace could be in a better place if the CFTC could avoid these dissents, and to be fair to Commissioner Pham, she raises a number of points that (for me) it is hard to appreciate why the CFTC would ignore or at least not provide some direct response in the action.
Summary
Job Posting: CFTC Compliance Experts who is fluent in multiple languages.
Reminder: Even though you are registered, you are also supposed to be sure that your counterparties are correct registered. If you do not, then bad things happen.
Introducing Broker versus Commodity Trading Advisor. Honestly, what is the difference at this point? It’s hard to tell, for the CFTC, the Courts and IBs.
Uniswap & Duty to Supervise. This one's for the crypto crowd and exchange operators. The CFTC is clearly pushing exchanges to take more responsibility in supervising and dealing with bad actors on their platforms.
Market Manipulation, but justified? This wasn’t covered in the sections below, but a recent case iinvolves an end-user whose bona fide hedge positions in the futures market left them in an interesting economic position. Essentially, they found themselves thinking, “If we can sell the physical product as low as possible, we can cover those losses and make more profit from the hedges.” So, not intent to be in this position, but here they are, and the right move for shareholders/profits seems to be obvious…
The takeaway: don’t try to push buyers into paying less than they’re willing to pay. While I understand and appreciate the dissent in this case (and I agree there are legitimate issues where, again, the Order could better flush out nuances), it’s hard to argue that you’re not manipulating the market if you’re actively pricing your sales at levels that differ from the prices being offered in the active marketplace…and that activity will impact the value of your futures contracts.
Multilingual CFTC Experts: Time to negotiate pay+benefits
Press Release. The Bank of New York Mellon (BNYM) was fined $5 million, part of which was due to swap data reporting failures—a common issue that nearly every dealer has faced or is currently dealing with. However, this marks the second time BNYM has been hit with a fine for this reason. The CFTC referenced a 2019 fine of $750,000 it imposed on BNYM for similar swap reporting failures.
Key takeaway: BNYM has now agreed to engage an independent compliance consultant to review and advise on the remediation steps outlined in the order. This is something we can expect to see more of going forward.
What did surprise me: The CFTC also cited BNYM for failing to supervise voice communications that were in languages other than English. As described in the order: “[A] substantial percentage of BNYM’s APs were based outside of the U.S. and U.K. and/or were communicating in languages other than English in order to conduct BNYM’s swap dealer business. Most if not all of BNYM’s APs utilized telephonic communications for the same purpose. During the Relevant Period, BNYM had no written policies and procedures in place, including use of a foreign lexicon, for monitoring the e-communications of its non-English speaking APs for compliance purposes. In addition, BNYM had no written policies and procedures in place to monitor the voice communications of its APs for compliance purposes.”
Live look at CFTC compliance teams outside of the US:
I can barely speak and type in English. If you are a multi-lingual CFTC expert, your stock is about to go up. Swap Dealers, this seems like the sort of policy/process to check internally ASAP, and if work is needed, then in addition to starting that now…flag whether to include this in your annual CCO Report.
Jeff White, an attorney here at MVA who has the pleasure of working on a variety of CFTC enforcement actions, noted: “[H]ow are registrants supposed to identify what languages its APs may use in communications in order to run non-English lexicons over those communications? Are they supposed to check each AP’s resume for language proficiencies and set up monitoring of that AP’s communications based on those language proficiencies? The less dramatic response is that compliance could periodically review AP communications to determine if any are in non-English languages, but that process is not going to catch potential issues contemporaneously. Compliance could ask APs to self-report what languages they use to conduct firm business, but there’s of course pitfalls with that approach, too.”
Reminder to ask: “Hey, I see you are not registered. Why is that the case?”
If you're an AP, it's a good idea to have a basic understanding of what a "Commodity Trading Advisor" (CTA) and an "Introducing Broker" (IB) are. In a recent CFTC action (outlined below), an individual was flagged for having multiple interactions with "FCM-1" to help his clients hedge crop production risks by introducing approximately twenty-four of his consulting clients to FCM-1.
The problem? This individual presented himself as a registered CTA when, in fact, he was not.
My guess, “FCM-1” is in the process of some difficult questions with the NFA/CFTC.
Please define CTA/IB: Both generally capture the registered role where an individual is helping another person enter into a swap. In one recent Order, the CFTC fined an individual for failing to register as an IB. In the Order with the CTA and FCM-1, an individual failed to register as a CTA. Both orders provide a concise definition, but nuances are significant here. This is where trainings are helpful.
AP’s need to spot market participants who have failed to correctly register: NFA Bylaw 1101 prohibits an NFA Member from conducting customer business with a non-Member who is required to be an NFA Member. For simplicity “NFA Member = CFTC Registrant”.
How to determine if someone is registered: The easiest way to determine whether a person/entity is an NFA Member would be to check the BASIC system on NFA's web site at www.nfa.futures.org. Alternatively, an AP could also send a request to NFA through the “contact” feature of the web site, or call NFA's Information Center at (800) 621-3570
CTA vs. IB – Key Differences and Nuances
Read this section carefully and think about whether or how you should update your trainings. Honestly, both a Commodity Trading Advisor (CTA) and an Introducing Broker (IB) might seem like they do the same thing: facilitate the execution of futures, swaps, or options and receive commissions or compensation for it.
However, there are distinctions. IBs are typically involved with a "Give-Up Agreement." In this setup, a customer goes to the IB to execute trades, and the IB finds a counterparty, executing the trade on behalf of the customer. The resulting transaction is directly between the customer and the counterparty. If you have a securities account, it's similar to how brokers operate. In its simplest form, an IB’s role is to be a middleman in financial transactions, focusing solely on soliciting or accepting buy/sell orders for commodities—nothing more.
CTAs, on the other hand, also execute trades but with the added layer of advising clients on trading strategies. In the securities world, they’re similar to investment advisors.
Here’s the nuance: IBs are always going to market and drum up interest in futures, swaps, and options trading. So the question is: At what point does an IB’s solicitation and communication cross the line, triggering the need for CTA registration?
To add to the frustration, CFTC Rule 4.14(a)(6) states that an IB does not need to register as a CTA if its “trading advice is solely in connection with its business as an introducing broker.” This exemption almost suggests that IBs are never expected to register as CTAs.
The key point to keep in mind: CFTC Letter 95-82 clarifies that if an IB is “guiding” trading in its accounts, then it must register as a CTA. The CFTC defines a "guided" account as one where (1) the customer has orally authorized the IB to initiate a trade, and (2) the IB provides details about the trade, such as when to buy or sell, the price, and the number of contracts.
In a more recent case, CFTC v James A. Donelson, the Court noted that “trading advice” as used in CFTC Rule 4.14(a)(6), refers to any recommendation aimed at profiting from a financial transaction. However, the court also highlighted the difficulty in determining the scope of this exemption, indicating that an IB would need to register as a CTA if it ever gives advice not directly tied to its IB business. This interpretation was supported in Udiskey v. Commodity Res. Corp., CFTC No. 98-R081, at *73–75 (April 2, 1999), where the court reached the same conclusion regarding Rule 4.14(a)(6). Essentially, the exemption doesn't apply if an IB provides any advice that is unrelated to its role as a solicitor or accepter of buy/sell orders for commodities.
Moreover, the CFTC has indicated that if an IB offers advice too frequently or to too many customers, it no longer qualifies for the exemption under CFTC Rule 4.14(a)(6). See FN 171 of the Udisky Case for more on this.
In CFTC v. Donelson, the court didn’t find sufficient evidence to support the CFTC’s claim that the IB (Long Leaf) was providing trading advice to non-brokerage customers, nor that the advice went beyond its role in soliciting or accepting buy/sell orders for commodities. As a result, the court has asked the lower court to further investigate this issue.
For lawyers and compliance professionals, this is definitely something to keep an eye on (or more likely for me to track, so I can keep you all updated with the much-anticipated sequel to this email…I use “anticipated” being very self-aware of how eager we are for legal updates).
Uniswap & Duty to Supervise
This one’s for the crypto crowd. If you’re running an exchange or infrastructure that could potentially execute derivatives, you should be mindful of registration risks—even if no actual derivatives are being executed, which would put the exchange/infrastructure under the CFTC's jurisdiction.
There’s a lot to unpack here, but for a solid breakdown, I highly recommend Mike Frisch’s piece HERE (Mike is a former CFTC attorney, now in the private sector). He does a great job explaining the new issues this action raises, as well as similar non-Uniswap cases. Mike points out that the exchanges cited in these cases weren’t designed to allow non-ECPs to trade derivatives on a leveraged basis—in other words, no one built the marketplace to engage in activities that would typically trigger registration requirements.
The issue, simplified, is that the CFTC is targeting developers of protocols/blockchains/exchanges because someone used the exchange to execute a problematic trade. Personally, I think if you create a marketplace that allows users to engage in a broad range of transactions, there’s some responsibility to monitor the activity.
However, Mike highlights that while this may feel right, it doesn’t align with what the law actually says or requires. The CFTC’s new theory is that being a “facilitator” of prohibited activities makes you an “offeror” of those activities. Although the CFTC claims this is consistent with their 2020 Interpretive Guidance, Mike explains why this argument is flawed.
Really, do read all of Mike’s piece, but a good takeaway from his essay: “In our view, applying this reasoning to a blockchain project that was specifically designed and marketed to enable leveraged trading (i.e. Ooki DAO) could be justified. But applying it to a token-agnostic piece of blockchain infrastructure like 0x or Uniswap is misguided, and strays too far from the statutory language. It is quite a stretch to say that Uniswap Labs was “facilitating” leveraged trading when there are no facts to support that it had any intent or involvement in those products being offered.”
Also, it's clear that the CFTC is pushing for marketplaces to do a better job of monitoring their platforms. I doubt CME issued their CME Group RA2403-5 just for fun—it’s likely a response to the CFTC (and other exchanges) raising questions about their supervision. As a result, they’re reminding market participants of their own duty to supervise.
If you're running any exchange or marketplace, one key consideration might be this: How much of a duty to supervise can you reasonably place on your users? By doing so, you might be able to hold users accountable for their bad actions, and potentially use these claims to mitigate the costs of future CFTC actions against the exchange.
