DSIO advisory to FCMs regarding accepting and holding customer virtual currency assets in segregation and guidance on practices to consider in developing and maintaining their risk management programs when holding suc...

Summary: DSIO advisory to FCMs regarding accepting and holding customer virtual currency assets in segregation and guidance on practices to consider in developing and maintaining their risk management programs when holding such assets as customer funds.

CFTC LETTER NO. 20-34 ADVISORIES OCTOBER 21, 2020

To:

Registered Futures Commission Merchants

Subject: Accepting Virtual Currencies from Customers into Segregation

Date:

October 21, 2020

I. Introduction.

Market participants have asked the Division of Swap Dealer and Intermediary Oversight

(the “Division”) of the Commodity Futures Trading Commission (“Commission”) how the

customer protection provisions of the Commodity Exchange Act (the “Act”) and its adopting

regulations apply to virtual currencies deposited by futures customers or cleared swaps

customers with futures commission merchants (“FCMs”) to margin futures, options on futures,

or cleared swap transactions.1 This advisory applies to deposited virtual currency underlying a

physically-delivered futures contract or swap. In this Advisory, the Division is providing FCMs

with its view regarding accepting and holding customer virtual currency assets and guidance on

practices to consider in developing and maintaining their risk management programs when

holding virtual currency as customer funds,2 as well as other considerations discussed below.

This Advisory does not address virtual currency held by FCMs on behalf of customers

trading futures or options on futures on foreign markets (i.e., Part 30 transactions). This Advisory

also does not address virtual currency assets held by FCMs on their own behalf, including in a

proprietary account

en

holding virtual currency as customer funds,2 as well as other considerations discussed below.

This Advisory does not address virtual currency held by FCMs on behalf of customers

trading futures or options on futures on foreign markets (i.e., Part 30 transactions). This Advisory

also does not address virtual currency assets held by FCMs on their own behalf, including in a

proprietary account.

1

The term “virtual currency” means “any digital representation of value that functions as a medium of exchange,

and any other digital unit of account that is used as a form of a currency (i.e., transferred from one party to

another as a medium of exchange); may be manifested through units, tokens, or coins, among other things; and

may be distributed by way of digital ‘smart contracts,’ among other structures.” 85 Fed. Reg. 37734, 37736 n.53

(June 24, 2020).

2

The term “customer funds” is defined in Commission regulation 1.3 and refers collectively to funds held by an

FCM and belonging to futures customers and cleared swaps customers.

U.S. COMMODITY FUTURES TRADING COMMISSION

Three Lafayette Centre

1155 21st Street, NW, Washington, DC 20581

Telephone: (202) 418-5000

www.cftc.gov

Division of Sw

ap Deale

r and

Inter mediary Oversight

Joshua B. Sterling

Director

Virtual Currency Advisory

October 21, 2020

Page 2

II. Background.

The Division has considered the following provisions of the Act, the Bankruptcy Code,

and Commission regulations for purposes of issuing this Advisory:

Sections 4d(a)(2) and 4d(f) of the Act. Section 4d(a)(2) requires an FCM to treat and

deal with all money, securities, and property received from a futures customer to margin,

guarantee, or secure contracts for the purchase or sale of a commodity for futures delivery, or an

option on that contract, or any money, securities, or property accruing to the customer as the

3

result of those trades or contracts, as belonging to the futures customer

d(a)(2) requires an FCM to treat and

deal with all money, securities, and property received from a futures customer to margin,

guarantee, or secure contracts for the purchase or sale of a commodity for futures delivery, or an

option on that contract, or any money, securities, or property accruing to the customer as the

3

result of those trades or contracts, as belonging to the futures customer. Section 4d(a)(2) of the

Act further requires an FCM to account separately for the futures customer’s funds. That

provision also prohibits the FCM from commingling the futures customer’s funds with the

FCM’s own funds, or from using the futures customer’s funds to margin or guarantee the trades

4

or contracts, or to secure or extend the credit, of any other person. For convenience, however,

Section 4d(a)(2) permits an FCM to commingle the funds of multiple futures customers and

deposit those funds in one or more accounts with a bank, trust company, or the DCO that clears

their the futures transactions. Section 4d(f) of the Act requires similar segregation requirements

on FCM for customers engaging in swap transactions that are cleared by or through a registered

DCO.

The purpose of these statutory provisions, and the Commission’s regulations adopted

thereunder, is to establish a system of segregation of customer property that is designed to result

in an FCM holding sufficient funds in segregated accounts to meet their customer obligations in

full.

The Bankruptcy Code and Commission Part 190 Regulations. An FCM is obligated

5

to cover a customer’s default. In certain situations, a customer loss may be of such a magnitude

that the FCM becomes insolvent because it cannot cover the loss from its own capital and

6

financial resources. Under applicable laws and Commission regulations, for an FCM that is

considered insolvent and thus subject to liquidation, a customer loss would generally be

apportioned pro-rata across the non-defaulting customers of the FCM, by what is referred to as

account origin

uch a magnitude

that the FCM becomes insolvent because it cannot cover the loss from its own capital and

6

financial resources. Under applicable laws and Commission regulations, for an FCM that is

considered insolvent and thus subject to liquidation, a customer loss would generally be

apportioned pro-rata across the non-defaulting customers of the FCM, by what is referred to as

account origin. For this purpose, all commodity futures customers are considered one origin (as

are all foreign futures and, separately, all cleared swaps customers). As a result, loss that could

not be restored by the FCM’s capital in any of these three origins, would be distributed pro rata

to all customers in that origin in a commodity broker liquidation under the Bankruptcy Code.

3

The term “futures customer” includes any person who uses an FCM as an agent in connection with trading in

any contract for the purchase of sale of a commodity for future delivery or any option on the contract. The

owner or holder of a “proprietary account” is excluded from that definition. See 17 C.F.R. § 1.3.

4

The term “futures customer funds” includes all money, securities, and property received by an FCM or

derivatives clearing organization (“DCO”) from, for, or on behalf of, futures customers to margin, guarantee, or

secure contracts for future delivery on or subject to the rules of a contract market or DCO. See 17 C.F.R. § 1.3.

5

See generally 17 C.F.R. §§ 1.22 and 1.23.

6

See generally 11 U.S.C. §§ 761-66 (commodity broker liquidation), 17 C.F.R. pt. 190.

s, and property received by an FCM or

derivatives clearing organization (“DCO”) from, for, or on behalf of, futures customers to margin, guarantee, or

secure contracts for future delivery on or subject to the rules of a contract market or DCO. See 17 C.F.R. § 1.3.

5

See generally 17 C.F.R. §§ 1.22 and 1.23.

6

See generally 11 U.S.C. §§ 761-66 (commodity broker liquidation), 17 C.F.R. pt. 190.

Virtual Currency Advisory

October 21, 2020

Page 3

Commission Regulation 1.11. The Commission requires an FCM to have a risk

management program.7 The program must include, with respect to segregation risk, policies and

procedures for assessing the liquidity, marketability and mark-to-market valuation of all

non-cash assets held as segregated funds, including permitted investments under Commission

regulation 1.25. Those policies and procedures must ensure that all non-cash assets held in

customer segregated accounts are readily marketable and highly liquid. The policies and

procedures must: require daily measurement of liquidity needs with respect to customers; an

assessment of procedures to liquidate all non-cash collateral in a timely manner and without

significant effect on price; and the application of appropriate collateral haircuts that accurately

reflect market and credit risk. 8

III. Guidance on Customer Funds and Virtual Currency.

In light of the foregoing provisions, the Division has considered the risks presented by an

FCM’s acceptance of virtual currency from customers. In particular, the Division has determined

that receiving virtual currency from a customer and holding that currency as segregated funds

creates additional risks for the other customers in the same origin. Specifically, virtual currencies

present a degree of custodian risk that is beyond what is currently present with depositories, such

as banks and trust companies

ual currency from customers. In particular, the Division has determined

that receiving virtual currency from a customer and holding that currency as segregated funds

creates additional risks for the other customers in the same origin. Specifically, virtual currencies

present a degree of custodian risk that is beyond what is currently present with depositories, such

as banks and trust companies.

Custodians of virtual currencies are typically not subject to a system of comprehensive

federal or state regulation and oversight, which includes safeguarding of these novel assets, and

this raises potential risks to the protection of customer funds held at such custodians. For

instance, virtual currencies raise complicated issues with respect to the effective safeguarding

and custodianship of such assets. There have been numerous reports of incidents involving the

loss or misappropriation of virtual currencies as a result of a custodian’s failure to effectively

safeguard assets or digital keys, including incidents of the hacking of systems designed to hold

virtual currencies and other forms of theft. There also have been reports of owner’s or

custodian’s losing the ability to access virtual currencies held in electronic wallets due to the loss

or misappropriation of digital keys that are necessary to perform transfers of, or otherwise

access, these virtual currencies. These events have resulted in millions of dollars’ worth of losses

to the ultimate owners of the virtual currencies. Moreover, commercial insurance to cover such

losses also appears to be limited at the current time, with payouts capped at low dollar

thresholds, and high premiums charged by the few firms that are willing to provide coverage.

The Division has considered these risks in light of the existing requirements for customer

funds held by FCMs

losses

to the ultimate owners of the virtual currencies. Moreover, commercial insurance to cover such

losses also appears to be limited at the current time, with payouts capped at low dollar

thresholds, and high premiums charged by the few firms that are willing to provide coverage.

The Division has considered these risks in light of the existing requirements for customer

funds held by FCMs. Accordingly, the Division is reminding FCMs that they must adhere to the

following when holding virtual currency as customer funds:

1)

Virtual currency held as customer funds by an FCM must be deposited only with a

bank, trust company, or another FCM, or with a clearing organization that clears

7

See 17 C.F.R. § 1.11.

8

See 17 C.F.R. § 1.11(e)(3)(i)(J).

Virtual Currency Advisory

October 21, 2020

Page 4

virtual currency futures, options on futures, or cleared swap contracts (each such

entity, a “Depository”).9

2)

An FCM must deposit virtual currency held as customer funds with a Depository

under an account name that clearly identifies the funds as customer funds and shows

that the funds are segregated as required by the Act and Commission regulations. An

FCM also is required to obtain the appropriate written acknowledgment letter from

each Depository holding customer funds.10

3)

Virtual currency must be available for withdrawal from a Depository upon the

demand of an FCM, so that delivery pursuant to the terms of the contracts to which

the virtual currency relates will be made without delay.11

4)

An FCM in preparing its daily and month-end segregation statements must report

customer’s virtual currencies at fair market value on Line 1.B. (“Net ledger balance –

Securities (at market)”) and on Line 12 (“Segregated funds on hand”). The FCM must

report the total fair market value of customer virtual currency held at a bank or

custodian, at a derivatives clearing organization, or at another FCM as supplemental

information. The fair market value of the virtual currencies must be reported in U.S

rrencies at fair market value on Line 1.B. (“Net ledger balance –

Securities (at market)”) and on Line 12 (“Segregated funds on hand”). The FCM must

report the total fair market value of customer virtual currency held at a bank or

custodian, at a derivatives clearing organization, or at another FCM as supplemental

information. The fair market value of the virtual currencies must be reported in U.S.

dollars, and must reflect the FCM’s reasoned judgment based on spot market or other

appropriate market transactions.12

5)

An FCM, in computing its daily and month-end segregation requirement, 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.

Therefore, an FCM may be required to deposit its own funds into segregation to cover

any debit or deficit. 13

6)

An FCM may not deposit its own virtual currencies in futures customer or cleared

swaps customer segregated accounts for any reason, including in order to meet

targeted or residual interest requirements.14

9

Section 4d and 4d(f) of the Act provide that all money, securities, and property of customers may be held at a

bank or trust company, or with a clearing house organization for the contract itself. The Division does not

expect FCMs to hold customer’s virtual currency directly. However, any FCM that wishes to hold customer

virtual currencies directly will have to demonstrate to the Division how the FCM satisfies the Commission’s

segregation requirements, including retaining the appropriate possession and control of the virtual currencies

and the safeguarding of the virtual currencies.

10

See 17 C.F.R. §§ 1.20(a), 1.20(d), 22.2, 22.5, and 22.6

11

See 17 C.F.R. § 1.20(h).

12

See 17 C.F.R. §§ 1.10, 1.32, and 22.2(g).

13

Virtual currencies held as customer funds in the context of this Advisory are not considered “readily marketable

securities” as that term is used in Commission regulations 1.32(b) and 22.2(f)(5).

14

See 17 C.F.R

d the safeguarding of the virtual currencies.

10

See 17 C.F.R. §§ 1.20(a), 1.20(d), 22.2, 22.5, and 22.6

11

See 17 C.F.R. § 1.20(h).

12

See 17 C.F.R. §§ 1.10, 1.32, and 22.2(g).

13

Virtual currencies held as customer funds in the context of this Advisory are not considered “readily marketable

securities” as that term is used in Commission regulations 1.32(b) and 22.2(f)(5).

14

See 17 C.F.R. §§ 1.23(a)(1), 22.2(e)(3)(i), and 22.17, which limit the types of proprietary funds an FCM may

add to segregated futures customer accounts and segregated cleared swaps customer accounts to cash and the

Virtual Currency Advisory

October 21, 2020

Page 5

7)

An FCM may not invest any segregated futures customer or segregated cleared swap

customer funds in virtual currency to be held on behalf of customers.15

In addition, the requirements of Commission regulation 1.11(e)(3)(i)(J) require FCMs

that receive virtual currency from customers to consider the specific risks presented by holding

such virtual currency as segregated or cleared swap customer funds. As a result, this Advisory is

establishing the following guidance that an FCM should follow when designing and maintaining

its risk management programs should the FCM accept virtual currency as customer funds:

8)

An FCM should limit the acceptance of virtual currency into segregated and cleared

swaps segregated accounts as follows:

a.

The particular type of virtual currency (e.g., bitcoin or ether) relates 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, provided that the virtual currency is intended to margin,

guarantee, or secure such customer trading and has been formally

determined to be an acceptable form of collateral for those contracts by the

relevant designated clearing organization; and

b

to customer trading of futures (or options on such futures) or cleared

swaps contracts that provide for the physical delivery of that virtual

currency, provided that the virtual currency is intended to margin,

guarantee, or secure such customer trading and has been formally

determined to be an acceptable form of collateral for those contracts by the

relevant designated clearing organization; and

b.

The amount of virtual currency accepted reasonably relates to the

customer’s level of trading in those contracts during each calendar quarter,

with the reasonable relationship to be determined by the FCM and the

determination to be documented in the books and records of the FCM

pursuant to its risk management program policies and procedures.

9)

All virtual currency accepted by an FCM should not provide margin value to any

contracts other than the contracts identified in Clause 8(a) above; provided, however,

that an 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, as applicable.

10)

An FCM that holds virtual currency for a customer should contact the customer and

initiate a return of that virtual currency if the customer has ceased trading the

contracts to which the virtual currency relates and thus there is no related open futures

position, with the notice and return to be completed within a reasonable time frame

that should not exceed 30 days after the customer has ceased trading for a period of

90 days (i.e., the return to be effected within a total of 120 days from the cessation of

trading).

types of instruments set forth as permitted customer investments under 17 C.F.R. § 1.25. Requirements

establishing targeted and residual interest amounts are set forth in 17 C.F.R. §§ 1.11(e)(3)(i)(D), 1.22, and 22.2

at should not exceed 30 days after the customer has ceased trading for a period of

90 days (i.e., the return to be effected within a total of 120 days from the cessation of

trading).

types of instruments set forth as permitted customer investments under 17 C.F.R. § 1.25. Requirements

establishing targeted and residual interest amounts are set forth in 17 C.F.R. §§ 1.11(e)(3)(i)(D), 1.22, and 22.2.

15

Virtual currency is not listed among the permissible investments for futures customers segregated funds under

Commission regulation 1.25. See also, 17 C.F.R. § 22.2(e)(1) for permitted investments of cleared swaps

customer funds.

Virtual Currency Advisory

October 21, 2020

Page 6

11)

Each withdrawal of virtual currency from a Depository upon demand by the FCM in

order to liquidate customer accounts or return customer funds should be completed

within a time that is technologically and operationally possible, but should not exceed

one day, unless the procedures of the Depository specify additional time as part of its

controls related to transfers of virtual currency.16

12)

Before accepting any virtual currency into segregation, 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.17 The prior written notice

should be delivered to customers in the same manner as those customers have elected

to receive other communications regarding their accounts with the FCM. An FCM

should thereafter include the total amount of customer activity in virtual currency

being supported by the deposit of actual virtual currency by customer origin as part of

its disclosures required under Commission regulation 1.55.18

Given the previously mentioned risks associated with virtual currency, the Division may

determine to examine any FCM that accepts and holds customer virtual currency assets to

determine how it is choosing to meet its obligations under Commission regulation 1.11

ted by the deposit of actual virtual currency by customer origin as part of

its disclosures required under Commission regulation 1.55.18

Given the previously mentioned risks associated with virtual currency, the Division may

determine to examine any FCM that accepts and holds customer virtual currency assets to

determine how it is choosing to meet its obligations under Commission regulation 1.11. The

Division may also instruct any FCM, at any time, to cease receipt of virtual currency from its

customers until such time as any non-compliance with the Act and Commission regulations is

addressed by the FCM.

This guidance in no way limits the ability of the Division to refer an FCM to the Division

of Enforcement for potential investigation relating to the FCM’s practices involving virtual

currencies, specific transactions involving virtual currencies or related contracts, or for any other

reason. Staff will reevaluate and revisit this advisory, as necessary, to address any new or

heightened concerns raised by FCMs holding customers’ virtual currency assets.

* * * * *

Issued in Washington, D.C. on October 21, 2020, by the Division of Swap Dealer and

Intermediary Oversight.

______________________

Joshua B. Sterling

Director

Division of Swap Dealer and

Intermediary Oversight

16

In this regard, the Division notes that Commission regulation 1.20(h) provides that all customer funds deposited

with a bank or trust company must be immediately available for withdrawal.

17

Commission regulation 1.55(k) requires an FCM to provide specific disclosures concerning the significant types

of business activities and product lines engaged in by the FCM, and the approximate percentage of the FCM’s

assets and capital that are used in each type of activity.

18

Such disclosures should be considered additional information to be provided under Commission regulation

1.55(o)(1).