You see the news about theft and loss of digital assets – having to keep track of those private keys – what a big nightmare! Since digital assets can be such a hassle to own and trade, what about offering customers an opportunity to purchase digital assets held in custody for cash at, say 20%, of the value and then letting the customer trade their own account – selling whenever they wish? Of course, providing leverage probably means you can’t let the customer walk away with the digital assets so you will maintain it in custody for her, keeping it nice and safe. Is this legal to do in the U.S.?
The idea to structure a commodity investment product that offers retail customers leverage has been around for a long time. Make an investment in a “hot commodity” for 20% and enjoy the upside. Leave the handling of the commodity and all the details to us. Much of the customer’s funds go to marked up fees and costs and the rest is used to satisfy a margin call when the market invariably turns against the customer, leaving the customer with nothing. For the promoter on the other hand it can be rather lucrative, especially when you control the underlying collateral and can use it to cover the customer’s losses.
This was the issue in CFTC v. Monex that was decided by the Ninth Circuit Court of Appeals in July 2018. Monex offered customers a program to purchase precious metals on margin, providing credit financing for the remainder of the full purchase price. Customers were free to trade their position and they could go long or short but Monex was the counterparty (or dealer) to every trade and set trade prices. Monex also maintained the relationship with the metals depository which meant it alone had direct authority to instruct the depository on how to handle the commodities. Full delivery was only possible by making payment in full and pick up or shipping was up to the customer. The CFTC filed suit on the basis that the Monex trading program was an illegal and unregistered leveraged retail contract transaction market.
The Commodity Exchange Act (CEA) provides an exception to the definition of a contract for future delivery regulated under the CEA if the retail customer could take delivery within 28 days of entering into the contract. This allows legitimate retail customers to continue to buy and sell spot commodities like precious metals for their own portfolio. The district court originally dismissed the CFTC’s complaint against Monex, focusing largely on whether “actual delivery” of precious metals had occurred consistent with the CEA’s exclusion for spot sales with actual delivery occurring within 28 days. Specifically, the district court determined that actual delivery had occurred, and as a consequence found that the transactions were excluded from CFTC jurisdiction and dismissed several counts of the complaint.
The 9th Circuit took a different view. The court noted the CEA exception to the futures definition could hypothetically be satisfied “when the commodity sat in a third-party depository” but not where, as here, “metals were in the broker’s chosen depository, never exchanged hands, are subject to the broker’s exclusive control, and customers had no substantial, non-contingent interests.” The court held that the Defendants’ delivery of metal to its customers in this manner “amounts to sham delivery, not actual delivery.” Because actual delivery had not occurred, the panel concluded that the CEA exclusion for spot transactions did not apply. The Ninth Circuit reinstated the CFTC’s charges and sent the case back to the District Court for further proceedings.
The main lesson here, though, is that a digital assets platform hosting spot commodity transactions may run afoul of the Commodity Exchange Act if it offers leverage or margin to the customer but retains control of the spot commodity until paid in full. The reason is that this type of product simply ends up mimicking futures trades, which have long been required to be transacted on exchanges and not spot platforms or bilaterally. Be careful out there.
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