The CFTC treats certain digital assets as commodities, including virtual payment tokens, utility tokens, and others under Section 1a(9) of the Commodities Act of 1936. CFTC regulated assets interests include: futures contracts, options on futures contracts, and swaps, including foreign exchange transactions. The CFTC has taken the position that virtual payment tokens, such as Bitcoin, are not considered currency because it is not accepted as legal tender in any jurisdiction.
Compared with the SEC, the CFTC has proven less of an obstacle for digital asset fund managers. CFTC commissioners have publicly encouraged forbearance and regulatory expansion to encourage the further development of digital asset innovation, including adding support to discussions calling for the creation of a self-regulatory organization to govern virtual commodities.
There are important distinctions between the scope of CFTC regulation of investment fund managers versus the SEC’s regulation of investment advisers. Unlike the SEC, which imposes adviser registration based on the inclusion of securities assets with the manager’s portfolio, the CFTC requires registration only from advisers that invest in commodities and other qualifying instruments using certain derivative strategies and leverage use.
- Leverage and Futures
Cryptocurrency fund managers that invest in cryptocurrency futures contracts, as opposed to straight cryptocurrencies, are required to either register with the CFTC and with the National Futures Association (NFA) or satisfy an exemption. Also, because of additions to the Dodd-Frank Act, cryptocurrency hedge fund managers that use leverage or margin need to register with the CFTC and NFA. The Dodd-Frank Act amended the Commodities Act to add new authority over certain leveraged, margined, or financed retail commodity transactions. The CFTC exercised this jurisdiction in an action against BFXNA INC. d/b/a BITFINEX in 2016. Fund managers should either avoid using margin/leverage or plan to register as a CTA and CPO with the CFTC and register with the NFA.
- CFTC Registration of CPOs and CTAs
A commodity pool operator (CPO) is an individual or organization that operates a commodity pool and solicits funds for that commodity pool. Unless an exemption applies, managers must register fund level vehicles that invest in qualifying transactions as CPOs. Principals and associated persons of the fund must also register as CPOs with the CFTC and register with the National Futures Association (NFA), the CFTC appointed self-regulatory organization governing the derivatives industry. Principals and associated persons of a CPO must pass a proficiency examination, known as the Series 3 Examination. As part of the NFA membership application, hedge funds must submit offering documents to the NFA for its review and approval, as well as submitting to an annual audit.
- Exemptions from Registrations
For digital asset fund managers, CFTC exemptions will typically not provide relief from registration, but available exemptions allow reduced compliance burdens. Accordingly, many digital asset funds have registered as CPOs with the CFTC. The CFTC lacks an AUM exemption from CPO registration analogous to the SEC’s Private Fund Adviser Exemption for funds with small pools. Any fund manager trading significant levels of commodities with an AUM exceeding $400,000 must register as a Commodity Pool Operator with the CFTC.
- Streamlined Process for QEP Funds
Digital Asset funds avoid the most burdensome CFTC compliance requirements by limiting investor participation to investors that meet the wealth standard of a “Qualified Eligible Person” (QEP) under CFTC Rule 4.7. Nearly all hedge funds trading CFTC regulated assets permit investment from QEP investors only. QEP requirements can be met in a number of ways, but the threshold levels for the most mechanical provisions require an investor to hold a portfolio of securities and other investments of $2 million or more. Most hedge fund managers expect this level of investor requirement because the SEC Investment Advisers Act qualified client standard requires a $2.1 million net investment from natural persons who enter into performance-based compensation contracts with hedge funds trading securities.
- De Minimus Exemption
Unlike the SEC, the CFTC provides an exemption for funds in which commodities transactions represents a small percentage of the fund’s portfolio instruments. The CFTC Rule 4.13(a)(3) de minimis exemption exempts from registration commodity pools with aggregate initial margin, premiums, and required minimum deposits in futures and swaps, less than five percent of the liquidation value of the fund’s portfolio, further requiring that the net notional value of positions in CFTC regulated instruments do not exceed 100 percent of the liquidation value of the fund’s portfolio. The de minimis exemption is widely relied upon by commodity pool operators. This exemption is not self-executing and requires an initial exemption filing and an annual renewed filing to attest that the fund’s portfolio has not exceeded the exemptions threshold.
In October 2018, the CFTC proposed rules that would ease the burden of satisfying the de minimis exemption by non-US CPOs, which currently requires an additional “sophistication” standard with which non-US CPO investors must comply 83 Fed. Reg. 52,902 (Oct. 18, 2018). https://www.federalregister.gov/documents/2018/10/18/2018-22324/registration-and-compliance-requirements-for-commodity-pool-operators-and-commodity-trading-advisors These requirements, as well as other streamlining provisions applicable to non-US CPOs, will reduce compliance burdens if the rules are finalized as currently proposed.
For further information on SEC and CFTC regulation of crypto asset hedge funds, please see our blog post, “SEC and CFTC Regulation for Startup Cryptocurrency Hedge Funds.”