Written by:
Jeffry Henderson, Shareholder, Greenberg Traurig
Douglas Arend, Of Counsel, Greenberg Traurig
On March 29, 2023, National Futures Association (NFA) adopted Compliance Rule 2-51 (Rule 2-51), which became effective on May 31, 2023. Rule 2-51 expands the scope of NFA’s authority to NFA members (Members) and associate members (Associates) engaging in spot or cash transactions in “digital asset commodities.” Rule 2-51 imposes anti-fraud, just and equitable principles of trade and supervisory requirements on Members and Associates transacting in such markets. Rule 2-51 also reconfirms NFA members’ disclosure obligations in such markets as originally set forth in NFA’s May 2018 Interpretive Notice 9073 (IN 9073). As adopted, Rule 2-51 applies only to Members’ or Associates’ spot or cash market activities in two digital assets that have derivatives listed on exchanges regulated by Commodity Futures Trading Commission (CFTC): Bitcoin (BTC) and Ether (ETH). In its rule submission to CFTC, NFA noted that if other digital assets are identified or designated as commodities in the future, NFA could amend Rule 2-51 to cover such assets.
Under IN 9073, NFA exercised only limited jurisdiction over Members’ activities in digital asset spot markets – including cryptocurrencies not yet clearly recognized by courts as commodities. IN 9073 implemented various customer risk disclosure and notification requirements for futures commission merchants (FCMs), introducing brokers, commodity pool operators and commodity trading advisors that engage in activities related to virtual currencies or virtual currency derivatives. Standardized disclosures required NFA members to inform customers that NFA does not have regulatory oversight over cash or spot virtual currency transactions. Although Rule 2-51 did not change the content of these disclosures, it represents a substantial expansion of NFA’s assertion of authority beyond these disclosures.
Because NFA operates under delegated authority from CFTC, it is axiomatic that NFA’s jurisdiction may not exceed that of CFTC. CFTC’s jurisdiction under the Commodity Exchange Act, as amended (“CEA”) includes regulating derivatives on “commodities” (as broadly defined in the CEA) and conduct constituting fraud or price manipulation in commodities in interstate commerce.
While many subsections of Rule 2-51 fall within CFTC’s authority over fraud and manipulation in spot markets and merely reiterates NFA’s virtual currency disclosure and notification requirements, two key sections arguably go beyond the scope of CFTC’s jurisdiction. Subsection (a)(ii) of Rule 2-51 states that Members may not make a communication that employs or is part of a “high-pressure approach.” However, not every “high pressure approach” rises to the level of market manipulation. Federal courts have held that there can be “no manipulation without an intent to cause artificial prices.” A “high pressure approach” may not be an attempt to influence market prices.
Further, “high pressure approach[s]” are not necessarily fraudulent. Under the CEA, fraud involves the “making of a misrepresentation, misleading statement, or deceptive omission.” Sales pressure could potentially be exerted on a customer without making misleading statements or misrepresentations or constituting fraud.
Subsection (a)(v) of Rule 2-51, which states members cannot “engage in manipulative acts and practices” and clearly falls within CFTC’s jurisdiction, would appear to make subsections (a)(iii) and (a)(iv) of Rule 2-51 redundant. Subsection (a)(iii), which prohibits members from “willfully mak[ing]” false records in connection with any transaction involving a digital asset commodity, and subsection (a)(iv), which prohibits the dissemination of “false or misleading information” that affects (or tends to affect) the price of any digital asset commodity, seem to fall within the scope of NFA’s authority to regulate Member fraudulent or manipulative practices.
While it is unclear what conduct NFA sought to regulate by adding subsections (iii) and (iv), presumably something more than manipulative conduct was the intended target. One possible explanation could be an attempt to expand NFA jurisdiction in the digital asset spot market beyond fraudulent or market manipulative Member conduct. Such attempted expansion may be open to challenge as falling outside the scope of CFTC’s, and thus NFA’s, authority.
Rule 2-51 subsection (b) requires Members to “observe high standards of commercial honor and just and equitable principles of trade” when conducting their business involving any digital asset commodity. While the term “just and equitable principles of trade” is broad enough to encompass fraudulent or manipulative activity, the term is not necessarily restricted only to such areas. NFA modeled subsection (b) on NFA Compliance Rule 2-4 (Rule 2-4), which requires Members to follow just and equitable principles in their commodity futures and swaps business.
In the context of futures and swaps, NFA has interpreted Rule 2-4 to require FCMs to disclose costs associated with futures and swaps to their customers. If, for example, fees and charges related to a future transaction are not calculated on a per trade or round-turn trade basis, then the FCM must explain to its customers in writing how it calculates such fees or charges. If such an interpretation were applied to Compliance Rule 2-51(b), Members in the digital asset commodity spot market would have to disclose more than risks of digital asset commodities. Members transacting in spot digital asset commodities would also have new required fee and charge disclosures. Again, such a result would arguably extend NFA’s authority beyond CFTC’s jurisdiction.
CFTC Commissioner Caroline Pham stated in connection with adoption of Rule 2-51 that a parallel exists between Compliance Rule 2-51’s expansion into the digital asset spot market, and Compliance Rule 2-36’s expansion to the spot retail foreign exchange (retail forex) market in the early 2000s. Both rules prohibit fraud and market manipulation by Members and discuss “just and equitable principles of trade” in forex and digital asset markets, respectively.
Commissioner Pham’s comparison of Compliance Rules 2-51 and 2-36 has potential implications she may not have considered. Although Compliance Rule 2-36’s prohibition regarding retail forex transactions was eventually codified by the Dodd-Frank Act to expand the jurisdiction of the CFTC, CFTC (and therefore NFA) did not always have statutory authority to regulate retail forex. For years, there existed a so-called Zelener loophole, named after the Seventh Circuit Court of Appeals decision in CFTC v. Zelener, which held that CFTC did not have jurisdiction to pursue enforcement actions involving rolling spot forex transactions. NFA’s expansion of authority to the digital asset spot market could potentially face similar legal challenges.
Future CFTC interpretations and court opinions upholding Rule 2-51 would potentially allow NFA broad authority to regulate transactions in any digital assets considered to be commodities. The boundaries of CFTC’s jurisdiction in this area are not set in stone. CFTC has taken the position in enforcement actions that Litecoin, Tether USD and “other digital assets” are also commodities. If grafted into Rule 2-51, such a position could further expand NFA’s authority over digital assets beyond BTC and ETH. If and whether such expansion occurs will likely be scrutinized as markets in cryptocurrencies continue to evolve and adapt.