If You Want To Trade Bitcoins, First Learn CFTC Rules

The CFTC requires counterparties, including brokers and exchanges, doing business with American retail customers to register if they offer “leveraged” or “financed” financial products, including derivatives. The CFTC brought an enforcement action against unregistered Bitfinex of Hong Kong because they offered leveraged cryptocurrency contracts to American retail customers. Several other unregistered offshore exchanges offer leveraged cryptocurrency contracts to American retail customers. Many Americans trade cryptocurrency on exchanges that do not provide leveraged contracts, and that seems okay.

Bitcoin is the most famous cryptocurrency, and there’s been significant price volatility the past few years. That’s attracted American retail traders to Bitcoin exchanges offering leveraged trading and derivative products based on Bitcoin price movements.

In this post, I discuss CFTC regulation for Bitcoin counterparties (exchanges and brokers), and in my related post, I cover tax treatment for trading Bitcoin. (See If You Traded Bitcoin, You Should Report Capital Gains To The IRS.)

Is Bitcoin trading legal for American retail customers?
Some American retail customers trade leveraged or financed cryptocurrency contracts with counterparties that are not registered with the Commodity Futures Trading Commission (CFTC) or another U.S. regulator to allow cryptocurrency trading by American retail customers. I asked the CFTC and National Futures Association (NFA) if that is legal, and both said CFTC regulations for American retail customers apply to counterparties, not American retail customers. Does that imply that leveraged Bitcoin and cryptocurrency trading may be legal for American retail customers, and illegal for counterparties? Perhaps, yes, but I am not sure. It’s risky for American retail customers to trade leveraged Bitcoin contracts or another leveraged cryptocurrency because the CFTC may take enforcement action against their counterparties as it did against Bitfinex (see below). Maintain control of Bitcoin wallets to avoid some counterparty risk with regulators.

CFTC regulations
The Commodity Futures Trading Commission (CFTC) requires counterparties, including brokers and exchanges, to register with the CFTC if they offer leveraged or margined financial products to American retail traders. That includes some Bitcoin exchanges and Bitcoin derivative products.

If a forex dealer wants to do business with American retail traders on leveraged forex contracts off-exchange, the CFTC requires the forex dealer register with the CFTC, SEC or bank regulator. There is CFTC-registered Retail Foreign Exchange Dealers (RFED), and CFTC-registered Futures Commission Merchant (FCM) Forex Dealer Members.

The CFTC considers Bitcoin a “currency,” but not a “foreign currency.” The CFTC says Bitcoin is not forex, so it doesn’t fall under the forex regulations. The CFTC also refers to Bitcoin as a “commodity.”

The North American Derivatives Exchange, Inc. (Nadex), a U.S.-based CFTC-regulated exchange, offered leveraged Bitcoin binary contracts until it discontinued that product at the end of 2016. On Dec. 16, 2016, Nadex filed a Self-Certification to Delist Bitcoin.

Bitcoin exchanges offering leverage try to escape CFTC jurisdiction
Bitcoin exchanges have sought exemption from CFTC jurisdiction in claiming traders are “making and taking delivery” of each trade on their “exchange,” by transferring the title into Bitcoin wallets. The CFTC does not regulate private transactions in commodities, or forward contracts when made for delivery within 28 days. For example, a farmer may sell wheat to a cereal manufacturer for immediate delivery, or with a forward contract. A warehouse receipt is evidence of delivery.

CFTC jurisdiction applies to counterparties offering futures, options, derivatives, and financed (or leveraged) retail transactions for future delivery. In the CFTC enforcement case cited below, the CFTC explained how leveraged trades in the spot Bitcoin market with an American retail customer fell under CFTC jurisdiction as a financed retail transaction. The CFTC also disagreed that Bitfinex made full delivery of Bitcoin to traders.

Two CFTC enforcement cases against Bitcoin exchanges
Bitfinex in June 2016, and Coinflip in September 2015. Read CFTC vs. BFXNA INC. d/b/a BITFINEX and CFTC Bitfinex Enforcement Action, an analysis by law firm Clifford Chance. Here are some excerpts from the Clifford Chance client briefing:

• “The Order expands the CFTC’s regulation of bitcoin and other cryptocurrencies into spot markets under certain conditions.”
• “The result is that spot trades qualifying as financed retail transactions will be regulated as if they were futures trades.”
• “The Exception does not apply since the bitcoins were not actually delivered. In finding lack of actual delivery, the CFTC looked to the fact that at all times Bitfinex held the private keys needed to access the wallet where bitcoins were held.”

On-exchange vs. off-exchange
On-exchange means a CFTC-registered U.S. futures, options or derivatives exchange like the CME, CBOE, ICE, NYMEX and NADEX.

On-exchange also includes foreign futures and options exchanges, providing the CFTC issued a “Part 30 Letter” granting the foreign exchange permission to solicit accounts with American retail customers. The exchange must demonstrate similar rules as in the U.S. including posting prices, setting margin requirements, meeting capital adequacy, and more. (See a list of CFTC Part 30 Letters on the CFTC website.)

The CFTC’s mission is to protect American retail customers
The CFTC prefers leveraged trading transactions for American retail traders conducted on-exchange, so the exchange may act as the counterparty to both buyer and seller, who otherwise do not know each other. With off-exchange forex, the CFTC-registered RFED and Forex Firms are the counterparties.

Consider the infamous failure of the largest (at the time) Bitcoin exchange, Mt. Gox, which filed for bankruptcy protection in Japan in 2014. The CFTC is trying to protect American retail customers from these types of losses.

Exemptions for ECP and ECE
Eligible Contract Participants (ECP) who meet certain high net worth requirements are “institutional” and exempt from CFTC regulations for American retail customers. ECP can trade off-exchange leveraged financial products, including Bitcoin derivatives. Eligible Commercial Entities (ECE) are exempt, too. (For a definition of ECP, click here and for ECE, click here.)

Republicans are interested in scaling back Dodd-Frank regulations
President Trump, his administration officials, and the GOP leaders in Congress have indicated they want to scale back elements of the Dodd-Frank Act. It’s conceivable they could reduce some of the CFTC limitations on American retail customers trading leveraged financial products off-exchange.

Tax reporting
Whether it’s legal or not under CFTC regulations, the IRS requires American resident taxpayers to report Bitcoin trading income and losses worldwide on U.S. resident tax returns. It doesn’t matter whether or not you repatriate funds back to the U.S. (See my blog post: If You Traded Bitcoin, You Should Report Capital Gains To The IRS.)