EFTA01074293.pdf

Discussion Draft — April 10, 2014 — Please do not cite. BITCOIN FINANCIAL REGULATION: SECURITIES, DERIVATIVES, PREDICTION MARKETS, & GAMBLING Jerry Britos• Houman Shadab," & Andrea Castillo" INTRODUCTION 2 I. BITCOIN AND THE FIRST WAVE OF REGULATION 3 A. Bitcoin in Brief 3 B. The First Wave of Regulation 6 II. REGULATION OF BITCOIN-RELATED FINANCIAL INSTRUMENTS 10 A. Bitcoin Derivatives 10 1. Futures 13 2. Forwards 16 3. Swaps 17 4. Options 20 B. Bitcoin Securities 21 1. Bitcoin Funds 22 2. Bitcoin Margin Trading 26 C. Bitcoin-Denominated Instruments & Gambling 29 1. Bitcoin-Denominated Derivatives and Markets 29 2. Bitcoin-Denominated Securities and Exchanges 33 3. Regulating Bitcoin-Denominated Transactions 40 4. Prediction Markets & Gambling 42 III. DECENTRALIZED MARKETS AND EXCHANGES 51 A. Decentralized Applications 55 1. Securities Exchanges 57 2. Predictions Markets 58 3. Gambling 60 B. Law and Decentralization 61 CONCLUSION 65 Senior Research Fellow, Mercatus Center at George Mason University. J.D., George Mason University School of Law, 2005; B.A., Political Science, Florida International University, 1999. The authors would like to thank Eli Dourado, Patrick O'Sullivan, and Jeff Garzik for their thoughtful input and Jacob Hamburger for his research assistance. • Associate Professor of Law, New York Law School. B.A. 1998, University of California at Berkeley; J.D. 2002, University of Southern California. • Research Associate, Mercatus Center at George Mason University. B.S., Economics, Florida State University, 2011. 1 EFTA01074293  Discussion Draft — April 10, 2014 — Please do not cite. INTRODUCTION Bitcoin presents a unique challenge to policymakers. On the one hand, because it is an open protocol and a decentralized network, there is no company or central server that can be regulated. On the other hand, there are a number of emerging new intermediaries operating on the Bitcoin network that are certainly susceptible to regulation and enforcement. These include exchanges, merchant processors, and money transmitters that provide Bitcoin services to consumers. To date, Bitcoin-related regulation has largely been focused on the application of "know your customer," anti- money-laundering rules, as well as consumer protection licensing, on these new intermediaries. The next major wave of Bitcoin regulation will likely be aimed at financial instruments, including securities and derivatives, as well as prediction markets and even gambling. While there are many easily regulated intermediaries when it comes to traditional securities and derivatives, emerging bitcoin-denominated instruments rely much less on traditional intermediaries. Additionally, the block chain technology that Bitcoin introduced for the first time makes completely decentralized markets and exchanges possible, thus eliminating the need for intermediaries in complex financial transactions. In this article we survey the type of financial instruments and transactions that will most likely be of interest to regulators, including traditional securities and derivatives, new bitcoin-denominated instruments, and completely decentralized markets and exchanges. We find that bitcoin derivatives would likely not be subject to the full scope of regulation under the Commodities and Exchange Act because such derivatives would likely involve physical delivery (as opposed to cash settlement) and would not be capable of being centrally cleared. We also find that some laws, including those aimed at online gambling, do not contemplate a payment method like Bitcoin, thus placing many transactions in a legal gray area. Following the approach to Bitcoin taken by FinCEN, we conclude that other financial regulators should consider exempting or excluding certain financial transactions denominated in Bitcoin from the full scope of the regulations, much like private securities offerings and forward contracts are treated. In particular, given that physical settlement of a commodity derivatives transaction likely means that it is excluded from regulation by the Commodities Futures Trading Commission, virtual settlement of Bitcoin transactions should likewise trigger a lighter regulatory framework. We also suggest that to the extent that regulation and enforcement becomes more costly than its benefits, policymakers should consider and pursue strategies 2 EFTA01074294  Discussion Draft — April 10, 2014 — Please do not cite. consistent with that new reality, such as efforts to encourage resilience and adaption. This Article is structured as follows. Part I presents a brief sketch of the Bitcoin technology and describes the first wave of Bitcoin-related regulation. Part II analyzes the legal treatment of traditional securities and derivatives that are either bitcoin-backed or which have bitcoins as the underlying, as well as non-traditional bitcoin-denominated securities, derivatives, prediction markets, and gambling. Finally, Part III considers the implications of completely decentralized markets and exchanges made possible by Bitcoin and other emerging technologies. I. BITCOIN AND THE FIRST WAVE OF REGULATION Bitcoin is a new Internet protocol, a peer-to-peer network, and a digital currency unit. Following the protocol, the network operates to maintain a global public ledger of bitcoin transactions.' As we will see in later sections, there are many different applications that this technology enables. To date, however, it is simple payments and money transfer that has captured the public's imagination, and it is therefore what has drawn regulators' attention. In this section we will present a brief overview of Bitcoin as a payments or money transfer system and the first wave of regulation that addressed those applications. A. Bitcoin in Brief Bitcoin is frequently described as a "digital currency."2 While that description is accurate, it can be misleading because it is at once too broad and too narrow. It is too broad because Bitcoin is a very particular kind of digital currency called a cryptocurrency (indeed, it is the first of its kind).3 It is too narrow because although currency is one aspect of the Bitcoin system, Bitcoin is more broadly an Internet protocol with many applications beyond payments or money transfer.4 Virtual or digital currencies are nothing new. From in-game currencies like World of Warcraft Golds or Linden Dollars,6 to vendor-specific I Lowercase vs. uppercase 2 Francois R. Velde, Bitcoin: A Primer, 317 Chicago Fed Letter (2013). 3 Jerry Brito & Andrea Castillo, Bitcoin: A Primer for Policymakers, (Is' ed. 2013). Jerry Brito, It's More Than Money, Cato Unbound, July 12, 2013, http://www.cato- unbound.org/2013/07/12/jerry-brito/its-more-just-money; Jerry Brito, Is Bitcoin the Key to Digital Copyright?, Reason Magazine, February 24, 2014, http://reason.com/archives/2014/02/24/is-bitcoin-the-key-to-digital-copyright. 5 Laurence H.M. Holland, Making Real Money in Virtual Worlds, Forbes Magazine, August 7, 2006, http://www.forbes.com/2006/08/07/virtual-world- 3 EFTA01074295  Discussion Draft — April 10, 2014 — Please do not cite. currencies like Facebook Credits? Microsoft Points,8 or even airline miles, digital currencies have been around for well over a decade. Even the dollars in one's PayPal account are essentially digital currency. What makes Bitcoin unique is that unlike all digital currencies that preceded it, a central authority, such as a company or government, does not issue Bitcoin and no central authority is required to verify a transfer from one individual to another.° Instead, Bitcoin employs cryptography and peer-to-peer networking to eliminate the need for third parties. Comparing Bitcoin to traditional payments and money transfer systems helps explain the distinction. Before Bitcoin's invention in 2008, online transactions always required a trusted third-party intermediary." For example, if Alice wanted to send $100 to Bob over the Internet, she would have had to rely on a third-party service like PayPal or MasterCard. Intermediaries like PayPal keep a ledger of account holders' balances. When Alice sends Bob $100, PayPal deducts the amount from her account and adds it to Bob's account. Without such intermediaries, digital money could be spent twice. Imagine there are no intermediaries with ledgers, and digital cash is simply a computer file, just as digital documents such as photos or Word documents are computer files. Alice could send $100 to Bob by attaching a money file to a message. But just as with email, sending an attachment does not remove it from one's computer. Alice would retain a perfect copy of the money file after she had sent it. She could then easily send the same $100 to Charlie. In computer science, this is known as the "double-spending" problem," and until Bitcoin it could only be solved by employing a ledger- keeping trusted third party. Bitcoin's invention is revolutionary because for the first time the double-spending problem can be solved without the need for a third party. jobs cx_de_0807virtualjobs.html. 7 Spencer Reiss, Virtual Economics, MIT Technology Review, December I, 2005, httriAvww.technologyreview.com/article/404979/virtual-economicst 7 Miguel Helft, Facebook Hopes Credits Make Dollars, New York Times (New York), September 23,2010 at Bl. 8 Ben Gilbert, Microsoft Points from Xbox 360 transfer to Xbox One as real money, `equal or greater in Marketplace value,' Engadget, June 12, 2013, http lAvww.engadget.com/2013/06/12/microsoft-points-conversion-xbox-onet 9 Satoshi Nakamoto, Bitcoin: A Peer-to-Peer Electronic Cash System, White Paper, (2008). N Id. II Jerry Brito & Andrea Castillo, Bitcoin: A Primer for Policymakers, (1" ed. 2013). 12 David Chaum, Achieving Electronic Privacy, Scientific American Magazine (New York), August 1992, at 96-101. 4 EFTA01074296  Discussion Draft — April 10, 2014 — Please do not cite. Bitcoin does this by distributing the necessary ledger among all the users of the system via a peer-to-peer network. Every transaction that occurs in the Bitcoin network is registered in a distributed public ledger, which is called the block chain. New transactions are checked against the block chain to ensure that the same bitcoins have not been previously spent, thus eliminating the double-spending problem. The global peer-to-peer network, composed of thousands of users, takes the place of an intermediary; Alice and Bob can transact online without PayPal. Transactions are verified, and double-spending is prevented, through the clever use of public-key cryptography.'3 Public-key cryptography requires that each user be assigned two "keys," one private key that is kept secret like a password, and one public key that can be shared with the world. When Alice decides to transfer bitcoins to Bob, she creates a message, called a "transaction," which contains and Bob's public key and how many coins she is sending. She then "signs" it with her private key and broadcasts the message over the network. By looking at Alice's public key, anyone can verify that the transaction was indeed signed with her private key, that it is an authentic exchange, and that Bob is the new owner of the funds. The transaction—and thus the transfer of ownership of the bitcoins-is recorded, time-stamped, and displayed in one "block" of the block chain. Public-key cryptography ensures that all computers in the network have a constantly updated and verified record of all transactions within the Bitcoin network, which prevents double-spending and fraud. Out of technical necessity, transactions on the Bitcoin network are not denominated in dollars or euros or yen as they are on PayPal, but are instead denominated in bitcoins. This makes it a virtual currency in addition to a decentralized public ledger. The value of the currency is not derived from gold or government fiat, but from the value that people assign to it. The dollar value of a bitcoin is determined on an open market, just as is the exchange rate between different world currencies. The number of bitcoins that are issued—that is, the size of the money supply-is not determined by any person, company, or central bank, but instead grows at a algorithmically pre-determined rate baked into the protocol." 13 Christof Paar, Jan Pelzl, and Bart Preneel, Introduction to Public-Key Cryptography, in Understanding Cryptography: A Textbook for Students and Practitioners, ch. 6 (Christof Paar and Jan Pelzl, eds., New York: Springer 2010). (New York: Springer, 2010), sample available at http://wiki.crypto.rub.de/Buch/download/Understanding -Cryptography- Chapter6.pdf. 14 The explanation of Bitcoin's mechanics presented here is a consciously abridged one. It might therefore be unsatisfying to those encountering Bitcoin for the first time. Readers looking for a more-detailed explanation of Bitcoin's operation should consult: 5 EFTA01074297  Discussion Draft — April 10, 2014 — Please do not cite. For these reasons, Bitcoin is unlike any digital currency that preceded it. Bitcoin is not just a virtual unit of account, but also a decentralized system for transferring value. It is a nyptocurrency, which means that a central authority does not issue the currency, nor is a central authority needed to verify transactions. Transactions are instead recorded in a decentralized and distributed public ledger and are cryptographically verifiable. Bitcoin was the world's first cryptocurrency, and since its invention other cryptocurrencies have emulated its model." As we'll see in Part III, infra, because Bitcoin is at root a decentralized and distributed public ledger, and because it is programmable, it has the potential to facilitate completely decentralized security exchanges, prediction markets, and gambling. B. The First Wave of Regulation Payments and money transfers are the most obvious application of the distributed public ledger technology, so they were the first application of the technology to be implemented. Merchants from Overstock.com16 to the 17 18 Sacramento Kings to WordPress.com have begun accepting payment in bitcoin, and startups like BitPesa vlan to use the Bitcoin network to facilitate international remittances. 9 By disintermediating traditional financial networks like PayPal, Visa, and Western Union, Bitcoin offers three main advantages: it can be cheaper, faster, and censorship-resistant. First, Bitcoin transaction costs are much lower than those of traditional financial networks. While credit card networks charge merchants fees in the range of 3 to 4 percent of the total amount of a transaction,26 and the Brito & Castillo; Velde. 18 Alex Liu, Beyond Bitcoin: A Guide to the Most Promising Cryptocurrencies, Motherboard, November 29, 2013, http://motherboard.vice.com/blog/beyond-bitcoin-a- guide-to-the-most-promising-cryptocurrencies. 16 Cade Metz, The Grand Experiment Goes Live: Overstock.com Is Now Accepting Bitcoins, Wired Magazine, January 9, 2014, http://www.wired.com/business./2014/01/overstock-bitcoin-livet 17 Cade Metz, Sacramento Kings Crowned First Pro Sports Team to Accept Bitcoin, Wired Magazine, January 16, 2014, http://virww.wired.com/business/2014/01/sacramento- kings-bitcoint. 18 Jon Matonis, What's Your Bitcoin Strategy? WordPress Now Accepts Bitcoin Across the Planet, Forbes Magazine, November 16, 2012, http://www.forbes.com/sites/jonmatonis/2012/11/16/whats-your-bitcoin-strategy- wordpress-now-accepts-bitcoin-across-the-planed. 18 Richard Boase, BitPesa Uses Bitcoin to Slash Kenyan Remittance Costs, CoinDesk, November 28, 2013, http://www.coindesk.com/bitpesa-uses-bitcoin-slash-kenyan- remittance•costs/. 20 Paul Downs, What You Need to Know About Credit Card Processing, New York Times, March 25, 2013, http://boss.blogs.nytimes.com/2013/03/25/what-you-need-to- know-about-credit-carthprocessing/. 6 EFTA01074298  Discussion Draft — April 10, 2014 — Please do not cite. average cost of international remittances is 8.5 percent,21 a Bitcoin transaction can cost less than 1 percent.22 Second, Bitcoin transactions can be much faster. For example, while international wire transfers can take days to complete, Bitcoin transactions take roughly ten minutes.23 Finally, Bitcoin is censorship-resistant. For example, while PayPal froze the accounts of WikiLeaks after it released secret State Department cables, and prevented its customers from making donations to the group,24 such transactional prior restraint would not be possible on the Bitcoin network because there is no intermediary. Bitcoin is in many ways a disruptive technology,25 and sensing a great profit opportunity venture capitalists and entrepreneurs are at present rushing to develop the network's infrastructure. Among the key parts of this first wave of startups are exchanges that allow consumers to trade fiat currency, such as dollars or euros, for bitcoins and vice versa; online wallets that allow consumers who do not want to run the more-complicated desktop software on their own computers to carry bitcoin balances and spend them; and merchant services, which easily allow merchants to accept bitcoin payments and have dollars deposited in their bank accounts, thus eliminating volatility risk. Like other disruptive technologies, Bitcoin is first taking hold in spaces that are underserved by incumbents. This includes innovative areas like micropayments26 and crowdfunding,27 but also payments related to the online sale of illicit goods, such as drugs and firearms in the U.S. or subversive actions against oppressive regimes like Iran28 and Russia.29 21 World Bank, Remittance Prices Worldwide, accessed March 26, 2014, http://remittanceprices.worldbank.org/. 22 Note that the tradeoff for the low transaction costs of a bitcoin transaction is the lack of insurance and perks that are paid for with traditional payment systems' higher fees. 23 Average transaction times are viewable at: blochain.info, Average Transaction Confirmation Time, accessed March 26, 2014, http://blockchain.info/charts/avg- confirmation-time. 24 Kevin Poulsen, PayPal Freezes WikiLeaks Account, Wired Magazine, December 4, 2010, http:/Avww.wired.com/threatleve1/2010/12/paypal-wikileakst 25 Timothy Lee, Bitcoin is a Disruptive Technology, Forbes Magazine, April 9, 2013, http://www.forbes.com/sites/timothylee/2013/04/09/bitcoin-is-a-disruptive-technologyt 26 Pete Rizzo, Bitcoin Micropayments Get Big Moment as Chicago Sun-Times Paywall Experiment Goes Live, CoinDesk, February 1, 2014, http://www.coindesk.comlmicropayments-chicago-sun-times-paywall-livet 27 Eric Blattberg, Crowdtilt launches free, open source crowdfunding solution and it supports Bitcoin, VentureBeat, February 20, 2014, http://venturebeat.com/2014/02/20/crowdtilt-launches-free-open-source-crowdfunding- solution-and-it-supports-bitcoin./. 25 Max Raskin, Dollar-Less Iranians Discover Virtual Currency, BusinessWeek, November 29, 2012, http://www.businessweek.comlarticles/2012.11-29/dollar-less- 7 EFTA01074299  Discussion Draft — April 10, 2014 — Please do not cite. Because Bitcoin is censorship-resistant, it can be employed for transactions that incumbent intermediaries would not process, or are not allowed by law to process. Indeed, it is possible that Bitcoin's network effects were bootstrapped by demand for use in facilitating illicit transactions.3° Given that the first application of the Bitcoin technology has been simple payments and money transfers, and given that the technology's censorship-resistance permits transactions that were previously restrained, it is no surprise that the first wave of regulatory activity related to Bitcoin has focused on money transmission. At the federal level, the Treasury Department's Financial Crimes Enforcement Network (FinCEN) issued guidance in March of 2013 advising that Bitcoin exchangers and other related enterprises qualified as money transmitters under FinCEN's regulations implementing the Bank Secrecy Act.31 As a result, such businesses are obligated to register with FinCEN as money services businesses (MSBs) and comply with "know your customer" rules, put in place robust anti-money-laundering programs, and file Suspicious Activity Reports.32 Money transmitters must be licensed by each state in which they do business, so at the state level financial regulators have been grappling with how existing money transmission laws and regulations apply to Bitcoin businesses.33 New York has taken the lead in making these determinations. In August 2013, New York's Department of Financial Services subpoenaed almost two-dozen Bitcoin-related businesses, as well as investors in those businesses, seeking more information about their activities.34 And in January of 2014, the Department held two days of hearings looking at how Bitcoin businesses should be licensed, and considering the possibility of a iranians-discover-virtual-currency. " Russian authorities say Bitcoin illegal, Reuters, February 9, 2014, httplAvww.reuters.comfarticle/2014/02/09/us-russia-bitcoin-idUSBREA1806620140209. 3° Eli Dourado, Can the War on Drugs Bootstrap Bitcoin?, blog post, June 4, 2011, http://elidourado.com/blog/can-the-war-on•drugs-bootstrawbitcoint. 31 US Department of the Treasury, Financial Crimes and Enforcement Network, Application of FinCEN's Regulations to Persons Administering, Exchanging, or Using Virtual Currencies (Regulatory Guidance, FIN-2013-G001, US Department of the Treasury, Washington, DC, March IS, 2013), http://fincen.govistatutes_regs/guidance/htrnI/FIN-2013-G001.html. 32 Id. 33 Marco Santori, Bitcoin Law: Money transmission on the state level in the US, CoinDesk, September 28, 2013, http://www.coindesk.com/bitcoin-law-money- transmission-state-level-ust 3° Greg Farrell, N.Y. Subpoenas Bitcoin Firms in Probe on Criminal Risk, Bloomberg, August 12, 2013, http:l/www.bloomberg.com/news12013-08.12/n-y-regulator-subpoenas- firms-over-bitcoincrime-risks.html. 8 EFTA01074300  Discussion Draft — April 10, 2014 — Please do not cite. new "BitLicense" tailored specifically for virtual currencies.35 Law enforcement actions to date have also centered on money laundering and unlicensed money transmission. In May of 2013, federal agents seized $5 million from accounts belonging to Mt. Gox, which at the time was the world's largest bitcoin exchange.'° According to the seizure warrant, the company had not registered with FinCEN as a money services businesses and had stated in its bank application that it was not engaged in money services.37 In January of 2014, federal agents arrested Charlie Shrem, CEO of the now-shuttered exchange Bitlnstant, on charges of money laundering, operating an unlicensed money transmitter, and willful failure to file suspicious activity reports with FinCEN.38 According to the criminal complaint against Shrem, he knowingly helped a bitcoin reseller exchange dollars for bitcoins to be used on anonymous online black market Silk Road.39 In the near term, state regulators will likely continue to develop guidelines for applying money transmission licensing rules to Bitcoin businesses. For its part, FinCEN has begun to release administrative rulings clarifying the applicability of its regulations to specific business cases 40 Other federal regulators are also developing guidance to explain how their regulations apply to Bitcoin. For example, the Federal Election Commission 39 Cater Dougherty, New York Vying With California to Write Bitcoin Rules, Bloomberg, January 27, 2014, httplAvvirw.bloomberg.com/news/2014-01-27/new-york- duels-califomia-to-write-bitcoin-rules.html. 36 Amar Toor, US seizes and freezes funds at biggest Bitcoin exchange, The Verge, May 15, 2013, http://virww.theverge.com/2013/5/15/4332698/dwolla-payments-mtgox- halted-by-homeland-security-seizure-warrant. 37 Seizure Warrant — In the Matter of the Seizure of The contents of one Dwolla account (D. Md. May 14, 2013) (13.1162 SKG), http://cdn.arstechnica.net/wp- content/uploads/2013/05/Mt-Gox-Dwolla-Warrant-5.14-I3.pdf.; Affidavit in Support of Seizure Warrant (D. Md. May 9, 2013) (B-1085SAG), http://thegenesisblock.com/wp- content/uploads/2013/08/Gox-Wells-Fargo-Seizure-Warrant.pdf. 35 Sealed Complaint — United States of American v. Robert M. Faiella, a/k/a "BTCKing," and Charlie Shrem, No. 14-MAG-0164 (S.D.N.Y. January 24, 2014), http://www.justice.gov/usao/nys/pressreleases/January14/SchremFaiel laChargesPRJFaiel la, %20Robert%20M.%20and%20Charlie%20Shrem%20Complaint.pdf. 39 Id. eo Department of Treasury Financial Crimes Enforcement Network, Application of FinCEN's Regulations to Virtual Currency Mining Operations, FIN-2014-R001, January 30, 2014, http://www.fincen.govinews_room/rp/rulings/pdf/FIN-2014-R001.pdf; Department of Treasury Financial Crimes Enforcement Network, Application of FinCEN's Regulations to Virtual Currency Software Development and Certain Investment Activity, FIN-2014-R002, January 30, 2014, http:/Avww.fincen.goWnews_room/rp/rulings/pdf/FIN- 2014-R002.pdf. 9 EFTA01074301  Discussion Draft — April 10, 2014 — Please do not cite. has been looking at the question of bitcoin campaign contributions,m and the Internal Revenue Service recently issued guidance on the tax treatment of bitcoins.42 However, as we will argue in the following Section, the next major wave of regulatory scrutiny that Bitcoin will face will not be related to money transmission, but will instead come from financial regulators, including the Securities and Exchange Commission and the Commodity Futures Trading Commission, looking at Bitcoin-related financial instruments and markets. II. REGULATION OF BITCOIN-RELATED FINANCIAL INSTRUMENTS There is some debate about whether bitcoins qualify as currency, securities, commodities, or a new asset class altogether.43 Whatever the answer, the fact is that as the Bitcoin economy develops one should expect to see demand for Bitcoin-related financial instruments to emerge, and indeed such demand is already beginning to manifest itself. In this Section we survey some of these instruments and analyze how existing law and regulation may apply to them. A. Bitcoin Derivatives Over the course of 2013, regulators and central banks around the world issued warnings to consumers about the risks associated with Bitcoin.44 Chief among these risks is the currency's historical volatility. The dollar- denominated market price of one bitcoin began 2013 at around $13.41 and closed the year at around $817.12 in December.45 In that time, the price reached a high of $1,147.25 on December 4th, and experienced single-day gains of $198.09,46 and losses of $208.47 This volatility obviously presents a d1 Benjamin Goad, FEC: No bitcoins in federal campaigns, The Hill, November 21, 2013, http://thehill.com/blogs/regwatchttechnology/191096-fec-no-bitcoins-in-federal- campaigns. d2 John D. McKinnon and Ryan Tracy, IRS Says Bitcoin Is Property, Not Currency, Wall Street Journal, March 25, 2014, http://online.wsj.cominews/articles/SB10001424052702303949704579461502538024502. d3 Reuben Grinberg, Bitcoin: An Innovative Alternative Digital Currency, 4 Hasting Set& Tech. L.J. 160 (2011). d1 Law Library of Congress, Global Legal Research Center, Regulation of Bitcoin in Selected Jurisdictions, Report for Congress, LL File No. 2014-010233, January 2014, httplAvww.hsgac.senate.govidownload/regulation-of-bitcoin-in-selected-jurisdictions. 45 Price data from the CoinDesk Bitcoin Price Index, which aggregates price data from multiple exchanges that meet certain criteria; in this case, Bitfinex, Bitstamp, and BTC-e. See: Bitcoin Price Index Chart, CoinDesk, accessed March 27, 2014, http://www.coindesk.comipricelli2012-12-31,2013-12-30,close,bpi,USD. 46 Gains for trades between the closing prices on November 17 and November I8, 2013. See: Bitcoin Price Index Chart, CoinDesk, accessed March 27, 2014, 10 EFTA01074302  Discussion Draft — April 10, 2014 — Please do not cite. challenge to anyone looking to transact using Bitcoin. lb la1 1w Im 3rro p M .1,O1.20O to DK.). NT? Itolflat dint OOP COSY „ 11 Ott 10 Figure 1— Bitcoin-dollar exchange ratefor 2013. There is nothing inherently volatile about Bitcoin, however.48 Its volatility is likely attributable to the fact that it is a new currency, still in the process of discovering its stable price.49 Additionally, as a nascent currency, it is very thinly traded and as a result a single large-enough trade can affect the exchange price substantially. Positive news, such as major retailers announcing they will accept the currency, can make the price jump dramatically, while negative news, such as unfavorable regulatory pronouncements, can send the price plummeting. And greater media coverage of any kind will no doubt introduce more and more persons to Bitcoin for the first time and thus drive new demand for the currency. Despite this volatility, tens of thousands of merchants accept bitcoins for payment.5° The reason is that while Bitcoin's present volatility may http://www.coindesk.com/pricell/2012-12-31,2013-12-30,close,bpi,USD. 07 Losses for trades between the closing prices on December 5 and December 6, 2013. See: Bitcoin Price Index Chart, CoinDesk, accessed March 27, 2014, http://www.coindesk.com/price/#2012-12-31,2013-12-30,close,bpi,USD. " Indeed, volatility has historically trended down. See: Eli Dourado, Bitcoin Volatility is Down Over the Last Three Years. Here's the Chart that Proves It, blog, January 20, 2014, http://elidourado.com/blogibitcoin-volatility/. d9 Timothy B. Lee, These four charts suggest that Bitcoin will stabilize in the future, Washington Post, February 3, 2014, http://www.washingtonpost.com/blogs/the- switch/wp/2014/02/03/these-four-charts-suggest-that-bitcoin-will-stabilize-in-the-futuret S0 BitPay Announces Bitcoin Payroll API, BusinessWire, January 13, 2014, 11 EFTA01074303  Discussion Draft — April 10, 2014 — Please do not cite. make it an unstable store of value, it can nevertheless serve as an excellent medium of exchange.5I As Marc Andreessen has put it, "Bitcoin can be used entirely as a payment system; merchants do not need to hold any Bitcoin currency or be exposed to Bitcoin volatility at any time.i52 This means accepting bitcoins for payment at the current exchange rate and then immediately converting those bitcoins to dollars or some other stable currency. This is what Overstock.com, one of the largest retailers to accept bitcoins, does.53 Overstock CEO Patrick Byrne has explained that the company will not hold bitcoins saying, "Until we can hedge through some kind of derivative instrument, we don't want to take that direct exposure."54 An astute reader will no doubt be thinking: well, someone has to be holding the bitcoins. Speculators account for a large portion of bitcoin holdings,55 but what about bitcoins that are actively being transacted? In the case of Overstock.com, the retailer is employing merchant services from Coinbase, a Silicon Valley startup backed by Andreessen Horowitz.56 When you make a purchase at Overstock, prices are denominated in dollars, and if you pay in bitcoins, Coinbase accepts the bitcoins and deposits the dollar amount into Overstock's bank account. This means that it is Coinbase that is accepting the exchange volatility risk.57 For its services, Coinbase charges Overstock a fee of about 1%, which is less than the fees associated with other electronic payments such as credit cards.58 However, that 1% fee by itself might not be enough to cover the exchange rate risk that Coinbase faces. At the moment, Coinbase is hedging http://www.businesswire.cominews/home/20140113006504/en/BitPay-Announces-Bitcoin- Payroll-API.; New Coinabase for Android, and Coinbase Merchant App Released for Android, Coinbase Blog, December 29, 2013, http://blog.coinbase.com/post/71607045439Inew-coinbase-for-android-and-coinbase- merchant-app. 51 Marc Andreessen, Why Bitcoin Matters, New York Times, January 21, 2014, http://dealbook.nytimes.com/2014/01/21/why-bitcoin-matterst 32 Id. 53 Rob Wile, Bitcoin Is Experiencing Its Longest Stretch of Price Stability In a While, Business Insider, January 29, 2014, http://www.businessinsider.com/bitcoin-volatility- slows-2014-I. 54 Id. 55 Will Knight, Show Me the Bitcoins, MIT Technology Review, February 2014, http://www.technologyreview.com/graphiti/524796/show-me-the-bitcoinst 56 Cade Metz, The Grand Experiment Goes Live: Overstock.com Is Now Accepting Bitcoins, Wired Magazine, January 9, 2014, http://www.wired.com/business/2014/01/overstock-bitcoin-live/. 57 Id. SR What fees does Coinbase charge for merchant processing?, Coinbase support, February 5, 2014, http://support.coinbase.com/customer/portallarticlesil 277919-what-fees- does-coinbase-charge-for-merchant-processing-. 12 EFTA01074304  Discussion Draft — April 10, 2014 — Please do not cite. using algorithmic trading.59 Other merchant services companies, like Founders-Fund-backed BitPay, seem to employ a similar approach.° But this approach is not as efficient as simply engaging in a swap or futures contract. It is not surprising, therefore, that bitcoin payment processors and others are clamoring for bitcoin derivatives.6I Such instruments could help calm Bitcoin's volatility and could allow the network's infrastructure to further develop. There are several types of derivatives contracts that parties seeking to reduce their exposure to Bitcoin price volatility can employ. We consider Bitcoin forwards, futures, swaps, and options. These types of Bitcoin derivatives come within the orbit of regulation by the Commodity Futures Trading Commission (CFTC) pursuant to the Commodity and Exchange Act (CEA).62 However, because Bitcoin derivatives would likely involve physical delivery (as opposed to cash settlement) and would not be capable of being centrally cleared, they would not be subject to the full scope of CFTC regulation, if any. 1. Futures In a futures contract, one party agrees to deliver an underlying asset or its cash-equivalent to another at a later time at a specific price.6 A party concerned with Bitcoin prices decreasing would take the "short" position in a futures contract and agree to sell Bitcoin at a specific price. For example, on January 1st one party may agree to sell 1 bitcoin on February 1st for $800. This agreement would lock in a bitcoin-to-dollar exchange rate of 0.00125 BTC. A company that owns or expects to be paid in bitcoins, and is concerned about the value of bitcoins dropping against the dollar, would be protected against that risk. On the other hand, if bitcoins became more valuable after January 1st, the forward contract would still require the buyer to sell at what would be below-market prices. Futures contracts are by " Cade Metz, The Grand Experiment Goes Live: Overstock.com Is Now Accepting Bitcoins, Wired Magazine, January 9, 2014, http://www.wired.com/business/2014/01/overstock-bitcoin-livet c'e Greg Simon, Exclusive Interview with Bitpay CEO Tony Gallippi, December 28, 2013, http://lmowmadiclife.corniblog/2013/12/28/exclusive-interview-with-bitpay-ceo- allippi. °I Cade Metz, The Next Big Thing You Missed: There's a Sure-Fire Way to Control the Price of Bitcoin, Wired Magazine, January 14, 2014, http://www.wired.com/business/2014/01ibitcoin-derivatives/. 62 CEA, 7 USC §1 et seq. 63 Futures contract, CFTC Glossary, U.S. Commodity Futures Trading Commission Education Center, accessed March 27, 2014, http://www.cftc.goviconsumerprotectionteducationcenterkfIcglossarya John C. Hull, Options, Futures, and Other Derivatives 6 (6th ed. 2006) 13 EFTA01074305  Discussion Draft — April 10, 2014 — Please do not cite. definition highly standardized and trade on exchanges. Accordingly, trading a futures contract requires parties to open an account with a futures exchange and abide by its requirements such a posting collateral when entering the contract (initial margin) and paying more collateral if the market value of the contract decreases (variation margin). This is often done through an intermediary known as a futures commission merchant. The CFTC defines a future as lap) agreement to purchase or sell a commodity for delivery in the future" in which the price is determined at the outset of the agreement.64 With few exceptions, the definition of commodity is defined broadly to include all agricultural products and "all services, rights, and interests . . . in which contracts for future delivery are presently or in the future dealt in."65 The definition of commodity includes interest rates, foreign exchange rates, indices, and even weather events." Futures contracts for commodities are subject to the provisions of the CEA and are regulated by the CFTC and entities that have self-regulatory responsibilities, including exchanges and the National Futures Association (NFA). The key regulatory aspect of futures is that they are standardized with respect to all terms except for price,67 and can only trade on regulated exchanges.68 The CEA categorizes regulated futures exchanges as a type of designated contract market and as such they are required to comply with 23 "core principles.s69 These principles effectively require them to establish m Id. See also CFTC v. Erskin (6th Cit. 2008) (defining and distinguishing futures and forwards contracts), http://caselaw.findlaw.com/us-6th-circuit/1106725.htrnl. 65 7 U.S.C. § la(9). Two interests that fall outside of the definition of commodity include onions and motion picture box office receipts. Id. b6 See CEA Section la(19), 7 U.S.C. §1a(19) (defining "excluded commodity" to include a wide range of financial interests); CFTC Glossary, Weather Derivative (definitive "weather derivative" as "A derivative whose payoff is based on a specified weather event, for example, the average temperature in Chicago in January"), httriAvww.cftc.goviconsumerprotectionteducationcenter/cficglossary/glossary_wxyz. 67 Under some circumstances a non-standardized contract may be categorized as a futures contract. In re Bybee, 945 F.2d 309, 312.13 (9th Cir. 1991). 68 CEA § 6(a). 69 CEA § 5(b-x), 7 USC § 7(d). A DCM is defined as "a board of trade or exchange designated by the CFTC to trade futures, swaps, and/or options under the CEA. A contract market can allow both institutional and retail participants and can list for trading contracts on any commodity, provided that each contract is not readily susceptible to manipulation." Commodity Market, CFTC Glossary. http://www.ctic.goviconsumerprotectionieducationcenterkftcglossary/glossary_co; Core Principles and Other Requirements for Designated Contract Markets 77 Fed. Reg. 36612 (CFTC June 19, 2012), http://www.cftc.gov/ucm/groups/publici@lrfederalregister/documents/file/2012- 12746a.pdf. 14 EFTA01074306  Discussion Draft — April 10, 2014 — Please do not cite. and enforce rules to protect customers, prevent fraud and manipulation, maintain and disclose records, and maintain fair and orderly markets by, for example, enforcing position limits 40 Regulated exchanges are available to retail investors. A similar regulatory framework applies to derivatives clearing organizations.71 In addition, other futures market intermediaries are required to register with the CFTC and are subject to wide ranging regulation. These intermediaries include futures commission merchants that serve the function of brokerages,72 introducing brokers,73 commodity pool operators,74 and commodity trading advisers.75 The CEA and CFTC regulation impose a wide variety of requirements on these intermediaries, including obligations involving disclosure, reporting, recordkeeping, ethical requirements, protection of customer funds, and capital requirements.76 Bitcoins likely fall under the CEA's broad definition of commodity. Accordingly, any futures contract referencing bitcoins will be subject to the full scope of regulation under the CEA. This means that Bitcoin futures must be traded on existing regulated exchanges such as the Chicago Mercantile Exchange. Otherwise, any platform that offers Bitcoin futures 7° See also 7 U.S.C. 6g(e) (requiring exchanges to publicly disclose daily trading volume). 71 7 USC § 7a-1(c)(2). 72 CEA la(28); 7 USC la(28) (defining FCM). 73 7 U.S.C. la(31) (defining introducing broker). 74 7 U.S.C. la(11) (defining commodity pool operator); Harmonization of Compliance Obligations for Registered Investment Companies Required to Register as Commodity Pool Operators, 78 Fed. Reg. 52308 (CFTC Aug. 22, 2013). 7 U.S.C. la(12) (defining commodity trading advisor); CFTC v. Equity Financial Group LLP, 572 F.3d 150 (3d Cir. 2009). 76 7 U.S.C. 6d(a)(1) (FCM registration requirements); 7 U.S.C. 6d(a)(2) (FCM customer funds segregation duties); 78 Fed. Reg. 68506, Enhancing Protections Afforded Customers and Customer Funds Held by Futures Commission Merchants and Derivatives Clearing Organizations„ Nov. 14, 2013 http://www.gpo.gov/fdsys/pkg/FR-2013-11- 14/pdf/2013-26665.pdf; 7 U.S.C. 6d(c) (requiring FCMs and introducing brokers to implement conflicts-of-interest systems); 7 U.S.C. 6g (reporting and recordkeeping requirements for futures commission merchants, introducing brokers, and floor brokers and traders); 7 U.S.C. 6f(cX2) (risk assessment recordkeeping requirements for futures commission merchants); 7 U.S.C. 6d(g) (introducing broker registration requirement); CFTC, Minimum Net Capital Requirements for Futures Commission Merchants and Introducing Brokers, http://www.cfrc.gov/IndustryOversight/Interrnediaries/FCMs/fcmibminimumnetcapital; 7 U.S.C. 6m(1) (registration requirements for CTAs and CFOs); 7 U.S.C. 6o(1) (prohibiting fraud by commodity trading advisers and commodity pool operators); 77 Fed. Reg. 20127- 20215 (CFTC Apr. 3 2012) (obligations of futures commission merchants); 7 U.S.C. 6n(3)(A) (recordkeeping requirements for commodity trading advisers and commodity pool operators); 77 Fed. Reg. 11252 (CFTC Feb. 24 2012) (compliance obligations for commodity pool operators and commodity trading advisers). 15 EFTA01074307  Discussion Draft — April 10, 2014 — Please do not cite. would have to come into compliance with the wide-ranging and costly regulation required of futures exchanges by the CEA. 2. Forwards A forward is a contract whereby parties agree to trade an asset at a later date at a price specified in the present." In a currency forward, for example, one party agrees to trade the currency with another at a later date at a pre- specified exchange rate." Currency forwards are one of the most widely used and liquid financial instruments.79 Forwards are generally heavily negotiated to be tailored to the specific risks and other terms that parties are concerned about. The distinction between a futures and a forward is not always clear and often depends detailed analysis of the facts and circumstances of the contract. The general distinction is that, compared to futures, forwards are non-standardized, do not trade on an exchange, and are intended for actual delivery of the commodity (as opposed to cash settlement).8° Other courts have articulated the distinction as being that futures markets are for the sale of contracts while forward markets are for the sale of commodities.81 Importantly, forward contracts are not subject to CFTC regulation.82 The court in CFTC v. Erskine explained the underlying policy: 77 Forward Contract, CFTC Glossary, U.S. Commodity Futures Trading Commission Education Center, accessed March 27, 2014, httriAvww.cftc.goviconsumerprotectionieducationcenterkficglossarya Hull, supra note 63, at 3.4. 71I 7 U.S.C. la(24). " Swap, CFTC Glossary, U.S. Commodity Futures Trading Commission Education Center, accessed March 27, 2014, http://www.cftc.goviconsumerprotectionieducationcenterkficglossaryt 8° Forward contract, CFTC Glossary, U.S. Commodity Futures Trading Commission Education Center, accessed March 27, 2014, http://www.cftc.goviconsumerprotectionieducationcenterkficglossaryt See al