New Disclosure Rules Enhance Crypto Investor Protection

Amid concerns that many investors may not fully understand the risks associated with virtual currencies, or the limits of regulatory oversight, the National Futures Association (NFA) recently issued an interpretive notice titled Disclosure Requirements for NFA Members Engaging in Virtual Currency Activities. Here is what you need to know about the new rules and how they might impact you as a market participant or a customer.

1. Which products does the notice apply to?

The notice is aimed at virtual currency derivatives, such as futures, options and cleared swaps. The NFA stated these products “have a variety of unique and potentially significant risks” that are often misunderstood by customers, including the substantial risk of loss.

2. What is the extent of the disclosure?

(a)  FCMs and IBs.

Under the new rules, futures commission merchants (FCMs) and introducing brokers (IBs) will be required to provide both current and prospective customers that engage in a virtual currency derivative transaction with or through the FCM or IB with the NFA Investor Advisory, Futures on Virtual Currencies Including Bitcoin, and the Commodity Futures Trading Commission CFTC Customer Advisory, Understand the Risks of Virtual Currency Trading.

Such FCMs and IBs will also be required to provide standardized disclosure stating that underlying or spot virtual currencies are not regulated by the NFA. Although the notice becomes effective on Oct. 31, FCMs and IBs will have until Nov. 30, 2018, to provide the standardized disclosure to their previous customers who have traded virtual currency derivatives.

(b)  CPOs and CTAs.

Other NFA members, specifically commodity pool operators (CPOs) and commodity trading advisors (CTAs), will be required to address the following items if they are relevant to their activities, and explain the risks associated with each item:

• Unique Features of Virtual Currencies: Virtual currencies are not legal tender in the United States, and many question whether they have intrinsic value.
  
  
• Price Volatility: The price of a virtual currency is based on the perceived value of the virtual currency and is subject to changes in sentiment, which makes these products highly volatile.
  
  
• Valuation and Liquidity: Virtual currencies can be traded through privately negotiated transactions and through numerous virtual currency exchanges and intermediaries around the world. The lack of a centralized pricing source makes valuation more difficult, and dispersed liquidity may pose challenges as well.
  
  
• Cybersecurity: The cybersecurity risks of virtual currencies and related “wallets” or spot exchanges include hacking vulnerabilities and a risk that publicly distributed ledgers may not be immutable.
  
  
• Opaque Spot Market: Virtual currency balances are generally maintained as an address on the blockchain and are accessed through private keys. Although virtual currency transactions are typically publicly available on a blockchain or distributed ledger, the public address does not identify the controller, owner or holder of the private key. This poses an increased risk of manipulation and fraud.
  
  
• Virtual Currency Exchanges, Intermediaries and Custodians: Virtual currency exchanges, and other intermediaries, custodians and vendors used to facilitate virtual currency transactions, are relatively new and largely unregulated in both the United States and many foreign jurisdictions.
  
  
• Regulatory Landscape: Virtual currencies currently face an uncertain regulatory landscape in the United States and many foreign jurisdictions. In the United States, virtual currencies are not subject to federal regulatory oversight but may be regulated by one or more state regulators. Many virtual currency derivatives are also regulated by the CFTC, and the Securities and Exchange Commission has cautioned that many initial coin offerings are likely to fall within the definition of a security and therefore will be subject to U.S. securities laws.
  
  
• Technology: The relatively new and rapidly evolving technology underlying virtual currencies introduces unique risks. For example, the loss, theft or destruction of a private key may result in an irreversible loss.
  
  
• Transaction Fees: Processing transactions and recording them on a blockchain is usually done by “miners” for a fee. These fees may vary significantly.

In addition to disclosing the risks described above, CPOs and CTAs must provide standardized disclosure clarifying that the NFA does not oversee virtual currencies, virtual currency exchanges, custodians or markets. Finally, they must disclose the specific risks associated with virtual currency derivatives. Although their promotional materials must be updated by Oct. 31, they will receive an additional 21 days (i.e., until Nov. 21, 2018) to update disclosure documents and offering documents and notify their customers accordingly.