Ether’s Security Designation Creates Risk of Market Disruption

A special purpose broker dealer, or SPBD, recently disclosed unilaterally that it would soon custody the digital asset ether, known as ETH, as a digital asset security. This move raises unknown legal consequences and profound confusion for industry participants and customers.

The SPBD, licensed with the Securities and Exchange Commission, made the announcement although ETH is commonly regarded as a non-security by most of the crypto industry, including the Commodity Futures Trading Commission.

Today, futures on ETH trade on multiple CFTC-registered exchanges, and through multiple CFTC-registered futures brokerage entities. If ETH is a security, however, these products are effectively transformed into a different type of financial instrument—a security future on a single security—that’s subject to joint SEC and CFTC oversight.

Generally, industry participants in transactions involving security futures must be dual-registered with the CFTC and SEC and comply with a host of additional obligations.

For example, a futures brokerage company—known as a futures commission merchant—that must also notice register as a securities broker-dealer to transact in security futures, must apply suitability and best execution requirements to customers and orders regarding that product—obligations it doesn’t have for customers and orders involving ordinary futures.

Such dual registered entities must also provide prospective customers a special disclosure document related to security futures before accepting a customer’s first order.

Ordinarily, the underlying security of a single-security futures contract must be common stock formally registered with the SEC and traded on a national stock exchange. The SEC and CFTC, however, can agree for another type of financial instrument to be the referent for a single-security futures contract, provided such adaptation “is necessary or appropriate in the public interest and is consistent with the protection of investors.”

However, nothing in the public record suggests the SEC and CFTC are in dialogue, let alone have formally agreed, regarding authorizing security futures on ETH.

Another possibility is that the SEC unilaterally might do all of the following:

  • Formally support the SPBD’s claim that ETH is a security
  • Acknowledge that futures on ETH are currently security futures
  • Unilaterally issue an exemptive order under Section 36 of the Securities Exchange Act of 1934, exempting futures on ETH from having to comply with any provision of the act related to security futures.

Under this scenario, such products would continue to trade as futures and not security futures.

In December 2020, the SEC used this authority to issue an exemptive order allowing the Minneapolis Grain Exchange to trade security futures on the SPIKES index (tracking volatility on the S&P 500) as futures.

However, a federal court disallowed this exemptive order on the grounds the SEC “failed adequately to explain its rationale and failed to consider an important aspect of the problem”— mainly “the potential resulting harms to SPIKES futures investors” that wouldn’t receive certain important risk disclosures had the product continued to trade as security futures.

Under law, in addition to security futures on individual securities, there are security futures on narrow-based security indexes. Among other elements, these indexes generally have at least one of the following:

  • Nine or fewer component securities
  • Any one component constitutes more than 30% of the index’s weighting
  • The five highest-weighted component securities constitute more than 60% of the index’s weighting.

Because the weighting of individual securities in an index often changes depending on market fluctuations, security indexes can morph from narrow-based to broad-based and vice-versa. A futures contract on a broad-based security index isn’t considered a security futures contract and is under the sole oversight of the CFTC. Existing law provides for orderly migration of futures contracts to security futures contracts over five to six months to avoid market disruption and customer harm.

All these issues arise because of the nature of an SPBD under a “statement” issued by SEC staff in December 2020. The statement indicated that for five years, the SEC would take no action against any firm that registered as an SPBD that handled solely digital asset securities.

One of the requirements of an SPBD is to establish, maintain, and enforce policies and procedures to determine whether a digital asset is a security offered and sold pursuant to an effective registration statement or an exemption from registration. According to the statement, the SEC isn’t required to review a determination made by an SPBD that a digital asset is a security, let alone approve it.

Industry participants and customers must consider the consequences of these developments. It’s also possible that, under a provision of law adopted in connection with the Dodd-Frank Act—any person proposing to list or trade futures on ETH going forward could file a notice with the SEC and CFTC for their formal assessment regarding whether the product is a security or non-security.

However, the chairs of the SEC and CFTC should determine together how to handle this potential development to minimize market disruption that likely will occur should the SPBD begin custodying ETH as a digital asset security without such coordination.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

Gary DeWaal is senior counsel for financial markets and funds at Katten.

Daniel J. Davis is partner and co-chair for financial markets and regulations at Katten.

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2024-04-02 08:30:00

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