For US digital assets fund managers that want to trade on offshore cryptocurrency derivative exchanges, a significant challenge is that such exchanges are often limited to non-US persons or “eligible contract participants” (ECPs) to avoid US commodities regulations. Similarly, many offshore non-derivative exchanges and issuers of initial coin offerings (ICOs) restrict their participants to non-US persons to avoid US securities regulations.
A creative solution for US managers attempting to participate in offshore non-derivative exchanges and ICOs involves utilizing an arm’s length transaction free of ownership (i.e. a participation agreement) between an offshore fund that is a permitted non-US person and a US investment vehicle. The participation agreement is a novel structure that may allow US managers to take advantage of some investment opportunities generally not available to US investors. However, would the same approach succeed with an offshore exchange for cryptocurrency derivatives/futures? Many offshore cryptocurrency derivatives exchanges carry the same “no US persons” requirement. However, in addition to avoiding any potential US securities regulations and tax concerns, these exchanges are also trying to comply with CFTC rules and regulations.
Regulatory Concerns of Offshore Cryptocurrency Derivative Exchanges
The CFTC considers cryptocurrency to be a commodity and has the authority to regulate exchanges for cryptocurrency derivatives and the funds that invest in them. As a result, many of these exchanges do not allow US participants except for those who are ECPs as defined by the CFTC. Derivatives exchanges limited to ECPs may not be required to register with the CFTC. Therefore, a US manager could potentially gain access to these exchanges by either (1) managing a US fund that is considered an ECP or (2) entering into a participation agreement with a non-US fund that is allowed on the exchange.
Of the two above options, the latter is certainly preferable as many managers will not be able to qualify their funds as ECPs. However, even if the participation agreement does allow US managers to bypass an exchange’s no US person requirement, it may still cause issues for the participating funds and the exchange. If the fund trading on the exchange is considered a commodity pool with US customers, then the CFTC may have a cause of action against the exchange for allowing non-ECP, US customers access to an unregulated derivatives exchange. As a result, the exchange would be required to register with the CFTC as a futures commission merchant (FCM), and any offshore exchange seeking to avoid US compliance obligations would undoubtedly not allow any participants who would bring about registration requirements.
There is a chain of analysis regarding whether, under the participation agreement structure, the US fund manager or the exchange would be subject to CFTC registration and disclosure requirements. First, is the US fund considered a commodity pool as defined by the CFTC? Second, if so, is the special purpose vehicle (SPV) serving as the corresponding offshore fund (with which the US fund enters a participation agreement also a commodity pool that is subject to CFTC regulation? Third, if the SPV is required to register under the CFTC, will the exchange be subject to FCM registration and disclosure requirements?
Based off existing CFTC rules and guidance, there is no clear answer as to whether the US entity that has a participation agreement with the offshore SPV would be considered a commodity pool. However, if the US entity is deemed a commodity pool, then the SPV and the exchange will likely be subject to CFTC registration and disclosure requirements.
- Is the US fund a commodity pool?
The CFTC defines “Commodity Pool” to “include any investment trust, syndicate, or similar form of enterprise operated for the purpose of investing in commodity interests.” This definition includes commodity pools that invest in commodity interests indirectly though other commodity pools. Beyond the language in the statute, we also have CFTC guidance stating that the term “created for the purpose of” should be interpreted broadly and not interpreted to exclude investment vehicles created primarily for other purposes.
The question, then, is whether the CFTC would deem the US entity as created for the purpose of investing in commodity interests given the statutory definition and past guidance. Here, although the fund technically would not “invest” in anything (it’s more a party to a contractual agreement), it would be created with the ultimate purpose of allowing US investors access to returns on commodity interests. With this mind, the CFTC would have a reasonable argument that the US entity is a commodity pool because it is effectively an investor in another commodity pool (the SPV) even if the “investment” is not structured as a traditional shareholder interest. In other words, the CFTC can argue that the US entity was created for the purpose of investing in commodity interests, even though it does no traditional investment on its own. Therefore, while there is an argument to be made on both sides, there is no guarantee that the CFTC will conclude that the US entity falls outside of their jurisdiction. Moving forward assuming the CFTC will conclude otherwise could be risky for the US fund manager and the exchange.
- Is the SPV subject to CFTC registration and disclosure requirements?
If the US entity is considered a commodity pool, there is likely a disclosure/registration requirement for the offshore SPV. The reasoning is three-fold.
First, a foreign entity with US customers that trades on a foreign exchange is subject to CFTC registration requirements. Likewise, as discussed above, if the US entity is considered a commodity pool, then the CFTC will likely argue that it is a commodity pool because the US entity participates in another commodity pool (the SPV). Therefore, the US entity could be a “customer” of the SPV in the CFTC’s eyes and require the SPV to register.
Second, there is some relief from disclosure, reporting and recordkeeping requirements for certain foreign pools that potentially sheds some light on the CFTC’s view of which non-US pools should be exempt from registration. CFTC advisory 18-96 states that a CPO does not have to disclose information on exclusively foreign pools that is manages. In the participation agreement structure, the SPV will likely be managed by a different CPO (management entity), and this exemption may not directly apply. However, it does offer insight into the CFTC’s concern with foreign pools and how they are likely to interpret the participation agreement scenario.
To take advantage of the relief, the CPO must follow certain requirements designed to ensure the foreign pool is removed from US involvement. There are three requirements of note that offer guidance here. First, the foreign pool must have no shareholders or other participants that are US persons. Second, the pool may not receive, hold, or invest any capital directly or indirectly contributed from sources in the US. Third, neither the pool, the manager, or any affiliate of either may undertake any marketing activity that could attempt to solicit participation from US persons.
Based off these three requirements, we see that the CFTC is concerned with pools that have even indirect ties to US persons through either affiliate marketing or indirectly contributed US capital. Therefore, since a participation agreement involves the SPV receiving some sort of capital from the US entity, the CFTC may see the transaction as one that brings about registration and disclosure requirements.
Third, the regular exemption to non-US managers may not apply to the foreign manager of the SPV. Generally, foreign CPOs with foreign customers that trade on foreign exchanges are not subject to registration requirements. However, if the foreign manager does have US customers, then it is only exempt if, among other things, it executes trades through a registered FCM. As discussed above, the foreign pool may be determined by the CFTC to have a US customer base. Therefore, the manager would only be exempt if the exchange it uses is a registered FCM – the exact requirement many offshore cryptocurrency derivative exchanges will be trying to avoid.
- Would the foreign cryptocurrency derivative exchange be subject to CFTC registration requirements?
As stated above, if the US entity is considered a commodity pool under CFTC jurisdiction, then the SPV may also be subject to CFTC regulations. In that case, the CFTC would require the foreign cryptocurrency derivative exchange to register as an FCM.
The CFTC generally has jurisdiction over exchanges not limited to ECPs. However, these exchanges fall outside of CFTC jurisdiction if the exchange is domiciled outside of the US and only has non-US customers.
If the participation agreement structure is used, it is likely that the SPV attempting to trade on the exchange is not an ECP. Further, if the SPV is required to register with the CFTC, it is likely because the CFTC sees the SPV as having ties to US customers. Therefore, if the SPV trades on the exchange, the CFTC will see that unregulated trading is occurring and could go after the exchange for not being registered.
Conclusion
To summarize, the participation agreement structure is a unique method potentially allowing US-based investors to participate in offshore cryptocurrency exchanges and ICOs. However, the participation agreement may not allow the same investors to participate in offshore cryptocurrency derivative exchanges as the CFTC may exert registration and disclosure requirements on the participating funds and the exchange, meaning the exchange would not want to allow the arrangement in the first place.
