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What U.S. Regulations Apply to Bitcoins as Commodities?
Are bitcoins commodities? In a previous article I showed that, under U.S. law, bitcoins are neither securities nor currency. So, what are bitcoins? Furthermore, what regulations, if any, apply to bitcoins designated as a commodity?
Bitcoins Are Commodities
Bitcoins are commodities. A “commodity” is defined under U.S. law as “[a] useful thing; an article of commerce; a moveable and tangible thing produced or used as the subject of barter or sale.” Ballentine’s Law Dictionary; See State ex rel. Moose v Frank, 114 Ark 47, 169 SW 333. A thing is tangible if it is “[c]apable of being possessed or realized; readily apprehensible by the mind; real; substantial; evident.” Ballentine’s Law Dictionary; See Williams v Board of Comrs. 84 Kan 508, 114 P 858.
Bitcoins are tangible, because each bitcoin is constructively possessed. Constructive possession is “control or dominion over a property without actual possession,” compared to actual possession, which is “[p]hysical occupancy or control over property” (Black’s Law Dictionary (9th ed. 2009), possession). U.S. courts have interpreted constructive possession to include, “an appreciable ability to guide the destiny” of the thing. United States v. Culpepper, 834 F.2d 879, 881 (10th Cir. Kan. 1987). Examples include electronic contracts, currency, child pornography, etc. See Pyro Spectaculars North, Inc. v. Souza, 2012 U.S. Dist. LEXIS 15801, 9-10 (E.D. Cal. Feb. 8, 2012); United States v. Moreland, 665 F.3d 137 (5th Cir. Miss. 2011); Walker v. United States, 2010 U.S. Dist. LEXIS 108981 (M.D. Ga. May 24, 2010); United States v. Riccardi, 258 F. Supp. 2d 1212 (D. Kan. 2003). Furthermore, many statutory provisions rely on constructive possession of electronic data, e.g., UCC 9-102(31) and 9-105.
Bitcoins are clearly useful articles of commerce capable of being possessed. Bitcoins are traded online every day for goods, services, U.S. dollars, and other currency. Each bitcoin is also controlled by a specific user. Even though every node on the bitcoin peer-to-peer network has knowledge of the bitcoins in each bitcoin wallet, however, the bitcoins in a particular wallet can be distributed only by the person with the bitcoin wallet.
U.S. Regulations Imposed on Commodity Contracts
Bitcoin is a commodity, but currently most bitcoin transactions are not subject to regulation by the U.S. Commodity Futures Trade Commission (“CFTC”), because bitcoins fall under an exception, 7 U.S.C. 1A(19). The CFTC was created by the U.S. congress through the Commodity Futures Trading Commission Act of 1974 (the “‘74 Act”). The mandate for the CFTC has been renewed through the recent Dodd-Frank Act. The ‘74 Act §2(a)(1)(A) gave the CFTC “exclusive jurisdiction” over all transactions that are substantially similar to, or commonly known as, an “option”, “bid”, “offer”, “put”, “call”, etc., and “transactions involving contracts of sale of a commodity for future delivery.”
The U.S. does not regulate commodity contracts whether delivery is made at the point of purchase (“PoP”), or is deferred; but, commodity options contracts are heavily regulated by the CFTC. See The Commodity Futures Trading Commission Act of 1974. The CFTC interprets the meaning of commodities broadly. A ”commodity” as defined under Commodity Exchange Act (7 U.S.C. 1A(4)) is:
wheat, cotton, rice, corn, oats, barley, rye, …, livestock, livestock products, …, and all services, rights, and interests …, in which contracts for future delivery are presently or in the future dealt in.
Not intuitively, however, the CTFC limited the use of the term “future delivery” such that the CFTC does not regulate commodities futures contracts (Commodity Exchange Act (7 U.S.C. 1A(19)):
The term “future delivery” does not include any sale of any cash commodity for deferred shipment or delivery.
A cash commodity is simply an actual physical commodity someone is buying or selling.
It is important to understand that even though the the ‘74 Act states “contracts of sale of a commodity for future delivery,” the types of contracts for future delivery regulated by the CFTC are traditionally known as options. Therefore the use of the term “forward contract” will refer to the commodity contracts exempted from regulation by the CFTC, the use of the term “options contract” will refer to the commodity contracts regulated by the CFTC. See In re Stovall, [1977-1980 Transfer Binder] Comm. Fut. L. Rep. (CCH) (CFTC Dec. 6, 1979).; and CFTC v. Zelener, 387 F.3d 624 (7th Cir. Ill. 2004). The issue then is to determine if the sale of a commodity is a forward contract or an options contract.
Differences Between Commodity Forward Contracts and Commodity Options Contracts
Forward contracts (a subset of futures contracts) are transferable contractual agreements to buy or sell a fixed amount of a certain commodity on a specified date; options contracts are the right to buy or sell a specified amount of a commodity within a certain period of time at a given price (called the strike price). Commodity Futures Trading Com. v. U. S. Metals Depository Co., 468 F. Supp. 1149, 1154-1155 (S.D.N.Y. 1979). Three functional distinctions between forward contracts and options contracts are (id. at 1155):
The holder of a forward contract is obligated to receive the commodity, whereas a holder of an options contract is not;
The price of a forward contract is applied to the ultimate sales price of the commodity, whereas the price of an option charges the buyer an initial nonrefundable premium; and
Profit of a forward contract is realized when the actual sale price of the commodity exceeds the purchase price of the contract, whereas profit of an options contract is realized when price of the commodity increases beyond the strike price plus the premium.
U.S. courts look at three factors to determine whether a commodities contract is an options contract (including transactions in options involving foreign currency) (In re Stovall, [1977-1980 Transfer Binder] Comm. Fut. L. Rep. (CCH) (CFTC Dec. 6, 1979)):
Directed operation to the general public,
Standardized contracts, which resemble futures contracts, and
Where the buyer does NOT take delivery of the commodity (most important).
The focus of the factors is to determine if the parties’ had a general expectation of delivery of the underlying commodity. See Id. In Stovall’s case, there was a single receiver for all purchasers of the contracts, therefore the court found that the contracts Stovall referred to as forward contracts were, instead, correctly designated as options contracts. Remember, U.S. courts will look to substance over form to determine whether a commodity contract is a forward or options contract. See Commodity Futures Trading Com. v. U. S. Metals Depository Co., 468 F. Supp. 1149.
Even commodity options contracts based on “spot and cash market” (e.g. contracts related to silver bullion, silver coin, foreign currency, etc. where the commodity is immediately received) are not beyond the scope of the ‘74 Act. CFTC v. American Board of Trade, Inc. 473 F. Supp. 1177 (S.D.N.Y. 1979). Metals Depository Co. sold options contracts of gold and silver, and argued that the ‘74 Act did not regulate options contracts unless those options pertain to future delivery. Id. The court disagreed and ruled that the ‘74 Act gives the CFTC exclusive jurisdiction over all commodity options contracts, including options contracts for foreign currency. Id.
Bitcoins are commodities, but, for the vast majority of transactions, bitcoins are not regulated by the CFTC. Most transactions on bitcoin exchanges are directed to the general public, however, standard contracts are not used and the buyer does intend to accept delivery of the bitcoins sold.
There are a handful of websites online that sell bitcoin forward contracts. These bitcoin forward contracts are usually sold by individual bitcoin miners. Successfully mining fifty bitcoins can take months, even for miners with considerable computing power. The BTCUSD market (where bitcoins are sold for U.S. dollars), however, is very volatile and subject to frequent crashes, and miners have a strong incentive to hedge against potential BTCUSD (or other currency) downturns by selling futures contracts. Furthermore, futures contracts provide leverage for miners to buy equipment to increase bitcoin production.
Bitcoin forward contracts do not have any of the characteristics of an options contract, and thus do not fall under the jurisdiction of the CFTC. The seller is obligated to send, and the buyer is obligated to receive, the bitcoins bargained for; the seller does not merely give the value the buyer would have received had the bitcoins actually been sent and received. The price of the forward contract is the price the bitcoins are being sold for, not simply a premium for the option to buy the bitcoins at a later time. The profit is realized when the bitcoins are received and exchanged, not when the exchange rate increases beyond both a strike price plus a non-refundable premium. Thus, bitcoin forward contracts are not regulated by the CFTC.
Bitcoin forward contracts sold primarily by large mining pools are not common place yet, however, bitcoin futures contract markets may soon evolve and become mainstream. Pools are groups of miners that combine computing power to increase the production of bitcoins. Pools divide the bitcoins produced between the members of the pool based on the amount of computing power donated by each member. The majority of bitcoins successfully mined are done so through mining pools because the combined computing power of a pool typically far outweighs an individuals computing capacity.
If a standardized futures market emerges where the sellers of the contracts are miners or mining pools, then contracts will likely not fall under the regulatory regime of the CFTC. If, however, a standardized futures market emerges where buyers may resell contracts, those transactions will fall under the jurisdiction of the CFTC. The most important prong of “the options test” is whether the buyer takes delivery of the commodity. In re Stovall, [1977-1980 Transfer Binder] Comm. Fut. L. Rep. (CCH) (CFTC Dec. 6, 1979). As long as buyers do not become the sellers, then clearly the buyers will take delivery of the commodity, and the CFTC does not have jurisdiction.
The emergence of bitcoin exchanges and brokers like Mt. Gox (largest bitcoin exchange located in Japan) and Bitcoinica (written by a 17 year old in Singapore), bring to light the realization that Bitcoin is dominated by nerds with the capacity to implement complex financial infrastructures and instruments very quickly. Bitcoinica, in particular, which already offers margin and interest bearing deposit accounts, may soon provide a standardized market for bitcoin futures contracts. It may also decide to offer bitcoin options contracts. I expect, however, strictly based on the overhead of regulation, to see standardized bitcoin futures contracts sold exclusively by mining pools, followed closely behind by bitcoin options contracts.
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