BitMEX BSA Case Raises Key Crypto Questions
The last two weeks have seen a flurry of activity in U.S. v. Hayes, the case against the founders of cryptocurrency exchange Bitcoin Mercantile Exchange, or BitMEX, in the US District Court for the Southern District of New York. First, on Feb. 24, two of the four indicted defendants pled guilty to violating the Bank Secrecy Act.1
On Feb. 28, the judge denied the defendants' motion to dismiss the indictment on due process grounds. And on March 7, a change of plea hearing for a third defendant was scheduled for March 9. So it appears that only one defendant currently plans to proceed to trial.
Although the court denied the defendants' motion to dismiss, the briefing surrounding that motion raised some interesting and timely questions regarding regulatory uncertainty in the digital assets space, some of which may be raised to the jury at trial.
What are cryptocurrencies—commodities, securities or something else? What are the laws and regulations that apply to cryptocurrency exchanges? And does the uncertainty surrounding these questions mean that the defendants lacked the requisite knowledge and intent to violate the BSA?
BitMEX is an online trading platform and exchange founded in 2014 that allows users to trade cryptocurrency derivatives, including bitcoin futures and bitcoin perpetual swaps.
In late 2020, an indictment was returned against BitMEX's founders, including its former CEO, Arthur Hayes; its former chief operating officer, Benjamin Delo; its former chief technology officer, Samuel Reed; and its former head of business development, Gregory Dwyer.
The indictment alleges that BitMEX was a futures commission merchant, or FCM, under the Commodity Exchange Act,2 and that the BSA therefore required BitMEX to establish anti-money laundering and know-your-customer programs.
The indictment further alleges that the defendants incorporated BitMEX abroad in order to avoid complying with the BSA, but then knowingly continued to facilitate trades from thousands of customers located in the US. 3
Hayes and Delo pled guilty Feb. 24. Reed appears to be planning to plead guilty this week. Dwyer's trial is set for Oct. 24.
Before the guilty pleas, the defendants filed a joint motion to dismiss, claiming they lacked notice that the BSA applied to BitMEX, and therefore arguing that the indictment violates their due process rights.
The defendants first argued that they were not on notice that BitMEX was required to register with the US Commodity Futures Trading Commission as an FCM.
They also argued that because the regulatory status of cryptocurrencies is unsettled, the defendants were not on notice that cryptocurrencies are commodities under the Commodity Exchange Act.
In response, the government argued that an indictment need only provide a plain statement of the essential facts constituting the offense charged in order to proceed to trial.
On Feb. 28, the court denied the motion to dismiss, and stated that the Indictment sufficiently alleged that the defendants knew that BitMEX was required to have compliant anti-money laundering procedures, and that BitMEX nonetheless lacked such procedures.
At trial, the government will have to prove that the remaining defendant knew or should have known that the BSA applied to BitMEX, and yet willfully failed to comply with the associated requirements, including establishing an anti-money laundering program.
If the defendant can offer evidence regarding regulatory uncertainty—such as expert testimony on the regulatory status of other entities, which the government has moved to preclude—he will likely argue that this uncertainty meant that he did not know, and could not have known, that the BSA applied to BitMEX.
This issue—what the defendant knew and intended—will be the key question for the jury to resolve at trial.
Was BitMEX a futures commission merchant?
The first argument in the defendants' motion to dismiss concerned whether BitMEX is properly classified as an FCM.
The government conceded that if BitMEX was not an FCM, then the BSA would not have applied during the period charged in the indictment, September 2015 to September 2020.4
In claiming that BitMEX was required to register as an FCM, the government relied primarily on the plain language of the statute.
Under the Commodity Exchange Act, an FCM is an entity "engaged in soliciting or accepting orders for the purchase or sale of a commodity for future delivery;. . .a swap" or other retail commodity transactions, and that, in connection with these activities, "accepts any money, securities, or property (or extends credit in lieu thereof) to margin, guarantee, or secure" such transactions.5
According to the indictment, BitMEX is an FCM under this definition because it solicited and accepted orders for trades in futures contracts and other derivative products tied to the value of cryptocurrencies, including bitcoin, and because it accepted bitcoin to margin and guarantee its derivative products.
According to the government, a plain reading of the statute required BitMEX to register as an FCM and comply with the BSA.
The defendants argued in response that an FCM historically was understood to be a financial intermediary between investors and futures markets—meaning that it would act as an agent for customers and send orders to a separate exchange for execution.
Because BitMEX was itself an exchange, the defendants argued that it was more properly classified as a designated contract market; foreign board of trade; derivatives clearing organization; or swap execution facility.6
To be clear, BitMEX did not register under any of these other categories either.7
The defendants responded that, in practice, the CFTC has not required exchanges to register as FCMs. The defendants provided several examples where exchanges that performed functions similar to BitMEX have registered with the CFTC as designated contract markets, swap execution facilities or derivatives clearing organizations, but have not been required to register as FCMs.
And the publicly available FCM registration database shows that several other peer-to-peer and derivatives trading exchanges are not, even now, registered as FCMs.8The defendants also pointed to CFTC Commissioner Dawn Stump's recent concurrence in an enforcement action, where she said that it would be "unprecedented for an entity to register both as a [designated contract market] and FCM."9
The defendants argued that, considering this broader context, exchanges like BitMEX would not have realized that the CFTC expected them to register as FCMs.
Of course, whether or not the CFTC has failed to enforce the registration requirement as to other exchanges would not excuse the defendants' failure to register if they knew or should have known they were required to do so.
And according to the government, it will present evidence at trial that the defendants did know that they were required to register and comply with the BSA.
The court therefore agreed that dismissal at this stage was not appropriate and that the government should have an opportunity to prove the defendants' knowledge and intent at trial.
What are cryptocurrencies?
This leads to the defendants' second set of arguments, which also related to regulatory uncertainty.
Specifically, the defendants argued that BitMEX was required to register as an FCM only if bitcoin and other cryptocurrencies were commodities under the Commodity Exchange Act, and that this question remained unsettled during the relevant period.
The CFTC defines a commodity, in relevant part, as "all other goods and articles ... and all services, rights, and interests ... in which contracts for future delivery are presently or in the future dealt in."10
Cryptocurrencies arguably fall under this broad definition. Beginning in late 2014, the CFTC noted in public testimony before Congress that virtual currencies such as bitcoin may fall within the CFTC's jurisdiction.11
And in late 2015, the CFTC issued two public enforcement orders in which it stated that bitcoin was a commodity under the Commodity Exchange Act.12
Courts, including in the Southern District of New York, have also interpreted Section 1a(9) of the Commodity Exchange Act to include cryptocurrencies like bitcoin.[[N:See, e.g., CFTC v. Reynolds , No. 19 Civ. 05631 (MKV), 2021 WL 796683, at *5 (S.D.N.Y. Mar. 2, 2021) ("Virtual currencies such as Bitcoin are encompassed in the definition of 'commodity' under Section 1a(9) of the [CEA]."); CFTC v. Gelfman Blueprint, Inc., No. 17 Civ. 7181 (PKC), 2018 WL 6320656, at *8 (S.D.N.Y. Oct. 16, 2018) (same); CFTC v. McDonnell, 287 F. Supp. 3d 213, 228 (E.D.N.Y. 2018) (virtual currencies "fall well within the common definition of 'commodity'").]]
However, as the defendants pointed out, the US Securities and Exchange Commission has claimed that in certain circumstances, cryptocurrencies are properly classified as securities.
Over the last few years, the SEC has brought several enforcement actions alleging that initial coin offerings constituted the unlawful offer and sale of unregistered securities.13
And in May 2019, the SEC issued a framework for investment contract analysis of digital assets, in which it applied the test established by the US Supreme Court's 1946 decision in SEC v. W. J. Howey Co. to assert that cryptocurrencies may be investment contracts, and therefore securities, if they are the investment of money in a common enterprise with a reasonable expectation of profits to be derived from the efforts of others.14
The SEC has also asserted that cryptocurrency products may be notes, and thus securities, under the test established by the Supreme Court in 1990 in Reves v. Ernst & Young.15
In SEC v. Kik Interactive Inc., US District Judge Alvin Hellerstein in the Southern District of New York agreed in 2020 that certain cryptocurrency products could be considered investment contracts under the Howey test.16
There is little doubt that some measure of uncertainty exists in this industry. The CFTC and SEC have both asserted jurisdiction over regulating cryptocurrencies, and the question of which cryptocurrency-related products are commodities and which are securities has not been definitively answered.[[N:See, e.g., CFTC v. McDonnell, 287 F. Supp. 3d at 228 (stating that the "SEC, IRS, DOJ, Treasury Department, and state agencies have increased their regulatory action in the field of virtual currencies without displacing CFTC's concurrent authority"); SEC, Testimony of SEC Chair Gary Gensler before the Senate Committee on Banking, Housing, and Urban Affairs (Sept. 14, 2021) (stating that the SEC and CFTC "each have relevant, and in some cases, overlapping jurisdiction in the crypto[currency] markets").]]
Various members of Congress recently have proposed legislation that would provide clearer guidance.17
And the White House is expected to issue an executive order this month to coordinate the federal government's approach to cryptocurrencies, which will include, in addition to the CFTC and SEC, the Office of the Comptroller of the Currency, the Federal Reserve, and the US Department of the Treasury.18 In short, regulatory lines are still being drawn.
In the context of the BitMEX case, however, the government successfully argued that the defendants knew or should have known, at the very least, that facilitating trades in bitcoin derivatives fell under the CFTC's jurisdiction.
The government argued that as of 2015, there was clear indication from the CFTC that it viewed bitcoin—putting aside other cryptocurrencies—as a commodity, and that the CFTC may regulate futures and swaps contracts in any commodity.
As Stump recently put it, "The CFTC does not regulate commodities," but instead "regulates derivatives—and this is true for digital assets just as for any other asset class."19
In other words, the government does not have to establish that all cryptocurrencies are commodities to prevail at trial; it need only establish that BitMEX facilitated trades in bitcoin derivatives, and that the defendant on trial knew or should have known that this activity meant that BitMEX had to comply with the BSA.
The same day the indictment was announced, the CFTC brought a related civil suit against BitMEX, as well as Hayes, Delo, and Reed individually. On August 10, 2021, a consent order was entered requiring BitMEX to pay a $100 million civil penalty. See CFTC, Federal Court Orders BitMEX to Pay $100 Million for Illegally Operating a Cryptocurrency Trading Platform and Anti-Money Laundering Violations (Aug. 10, 2021).
The Anti-Money Laundering Act of 2020 expanded the definition of financial institutions to include businesses "engaged in the exchange of ... value that substitutes for currency or funds." 31 U.S.C. § 5312(a)(2)(J).
Designated contract markets are regulated markets for trading futures and options; a foreign board of trade is a foreign designated contract market; a derivatives clearing organization is a clearinghouse for derivatives; and a swap execution facility is a marketplace that offers exchange trading of swaps.
The CFTC's parallel action in this case charged that BitMEX failed to register as an FCM, and that it also failed to register as a designated contract market, foreign board of trade, or swap execution facility. See CFTC, CFTC Charges BitMEX Owners with Illegally Operating a Cryptocurrency Derivatives Trading Platform and Anti-Money Laundering Violations (October 1, 2020).
In the Matter of TeraExchange LLC, CFTC No. 15-33, 2015 WL 5658082 (Sept. 24, 2015); and In the Matter of Coinflip, Inc., CFTC No. 15-29, 2015 WL 5535736 (Sept. 17, 2015). See also In the Matter of BFXNA Inc., CFTC No. 16-19, 2016 WL 3137612 (June 2, 2016); CFTC v. 1Pool Ltd., No. 18 Civ. 2243 (TNM), 2019 WL 1605201 (D.D.C. Mar. 4, 2019).
SEC, Framework for "Investment Contract" Analysis of Digital Assets; SEC v. W.J. Howey Co., 328 U.S. 293 (1946).
See Crypto-Currency Act, H.R. 6154, 116th Cong. (2020) (establishing concurrent authority between the CFTC, SEC, and Secretary of the Treasury to regulate "crypto-commodities," "crypto-currencies," and "crypto-securities," respectively); see also Digital Asset Market Structure and Investor Protection Act, H.R. 4741, 117th Cong. (2021-2022).
See White House is Set to Put Itself at Center of US Crypto Policy, Bloomberg Law (Jan. 21, 2022, 5:30 PM).