Highlighting Regulatory Issues with Forward Contracts on Crypto Assets

By: Mike Frisch, Alexander Lindgren, and with contributions from Karl Lindgren

Many early-stage investors in crypto projects invest at a time when the details of a project’s token — including whether and when it will even launch one — are unclear. When an investor does receive its interest in a project’s token, it is usually subject to a multi-year vesting and lock-up schedule. What this means is that a crypto investor looking to liquidate its position or hedge the downside risk attendant to its investment has few options. For a project with no circulating token, there is no way to sell a token short, and no active derivatives markets on which to lay off risk. The tool that some investors turn to is the deliverable forward contract — a promise to sell (and deliver) a specified quantity of tokens at a specified price to a buyer at a future date. For a U.S.-based firm subject to the jurisdiction of the Commodity Futures Trading Commission (“CFTC”), such arrangements can be traps for the unwary, and can raise questions as to whether the contract is a “swap” under the Commodity Exchange Act (the “Act”) and its regulations.

Contracting to sell a portion of your tokens can be a good way for an investor to lock in some profit and better define its risk. But if the contract is a “swap,” a bevvy of regulatory consequences follow. This article argues that some “crypto forward” arrangements can be structured to fit within the Act’s longstanding forward contract exclusion. If the contract is properly characterized as a “forward,” it is considered a species of “cash” contract, outside the Act.

What is a Swap?

The CFTC is the federal agency that is authorized under the Commodity Exchange Act, 7 U.S.C. § 1, et seq. (the “CEA” or “Act”), to oversee and regulate most segments of the derivatives markets in the U.S., which includes futures, options on futures, commodity options and swaps. In order to be subject to the Act, the underlying asset must be a “commodity.” The Act’s definition of “commodity” is famously broad, and this article assumes that any token in question would fit. [FN1]

The term “swap” is defined broadly and covers many types of derivative structures. [FN2] This include any agreement, contract or transaction that “is a put, call, cap, floor, collar, or similar option of any kind” based on the value of another asset. It also includes any agreement that provides for the purchase, sale, payment or delivery “that is dependent on the occurrence, nonoccurrence, or the extent of the occurrence of an event or contingency associated with a potential financial, economic, or commercial consequence.”

If a contract involving tokens is a swap, it can only be executed bilaterally if both participants are Eligible Contract Participants (“ECPs”). [FN3] The ECP definition sets very high net worth/asset levels for individuals and business entities. [FN4] For example, no company can be an ECP unless it has at least $10 million in assets, among other requirements. Most importantly, all swap transactions — including those executed bilaterally off exchange — must be reported in real time to a “swap data repository” pursuant to Part 43 of the CFTC’s regulations. In addition, persons that hold themselves out as dealers or regularly enter into swaps may have to register with the CFTC as “swap dealers” or “major swap participants” if certain requirements are met.

Understandably, therefore, most crypto investors, VCs, funds, participants in blockchain networks, and individuals with U.S. connections would prefer that the contracts, agreements and transactions they enter into are not swaps.

The Forward Contract Exclusion

One thing that is not a swap is a “forward contract.” Unfortunately, the line between a “forward contract” and a “swap”can often be blurry, leading to reams of CFTC guidance and perpetual employment for lawyers like the undersigned authors. Some background may help. From time immemorial, market participants engaged in transactions that involved the immediate sale of a commodity, but with physical delivery delayed until some time in the future. For generations, farmers would sell off all or a portion of their harvest as the seed goes into the ground, and deliver their grain months later at a pre-negotiated price. Such transactions are “forward contracts,” and they have always been excluded from the CFTC’s oversight in recognition of this historical practice, and distinguished from more financialized transactions. Thus, the CFTC regulates the trading of futures contracts, not agreements to physically deliver commodities; indeed, it simply has no authority to regulate “cash markets” for commodities, such as the aforementioned farmers selling their grain before harvest.

This historical distinction between commercial transactions for future delivery and those for financial purposes is recognized in the Act. Section 1a(27) of the Act provides that the term “future delivery” used in § 2(a)’s grant of jurisdiction to the CFTC over futures trading does not include “any sale of any cash commodity for deferred shipment or delivery.” This exclusion — called the “forward contract exclusion” — has been part of the series of statutes preceding the Act since 1922.

Given the broad definition of “commodity,” were it not for this exclusion almost any executory sale would risk being deemed the sale of a commodity for future delivery subject to the provisions of the Act. [FN5] However, no one disagrees that buying lumber to build an addition to your home should not be regulated by the CFTC, even if you’re buying the 2x4s months before they’re delivered. [FN6] As one senator explained during debate on the Future Trading Act of 1921 (one of the earliest attempts to regulate the futures market):

“[T]he bill does not concern itself at all with the sale or purchase of actual grain, either for present or future delivery. The entire business of buying and selling actual grain, sometimes called ‘cash’ or ‘spot’ business, is expressly excluded. It deals only with the ‘future’ or ‘pit’ transaction, in which the transfer of actual grain is not contemplated.”

[FN7]

Unfortunately this distinction is often easier described in theory than determined in practice. For example,what about a contract that was intended to result in physical delivery, but which permitted the buyer and seller to change the amount of the commodity being sold? (This is referred to as “embedded volumetric optionality”). [FN8] Or what about a contract that allowed the parties to modify the delivery date, and “roll” the agreement forward in time? What if the “commodity” being “delivered” was intangible or financial, like a quantity of a foreign currency? Would that still qualify? You don’t have to squint much for the economic consequences of such an arrangement to begin to look less like a commercial merchandising agreement with deferred delivery and more like a risk-shifting option or futures contract. Needless to say, this problem of distinguishing between fundamentally ‘commercial’ transactions from more financialized transactions was (and remains) an active area of dispute and guidance in commodities market regulation.

Skipping over nearly a century of history, when Congress gave the CFTC oversight of the behemoth swaps market in the wake of the 2008 financial crisis via the Dodd-Frank Wall Street Reform and Consumer Protection Act, it preserved the historical distinction between commercial and financial transactions for future delivery of commodities, and carved out forward contracts from the Swap definition. Specifically, § 1a(47)(B)(ii) of the Act, excludes from the definition of the term “swap” “any sale of a nonfinancial commodity or security for deferred shipment or delivery, so long as the transaction is intended to be physically settled.”

The CFTC provided guidance on the meaning of this exclusion four years later. [FN9] There, it affirmed the “historical interpretation […] that forward contracts with respect to nonfinancial commodities are ‘commercial merchandising transactions[,]’” and “the [CEA’s] regulatory scheme for futures trading simply should not apply to private commercial merchandising transactions which create enforceable obligations to deliver but in which delivery is deferred for reasons of commercial convenience or necessity.” The 2012 Guidance makes clear that the actual intent to make physical delivery, and the need or intended use by the buyer, is key to the facts-and-circumstances analysis of whether a particular contract is excluded.

Excluded Crypto Forward Contracts?

Can a crypto forward qualify for this exclusion? Maybe. It depends on the nature of the underlying digital asset and all of the facts and circumstances of the arrangement. The more squarely a crypto market participant can situate its forward contract into this exclusion, the less regulatory risk it has.

To start, most digital assets bought or sold on a fully paid basis with immediate delivery would likely be characterized as cash market trading outside the CEA’s reach (absent fraud or manipulation) under current law. [FN10] Similarly, “spot contracts” traded in cash markets are contracts for the sale of a commodity for delivery where delivery occurs within two days, or such other short timeframe consistent with applicable cash market convention. Such contracts which settle by near-immediate delivery are generally outside its authority to regulate as futures or as swaps under the Act. The more troublesome situation is where the token either does not yet exist, or cannot be transferred due to a lock-up or some mechanical restriction — a common situation in sales of tokens in secondary markets, particularly for early-stage investors in the sector. To determine whether a particular transaction fits within the exclusion, we must turn to the CFTC’s guidance.

First, the exclusion from the Swap definition can apply only when the underlying asset is a “nonfinancial commodity”? [FN11] What does that mean? The CFTC interprets the term “nonfinancial commodity” to mean a commodity that can be physically delivered and that is an “exempt commodity” or an agricultural commodity. Helpfully, the Act defines an “exempt commodity” as ‘‘a commodity that is not an excluded commodity or an agricultural commodity.’’ 7 U.S.C. 1a(20). “Excluded commodities” are defined at § 1a(19) of the CEA and include things like “interest rates,” “credit risk or measure” and indexes. These items are financial in nature and intangible.

Obviously since the Act has not been updated since the proliferation of crypto, digital assets are not included in the definition of “excluded commodities;” we think most would therefore be “exempt commodities.” [FN12]

Are they really “nonfinancial,” though? The CFTC’s 2012 Swap Guidance included a long discussion of the term, and concluded that certain intangible commodities could qualify as such. Specifically:

“[T]he CFTC is providing an interpretation that an intangible commodity (that is not an excluded commodity) which can be physically delivered qualifies as a nonfinancial commodity if ownership of the commodity can be conveyed in some manner and the commodity can be consumed. One example of an intangible nonfinancial commodity that qualifies under this interpretation, as discussed in greater detail below, is an environmental commodity, such as an emission allowance, that can be physically delivered and consumed (e.g., by emitting the amount of pollutant specified in the allowance).”

In its discussion of environmental credits, the CFTC recognized that market participants “often engage in environmental commodity transactions in order to transfer ownership of the environmental commodity (and not solely price risk), so that the buyer can consume the commodity in order to comply with the terms of mandatory or voluntary environmental programs.” It found that those two features — ownership transfer and consumption — “distinguish such environmental commodity transactions from other types of intangible commodity transactions that cannot be delivered, such as temperatures and interest rates.” [FN13]

The question, then, is whether the tokens at issue are more akin to carbon credits, which have consumptive use or utility separate and apart from their role in transferring price risk or use in financial transactions, or are they more akin to purely financial commodities like interest rates or macroeconomic indexes?

Some digital assets (i.e. stablecoins) would clearly be “financial” in nature; the sole utility of a stablecoin is to transfer economic value. But on the other hand, some digital assets would appear clearly nonfinancial in character. At the other extreme, consider a token that is redeemable, or otherwise usable, for gaming, use in an online DePin network, or some other noninvestment or nonfinancial service — akin to a digital “arcade token.” Such a token would not present an obvious financial use.

But what about a blockchain’s native token like Ethereum? As a threshold matter, “ownership” of a specifically identifiable quantity of Eth can be clearly and conclusively transferred by virtue of submitting a transaction on the blockchain. This makes it more like a carbon credit (where each specific credit can be identified and transferred) and less like an interest rate (which cannot). And Ethereum can be actually delivered (if not “physically” so), much like ownership over specific carbon credits can be assigned. Indeed, the CFTC put out a separate interpretive guidance in 2020 specifically discussing the requirements via which digital assets could meet the “actual delivery” exemption under a different section of the Act. [FN14]

If one can get over that hump, the next trick is that many tokens could have financial, or nonfinancial qualities, and a purchaser could intend for either. Again, consider Ethereum. While a quantity of Eth cannot be “consumed” or “used up” in the same sense as a carbon credit, unlike a purely financial commodity like an interest rate, some purchasers need Eth as an input to conduct their business operations. Purchasers of other tokens may intend to purchase the asset not only as a speculative investment (or with little to no speculative intent at all), but because they intend to be an active participant in the relevant underlying blockchain network. This might take the form of proof of stake validation, use of the token to access games or services, posting a ‘bond’ in connection with the operation of a validator, participation in governance, intent to inscribe and resell ‘ordinals’ or other non-fungible commercial artifacts on the network, or other means. [FN15] This is where the facts matter, but depending on their businesses and the nature of the assets in question, many buyers can argue that the tokens in question have a utility separate and apart from their economic value. This sets such assets apart from purely financial intangible commodities like interest rates, which have no independent utility.

Assuming the tokens in question could be “nonfinancial commodities,” in order to meet the forward contract exclusion in § 1a(47)(B)(ii), the arrangement would still have to meet the underlying intent and purpose of the provision. In its 2012 Guidance, the Commission wrote:

“The CFTC’s historical interpretation has been that forward contracts with respect to nonfinancial commodities are commercial merchandising transactions. The primary purpose of a forward contract is to transfer ownership of the commodity and not to transfer solely its price risk. The underlying postulate of the forward exclusion is that the CEA’s regulatory scheme for futures trading simply should not apply to private commercial merchandising transactions which create enforceable obligations to deliver but in which delivery is deferred for reasons of commercial convenience or necessity.” [FN16]

The true “intent to deliver” is and remains a focus of the test: “the CFTC reads the ‘intended to be physically settled’ language in the swap definition with respect to nonfinancial commodities to reflect a directive that intent to deliver a physical commodity be a part of the analysis of whether a given contract is a forward contract or a swap.” [FN17]

Throughout its 2012 Guidance, the CFTC reaffirmed that the core of the exemption is for commercial merchandising transactions between sophisticated commercial parties that have a real need or use for the commodity. In the 2012 Guidance, the CFTC distinguished between an investment fund taking delivery of gold as part of its investment strategy (which would not fly), versus the situation where, for example, that investment vehicle owned a gold mine and sold the output of the gold mine for forward delivery, or owned a chain of jewelry stores that produced its own jewelry from raw materials. [FN18]

And so, the position that a transaction is an excluded “crypto forward” would be available if the buyer had a real commercial need or use for the tokens in question, and an actual intent to take delivery at the time the forward is executed. As discussed above, this could mean that the buyer planned to actually participate in the underlying blockchain network, and not just hold the tokens passively for investment purposes. We recommend that parties document this intent with specificity in the transaction document itself. [FN19]

In addition, the parties should question why the delivery of the tokens had to be deferred. The CFTC has long considered the “underlying postulate of the forward exclusion” to be the situation when a contract “create[s] enforceable obligations to deliver but in which delivery is deferred for reasons of commercial convenience or necessity.” [FN20] If a token could be immediately delivered, but the parties choose to delay, that looks more like a swap. By contrast, the existence of a lock-up provision that precludes delivery, or the fact that that the tokens do not yet exist, both are bona fide reasons why deferred delivery may be commercially necessary.

More broadly, the cleaner and simpler the agreement, the less risk parties create for themselves; increasing levels of complexity often tend to point towards a more ‘financialized’ intent, or implicate a more stringent test. For example, in 2015, the CFTC issued a follow-up rulemaking to discuss “forward contracts with embedded volumetric optionality.” Forward Contracts with Embedded Volumetric Optionality, 80 FR 28239 (May 18, 2015). Those are forward contracts that provide for variations in delivery amount. In the case of a crypto forward, an example of such a contract could be one for delivery of BTC at a fixed price by a bitcoin mining operation to hedge against price volatility, but which includes variable delivery amounts depending upon uptime, overall hashrates, or electricity demand shedding requirements. [FN21] According to the CFTC, such contracts can qualify for the forward exclusion, but they would be more carefully scrutinized than a contract that provided for the delivery of a fixed amount of tokens. [FN22]

Some Practical Advice

Whenever entering into a crypto forward, we recommend carefully and accurately describing and documenting the transaction. As set forth above, the commercial intent and purpose of the transaction should be memorialized. If possible, we also advise obtaining ECP representations from counterparties in these transactions, given the highly fact-sensitive, and potentially uncertain, analysis involved. As noted earlier, this gives a fallback option for compliance (as off-exchange swaps participants must be ECPs) — albeit an imperfect one, as the parties may have reporting obligations on such transactions that they are unlikely to have made in a timely fashion. Nevertheless, this is often a straightforward representation to obtain from the relevant market participants and should be included, if possible.

As a final note, which is beyond the scope of this article, there are a number of key practical and legal considerations which are likely to present themselves in the contexts discussed in this article. Depending upon how the token was originally acquired or generated, there may be a functional ‘issuer,’ implicating corporate law issues that might not otherwise be typical in a commodity transaction. For example, written consent to transfer the token may be required prior to the expiration of a lock-up; on a more technical level, it may be wise to pre-determine treatment of a hard fork in the underlying blockchain. Finally, treatment of crypto under securities law is evolving, but can also impact this discussion. If a token itself were deemed to qualify (or were viewed by a regulator as qualifying) as a security instrument in and of itself, then there could be an issue of the transaction constituting a “security-based swap”, regulated by the SEC.

The complexities and nuances of these transactions means that engaging counsel competent in the full range of issues presented — both legal understanding of securities and commodity derivatives, and the technical issues underlying these markets and assets — is key. Otherwise, you could find yourself facing any number of problems, from any number of regulators.

***

[FN1] As defined under § 1a(9) of the CEA, commodities, with limited exceptions, includes all manner of “other goods and articles, . . . and all services, rights, and interests . . . in which contracts for future delivery are presently or in the future dealt in.” Numerous courts have found digital assets to be commodities under the Act. See, e.g., CFTC v. McDonnell, 287 F.Supp.3d 213, 228 (E.D.N.Y. 2018).

[FN2] Defined in CEA § 1a(47) and CFTC Regulation 1.3.

[FN3] The CFTC has authority to require some swaps to be centrally cleared and executed on a regulated trading facility such as a designated contract market or swap execution facility. To date, the CFTC has not required that any swaps involving digital assets be centrally cleared.

[FN4] Defined in CEA § 1a(18) and CFTC Regulation 1.3.

[FN5] See The Forward Contract Exclusion: An Analysis of Off-Exchange Commodity-Based Instruments, 41 Bus. Law. 853, 854 (1986)

[FN6] Id., fn 3.

[FN7] 61 Cong. Rec. 4762 (1921) (statement of Sen. Capper).

[FN8] See Forward Contracts With Embedded Volumetric Optionality, 80 Fed. Reg. 28239 (May 18, 2015); see also https://www.cftc.gov/PressRoom/PressReleases/7174-15.

[FN9] When the CFTC adopted the swap product definitions, it provided extensive interpretive guidance for determining whether contracts on nonfinancial commodities are excluded forward contracts. See Further Definition of “Swap,” “Security-Based Swap,” and “Security-Based Swap Agreement”; Mixed Swaps; Security-Based Swap Agreement Recordkeeping, 77 Fed. Reg. 48208, 48232 (Aug. 13, 2012) (2012 Guidance). Congress used different language to describe the exclusion than it did in the futures context, but when the CFTC and SEC jointly adopted swap product definition rules in August 2012, the CFTC stated that it interprets the forward contract exclusion from both the futures and swap definitions in a consistent manner. Id..

[FN10] Practitioners should note that there are ongoing proposals in Congress to change this and grant the CFTC spot market authority over crypto assets; however, this would represent a major shift in regulatory frameworks for commodities. See H.R.4763 — Financial Innovation and Technology for the 21st Century Act.

[FN11] To the extent that the Tokens are “securities,” a specific species of “commodity,” the transaction would be excluded from the Act’s Swap definition and would be outside the CFTC’s jurisdiction. (Whether they would be characterized as security-based swaps is a separate question, outside the scope of this article.)

[FN12] The CFTC has not taken a clear position on whether “virtual currencies” — one subspecies of digital assets — are exempt or excluded commodities. A respected ABA treatise took the position that the CFTC has “signaled” that it views certain digital assets (namely Bitcoin) as “exempt, not excluded commodities.” See https://www.skadden.com/-/media/files/publications/2020/12/section2commodityexchangeactandcftcregulation.pdf (page 79). This is because a number of cases involving leveraged trading in Bitcoin and similar assets were brought under section 2(c)(2)(D) of the Act rather than “the analogous retail foreign exchange transaction exception” which deals with exempt commodities (foreign exchange). Id at 80 (noting that the CFTC’s proposal to issue guidance on the Actual Delivery of digital assets described virtual currencies as “proposed as alternatives to gold and other precious metals.”) (citing Retail Commodity Transactions Involving Virtual Currency, 82 Fed. Reg. 60,335 (proposed Dec. 20, 2017)).

[FN13] 2012 Swaps Guidance at 48234.

[FN14] Section 2(c)(2)(D) of the Act provides that all “Retail Commodity Transactions” (transactions in commodities that involve financing or leverage) are treated “as if” they are futures contracts and must be conducted on-exchange. However, transactions that result in “actual delivery” within 28 days are excepted. The CFTC’s 2020 guidance discussed what “actual delivery” meant in the context of digital assets. See Retail Commodity Transactions Involving Certain Digital Assets, 85 FR 37734 (June 24, 2020).

[FN15] Note that some of these activities, particularly staking, may be more or less ‘commercial’ for these purposes, and practitioners should assess the specific facts involved; nevertheless, the authors view these as representative of the sorts of activities which might qualify and should be considered; an example might be taking receipt of the tokens directly to an operating subsidiary of the fund that actually conducts the relevant staking activity, rather than the master fund vehicle itself.

[FN16] 2012 Swap Guidance at 48228 (cleaned up; citations omitted).

[FN17] Id.

[FN18] 2012 Swap Guidance at 48229.

[FN19] At the same time, many of the market participants entering into these agreements may have tax, corporate, or other regulatory limitations and sensitivities that practitioners should keep in mind when approaching these agreements. Although beyond the scope of this article, many of the activities which might best support the commercial use intent in crypto (e.g., node operation or governance participation) may be in tension with these other areas, particularly for private funds.

[FN20] 2012 Swap Guidance at 48228 (citing the Brent Interpretation).

[FN21] Note that it is not entirely clear whether these sorts of factors would necessarily be sufficient to satisfy the elements of the test described infra at FN 21, particularly the last prong, but the authors view them as representative of the sorts of factors that would need to be assessed and relied upon.

[FN22] Contracts with volumetric optionality are subject to a seven-part test to determine if they qualify: (i) the embedded optionality does not undermine the overall nature of the agreement, contract, or transaction as a forward contract; (ii) the predominant feature of the agreement, contract, or transaction is actual delivery; (iii) the embedded optionality cannot be severed and marketed separately from the overall agreement, contract, or transaction in which it is embedded; (iv) the seller of a nonfinancial commodity underlying the agreement, contract, or transaction with embedded volumetric optionality intends, at the time it enters into the agreement, contract, or transaction to deliver the underlying nonfinancial commodity if the embedded volumetric optionality is exercised; (v) the buyer of a nonfinancial commodity underlying the agreement, contract or transaction with embedded volumetric optionality intends, at the time it enters into the agreement, contract, or transaction, to take delivery of the underlying nonfinancial commodity if the embedded volumetric optionality is exercised; (vi) both parties are commercial parties; and (vii) the embedded volumetric optionality is primarily intended, at the time that the parties enter into the agreement, contract, or transaction, to address physical factors or regulatory requirements that reasonably influence demand for, or supply of, the nonfinancial commodity. 2012 Swap Guidance at 48238–43.