What is the legal logic behind the CFTC’s lawsuit against CZ and Binance for violating US regulations?

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After reading the entire 74-page indictment, there is nothing wrong with the CFTC's complaint against CZ and its related parties this time. The core logic is: CZ controls Binance to carry out a series of virtual asset Derivatives trading business, because American customers contribute a considerable part of profits, so how to help American customers evade supervision and compliance control is the first priority of CZ, a shrewd businessman .

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1. Compilation of CFTC press releases

CFTC Charges Binance and Its Founder CZ for Deliberately Evading U.S. Laws and Illegally Operating a Virtual Asset Derivatives Exchange

On March 27, 2023, the U.S. Commodity Futures Trading Commission (CFTC) announced that it had filed a civil lawsuit with the U.S. District Court for the Northern District of Illinois, accusing CZ and three entities operating the Binance platform of repeatedly violating the Commodity Trading Act (CEA) and CFTC regulations. At the same time, the CFTC also accused Binance’s former chief compliance officer, Samuel Lim, of aiding and abetting Binance’s violations.

According to the indictment, from July 2019 to the present, Binance offered and executed virtual asset Derivatives transactions to U.S. persons (despite shielding U.S. IP addresses), and at the direction of CZ, Binance directed its employees and customers to bypass compliance controls, including Through VPNs, setting up shell companies, etc.), deliberately evading US laws, conducting business through opaque methods, ignoring CEA and CFTC regulations, while systematically engaging in regulatory arbitrage for commercial gain.

The CFTC accused Binance, an entity that provides virtual asset Derivatives services in the United States, to register with the CFTC as a Futures Commission Merchants (FCM) to undertake compliance obligations similar to KYC, and to implement measures aimed at preventing and detecting terrorist financing. and basic compliance requirements for money laundering activities. According to the Derivatives trading business carried out by Binance, it should also be registered with the CFTC as a designated contract market (Designated Contract Market, DCM) or a swap execution agency (Swap Execution Facility, SEF). And Binance has never registered with the CFTC.

Therefore, the CFTC accused CZ and its affiliates of violating relevant laws and regulations on futures trading, illegal off-exchange commodity options, unregistered futures commission merchants, or designated contract markets, or swap execution agencies through civil lawsuits, and negligently Due to regulation, failure to implement KYC or anti-money laundering procedures, and establishment of substandard compliance programs, etc., the court is seeking civil penalties and permanent trading and registration bans against CZ and its related parties.

CFTC Chairman Rostin Behnam said, "Today's enforcement action demonstrates that no district, or purported jurisdiction, can prevent the CFTC from protecting U.S. investors. I have made it clear that the CFTC will continue to use all of its Misconduct in the volatile and high-risk virtual asset industry...For years, Binance knew they were in violation of CFTC regulations, yet worked aggressively to keep funds flowing and avoid compliance. This should be to everyone in the virtual asset world Warning that the CFTC will not tolerate deliberate circumvention of U.S. laws."

Second, first summarize

After reading the entire 74-page indictment, there is nothing wrong with the CFTC's complaint against CZ and its related parties this time. The core logic is: CZ controls Binance to carry out a series of virtual asset Derivatives trading business, because American customers contribute a considerable part of profits, so how to help American customers evade supervision and compliance control is the first priority of CZ, a shrewd businessman .

On the surface, Binance manages a luxury compliance team of hundreds of people and blocks American customers, but CZ recruited Chief Compliance Officer Samuel Lim to advise him, through VPNs, setting up offshore shell companies, etc., which were called by the CFTC In the way of "Creative Means", it continued to provide Derivatives trading business for American customers knowingly violating the laws of the United States.

This hits the gunpoint of CFTC. CFTC's regulatory logic for virtual assets is: first of all, all virtual assets are commodities. The financing of virtual asset commodity futures transactions, as well as the compliance registration of relevant participants, should comply with the provisions of the CEA and be regulated by the CFTC.

In fact, there is still a crypto regulatory vacuum here. If all virtual assets are managed by the CFTC, although the CFTC has the ability to supervise fraud and market manipulation in the virtual asset spot market, the CFTC has no ability to supervise virtual asset futures transactions that do not involve margin, leverage, or financing. If we let the SEC manage it, then the SEC can only exercise its jurisdiction if it recognizes virtual assets as "securities". Under this high standard, fraud involving securities, market manipulation, etc. will be derived. So we see that in almost all SEC cases against virtual assets, the first sentence is: "XXX issued and sold unregistered securities."

In any case, under the background of the SEC's frequent attacks on industry giants in the first quarter, this time the CFTC directly pointed the finger at CZ and Binance, which really made Rostin Behnam shine, and his speech in the press release was quite villainous Dezhi's feeling: "This should be a warning to anyone in the digital asset world, there is no location, or claimed lack of location, that will prevent the CFTC from protecting American investors." If CZ chooses hard steel, at least Binance. The US is hardly immune, and Binance's acquisition of Voyager may fall through, which may slowly tear away the mystery of the Binance empire.

3. Reanalysis - The legal basis for the CFTC to file a lawsuit against CZ and Binance

Introduction of CFTC and CEA

The Commodity Futures Trading Commission (CFTC) is an independent agency established by the US government in 1974. The U.S. Congress authorized CFTC to manage and implement the U.S. Commodity Exchange Act of 1936 (CEA) and its regulations. To promote the public interest and the integrity of financial markets in order to protect market participants and the public from fraud, market manipulation and other market disruptions.

CFTC Commodity Designation for Virtual Assets

As early as 2015 in its enforcement action against Coinflip, Inc., the CFTC defined Bitcoin as a “commodity” under the CEA. In this case, Coinflip, Inc. operated a bitcoin financial trading platform called Derivabit, which matched bitcoin options contracts for investors. During the operation period, it failed to comply with the regulatory requirements of CEA and CFTC to fulfill its compliance obligations, thus being subject to CFTC law enforcement penalties.

Since then, the CFTC has identified virtual currencies as commodities regulated by the CEA. Goods under the CEA are a very broad definition, which includes not only physical goods, but also intangible goods, and rights and interests similar to carbon emission rights (…all other goods and articles…and all services, rights, and interests...in which contracts for future delivery are presently or in the future deal in). In addition, multiple judicial precedents in the United States have also determined that virtual currency is a "commodity" under the definition of the CEA, which must comply with the regulations of the CEA and be regulated by the CFTC.

In addition, the current CFTC chairman Rostin Behnam also stated that the CFTC's regulatory framework already has the ability to supervise most virtual currencies in the virtual asset market, including Bitcoin and Ethereum. Information about virtual assets (mainly involving virtual currencies) is also published in the Digital Assets column of the CFTC official website.

A digital asset is any asset that can be stored and transmitted electronically and has related ownership or use rights. Virtual assets are digital representations of asset value, including as a medium of exchange, unit of account, and store of value. Some virtual assets, such as BTC, ETH, LTC and at least two fiat-backed Stablecoin: Tether (USDT) and Binance UDS (BUSD), as well as other virtual currencies mentioned in this article, are subject to CEA Regulation 1 a (9) Section definition, all belong to "commodity". With the development of the virtual asset industry in recent years, exchanges registered with the CFTC (such as the Chicago Mercantile Exchange and the Chicago Board Options Exchange) also provide some futures contracts for virtual assets.

This gives the CFTC the ability to regulate activities such as fraud and market manipulation in the virtual asset spot market, however, the CFTC does not have the ability to regulate virtual asset futures transactions that do not involve margin, leverage, or financing. However, as many legislative proposals currently being considered by Congress will give CFTC greater powers, it is believed that the current embarrassing situation of CFTC will soon be improved.

Determination of "commodity" futures trading

If the transaction of virtual assets meets the following conditions, then the transaction will be defined as "futures transaction (a contract of sale of a commodity for future delivery)" under CEA Article 2 (c) 2 (D), then the result is Platforms that provide transactions and entities engaged in transactions must comply with the regulations of the CEA and be regulated by the CFTC:

(i) The transaction object must be a "Non-Eligible Contract Participant" as defined by CEA. According to the relevant provisions of the CEA, if the party accepting the commodity transaction is a "qualified contract participant" or "qualified commercial subject" defined by the CEA, the transaction does not belong to the type of retail commodity transactions (Retail Commodity Transactions) stipulated by the CEA. . The retail commodity transactions here are equivalent to retail transactions in the usual sense, and the purpose is to protect the legitimate rights and interests of general investors.

In addition, special attention should be paid to the retail commodity transaction relationship adjusted by the CEA not only includes the situation where the contract has been concluded (confirming the execution), but also includes the relevant parties providing such transaction opportunities (offering to enter into) before the transaction is concluded, and issuing an offer or The act of entering into such a transaction.

(ii) The transaction is carried out on a leveraged or margined basis or through financing arrangements to complete the transaction. In essence, the buyer does not need to pay the full payment to obtain the target product of the transaction, or the buyer can use part of the funds to purchase several times the actual amount of the product that can be purchased, which is what we usually call leveraged trading.

(iii) The merchandise has not been "actually delivered" within 28 days, or such longer period as may be prescribed by the CFTC. How to determine "actual delivery" has become the most concerned issue in CFTC's regulatory practice, and CFTC has therefore issued relevant regulatory opinions.

Compliance requirements for virtual asset Derivatives

Derivatives are financial instruments, such as futures, options or swaps, whose value comes from underlying assets, including benchmark interest rates, physical commodities such as oil or wheat, and virtual asset commodities. Pursuant to the requirements of the CEA, commodity Derivatives must be traded on exchanges designated or registered by the CFTC, subject to certain exemptions.

Therefore, with few exceptions, pursuant to the provisions of the CEA and the CFTC (Section 5 h (a) of the Act, 7 USC § 7 b-3, and Regulation 37.3, 17 CFR § 37.3 (2022)), in the absence of notification to the CFTC It is illegal for anyone to provide a swap trading platform (Swap) while registering as a Designated Contract Market (DCM) or a Swap Execution Facility (SEF).

Pursuant to Article la (28)(A) of the CEA, a Futures Commission Merchant (FCM) is an individual, association, partnership, company or trust engaged in (i) regulated trading in futures, swaps, commodity options or retail commodities transaction solicitation or acceptance of orders, or (ii) acting as a counterparty to a retail commodity transaction; or in connection with any of these activities and engaging in "acceptance of any money, security or property (or credit security as described above) Guarantee any possible transaction or contract".

FCM is a financial intermediary that holds customers' funds and provides margins for Derivatives transactions. It is a key component of the US financial system and must comply with the relevant regulations of the CEA, CFTC, and the US Bank Secrecy Act and FinCEN. The most basic The requirement is to register with the CFTC and comply with a series of compliance requirements from the CFTC or FinCEN.

Any subject that violates the above provisions of the CEA and CFTC, as well as the CEA anti-circumvention principle, shall bear the responsibility of relevant laws.

Binance Offers Unregistered Virtual Asset Derivatives Trading in the U.S.

In the FACTS part of the indictment, the CFTC listed a large number of facts about CZ and its related parties related to the allegations, including: A. A summary of the operation of the Binance platform; B. The relevant financial Derivatives products provided by the Binance platform; C. D. Operating in the US; E. CZ’s control over Binance; F. Created the appearance of restricting US users, saying that the compliance program was just a cover; G. Knowing that the Binance platform needs to comply with US laws , but chose to ignore; H. Instructing American customers to circumvent compliance controls through VPNs and other means; I. Instructing VIP customers to pass KYC verification in violation of regulations; J. Hiding American customer information in internal documents and data; K. Binance relies on intermediaries to introduce customers, But there is a lack of effective means of compliance; L. Cases of evasion of compliance controls.

Based on the above facts, the CFTC accused CZ and its affiliates of violating the relevant regulations of the CEA and the CFTC: (1) executing futures transactions on unregistered exchanges; (2) illegally conducting off-exchange transactions; (3) failing to register (4) Failure to register as DCM or SEF; (5) Ineffective supervision; (6) Failure to implement CIP, KYC, AML compliance measures; (7) Evasion of US legal supervision. Meanwhile, the CFTC is seeking civil penalties and permanent trading and registration injunctions against CZ and its affiliates.

This article is for learning and reference only, and I hope it will be helpful to you. It does not constitute any legal or investment advice, not your lawyer, DYOR.

REFERENCE:

[1] CFTC Charges Binance and Its Founder, Changpeng Zhao, with Willful Evasion of Federal Law and Operating an Illegal Digital Asset Derivatives Exchange

https://www.cftc.gov/PressRoom/PressReleases/8680-23

[2] Commodity Futures Trading Commission v. Zhao et al

https://www.courtlistener.com/docket/67092867/1/commodity-futures-trading-commission-v-zhao/

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Disclaimer: The content above is only the author's opinion which does not represent any position of Followin, and is not intended as, and shall not be understood or construed as, investment advice from Followin.
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