Insider Trading in Cryptocurrency: Exploring New Territory for the CFTC

Introduction

Insider trading in cryptocurrency has been a hot topic in industry and (to some extent) mainstream press[1]. Allegations that employees of Coinbase, a popular cryptocurrency exchange, bought Bitcoin Cash (BCH) in advance of its listing on the exchange sparked much of this recent interest. These allegations have even spawned a lawsuit by disgruntled BCH traders^[2]. While that is a private suit not premised on traditional theories of insider trading liability, recent enforcement practices by the Commodity Futures Trading Commission (CFTC) have raised the possibility that cryptocurrency will face insider trading regulation akin to that applied to securities by the SEC. This post will lay out the law underlying CFTC regulation of insider trading in cryptocurrency and examine the legal and policy implications of such regulation as applied to exchanges and their employees.

The Legal Background

Regulatory enforcement against insider trading in cryptocurrency would come from the CFTC, whose recent enforcement practices suggest they may assert such authority. First, note that this post examines cryptocurrencies rather than ICOs, which resemble traditional securities. The CFTC considers cryptocurrencies commodities under the Commodity Exchange Act^[3]. The CFTC recently promulgated rules, including Rule 180.1, pursuant to subsection 6(c)(1) of the Commodities Exchange Act asserting broad anti-fraud and anti-manipulation authority over commodity transactions^[4]. To quote the CFTC, the language of subsection 6(c)(1) “is virtually identical to the terms used in section 10(b) of the Securities Exchange Act of 1934.”^[5] Section 10(b), of course, is the section under which the SEC promulgated Rule 10b–5, the wellspring of SEC regulatory enforcement of insider trading in securities. When making Rule 180.1, the CFTC decided to “model final Rule 180.1 on SEC Rule 10b–5” and noted that one who trades “on the basis of material nonpublic information in breach of a pre-existing duty… may be in violation of final Rule 180.1.”^[6]This language mirrors the misappropriation theory of insider trading liability under Rule 10b–5 laid out in United States v. O’Hagan[7].

A recent CFTC enforcement order signaled their willingness to use Rule 180.1 to bar insider trading. In 2015, the CFTC issued an order settling charges against a trader, Motazedi, in which it asserted that Motazedi had violated Rule 180.1 by trading on material, nonpublic information obtained from his employer, in breach of his duty to his employer (i.e. under the misappropriation theory)^[8]. While these trades were in futures contracts, Rule 180.1 extends to transactions in commodities in interstate commerce^[9]. As such, it could be applied against cryptocurrency traders making trades on the basis of material nonpublic information in breach of a pre-existing duty. There is no evidence the CFTC intends to pursue insider trading in cryptocurrency. Still, Rule 180.1 and the Motazedi case show that it asserts the authority to regulate the insider trading of commodities and is willing to use that authority in some cases.

The Exchange Example: Law

While insider trading by cryptocurrency exchanges and their employees would not necessarily violate Rule 180.1, the alleged actions of Coinbase employees prior to the BCH listing likely would constitute a violation. To violate Rule 180.1, the material, nonpublic information leading to a trade must be obtained in breach of a duty, or through fraud and deception^[10]. In fact, the CFTC has explicitly said that it “does not prohibit trading on the basis of material nonpublic information except as provided in the following paragraph [which outlines the above situations].”^[11] As such, Coinbase itself could have bought BCH, knowing that its impending listing would boost the price. No duty would have been breached and no fraud perpetrated. However, internal Coinbase policies specifically prohibited employee trading on the basis of material nonpublic information^[12]. When asserting that Motazedi had violated Rule 180.1, the CFTC cited the employer-employee relationship and internal policies barring trading on information obtained through the employer to establish Motazedi’s duty to his employer^[13]. As such, Coinbase employees who violated internal policies to trade on the impending BCH listing also violated Rule 180.1, at least as it was interpreted by the CFTC in the Motazedi case.

The Exchange Example: Policy

Enforcing Rule 180.1 against rogue employee trading is likely a good idea. Allowing employees to trade on inside information in contravention of internal policies would enhance price accuracy, in that information about impending listings would be more quickly incorporated into coin price. However, the Coinbase example suggests this may not be especially useful in practice. The BCH price did not substantially shift until about a day before the December 19 listing^[14], so price accuracy was only improved for a short period. This makes sense, as those willing to risk their jobs by breaching internal policies may often be lower level employees with limited access to information. Conversely, this insider trading undermined confidence in the market by signaling impropriety on the part of those with at least some influence at exchanges. Given pre-existing fears surrounding market manipulation by exchanges^[15], any behavior that signals impropriety could threaten to scare off investors. Even before reaching other negatives associated with insider trading (e.g. higher prices based on the expectation of more informed trading), this rationale is sufficient to justify a prohibition on insider trading by rogue exchange employees.

Barring exchanges from trading on inside information, to the extent that the CFTC could prohibit them from doing so[16], is more complicated. Exchanges provide value when they choose to list coins. Allowing exchanges to trade on pending listings would increase the incentive for large, reputable exchanges like Coinbase to list more coins. This would allow more people (e.g. those who only trust such exchanges or who only want to purchase coins with fiat currency, a feature most exchanges lack) to purchase those coins leading to increased demand and liquidity in the market. Of more concern might be delisting. Exchanges could choose to de-list smaller coins after shorting them, reaping profits while providing no value. Looking to other factors, some traditional economic rationales behind insider trading regulation apply in the case of cryptocurrency (e.g. higher prices based on the expectation of informed trading), but others do not (e.g. increasing the cost of capital for issuers). One could argue that insider trading by exchanges would stoke fears of manipulation, but unlike the manipulation at Mt. Gox[17] insider trading would increase, rather than decrease price accuracy. If exchanges openly practiced insider trading while eschewing other manipulation, they may actually increase market confidence in accurate prices.

All this worry may be for nought, though, as market incentives push hard against insider trading by exchanges. The reaction to the allegations of Coinbase insider trading suggests that exchange reputation, an extremely valuable asset in a market with a history of costly exchange hacks and scams, might be damaged by such trading. As a result, it is unlikely exchanges will choose to trade on this information, at least to the extent such trading is discoverable by the public. Coinbase’s swift, strong response to the allegations of trading by its employees^[18] goes to this point. Moreover, trading on the basis of delisting (identified above as the most concerning sort of exchange insider trading) would be especially easily discoverable, as an unwarranted de-listing coupled with sizable short orders would be a clear signal to the market that the exchange had traded on this information. Ultimately, the CFTC may not need to worry about exchanges themselves trading on insider information given the strong, negative market reaction to this behavior.

Conclusion

The exchange example shows that the CFTC is empowered to regulate some forms of cryptocurrency insider trading, and that it ought to exercise that power against rogue exchange employees. As the case of exchanges themselves trading on inside information suggests, things are less clear in other areas. Cryptocurrencies are unique in the types of market participants (e.g. developers, miners, chip makers, firms partnering with cryptocurrencies) who may have inside information. The CFTC may not be able to regulate insider trading by all of these actors, but it may be able to do so in some cases. Because the regulatory landscape is so new, the CFTC has the opportunity to craft comprehensive policy through its future rules and enforcement practices. Careful analysis of the policy implications of those choices, analysis that recognizes how cryptocurrency differs from both securities and traditional commodities, will be vital to ensuring the health and efficiency of cryptocurrency markets.

[1] See, e.g., https://www.coindesk.com/korean-regulator-investigating-staff-insider-trading-of-cryptocurrencies; https://www.theverge.com/2017/12/20/16800940/coinbase-bitcoin-cash-fork-insider-trading-probe

[7] United States v. O’Hagan, 521 U.S. 642, 655-656.

[16] While an exchange could almost certainly trade on their own impending listing under Rule 180.1, it is possible the CFTC could characterize such trading as fraudulent or manipulative on other rationales. As such, this post will address the policy implications of a potential ban.

[17] Mt. Gox, the exchange famous for a 2014 hack that crashed crypto markets, operated a trading bot that fraudulently purchased Bitcoin, driving up its price. https://www.cbsnews.com/news/bitcoin-cryptocurrencies-fear-of-market-manipulation/