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Smart Contracts: Not quite the Wild West of fintech

A US perspective on smart contract regulation

18 July 2019

The hype on smart contracts is just about impossible to escape if you are at all involved in Fintech. They will eliminate middlemen, bring about vast efficiency gains and change the world. All of that might be true, but one aspect of smart contracts and their Blockchain-based brethren remains murky: who's policing all of this and what happens when something goes wrong?

Fintech has a Wild West feel to it: there are no direct rules and no specific rulemakers. Some old-school U.S. regulatory authorities, however, have a slightly different view: even if e-currency and smart contracts feel completely different and new, you still have to follow the laws written before smart contracts were a gleam in Satoshi Nakamoto's eye. If you don't, a self-appointed sheriff and his posse will come find you.

One of the most active sheriffs so far appears to be the U.S. Commodity Futures Trading Commission, or the CFTC. In 2015, the CFTC brought what was believed to be the first enforcement action against a Bitcoin-based market when it took action against Derivabit, "a risk management platform ... that connects buyers and sellers of standardized Bitcoin options and futures contracts." Derivabit was a Bitcoin-based market that sold futures contracts – contracts with Bitcoins as the asset underlying the options, where users could place put and call bids executed at the speed of their computer processor.  

Sound like a souped-up, teched-up version of a commodities exchange? That's what the CFTC thought too. And because the CFTC has responsibility for regulating commodities and futures trading the enforcers took a close look at Derivabit.  

It turns out that the word "commodity" in the Commodity Exchange Act is interpreted broadly. So broad, in fact, that virtual currency, such as Bitcoins, fits within the definition. Derivabit was found to have violated the Act and its CEO and "controlling person" wound up holding the (virtual) bag. The CFTC didn't hang 'em high, but it did shut down the exchange, basically for trading without a license.

Something similar happened to Bitfinex, an "online platform for exchanging and trading cryptocurrencies," in 2016. If Derivabit was an online version of a commodities exchange, Bitfinex was an online version of a currency exchange that dealt in e-currency — again, executing contracts bid on by buyers and sellers and executed at the speed of silicon. When the CFTC took a look, it didn't go well for Bitfinex. The CFTC found that Bitfinex was "engaged in illegal, off-exchange commodity transactions and failed to register as a futures commission merchant," violating the Commodity Exchange Act. The company got shut down and paid a $75,000 fine. Here's guessing it couldn't pay in Bitcoins.

By now it should be obvious that just because the regulators acknowledge that smart contracts and Blockchains are "moving rapidly, faster than underlying legal and regulatory frameworks," and that regulations "are currently unwritten and likely years away," it doesn't mean smart contracts are free from regulatory scrutiny. Regulators in the UK and Australia are among those toying with new models for regulating smart contracts and other next generation financial products and services, but regulators are also looking at ways existing laws apply to these new technologies, often with dire results for entrepreneurs.

Bottom line? The rules for smart contracts may take years to be written but, at least in the U.S., regulators consider cryptocurrencies to be commodities. That means innovators need to be smart with their smart contracts and follow the Commodity Exchange Act if their business model involves the exchange of contracts, options, derivatives, or other products that look and feel like something within the regulators' traditional portfolio. 

In the end, maybe smart contracts and fintech really are like the Wild West: the law doesn't exist, until the lawman shows up.