There has been much publicity around the cases that the U.S. Commodity and Futures Trading Commission (“CFTC”) has brought against exchanges, such as Binance. Those cases, according to the CFTC, were meant to demonstrate that the CFTC would not tolerate digital asset exchanges that fail to register with the CFTC or comply with the agency’s rules concerning the derivatives markets. On May 13, 2024, the CFTC went one step further down the chain in, for the first time, charging that an intermediary inappropriately facilitated access to exchanges.
The CFTC issued an Order simultaneously filing and settling charges against Falcon Labs, Ltd., an entity organized under the laws of the Seychelles, for failing to register with the CFTC as a futures commission merchant (FCM). According to the Order, Falcon Labs acted as a “prime broker” by offering a product it called “Edge” to its institutional customers, including customers located in the United States. Edge provided certain Falcon Labs customers with cross-margined, direct access to digital asset exchanges to trade derivatives, including futures and swaps. Falcon Labs functioned as an intermediary facilitating its customers’ trading on various digital asset exchanges, including U.S.-located customers, and provided them with direct access to those exchanges. Falcon Labs did not provide the digital asset exchanges with any customer-identifying information for its customers who traded on the exchanges. Falcon Labs also accepted money or other assets from the customers to margin or collateralize customers’ trading activity. Through these activities, Falcon Labs satisfied the definition of an FCM. Persons that act as FCMs must register as such with the Commission under Section 4d(a)(1) of the Commodity Exchange Act,. Falcon Labs violated the statute because it was not registered as an FCM.
The CFTC noted that Falcon Labs voluntarily improved its controls for identifying the location of its customers after the CFTC brought a complaint against an exchange, alleging in part that prime brokers opened “sub-accounts” through which U.S.-located customers traded digital asset derivatives on the exchange. More specifically, Falcon Labs updated and enhanced its KYC procedures for onboarding to the Edge platform and conducted a review of existing Edge customers to ensure that access would only be offered to those who meet certain criteria. Under the revised procedures, Falcon Labs required Edge customers to provide additional documentation regarding the customer’s jurisdiction of organization and principal place of business; the residency of traders using the Edge product or directing trading decisions made using the Edge product; and the jurisdiction of organization, principal place of business and residence, as relevant, of the customer’s ultimate beneficial ownership. Falcon Labs assessed each customer’s eligibility for Edge based on specific criteria that it established in light of the allegations in the Binance case. In applying these enhanced criteria retroactively to its existing clients, Falcon Labs off-boarded any customers who did not meet the criteria. Falcon Labs also required Edge customers to provide written representations as to their non-U.S. status. Further, Falcon Labs applied engineering solutions designed to detect customer use of U.S. IP addresses that could be inconsistent with the customer’s KYC documentation and representations.
This self-improvement, along with the substantial cooperation of Falcon Labs with the CFTC, was reflected in the form of a reduced civil monetary penalty. The CFTC said that it hoped this would encourage other digital asset intermediaries operating illegally to come forward and report their activities to the agency.
Under the Order, without admitting or denying liability, Falcon Labs agreed to (i) cease and desist from violating Section 4d(a)(1) of the Act; 3; (ii) pay disgorgement in the amount $1,179,008 (the amount of net fees from customers entering into digital asset derivative transactions intermediated by Falcon Labs); and (iii) pay a civil monetary penalty in the amount $589,504 (half the disgorgement amount).
