CFTC v Binance
Crypto Goes to Commodity Court
The CFTC took direct aim at Binance this week. Binance is the global crypto exchange. It’s a global behemoth. Binance has 70% market share of crypto spot trading volume. It’s fabulously profitable. Binance was estimated to be worth $300 billion at the peak of the market. It’s the biggest crypto company by far.
The CFTC sued Binance and its founder for violating commodity regulations. The 74 page suit is detailed and damning. The investigation revealed staggering internal Binance communication corroborating the salacious allegations.
The severity of the allegations likely spell the demise of Binance as we know it today. The investigation states Binance i) operated an unlicensed commodities and derivatives exchange, ii) deliberately circumvented regulatory procedures, iii) traded against its clients and iv) knowingly facilitated terrorist financing. The suit states btc, eth and others are commodities pinning the CFTC against the SEC.
This article lays out:
What happened
Why it’s a big deal
The CFTC’s evidence
Binance’s response
How things will play out
So what…
What happened?
On March 27, 2023 the Commodities Futures Trading Commission (“CFTC”) filed a civil enforcement action against Binance and its CEO Changpeng Zhao (“CZ”) for numerous violations of the Commodity Exchange Act. The CFTC is seeking disgorgements of profits, civil monetary penalties, permanent trading and registration bans and permanent injunction against further violations of regulations.
Defendants’ alleged willful evasion of U.S. law is at the core of the Commission’s complaint against Binance. The defendants’ own emails and chats reflect that Binance’s compliance efforts have been a sham and Binance deliberately chose – over and over – to place profits over following the law.
- Gretchen Lowe, CFTC’s Enforcement Division Principal Deputy Director and Chief Counsel.
The CFTC believes Binance broke US law. The Commission wants to ban Binance from ever doing business with Americans. Trading of commodities, futures and options in the US needs to be done according to the Commodity Exchange Act. The CFTC sees to it.
Binance operates Binance.US, which caters to US crypto traders. Binance.com caters to non-US traders. Traders prefer trading on Binance.com. There are more assets to trade. Trade execution is better. The profit potential is larger. The CFTC asserts that Binance enabled US customers to illegally trade through Binance.com.
Why it’s a big deal
1. Damaging allegations
The CFTC alleges that 20% of Binance business was from American clients. That’s what gives CFTC ground to sue Binance. The allegations include:
Binance knowingly broke US laws
Binance Know-Your-Customer (“KYC”) and Anti Money Laundering (“AML”) procedures were a sham
Binance aided US customers to circumvent their KYC and AML procedures
Binance’s founder was directly involved in setting policies to break US laws
Binance knowingly facilitated terrorist financing
Binance traded against its customer’s accounts
2. Jeopardizes Binance’s future
Binance’s business is in peril if the allegations are true. Binance would cease business with all US clients. The CFTC notes US traders are 20% of Binance’s business. American traders likely make up even more than 20% of Binance’s volume. They’re highly sophisticated and well capitalized trading firms that need to overcome several hurdles to get onto Binance. Losing over 20% of volume for an exchange is detrimental.
Declining trading volumes have cascading effects. Once trading volume is removed from the exchange, more volumes follow. The remaining traders can’t find the liquidity they’re used to. Execution deteriorates. Trade opportunities diminish. Enterprising traders leave in search of other venues and opportunities to profit.
The CFTC sued BitMex in 2020 for “operating an unregistered trading platform and violating multiple CFTC regulations.” BitMex was at the time the largest crypto derivatives exchange. FRNT’s Morning Note points out that BitMex lost 50% of its deposits and its ranking as the top derivatives exchange in the months following the indictment.
Binance could face a similar volume exodus imperiling its business. The road of high-flying crypto exchanges is littered with carcasses.
3. Knock on effects to crypto markets
If the suit does endanger Binance’s business, some traders will shift to other exchanges, others will leave the industry. The profit opportunity for trading declines when volumes drop. There is less stuff to trade, with fewer people. The net impact is less volume and less liquidity. The result of which is lower prices, especially for thinly traded assets.
Rival exchanges will benefit from volumes departing Binance. Coinbase could be a modest beneficiary. American traders could switch from Binance to Coinbase. That won’t happen en masse. There is far less to trade on Coinbase than Binance. Binance has 70% share of the spot market. Coinbase has 6%. Binance lists 2,174 trading pairs. Coinbase lists 589.
Crypto trading volumes will decline substantially if the largest crypto exchange by far gets scaled back. Less trading. Less capital. Less people. Less innovation.
4. CFTC says btc, eth, ltc, USDT, BUSD are commodities
The CFTC stated unequivocally in its suit against Binance that btc, eth, ltc and at least two fiat-backed stablecoins (USD Tether and Binance USD) are commodities.
CFTC views these digital assets as commodities, which is what gives it grounds to sue Binance for failing to abide by commodities laws.
5. CFTC v SEC: commodity or security?
The CFTC and SEC are now officially in a turf battle for US digital asset regulation. They have both picked their legal battles to prove their respective views.
The SEC served Coinbase a Wells Notice on March 22, 2023 for potentially violating securities laws (read SEC v COIN: The Heavyweight Battle for US Crypto).
The CFTC picked up the fight five days later by suing Binance. The CFTC claims that it is the appropriate regulator because digital assets are commodities.
So what happens?
Fellow Crypto Clarity readers Austin Campbell and Laura Shin discussed this on the Unchained Podcast.
Austin explained that a judge decides. The CFTC is making a blunt assertion in court that the digital assets in question are commodities. The presiding judge will determine if the CFTC has jurisdiction to bring the suit based on two factors i) are the assets commodities and ii) are Americans involved. The case for the latter is clear. The case for the former is less so.
If the case proceeds it establishes a body of law that suggests the assets in question are commodities. Someone could object to the suit. The obvious objector would be the SEC. It would be bizarre and a likely precedent for the SEC to object to a CFTC lawsuit. Federal regulators don’t contest each other in federal court.
There is a good chance the case moves forward establishing a precedent that btc, eth, ltc, USDT and BUSD are commodities, unless the SEC objects to the CFTC’s suit against Binance.
6. US ostracizing crypto
The CFTC suit against Binance aims to prevent American firms from engaging with crypto. The suit is another example in a litany of actions taken in 2023 to ostracize crypto from the US (read Crypto Crackdown: Regulators Mount Up).
The SEC’s cases against crypto companies aim to defend the American retail investor against conniving crypto scams. That’s not what the CFTC case against Binance is about. The crux of the CFTC’s argument lies with highly sophisticated well capitalized American trading firms. The CFTC is not worried about these firms being taken advantage of.
US regulators can’t shut down crypto. But they can prevent US firms and capital from engaging with crypto. That’s what this case is about. Regulators can’t shut down Binance. But they can prevent American firms, which represent at least 20% of Binance business, from trading with Binance. That would be a big blow to Binance’s business and crypto in general.
7. American trading firms be warned
The CFTC case sent chills to American crypto trading firms. The CFTC suit presents three unnamed American trading firms who Binance helped get access to Binance.com.
Radix Trading, a Chicago based quantitative trading firm, identified itself as one of the trading firms in the CFTC lawsuit. Radix confirmed it “traded on Binance during the past few years using offshore affiliates and a prime brokerage that provided access to the exchange.” The WSJ reported that “such arrangements are common among U.S.-headquartered trading firms active in crypto.” Radix is cooperating with the CFTC. It is not under investigation. It does not believe it acted illegally.
Tarun Chitra stated on the Chopping Block podcast that the other two unnamed trading firms are Jane Street and Tower Research.
Regulators tend to not go after trading firms in these cases. The exchange is responsible for following the required regulatory framework. The trading firms in question are not embroiled in the suit as far as we know. But they’re in the cross hairs. I suspect they’re reconsidering trading with Binance in any capacity. If they risk losing their license, their volumes will immediately vanish from Binance.
The CFTC’s evidence
The CFTC obtained internal communications evidencing Binance’s willful disregard of US law. The CFTC evidence includes:
1. 20% of Binance’s business came from US
Binance actively solicits US customers to Binance.com, according to the CFTC. Americans contribute a meaningful part of Binance’s business. The CFTC disclosed evidence that 19% of Binance’s July 2019 revenue was from the US. 20% of customers were located in the US as of June 2020.
2. Binance aided US customers to circumvent regulation
American clients are not allowed to trade on Binance.com. It's an unregistered commodities exchange. Binance aided Americans clients to trade on Binance.com by facilitating workarounds including:
i) 2 BTC threshold
Binance did not restrict the ability of US customers to access its platform for the first two years of its operation, per CFTC disclosure. Binance implemented restrictions on US clients in mid-2019. The CFTC believes Binance deliberately left a loophole for US clients to gain access to Binance.com. Americans were able to sign up, deposit assets, trade and make withdrawals without KYC procedures as long “as the customer withdrew less than the value of two BTC in one day.” The value of 2 btc in mid-2019 was $25,000.
ii) Self-certification
Binance stated it blocked US IP addresses as of September 2019. The CFTC claims that was a ruse. Clients were not blocked. Instead, they were asked to self-certify that they were not a US person.
iii) VPN use
The CFTC claims that Binance encouraged US clients to use VPNs to conceal their true location. Binance published a guide on its website in April 2019 explaining how to use a VPN and hinted “you might want to use a VPN to unlock sites that are restricted in your country.”
iv) ‘New’ KYC docs
Binance introduced the “VIP Handling” policy in October 2020. The policy formalized Binance’s processes for instructing high value American clients on how to evade its compliance protocols. VIP clients were instructed to complete ‘new’ compliance documents that omitted any reference to their existing US enterprise. Shell companies incorporated outside of the US were established by clients to act as the nominee for the new account. The VIP status of the ‘old American’ account was transferred to the ‘new non-American’ account. VIP status enabled lower trading fees and better execution. The process obfuscated a ‘US-client’ into a ‘non-US-client.’
The CFTC presents the case of three large American quantitative trading firms who Binance aided to circumvent the law. These firms are incorporated in the US, owned by Americans, have significant capital from Americans and the key employees are Americans. Binance guided them from 2019 onward to use a combination of VPNs, personal foreign accounts and shell companies to gain access to Binance.com.
3. Binance knew they were evading US law
The CFTC argues that Binance knew it was evading US law. The investigation surfaced damning communications indicating as much.
The CFTC has messages stipulating that CZ was directly involved in advising one of the three American firms in question. On October 9, 2020, the following message exchange took place between CZ and a Binance employee:
Employee: Hi CZ . . . I went through list of affected API clients, it includes a number of large strategic accounts including [a Chicago-headquartered trading firm] who is currently is a top 5 client and 12% of our volume
CZ: Give them a heads up to ensure they don’t connect from a us Ip. Don’t leave anything in writing. They have non us entities. Let’s also make sure we don’t hit the biggest market makers with that email first. Do you have signal?
‘Signal’ is referring to the non-traceable messaging app. The investigation revealed that all Binance US communication was done via Signal at CZ’s request.
Samuel Lim, Binance’s former Chief Compliance Officer, is charged with aiding and abetting Binance’s violations. He explains, in February 2020, why US clients can’t access Binance.com and how ‘creative means’ should be used to get them access:
Employee: hi Samuel, we are helping [an intermediary] to integrate with us to introduce new users and trade liquidity, but find most of their users are from US. Now Binance.com block US IP from registration. May I ask whether it is still a hard requirement nowadays?
Lim: Yes, it still is. Because if US users get on .com we become subjected to the following US regulators, fincen ofac and SEC. But as best we can we try to ask our users to use VPN or ask them to provide (if there are an entity) non-US documents. On the surface we cannot be seen to have US users but in reality we should get them through other creative means.
Lim's messages suggest he was aware of the different regulatory requirements and potential punishment. He texted in October 2020:
US users = CFTC = civil case can pay fine and settle
no kyc = BSA [Bank Secrecy Act] act [sic] = criminal case have to go [to] jail
Lim’s messages offered more damning evidence. In January 2019, he noted that “Cz doesn’t wanna do us kyc on .com.” In March 2019, Lim explained that:
“CZ wants people to have a way to know how to vpn to use [a Binance functionality] . . . it’s a biz decision.” Lim continued “We are actually pretty explicit about [encouraged VPN use] already – even got a fking guide.”
Binance fabricated Money Laundering Reports according to the CFTC. Its Money Laundering Reporting Officer (“MLRO”) lamented in November 2020 that she “need[ed] to write a fake annual MLRO report to Binance board of directors wtf.” Lim assured her, “yea its fine I can get mgmt. to sign.” He was aware Binance did not have a board.
Fabricated reports suggesting Binance is AML compliant to gain client business is fraud.
4. Binance trading against clients
The CFTC revealed that Binance trades against its own clients on its platform through 300 “house accounts'' and proprietary trading firms Merit Peak and Sigma Chain, which are both owned by CZ. The proprietary trading accounts are not subject to “insider trading” policy. They are not disclosed to Binance customers.
Any form of exchange using insider information to trade against or front-run its own clients is illegal.
5. Facilitating money laundering and terrorist financing
The investigation indicated that Binance employees acknowledge the platform has facilitated illegal activities.
In response to transactions regarding Hamas, Lim commented in February 2019 that terrorists usually send “small sums” as “large sums constitute money laundering.” A colleague replied “can barely buy an AK47 with 600 bucks.”
Astounding. Binance barely makes money on the $600 transaction. Yet, according to the CFTC, they processed it anyway knowing it was tied to Hamas and then joked about it in writing.
In regards to Russian clients, Lim said in February 2020 “Like come on. They are here for crime.” Binance’s Money Laundering Reporting Officer quipped “we see the bad, but we close 2 eyes.”
Binance’s response
CZ tweeted 4. His code to ignore the FUD (Fear, Uncertainty, Doubt).
Binance later responded. Binance stated it has cooperated with the CFTC for two years. Binance stated that the CFTC’s complaint:
appears to contain an incomplete recitation of facts, and we do not agree with the characterization of many of the issues alleged in the complaint.
Binance is the first global exchange to implement a mandatory KYC program. It blocks US users through several means. Binance is committed to cooperating with regulators. Binance employs 750 people in its compliance team. Binance does not trade against its own clients. The “house accounts” are used to convert Binance’s crypto into fiat and provide liquidity. The accounts are monitored to “not to have large profits.”
I think Binance’s best defense is rooted in its remedying actions. The majority of the allegations span from 2018-2020. The CFTC will look favorably on Binance if it can prove it has remedied its shortcomings. I have no idea if Binance’s policies and implementation are any better.
I don’t think Binance has much defense in not knowing the assets were viewed as commodities by US regulators. The real issue for Binance is they were trading futures and options derived from crypto assets. The US law is clear that if you trade derivatives, you need a license. That’s why Coinbase only trades spot in the US. That’s why BitMex, formerly the largest crypto derivatives exchange, was sued by the CFTC in 2020.
How this could play out
CZ and Binance have three options to settle the suit: ignore, fight or settle.
Ignore
CZ and Binance could ignore the suit. If they failed to defend themselves, the CFTC would likely win. CZ and all would likely face additional charges of contempt and obstruction of justice.
So what…
Well CZ and his associates would then be criminals on the run. They could be apprehended and extradited to the US. No western world financial institution would be willing to interact with Binance and its associates thereafter. The American trading firms in question would defect, and likely many more would follow suit.
Whatever remains of Binance would be a fraction of its current state.
Fight
Binance and CZ would open up its books during the discovery process to US regulators. That leaves them wide open for other litigation.
The DoJ has been mulling pressing criminal charges on Binance and CZ since December 2022. The SEC is rumored to be investigating Binance as well.
Does Binance really want to invite more scrutiny into its operations with so many knocking down the door?
Settle
Perhaps the most appealing option is to settle. Binance would pay a large fine and rescind all US linked operations. It would not admit any wrongdoing. It would remain an off-shore exchange. Financial institutions tied to the western world would likely sever ties.
Binance would look dramatically different than it does today.
So what…
There are far reaching implications for Binance, US crypto and global crypto.
For Binance:
The outcome is dependent on i) if the DoJ presses criminal charges, ii) if US trading firms are jettisoned and iii) how much have the bad actions been remediated.
If the DoJ presses charges and US trading firms are forcefully ejected, Binance’s demise will be a matter of months.
If Binance corroborates with the CFTC, can prove that it has drastically remedied its negligence and CZ was not aware of malfeasance, then a favorable settlement is possible. Binance pays a fine. CZ stays in power. US accounts are blocked. But ‘US-offshore’ accounts, like the three trading firms mentioned, continue to trade on Binance. Volumes don’t drop dramatically.
I think an outcome in between these two is most likely. Binance is not getting a slap on the wrist. The combination of crypto blood-thirst and flaunting regulation is too prevalent. Binance could settle for a large fine. Complete removal from all US-linked accounts. No interaction with the US whatsoever. Volumes decline. Binance’s dominance weakens.
For US crypto:
Regulators fighting themselves in public is not how I expected US regulation to play out. The litigious action will force regulatory discussion to the forefront.
We will get clarity on security, commodity or something else.
I suspect the SEC will not contest the CFTC suit. The CFTC suit will move ahead faster than the SEC’s investigation of Coinbase. The precedent for digital assets as commodities will emerge. Overturning that precedent will be challenging, by which time Gensler will be out of the SEC.
For global crypto:
Trading volumes will decline. Liquidity will deteriorate and will be spread across several exchanges. Crypto trading will become less profitable. The partial dismantling of Binance’s empire extends the bear market.
Clearer regulation and the diminished ‘financialization’ of crypto spawns more useful innovation.
Stay curious.
Follow me on Twitter @samuelmandrew for my latest.
Thinking for this article was informed by Matt Levine, Austin Campbell, Adam Cochran, Laura Shin, Haseeb Qureshi, Rob Leshmer, Tarun Chitra, Tom Schmidt. Thank you.