CFTC Partners With SEC And DOJ To Bring Coordinated DeFi Enforcement Action Targeting Oracle Manipulation - Financial Services

In Short

The Situation: Decentralized finance
(“DeFi”) is a rapidly growing sector that, by definition,
eschews centralized financial institutions altogether. Misconduct
that has accompanied that growth has drawn the attention of the
Commodity Futures Trading Commission (“CFTC”), which has
brought three DeFi cases in the last 12 months.

The Result: The latest subject of this scrutiny
allegedly artificially affected prices through “oracle
manipulation” on three digital asset exchanges to benefit his
“perpetual futures” contract positions on a DeFi market.
In response, the CFTC recently brought a civil enforcement action,
its first for a fraudulent or manipulative DeFi scheme, charging an
individual with wash trading and with unlawfully obtaining more
than $110 million in digital assets through this manipulative
scheme.

Looking Ahead: The CFTC, U.S. Securities and
Exchange Commission (“SEC”), U.S. Department of Justice
(“DOJ”), and other federal agencies will continue to
bring cases involving issues of first impression to apply their
jurisdiction in new markets, including DeFi markets, in response to
new methods of perceived violations of the statutes they
administer.

On January 9, 2023, the CFTC initiated a civil enforcement
action against the defendant, who came under scrutiny in October
2022 when he allegedly employed a manipulative strategy across
three digital asset exchanges, and Mango Markets, a DeFi protocol,
that yielded over $110 million in digital assets. The DOJ and SEC
also brought parallel charges. In its complaint, the CFTC alleges
that on October 11, 2022, the defendant misappropriated more than
$110 million in digital assets from Mango Markets through oracle
manipulation. An oracle is a data feed that moves data on and off a
blockchain. Oracle manipulation can consist of artificially
influencing the data feed to the oracle and/or into the
blockchain—in this case, the Mango Markets blockchain. This
is the type of oracle manipulation the CFTC alleged in its
complaint.

The defendant allegedly executed his improper scheme by creating
two anonymous accounts on Mango Markets, which he used to establish
long and short perpetual futures contracts in the different
accounts based upon the relative prices of MNGO, the native Mango
Markets token; and USDC, a stablecoin. According to the complaint,
the defendant then began purchasing substantial quantities of MNGO
on three digital asset exchanges that were the inputs for the Mango
Markets oracle. The complaint alleges that these high quantity,
large-scale transactions severely inflated the price of MNGO on
those exchanges, in turn significantly increasing the value of the
defendant’s long perpetual futures position on Mango Markets.
He then purportedly cashed out his position by taking a loan he did
not intend to repay, which was collateralized by the value of the
long position, effectively completely draining Mango Markets’s
liquidity, and requiring it to suspend operations. Although the
value of the defendant’s short position decreased dramatically,
the defendant needed to establish the short position so that he
would have a counterparty for his long position in his other
account, according to the complaint. The CFTC charged the defendant
with wash trading for executing this offsetting trade.

The complaint states that the defendant then contacted the Mango
Decentralized Autonomous Organization (“DAO”)—the
Mango Markets blockchain operator—to negotiate his return of
some of the digital assets that he had “borrowed,”
conditioned on Mango Markets agreeing, among other things, to not
pursue any criminal investigations or freeze the defendant’s
funds. The defendant agreed to return approximately $67 million in
digital assets but retained about $47 million, according to the
complaint.

This case represents the first CFTC enforcement action involving
DeFi manipulation and fraud and the third CFTC DeFi action overall
in a relatively short span of time, since January 2022. The first
two were actions against Polymarket in January 2022 and
Ooki DAO in September 2022. This trend
suggests that the CFTC is attuned to DeFi developments and focused
on this space. Two CFTC commissioners released statements
concurrent with the announcement of the complaint suggesting that
the CFTC is just getting started. For instance, Commissioner
Kristen Johnson noted that she supports the CFTC using its
“existing authority to vigorously pursue misconduct … in
novel venues like a decentralized digital asset exchange.”
Commissioner Caroline Pham noted that this enforcement action makes
clear that perpetual futures can constitute a swap, which brings
such a scheme within the CFTC’s jurisdiction.

As to perpetual futures, it is interesting that, although the
product is called a perpetual “futures,” a product over
which the CFTC also has jurisdiction, the CFTC characterized it as
a swap. This may be because the CFTC has lost several cases (e.g.,
CFTC v. Zelener, 373 F.3d 861 (7th Cir. 2004); CFTC v.
Erskine, 512 F.3d 309 (6th Cir. 2008)) in which it sought to
characterize products as futures; and the definition of
“swap” in the Commodity Exchange Act (“CEA”),
the statute the CFTC administers, is quite broad and possibly
easier to apply to particular new products. The CFTC has also
stated in the past that the name given to a product does not
dictate its legal treatment.

The case is also a notable example of cooperation and
coordination among the CFTC, DOJ, and SEC in the DeFi enforcement
space. In that regard, the CFTC’s Division of Enforcement has
an Office of Cooperative Enforcement, which
“provides expert help and technical assistance with case
development and trials to U.S. Attorneys’ Offices, other
federal and state … agencies, and international
authorities.” The CFTC’s Mango Markets enforcement press
release makes clear that it is working closely with the DOJ and
the SEC (which charged the defendant with manipulating
MNGO, “a so-called governance token that was offered and sold
as a security”), to crack down on various fraudulent schemes
involving digital assets. Relatedly, DOJ’s criminal complaint against the
defendant was unsealed on December 27, 2022.

Two Key Takeaways

The CFTC and other federal agencies are focused on DeFi
misconduct.

Though DeFi is new, the statutes cited in enforcement actions
administered by the CFTC, DOJ, and SEC (including the CEA,
securities laws, or wire fraud) are not new. Therefore, DeFi
innovators wishing to avoid a federal enforcement action would be
well advised to become familiar with the applicable federal
regulatory scheme.

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guide to the subject matter. Specialist advice should be sought
about your specific circumstances.