Member Article

The Commodity Futures Trading Commission (CFTC) has clarified the priorities and expectations when a designated contract market (DCM) or swap execution facility (SEF) lists new virtual currency derivatives or when a derivatives clearing organization (DCO) clears virtual currency derivatives.  

Background and Key Terms

The CFTC is an independent federal agency that administers the Commodity Exchange Act, which regulates transactions in commodity interests.  Accordingly, the CFTC’s 2015 determination that Bitcoin and other virtual currencies are classified as “commodities” provides the CFTC with the basis to assert regulatory authority over virtual currency derivatives. 

Prior to listing a product for trading, CFTC Regulations 40.2 (self-certification) and 40.3 (voluntary submission for review and approval) require that DCMs and SEFs either self-certify compliance with the Commodity Exchange Act and CFTC regulations or submit the product for CFTC review and approval.  Similarly, a DCO must generally follow the same rules and regulations prior to accepting a product for clearing. 

DCMs – Designated contract markets are large recognized exchanges on which physical commodities and other derivatives, including certain swaps, are traded. 

DCOs – A derivatives clearing organization is an entity that enables each party to an agreement, contract, or transaction to substitute, through novation or otherwise, the credit of the DCO for the credit of the parties; arranges or provides, on a multilateral basis, for the settlement or netting of obligations; or otherwise provides clearing services or arrangements that mutualize or transfer credit risk among participants.  A DCO that seeks to provide clearing services with respect to futures contracts, options on futures contracts, or swaps must register with the CFTC before it can begin providing such services.

SEFs – Swap execution facilities are electronic swaps trading platforms that allow market participants to enter into derivatives transactions with one another, bypassing the large banks that have traditionally been the gatekeepers to these markets. 

The Chicago Mercantile Exchange, for example, is registered with the CFTC as a DCO, DCM and SEF.  Another commonly-recognized example is the Cboe Futures Exchange, which is registered with the CFTC as an SEF.  Following the two exchanges’ self-certification of Bitcoin futures products in December 2017, staff from both the Chicago Mercantile Exchange and the Cboe Futures Exchange have continued to work collaboratively with the CFTC (see links in “More Reading” below). 

The Advisory

The Advisory is the latest among CFTC efforts to provide risk-management guidance in the virtual-currency market to help clearinghouses and exchanges provide proper safeguards and vetting for virtual currency derivative products due to heightened concerns of market manipulation, short history of trading (marked by periods of volatility) and the difficulty in setting adequate margin levels.

The CFTC highlights the below five key areas requiring particular attention when issuing or clearing virtual currency derivative products pursuant to CFTC Regulations 40.2 or 40.3:

1.  Enhanced Market Surveillance

The CFTC requires the establishment of an effective oversight program designed to ensure that listed contracts are not susceptible to manipulation and to detect and prevent manipulation, price distortion and disruptions of the delivery or cash-settlement process.  A well-designed market surveillance program for virtual currencies would include the following:

• An information sharing arrangement with the underlying spot markets;
• A heightened level of real-time monitoring with respect to trading on the spot markets, including real-time monitoring of relevant data feeds (price, volume, etc.); and
• Enhanced visibility into spot markets allowing for regulations similar to federal know your customer (KYC) or anti-money laundering (AML) regulations.

2. Coordination with CFTC Staff

The CFTC staff expects exchanges to engage in regular discussions with the CFTC regarding monitoring for potential manipulation and fraud and to provide surveillance information as requested by the CFTC.

3. Large Trader Reporting

Under the CFTC’s Large Trader Reporting System, reporting firms are required to file daily reports showing futures and option positions of traders with positions at or above specific reporting levels set by the CFTC. Accordingly, the CFTC set the large-trader reporting threshold for any virtual currency derivative contract at five Bitcoins or the equivalent for other virtual currencies.

4. Outreach to Members and Market Participants

The CFTC expects exchanges to take extra care to meaningfully engage with both market participants and members, including:

• Soliciting comments on issues relating to the listing beyond those that relate to the contract’s terms and conditions and susceptibility to manipulation;
• Consulting and soliciting comments from members and relevant stakeholders beyond those interested in trading the new contract; and
• As part of its submission to the CFTC (on either a self-certification or prior approval basis), including an explanation of any substantive opposing views learned from this outreach and how the exchange addressed such views or objections.

5. DCO Risk Management

Once the DCO that will clear the proposed contract has been identified, the CFTC staff will request from the DCO the following information:

• Proposed initial margin requirements;
• The ability of the proposed margin requirements to adequately cover potential future exposures to clearing members based on an appropriate historic time period; and
• The governance process for approving the proposed contracts (which the CFTC will review for adherence), including its consideration of the views of clearing members in approving the contract and the DCO’s response to any dissenting views regarding how the contract will be cleared.

More Reading

CFTC Regulation 40.2

CFTC Regulation 40.3

CFTC Backgrounder on Oversight of and Approach to Virtual Currency Futures Markets

CFTC Backgrounder on Self-Certified Contracts for Bitcoin Products

Also on May 21, 2018, the CFTC announced, in a joint press release with the North American Securities Administrators Association, that it had signed an agreement to establish a closer working relationship and greater information sharing between the CFTC and state securities agencies in enforcing the Commodity Exchange Act.  

 

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