The Commodity Futures Trading Commission is attempting to update its regulatory framework for derivatives clearinghouses to address the rise of new business structures that integrate certain functions that previously were separated. The agency’s five commissioners disagree on the way forward, however, with some calling for moving forward one step at a time and others urging a slower, more comprehensive approach.
Two pending proposals have brought these differences to light. At an open meeting today, the CFTC’s five commissioners discussed a proposal to close a gap in its customer protection requirements that was exposed by the failure of FTX a year ago. The commissioners also discussed a separate proposal from a company that is seeking to combine a clearinghouse, an exchange, and a futures commission merchant in one organization.
Direct Clearing
CFTC Chairman Rostin Behnam, describing the first proposal, explained that the agency’s approach to customer fund protections was based on the “historically prevailing model” in which intermediaries – namely FCMs – hold customer funds. A newer model has emerged, however, in which the clearinghouse clears directly for customers without any intermediation. In such models, the funds of these customers, who are often individuals, are not covered by the existing protections.
The proposed rule would seek to address that problem by creating analogous protections for the members of those clearinghouses. Those protections would include the segregation of clearing member property from the clearinghouse’s own funds and the daily reconciliation of balances owed to clearing members against the amount actually held in segregation.
“The growth and evolution of the non-intermediated clearing model necessitates the closure of the gap in our regulations that the lack of a regime for the safeguarding and protection of clearing member funds presents,” Behnam said. “The proposal of safeguards and protections for clearing member funds that are comparable to those applicable to customers is sound policy.”
Two CFTC commissioners expressed opposition to the proposal, however, and voted against issuing it in its present form.
Commissioner Christine Goldsmith Romero, a Democrat, warned that this new type of clearinghouse model raises many concerns, and the proposal only addresses one area. She stressed in particular the risk that this model would bypass the protections against money laundering and terrorist financing that are the responsibility of FCMs, and asked why the proposal did not make this the responsibility of the clearinghouse instead. The CFTC staff explained that they are in the process of analyzing whether the CFTC has the legal authority to impose this on clearinghouses, and said they are discussing this issue with the Treasury Department, which sets federal policy in this area.
Commissioner Summer Mersinger, a Republican, expressed similar concerns, and emphasized that the CFTC staff did not provide enough time for the commissioners to consider all the implications. The proposal was shared with the commissioners shortly before the Thanksgiving holiday, she said, and she asked why the agency needed to act on the proposal so quickly.
Commissioner Kristin Johnson joined Behnam in strongly supporting the proposal. Johnson’s staff worked closely with the CFTC staff in the development of the proposal, and she explained that it addresses one of her top priorities, customer protection.
Commissioner Chrstine Pham, a Republican, voted to “concur” with the proposal, allowing the CFTC to move forward and release the proposal for public comment.
Bitnomial Proposal
The second proposal, which was submitted by Bitnomial, a Chicago-based startup, also posed novel issues for the CFTC. Bitnomial, which is backed by several trading firms and cryptocurrency firms, has been seeking CFTC approval for a clearinghouse that it wants to establish for contracts that trade on its exchange. The novel issue is that Bitnomial also owns an FCM, and under its proposal that FCM would be a member of the clearinghouse.
Several commissioners warned that this “vertical integration” model would create significant conflicts of interest. For example, the clearinghouse might share confidential information about other clearing members with its own affiliate, giving its affiliate a competitive advantage. Another example would be that the affiliated FCM might get preferential treatment.
Johnson, who voted to approve the application, commented that FTX was a real-world example of conflicts of interest in a vertical structure, and she called for a new set of rules to address this trend in clearinghouse models. She emphasized, however, that in negotiations with the CFTC, Bitnomial agreed to put in place several additional protections to address the risks arising from this structure.
Goldsmith Romero, who voted no, said her concerns go well beyond conflicts of interest and she urged the agency to develop a more comprehensive approach before approving this application. She pointed to the request for public comment recently issued by the CFTC on the issues that arise in this type of organizational structure, and said many of the responses offered worthwhile recommendations to address the risks arising from this type of clearinghouse model. She cited as examples recommendations that such clearinghouses should be required to have higher capital requirements and conduct stress testing to assess the risk if an affiliate fails.
Behnam defended the agency’s approach, pointing out that two other companies have been able to take this vertical approach by simply buying an FCM. Under CFTC rules, an application to form a clearinghouse with an affiliated FCM requires CFTC approval, but an acquisition does not. Behnam stressed that the agency must treat market participants fairly and avoid “arbitrary” decisions, and he emphasized that he was satisfied by the additional protections agreed by Bitnomial.
The final vote was two yes votes from Behnam and Johnson, one no vote from Goldsmith Romero, and two concurring votes from Mersinger and Pham.
Bitnomial was founded in 2014. In 2020 it received CFTC approval to operate a futures and options exchange and in 2021 it began offering physically settled futures on bitcoin, with support from several non-bank FCMs. Its subsidiary, Bitnomial Clearing LLC, was approved as an FCM in 2022. Until now, it has relied on the clearinghouse operated by the Minneapolis Grain Exchange to act as its clearinghouse.
