22 June, 2018
On May 21, 2018, the Commodity Futures Trading Commission (CFTC) announced two actions intended to increase surveillance of virtual currency markets and enforcement of the Commodity Exchange Act in relation to these markets.1 First, the CFTC and North American Securities Administrators Association (NASAA) signed a mutual cooperation agreement that is “intended to provide a framework for the sharing of confidential information between the CFTC and state securities regulators.”2 Second, the CFTC’s Division of Market Oversight and its Division of Clearing and Risk jointly issued an advisory regarding the listing of new virtual currency derivative products.3 Both actions evidence a recognition that the quickly evolving, tech-driven, virtual currency markets involve significant risks and require greater oversight. The CFTC looks to engage state securities regulators and self-regulatory organizations to provide additional oversight of these markets.
CFTC and NASAA Mutual Cooperation Agreement
The NASAA is an organization of state securities agencies with the mission of protecting customers who purchase securities or investment advice. Unlike at the federal level, where securities and commodities are regulated by separate agencies, state securities regulators may bring enforcement actions for commodities law violations. The mutual cooperation agreement provides that the CFTC and state regulators might share confidential information. Signatory states stand to receive whistleblower generated investigative leads, tips, complaints and referrals from the CFTC. This agreement should leverage state-level enforcement capabilities to help “ensure that the rapidly evolving financial technology space has the appropriate oversight to pursue bad actors [and] protect market participants . . . .”4
CFTC Virtual Currency Derivative Product Listing Advisory
Recently, exchanges introduced three derivatives contracts for virtual currency through the self-certification process for new products. Accordingly, the contracts were listed with limited input from the CFTC.
The CFTC staff’s advisory regarding virtual currency derivative product listings presents staff’s current thinking about the self-regulatory obligations of exchanges and clearinghouses with respect to virtual currency derivative products. The advisory describes the exchanges and clearinghouses as frontline regulators that ensure “proper surveillance and oversight of the trading and clearing of virtual currency contracts . . . .”5 CFTC staff, in issuing the advisory, seeks to clarify its “priorities and expectations in its review of new virtual currency derivatives to be listed on a designated contract market or swap execution facility, or to be cleared by a derivatives clearing organization.”6
The advisory acknowledges that “[v]irtual currencies are unlike any commodity that the CFTC has dealt with in the past.”7 Transactions and prices in the virtual currency spot market can be observed. However, unlike with other commodities, it is difficult to connect the price of a virtual currency to its intrinsic value, a commercial market or supply and demand for the virtual currency.8 According to the advisory, this creates risk of potential market manipulation and potentially threatens the stability of clearinghouses during times of extreme price volatility.9 In light of these risks, the staff seeks greater transparency in the process for listing a new virtual currency derivatives contract pursuant to the self-certification process by addressing the five key topics discussed below.
1. Enhanced Market Surveillance
The advisory expresses the concern that diminished visibility into the underlying spot market makes it more difficult for exchanges to detect and prevent manipulation, price distortion and disruptions of the settlement process. Accordingly, an exchange’s market surveillance program for virtual currency derivatives should allow the exchange to access spot market trade data, including trader identities, prices, volumes, times and quotes.10 Exchanges are instructed to continuously monitor spot market data feeds, particularly during the closing period, to identify disorderly trading or other market anomalies.11
2. Close Coordination with CFTC Surveillance Group
The CFTC seeks close coordination with the exchanges in order to monitor for manipulation or fraud involving virtual currency derivative contracts.12 The staff expects regular surveillance discussions with exchanges and exchanges to provide surveillance information and data upon request so the staff can conduct its own independent surveillance.13
3. Large Trader Reporting
The CFTC’s large trader reporting system requires reporting firms to file daily reports showing reportable futures and options positions. The staff recommends that exchanges set the reporting threshold for virtual currency derivatives at five contracts, a reporting level likely to cover 70% to 90% of total open interest.14 The recommendation is based on the concern that manipulative trading in the opaque spot market could occur for the purpose of affecting the related derivative markets.15
4. Outreach to Members and Market Participants
CFTC staff expects exchanges to reach out to market participants as they develop contract terms and conditions before listing a new virtual currency-related contract.16 The staff would like exchanges, when submitting a certification to the CFTC to list a new product referencing a virtual currency, to include discussions beyond the terms and conditions of the listed contract and its susceptibility to manipulation. The staff would like the submission to include opposing views and how the exchange addressed such views or objections.17
5. Derivative Clearing Organization Risk Management
The advisory notes that CFTC staff will review the initial margin level proposed by the clearing organization intending to clear the proposed contract and require appropriate adjustments to the margin level.18 In approving the proposed contract for clearing, the staff expects the organization to explain its responses to any dissenting views provided by clearing members as to how the virtual currency derivatives contract will be cleared.19
The advisory is a clear signal to exchanges and clearinghouses that the CFTC staff expects greater surveillance and oversight for virtual currency contracts given the unique risks and challenges associated with these derivative products and their underlying spot markets. Similar to the message sent by the memorandum of agreement with the NASAA, the CFTC is signaling to state regulators and self-regulatory market participants that it seeks cooperation in addressing the challenges of regulating markets for virtual currencies and related listed derivatives contracts.
Gregory S. Kaufman, Partner, Eversheds
gregkaufman@eversheds-sutherland.com
1 In 2015, the CFTC found that bitcoin and other virtual currencies are properly defined as commodities. See In re Coinflip, Inc., CFTC No. 15-29, 2015 WL 5535736 (Sept. 17, 2015).
2 CFTC Release No. 7730-18.
3 CFTC Staff Advisory No. 18-14, “Advisory with respect to Virtual Currency Derivative Product Listings.”
4 See supra n. 2.
5 See supra n. 3 at p. 1.
6 See id. at pp. 1-2.
7 See id. at p. 2.
8 See id.
9 See id. at p. 3.
10 See id.
11 See id. at pp. 3-4.
12 See id. at p. 4.
13 See id.
14 See id. at p. 5.
15 See id.
16 See id.
17 See id. at p. 6.
18 See id.
19 See id.
