CFTC Staff Advisory Sets Challenging Standards for Future Virtual Currency Derivatives
On May 21, the Commodity Futures Trading Commission (CFTC) issued a special Staff Advisory with guidance to regulated trading platforms and clearing organizations that propose to list and trade derivatives contracts on virtual currencies.1 The Staff Advisory follows the somewhat controversial listing of Bitcoin futures contracts on two CFTC-regulated exchanges earlier this year, and focuses on the potential for market manipulation. It was issued only days before reports of investigations by the Justice Department and the CFTC into potential manipulation of the prices for Bitcoin and Ether.2
The Staff Advisory is likely to make it more difficult to list and trade new virtual currency derivatives, resulting in fewer trading options for hedgers and speculators. It also calls for derivatives exchanges to more closely coordinate surveillance efforts with spot market trading platforms for virtual currencies. As an indirect result, spot trading platforms and their users can expect greater scrutiny from CFTC-regulated entities and from federal regulators.
Summary of the Staff Advisory
Staff Advisory No. 18-14 was issued jointly by the CFTC's Division of Market Oversight and Division of Clearing and Risk, the two divisions with chief responsibility for oversight of trading, trade processing, clearing and exchanges. The Staff Advisory notes that "[v]irtual currencies are unlike any commodity that the CFTC has dealt with in the past," and acknowledges that there are substantial difficulties in ascertaining the relationship between spot market prices for virtual currencies and traditional forces of supply and demand. In this context, the Staff Advisory describes expectations for new derivative products in the following areas: (A) market surveillance; (B) large trader reporting; (C) coordination with CFTC staff; (D) outreach to stakeholders; and (E) risk management for derivatives clearing organizations (DCOs).
A. Market Surveillance
Under the Commodity Exchange Act (CEA), derivatives exchanges must ensure that listed contracts are not readily susceptible to manipulation. Exchanges must also be able to detect and prevent manipulation, price distortion, and disruptions of the delivery or cash-settlement process.3 For these purposes, exchanges must be able to require their traders to provide information about their activities in the underlying spot markets.4 However, the Staff Advisory indicates that in order for an exchange to detect and prevent abuses with respect to virtual currency derivatives, it should also have information sharing arrangements with any reference spot market(s). Such arrangements should provide the listing exchange with the right and ability to access trade data on the relevant spot market(s), including, but not limited to, the identities of traders, prices, volumes, times, and quotes. The staff further expects that derivatives exchanges will base their contracts on prices generated by spot market trading platforms that follow the pattern of federal know-your-customer (KYC) and other anti-money laundering (AML) regulations. If the reference platform is located outside the United States, that platform should comply with its local jurisdiction's KYC/AML standards, which must be consistent with those developed by the Financial Action Task Force on Money Laundering.
Exchanges are also already required to conduct real-time monitoring of all trading activity on their electronic trading platforms in order to identify disorderly trading and any market or system anomalies. Staff Advisory 18-14 elaborates by explaining that for virtual currency derivatives, an exchange should continuously monitor data feeds from the underlying spot market(s) in order to identify events or transactions that might affect trading on the exchange. In such cases, the derivatives exchange should engage in appropriate follow-up, including by obtaining trader-level data from the spot market trading platform. CFTC staff expects that derivatives exchanges will conduct a heightened level of monitoring of the spot markets for virtual currency markets.
B. Large Trader Reporting
Under the CFTC's Large Trader Reporting System, clearing firms, futures commission merchants (FCMs), and foreign brokers (reporting firms) file daily reports that show futures and option positions of traders at or above specific reporting levels.5 Exchanges may set these reporting levels for particular contracts at lower levels than those specified in CFTC rules. In order to assist in the identification of traders who may be involved in manipulation, the Staff Advisory recommends that exchanges set the large trader reporting threshold for any virtual currency derivatives at five Bitcoin (or the equivalent in other virtual currencies). The staff recognizes that such low thresholds for reporting "will cover 70-90 percent of the total open interest in these contracts."6 Furthermore, the Staff Advisory notes that derivatives traders subject to large trader reporting may also be subject to reporting as to their spot market activities.
C. Coordination with CFTC Surveillance Staff
CFTC Staff expects derivatives exchanges to regularly engage with them on issues related to the surveillance of virtual currency derivatives contracts, and to provide surveillance information upon request. In addition, in order to assist the CFTC's own independent surveillance, the exchange must stand ready to provide any requested data related to the settlement process for spot market trades referenced by the derivative contract.
D. Outreach to Members and Market Participants
The Staff Advisory notes that certain participants in an exchange or DCO may not plan on trading derivatives on virtual currency but may nonetheless have insights or experience that would be useful in creating and listing a new product. The Advisory states that the process for listing new contracts should include consultation with such participants. As an example, the Staff Advisory notes that clearing members and FCMs, including those who do not plan to offer services related to the new contract, can provide valuable insight into DCO risk management. In its filings with the CFTC, an exchange should discuss opposing views on the listing and explain how any issues raised were addressed.
E. Risk Management by DCOs
For virtual currency derivative contracts that are subject to central clearing, CFTC staff will request and evaluate the relevant DCO's proposed initial margin requirements. Because the spot markets for virtual currencies are notoriously volatile, Advisory 18-14 explains that the Staff will assess whether the proposed margin requirements will be commensurate with the risks involved and that margin requirements for these products are expected to exceed those based on less volatile commodities. The Staff will reject margin standards that it believes are not sufficient to adequately cover potential exposures to clearing members. In addition, the Advisory states that CFTC staff will assess the DCO's adherence to its own product eligibility standards, including those relating to "the availability of reliable prices for the contract, the ability of the DCO to measure risk for purposes of setting margin requirements, and the operational capacity of the DCO and its clearing members to address any unusual product risk characteristics."7
Implications of the Advisory
Two futures contracts on Bitcoin were previously listed on CFTC-registered exchanges pursuant to certification processes that provide for limited CFTC review powers. Staff Advisory No. 18-14 effectively raises the bar for future listings of derivatives on virtual currencies. The Staff Advisory looks to the overall compliance standards for exchanges and DCOs in order to indirectly establish broader authority to review new listings for derivatives on virtual currencies. It also identifies surveillance and enforcement responsibilities that may be challenging to fulfill, and places the onus for compliance squarely on listing exchanges.
The enhanced expectations of the Staff are likely to make exchanges more cautious in listing new derivatives contracts on virtual currencies. Exchanges may find it difficult to have confidence in their abilities to surveil the underlying spot markets for virtual currencies, especially given recent news reports relating to investigations of manipulation. The Staff Advisory may also require derivatives exchanges and spot market trading platforms to examine their current relationships, and require enhanced information gathering from their participants.
Staff Advisory 18-14 therefore makes it more difficult for trading platforms to list and trade new derivatives on virtual currencies. In addition, its characterization of surveillance and other obligations may have an even broader impact that extends beyond derivatives exchanges, and into the underlying spot markets.
© Arnold & Porter Kaye Scholer LLP 2018 All Rights Reserved. This Advisory is intended to be a general summary of the law and does not constitute legal advice. You should consult with counsel to determine applicable legal requirements in a specific fact situation.
Advisory With Respect to Virtual Currency Derivative Product Listings, CFTC Staff Advisory No. 18-14 (May 21, 2018) (available here).