Monday, December 11, 2017

FIA warns on risks of cryptocurrency derivatives, calls for more CFTC oversight

By Lene Powell, J.D.

Given the extreme volatility of bitcoin and a lack of historical data, the CFTC should not have given the go-ahead to several exchanges to list bitcoin futures contracts and binary options through the expedited self-certification process, FIA CEO Walter Lukken said in an open letter to the CFTC. Without a robust public discussion of the risks, FIA is concerned that important issues may not have been fully considered, including whether there should be a separate guarantee fund for the unproven products.

“While we greatly appreciate the CFTC’s efforts to receive additional assurances from these exchanges, we remain apprehensive with the lack of transparency and regulation of the underlying reference products on which these futures contracts are based and whether exchanges have the proper oversight to ensure the reference products are not susceptible to manipulation, fraud, and operational risk,” Lukken wrote.

Products self-certified by exchanges. On December 1, 2017, the CFTC announced that the Chicago Mercantile Exchange Inc. (CME) and the CBOE Futures Exchange (CFE) had self-certified new contracts for bitcoin futures products, and the Cantor Exchange (Cantor) had self-certified a new contract for bitcoin binary options.

Under the self-certification process, a designated contract market (DCM) must determine that the new product complies with the Commodity Exchange Act (CEA) and CFTC regulations, including that the contract is not readily susceptible to manipulation. If the Commission does not find that the product would violate the CEA or regulations, the DCM may then list the new product one full business day later. Completion of this process does not constitute Commission approval, nor endorsement of the use or value of the products.

According to the CFTC, the “vast majority” of new products are brought to market through this process, and CFTC staff held “rigorous discussions” with the exchanges for weeks and months before the self-certifications. CFTC Chairman J. Christopher Giancarlo noted that the exchanges agreed to changes requested by staff on contract design and settlement, as well as to information-sharing and surveillance commitments. The CFTC said that after the products are launched, the agency will monitor risks, conduct reviews of designated contract markets, derivatives clearing organizations (DCOs), clearing firms and individual traders, and will also work closely with the National Futures Association (NFA).

FIA concerns. The price of bitcoin, the underlying reference product, has shot up over the past year. According to Coindesk, an information services provider for the digital asset industry, the price of one bitcoin passed $1,000 for the first time on January 1, 2017, and reached $16,601 on December 1, 2017. In addition, prices can swing wildly intraday and sometimes diverge significantly between bitcoin exchanges.

Given the extreme volatility of the underlying reference product and the novel, untested nature of the self-certified derivatives products, FIA is concerned that clearing firms bear the brunt of the risk through guarantee fund contributions and assessment obligations, rather than the exchanges and clearinghouses who list them. According to FIA, the one-day self-certification process did not allow for proper public transparency and input.

In particular, FIA believes the CFTC should have had public discussion on whether a separate guarantee fund for the products was appropriate or whether exchanges put additional capital in front of the clearing member guarantee fund. In addition, not all risk committees of the relevant exchanges were consulted before the certifications, per FIA’s understanding. FIA said that CPMI-IOSCO guidance and good governance would suggest that this should have happened.

FIA said it looks forward to a “healthy public discussion” on how to improve the self-certification process in the future, as well as the CFTC’s continued oversight of the emerging instruments.

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