Wednesday, May 23, 2018

CFTC staff advises exchanges, clearinghouses dealing in virtual currency products

By Amy Leisinger, J.D.

The CFTC staff has issued an advisory to provide guidance for registered exchanges and clearinghouses dealing in virtual currency derivative products. The advisory clarifies the staff’s expectations during review of new virtual currency derivatives for listing or clearing and highlights areas that require particular attention, including, among other things, enhanced market surveillance, large trader reporting, and risk management. According to the staff of the Division of Market Oversight and the Division of Clearing and Risk, the advisory is designed to help registrants to meet their statutory and self-regulatory obligations while facing the unique challenges associated with these emerging products.

Noting the importance of encouraging innovation and growth in virtual currency derivatives products within an appropriate oversight framework, the advisory provides guidance for registrants considering 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. Because of the differences between virtual currencies and other commodities, it is difficult to provide frame of reference for the virtual currency prices quoted on the spot markets, the advisory recognizes. In addition, the advisory notes that potential risks virtual currency platforms present to CFTC-regulated markets justify close scrutiny, particularly as they lack the transparency and regulatory protections of traditional derivatives platforms.

Surveillance. In light of these concerns, the advisory provides a list of key areas that warrant particularized attention when listing a new derivatives contract based on virtual currency pursuant to self-certification or voluntary submission for Commission review. As self-regulatory organizations (SROs), DCMs and SEFs must establish and maintain effective oversight programs designed to detect and prevent manipulation and delivery and cash-settlement disruptions. However, the advisory states that, without a clear view into the spot markets underlying trading in listed virtual currency derivatives, an exchange may lack the ability to effectively identify and address risks.

As such, the advisory explains that the CFTC staff will assess an exchange’s ability to look into underlying spot markets as part of its review of the exchange’s market surveillance program. The advisory posits that a well-designed surveillance program for virtual currency derivatives includes information-sharing arrangements with the underlying markets that provide access to trade data, including prices, volumes, times, and quotes. Regular monitoring serves to identify anomalies and address problems in a timely manner, according to the advisory, and close coordination with the CFTC’s surveillance group will allow the staff to better oversee and monitor trading in newly listed contracts.

Reporting. Under the CFTC’s rules, clearing members, futures commission merchants, and foreign brokers must file daily reports with the agency showing futures and option positions of traders with large positions; however, an exchange can set the reporting level in a particular commodity at a lower level than specified by the Commission, and thereby provide additional reporting. Because it could be difficult to obtain information about trading in the virtual currency spot markets, the advisory suggests that the existing large trader reporting framework could help to identify traders engaging in manipulative activity in virtual currency markets. The staff recommends that exchanges set the reporting threshold for any virtual currency derivative contracts at five bitcoin (or equivalent) to facilitate surveillance of relevant information in the spot markets.

Outreach and risk management. In light of the concerns about price volatility and lack of transparency regarding virtual currencies underlying derivatives contracts, the advisory urges exchanges to engage with relevant stakeholders in developing contract terms and related rules.

According to the advisory, the CFTC staff expects exchanges to solicit stakeholder views prior to listing a new contract on virtual currency, including individuals and entities beyond those interested in trading the new contract. Further, the advisory explains that exchanges should consider including explanations of substantive opposing views as part of its submission to the Commission for self-certification or prior approval for listing of a virtual currency derivative contract.

To increase transparency, if the staff cannot confirm that a contract subject to self-certification complies with the Commodity Exchange Act and CFTC regulations while the exchange lists (or intends to list) the contract, the staff may inform the exchange of its concerns and publish the notification as appropriate.

In addition, once the DCO that will clear a proposed contract is identified, the CFTC staff will request information relevant to clearing and review proposed margin requirements to assess whether they match up with the risks of the contract.

In a statement, CFTC Commissioner Rostin Behnam said that the advisory represents “another step in providing the public with greater transparency into this process.” However, he noted his desire to continue to explore further options, including possible parameters for determining when self-certification may not be appropriate and when matters should be brought before the Commission.