On May 21, 2018, the U.S. Commodity Futures Trading Commission (CFTC) issued a joint staff advisory giving guidance to exchanges and clearinghouses registered with the CFTC for listing virtual currency derivative products. The advisory serves to clarify the CFTC’s priorities and expectations in reviewing new virtual currency derivatives to be listed on a designated contract market (DCM) or swap execution facility (SEF), or to be cleared by a derivatives clearing organization (DCO), with the aim of helping exchanges and clearinghouses discharge their statutory and self-regulatory responsibilities.
Because investment, speculative and financial transactions predominate commercial uses of virtual currency, it is difficult to provide context for the prices quoted on spot markets. Virtual currency platforms also raise concerns about their potential impact on CFTC-regulated markets, including market manipulation, because they lack the transparency and regulation of U.S. derivatives platforms. With these risks in mind, the advisory highlights five key areas for exchanges and clearinghouses to consider when listing new virtual currency derivatives contracts, either by self-certification or submission for CFTC approval:
Enhanced Market Surveillance
- As self-regulatory organizations, DCMs and SEFs must have effective oversight programs with adequate visibility into the underlying spot markets. For an exchange of virtual currency derivatives, the CFTC believes a well-designed market surveillance program includes an information sharing arrangement with the underlying spot market(s) that make up the cash settlement price to facilitate the exchange’s access to a range of trade data. This may include, but is not limited to, information relating to the identity of the traders, prices, volumes, times and quotes from the relevant market makers or traders.
- The CFTC recommends continuous monitoring of relevant data feeds, especially during and around the settlement period, to identify anomalies and disproportionate moves in the spot market(s) which may impact trading on the exchange. This would also allow the exchange to engage in appropriate inquiries with the underlying spot market when this occurs.
Coordination with CFTC Surveillance Group
- The CFTC believes that close coordination between CFTC staff and the listing exchange in monitoring for potential manipulation or fraud serves a critical role in effective oversight of virtual currency derivatives contracts. This would include regularly discussing issues related to surveillance and sharing surveillance information, including data related to the settlement process referenced by the contract so that CFTC staff may conduct their own independent surveillance, as well as coordinating the timing of derivative contract launches with the CFTC.
Large Trader Reporting
Under the Large Trader Reporting System, clearing members, futures commission merchants (FCMs) and foreign brokers file daily reports showing futures and option positions of traders with positions at or above specific reporting levels. Because of the difficulties in obtaining information related to trading in the spot markets and the potential adverse effects those markets may have on derivatives markets, the CFTC recommends that exchanges set the large trader reporting threshold at five bitcoin (or the equivalent for other virtual currencies).
Outreach to Members and Market Participants
- Prior to listing a new contract on virtual currency, CFTC staff expects an exchange to solicit views on issues related to the listing, beyond those that relate to the contract’s terms and conditions and its susceptibility to manipulation. In addition to soliciting input from market participants interested in trading the new contract, exchanges should consider consulting with clearing members and FCMs, including those who do not plan to offer clearing services, as they can provide valuable insight into DCO risk management.
- As part of its submission to the CFTC for the virtual currency derivative contract listing, exchanges should generally include as much information as possible, including an explanation of any substantive opposing views learned from this outreach, and how the exchange addressed such views or objections.
DCO Risk Management and Governance
- The CFTC will review the DCO’s proposed initial margin requirements to assess whether they are commensurate with the risks of the contracts, including risks that result from any unusual product characteristics. The CFTC expects these to exceed those of less volatile commodities.
- CFTC staff will also be looking at the ability of proposed margin requirements to adequately cover potential future exposures to clearing members based on an appropriate historic time period. If the initial margin level is not adequate, the CFTC will require the DCO to make appropriate adjustments.
- Additionally, the CFTC will seek information related to the governance process for approving proposed contract(s). DCOs will be expected to explain how it considers the views of clearing members in approving the proposed contract, including its response to any dissenting views on how the contract will be cleared. CFTC staff will review the DCO’s adherence to internal governance procedures, including an assessment of its compliance with its product eligibility requirements.
The CFTC expects to reevaluate and revisit its advisory, as necessary, to address new or heightened concerns. Additionally, if CFTC staff is unable to confirm that a contract being self-certified complies with the Commodity Exchange Act and CFTC regulations, the CFTC may notify the exchange of its concerns and may make such notice public