Responding to concerns about the risks of bitcoin derivatives, the Commodity Futures Trading Commission recently issued an advisory outlining the steps that exchanges should take before they launch any new contracts.
The agency's “enhanced” review process calls for increased input from clearing firms that are members of exchanges, giving them an opportunity to be more involved with any potential cryptocurrency product launches in the future.
Four CFTC-regulated exchanges currently offer bitcoin derivatives and several others have said they are talking with the CFTC about joining this new market. The CFTC has said it wants to help the markets keep pace with innovation but also make sure that potential risks are addressed.
The May 21 advisory aims “to aid market participants in their efforts to design risk management programs that address the new risks imposed by virtual currency products,” Brian Bussey, head of the agency's division of clearing and risk, said in a statement issued in conjunction with the advisory. He added that the advisory also will help ensure that "market participants follow appropriate governance processes with respect to the launch of these products.”
Under the CFTC's rules, existing exchanges such as CME Group and Cboe Futures Exchange can “self-certify” new products instead of seeking approval from the CFTC. That gives them the ability to bring new products into the market relatively quickly. The new advisory clarifies the process for self-certification, however, by outlining the obligations exchanges must meet when listing any new derivative contracts based on virtual currency. Those obligations fall into five areas: enhanced market surveillance, close coordination with CFTC staff, large trader reporting, outreach to members and market participants, and the risk management and governance arrangements at the clearinghouses handling these products.
The decision to issue the advisory stems from a flurry of activity last fall, when CME and Cboe rolled out futures on bitcoin. Some participants in the futures markets said they were not given enough time to prepare for the launch. Some also raised concerns about the extreme volatility of bitcoin prices and the susceptibility of the underlying markets to fraud and manipulation.
In response, the CFTC agreed to address these concerns and hosted a public meeting of its Market Risk Advisory Committee in January to explain its approach to these new products and gather feedback from market participants. At that meeting, several clearing firms expressed concerns about the use of the self-certification process not only for cryptocurrency derivatives but also for any new products that pose novel and complex risks. The clearing firms also stressed the need to make sure that market participants are ready to manage the risks before new contracts are launched.
The advisory sought to address these concerns. It said that prior to listing a new contract on derivatives, the CFTC staff will expect an exchange to solicit comments from market participants on the potential impact. For example, clearing members can provide valuable insight into clearinghouse risk management, the advisory said. Furthermore, an exchange will be expected to include "any substantive opposing views" received through the outreach process in the plans it submits to the CFTC for review.
CFTC Commissioner Rostin Behnam, who sponsored the public meeting in January, welcomed the issuance of the advisory as "another step in the providing the public with greater transparency" into the listing process. He added, however, that the CFTC should consider setting some "parameters" for determining when self-certification may not be appropriate.
Crackdown on ICOs
The release of the advisory coincided with a flurry of activity among federal and state regulators to coordinate their approaches to this new market. CFTC Chairman Chris Giancarlo, speaking on May 21 at a forum organized by the North American Securities Administrations Association, cited the advisory as the latest in a series of steps taken by the agency. “Our task, as market regulators, is to set and enforce rules that foster innovation while promoting market integrity and confidence,” Giancarlo said.
The CFTC chairman also called out a need to “explore the interplay of state and federal laws to ensure a coherent and rationalized approach.” That was illustrated this week by coordinated investigations across the U.S. and Canada intended to crack down on fraudulent initial coin offerings, or ICOs. NASAA announced that its members, who regulate securities offerings at the state and provincial level, have opened dozens of investigations and are pursuing multiple enforcement actions. Many are also conducting public outreach initiatives to warn investors.
“The persistently expanding exploitation of the crypto ecosystem by fraudsters is a significant threat to Main Street investors in the United States and Canada, and NASAA members are committed to combating this threat,” said Joseph Borg, the president of NASAA and the director of the Alabama Securities Commission. “Despite a series of public warnings from securities regulators at all levels of government, crypto criminals need to know that state and provincial securities regulators are taking swift and effective action to protect investors from their schemes and scams.”
ICOs were held at a record pace in 2017, raising more than $4 billion in equivalent value—up more than 40-fold from less than $100 million in 2016. The rise of coin offerings, however, has been mirrored by a rise in fraudulent activity. In fact, cryptocurrency fraud has become a big enough issue that the Securities and Exchange Commission has created a website to promote a fictitious initial coin offering dubbed HoweyCoin to illustrate how bad actors can use big promises and vague details to ensnare unwary investors. When unwary investors click the link to participate in this phony ICO, they are redirected to educational materials explaining the pitfalls of initial coin offerings.
Overseas, market regulators have also cracked down on various elements of the cryptocurrency markets. Earlier this year, the Hong Kong Securities and Futures Commission warned investors the risk of investing in initial coin offerings. And announced a crackdown on cryptocurrency exchanges that operate in Hong Kong without a license or violate local securities laws. Separately, three pan-European regulatory bodies issued an EU-wide warning to consumers regarding the risks of buying virtual currencies, emphasizing that they are highly volatile.