Conflicts of interest at exchanges and swap execution facilities (SEFs) present serious risk to market fairness, integrity, and financial stability.  The CFTC plays a critical role in implementing strong rules to prevent conflicts from hurting customers, markets, market participants, and end users.  As designated self-regulatory organizations, exchanges serve as the front line for market integrity.[1]  And given the contribution to the financial crisis of opaque caveat emptor swaps markets,[2] the Dodd-Frank Act created SEFs and gave them important regulatory responsibilities to ensure transparency in the swaps markets.[3]  In order for markets to function well and fairly, these important regulatory responsibilities must be performed free of conflicts of interest.

Existing CFTC rules already require exchanges and SEFs to establish and enforce rules to minimize conflicts of interest, and we have issued accompanying guidance to exchanges.  Though I support the rule, I consider it to be a baseline minimum, largely codifying existing guidance,[4] extending it to swap execution facilities, and adding a few additional requirements.

This proposed rule would not create an adequate conflicts of interest regulatory regime to cover conflicts that come from affiliated entities serving multiple functions (i.e. broker, exchange, clearinghouse, etc.)—so called “vertical integration,” which the proposal acknowledges.[5]  Therefore, this rule does not serve as a basis for future approval of additional vertically integrated structures that break from the traditional structure on which the Commodity Exchange Act and CFTC rules are based.

The proposal purposely attempts to carve out vertical integration from this rulemaking and commits to addressing it in the future in light of the recently completed request for comment on affiliated entities.  By September, the CFTC received more than 100 comments expressing significant concern over conflicts of interest with vertically integrated market structures.[6]  Serious concerns about vertically integrated market structures in digital assets had already been expressed by the White House in the Economic Report of the President,[7] the Financial Stability Oversight Council (FSOC),[8] Treasury Secretary Janet Yellen,[9] then-Federal Reserve Vice Chair Lael Brainard,[10] and Acting Comptroller of the Currency Michael Hsu before we issued the request for comment.[11]  The CFTC has not issued any new rules or guidance based on those comments.  Last month, the Commission approved a vertically integrated market structure for the first time (on which I dissented given that we were in the middle of studying the risks and had not engaged in rulemaking),[12] and it was said in the open meeting that there are other pending applications.  As this proposal’s record will not reflect comments submitted in response to the request for comment on vertical integration, I encourage commenters to resubmit relevant sections of those comments in response to this proposal.

Requirements of the Proposed Rule

The rule would require an exchange or SEF to report any change to the entity or person that holds a controlling interest, either directly or indirectly, as opposed to the more limited notification requirements (10% change in ownership of an exchange or 50% ownership of a SEF).  Any owners of exchanges and SEFs may have other interests (financial or otherwise) that may not align with the exchange’s or SEF’s responsibilities.

The rule would require officers or directors with an actual or potential conflict of interest in the subject of a matter to abstain from both voting and deliberation.  The proposal also creates a baseline definition of what is a conflict of interest, and requires documentation of compliance with the rule, which facilitates oversight.

Officers, directors, those with an ownership interest in the exchange of at least 10%, and employees would be banned from trading on or disclosing material non-public information.  I would like to hear from commenters if the 10% ownership threshold is appropriate or should be lowered.  I would also like to hear whether commenters think the proposed requirements are sufficient to prevent the misuse of non-public information, especially in cases where employees, officers, directors or owners are also employed by a company that trades in contracts for commodities traded on the exchange.  I am especially interested in comments about whether the Commission should ban use of material non-public information for trades on a spot exchange by an officer, director, owner or employee of an affiliated derivatives exchange.[13]

The proposal would codify guidance by requiring establishment of a regulatory oversight committee, comprised entirely of independent public directors tasked with monitoring the effectiveness of an exchange or SEF’s regulatory functions and minimizing and resolving conflicts of interest, and requires every exchange to have a Chief Regulatory Officer (“CRO”).[14]  Requirements for the regulatory oversight committee include approving the size and allocation of resources and the number of market regulation staff.

The proposal does not address the issue of shared resources of affiliated entities, including for example dual-hatted employees.  Shared resources lead to concerns about whose interest will dominate when it counts the most, during times of stress.  Shared resources also raise concerns over capacity to fulfill regulatory responsibilities, including for example, a derivatives exchange’s ability to fulfill its front-line market integrity responsibility when using shared resources of an affiliated spot exchange.[15]

I want to thank the staff for working with me to strengthen this proposal, including in the way it incorporates affiliates in certain areas, particularly given that affiliated entities can raise conflicts of interest even outside of the vertical integration structure.  I continue to urge further rulemaking to address conflicts of interest, including those associated with vertically integrated market structures.