The CFTC is seeing more applicants seeking to change the traditional market structure of separate entities as exchange, broker, and clearinghouse to a bespoke “vertically integrated” market structure to accommodate their affiliates.[1]  It is important for the Commission to understand the reasons why applicants seek this novel market structure, and to understand any benefits to applicants as well as the risks to customers, markets and financial stability.  Seeking public opinion on what we will consider in the future is important, but should not delay us from acting now to protect customers and financial stability on the live issues coming before us now.

I am open to considering changes to traditional market structure, but only if it does not result in increased risk, especially to customers and financial stability.  I am glad that we are undertaking to study the risks, one part of which is seeking public opinion.  Right now, we are faced with too many unknowns.  The immediate risk that comes to mind is conflicts of interest.  But, we do not know all of the other risks, and potential impacts, including unintended consequences.  We do not know if risks can be adequately mitigated to protect customers and financial stability.  If they can be mitigated, we have not yet worked out how.

If the Commission wishes to consider approving this type of integrated market structure with the same parent of a broker, exchange, and clearinghouse, the Commission should first engage in a comprehensive study of the risks and consequences, particularly to customers and financial stability, through this vehicle as well as through internal analysis.  As part of this study, the Commission should consider unregulated affiliates, including for example, market makers, settlement facilities, custodians, and spot exchanges.

The Commission should analyze conflicts of interest risk, clearing system risk, concentration risk, contagion risk, financial stability risk, and any other risk, including for example, a loss of confidence based on a perception of favorable treatment.  Confidence is essential to well-functioning markets.  Through this vehicle and internal analysis, the Commission should also study and analyze whether the risks can be sufficiently mitigated to prevent harm to customers and financial stability, and if so, seek to mitigate those risks.

I welcome commenters’ views on all of these issues.

Same Risk, Same Regulatory Outcome

The Commission should follow a “same risk, same regulatory outcome” approach.[2]  This approach starts with establishing the basic foundation of customer protections and guardrails that investors and customers are familiar with, and expect, from other regulated financial products and markets[3]—precisely because those are tested.  To the extent that we stray from a tried and tested market structure, the Commission should undertake the hard work of determining what the risks are and what is the “same regulatory outcome.”

As I said while FTX’s application for a bespoke market structure was pending before us, “As companies seek bespoke treatment, I will be guided in my decisions by the twin pillars of financial stability and customer protection, in particular for retail investors….On balance, regulators must be careful in allowing bespoke treatment that could increase financial stability risks—risks that are well in check with our existing framework.”[4]  Weeks later, FTX failed.

The traditional market structure contains inherent bumper guards—market discipline resulting from differing interests of different entities—that promote financial stability.  Expanding to a novel vertically-integrated market structure for example, for clearinghouses raises particular concern because the resilience of our clearing system depends in significant part, on the disciplining effect that clearing members can have on clearinghouses.  Because clearing members may be asked to mutualize losses and accept risks in a default waterfall, they have much at stake in the decisions made by clearinghouses.  They often have a different perspective, and do not always have fully aligned interests with the clearinghouses.  What happens to that disciplining effect where the clearing member (the futures commission merchant (FCM)) is owned by the same parent company as the clearinghouse?

Additionally, the viability of clearinghouses depends on a deep source of capital through multiple clearing members.  What happens to financial stability if the clearinghouse gives preferential treatment to its affiliated FCM, resulting in a loss of confidence by the other FCMs—could it lead to fleeing capital? What happens if the affiliated FCM takes an outsized role and becomes the primary source of capital?  Will the clearinghouse have the financial resources needed to promote financial stability? If the clearinghouse asks for information from the FCMs, will non-affiliated FCMs feel secure in giving their confidential information to an affiliate of their competitor?

I am especially interested in the impacts on customers.  I would like to hear from commenters about whether a vertically integrated market structure reduces customer protections.  Our clearinghouse rules were not set up to protect customers, because they were written with the idea of a separate intermediary that interacted with customers and had regulatory obligations for customer protections.  If that intermediary is affiliated with the clearinghouse, will customers have adequate protection?  Will an affiliated intermediary adequately inform customers about their rights and risks?  How can we be sure?

Separately, there is a public interest in competition.  Competition helps customers get better service or products at better prices.  Customers, particularly retail customers, can be harmed by a lack of competition.  Would a vertically integrated market structure harm competition? Is it possible to forecast the consequences of a lack of competition on customers?

I am interested in comment about whether we should disallow a clearinghouse to have an affiliated broker (FCM).  If so, under which authority can we make that determination, and what controls can we put in place to mitigate conflicts of interest and other risks?

When it comes to exchanges, there are other concerns, including the exchange’s ability to fulfill its role as a self-regulatory organization (SRO) with its affiliate, and the impact on market integrity.  Can one hand really watch the other?

I am also interested in comments about whether a vertically integrated structure increases risk in trade execution.  Trade execution is an important factor to consider in terms of harm to customers.  How do we ensure that an exchange does not favor its affiliate or their customers, giving less favorable trade execution for non-affiliates?

Digital Assets

Conspicuously absent from this request for comment is a discussion of vertical integration of crypto platforms.  This market structure has come up the most in that context, given that many crypto companies are vertically integrated in the unregulated space.  Appropriate regulation does not mean that we automatically port over to regulated markets a structure that exists in the unregulated space.

As the sponsor of the CFTC’s Technology Advisory Committee, I believe that the Commission can engage in appropriate regulation of the digital asset derivatives market to protect customers, particularly retail customers, while allowing for markets to develop responsibly and safely with the potential in the future for expanded access to financial markets, fair competition, and efficiency.

Adjusting for the reality of technology is not the same as adjusting for market structure.  In my conversations with digital asset companies, the takeaway has been less about whether they can follow a traditional market structure, but more that they do not want to, and would prefer to have their companies control the whole stack.  What the digital asset industry may see as superfluous is actually decades of regulations that protect customers and promote financial stability, including post-crisis reforms after the Dodd-Frank Act.

I am glad that we are beginning to study the risks of vertical integration, as I have expressed concerns about the risks to customers and financial stability.  In April, I gave a speech on risks in cryptocurrency related to a vertical integration structure.[5]  Also, in October, prior to the fall of FTX, I warned, “Crypto-related companies may serve multiple functions that are separated into different entities in traditional finance. An exchange may also be a market maker, clearinghouse, lender, and/or custodian. These conflicts present significant risk that in a regulated environment would be disclosed and resolved.  In an unregulated environment, the full extent of these conflicts may not be disclosed or resolved, which could lead to cascading losses and contagion risk.”[6]  It is our responsibility as a regulator to understand the risk and implement common sense regulation to address the risk.

We should coordinate with others in the Administration also analyzing vertical integration in the digital asset space.  Treasury Secretary Janet Yellen said that Treasury is “working to address risks associated with vertical integration of crypto-trading platforms and lack of visibility into the operations of subsidiaries and other entities across these businesses.”[7]  The recent Economic Report of the President stated, “there can be conflicts of interest at crypto asset platforms.  For example, some crypto asset platforms combine exchanges, brokerage, market making, and clearing agency functions.  This vertical integration of products and services has long been prohibited in traditional markets and leads to risks to customers.”[8]

Lessons from the 2008 Financial Crisis

We can draw on lessons learned from the 2008 financial crisis.  As the then-Special Inspector of the Troubled Asset Relief Program (“SIGTARP”),[9] I testified before the Senate on regulators failing to understand risk related to novel, innovative products that arose outside of regulated markets.[10]  Excitement about innovative products like mortgage-backed securities and credit default swaps led to market adoption, while risks were not identified or understood, or were ignored by market participants.

In my Congressional testimony, I cited to then-Treasury Secretary Timothy Geithner who told Congress on June 18, 2009, that the rise of new financial instruments “that were almost entirely outside of the Government’s supervisory framework left regulators largely blind to emerging dangers.”[11]  The same could be true of a vertically integrated market structure.  Without visibility into the risks, we would be largely blind as to emerging dangers to customers and financial stability.  Public comment can help give visibility.  However, we may still lack visibility into unregulated affiliates.

Shared Resources

Shared resources is a live issue before us with our registrants, rather than a discussion about what we will allow in the future for applicants, so we should deal with it now through separate rulemaking.  Too often, we see registrants in a vertically-integrated structure who share resources, including personnel, surveillance systems and other systems, physical space, and practically everything else.  Employees are dual hatted working for more than one affiliate.  Affiliates make decisions about things like the selection of, and compensation of the chief compliance officer of the regulated entity.

Shared resources lead to concerns about whose interest will dominate when it counts the most, during times of stress.  Shared resources also raises concerns over capacity to fulfill regulatory responsibilities.  This has particularly come up the most with derivatives exchanges that have affiliated unregulated spot exchanges.  For example, that structure raises critical questions about whether the derivatives exchange can fulfill its front line market integrity responsibility to ensure that contracts are not readily susceptible to manipulation, particularly when the underlying reference comes from the affiliated spot exchange.  Recently, it has also come up in the clearinghouse context.

Given that this issue is a live issue before us now, I urge the Commission to take up the issue of shared resources now in planned rulemaking related to exchange conflicts of interest and governance, rather than through this vehicle which is more about the future.  Public comment can be obtained through that rulemaking.

I hope that this request for comment is the starting line, not the finish line, of hard work.  These applications are before us, and are not abating.  Therefore, I believe it is necessary to study these issues through this and other vehicles, and make determinations.  If we consider novel market structures with affiliated entities, we cannot increase risk to customers or financial stability.