The action we considered this week is precedential as it was the first Commission vote to approve a vertically integrated market structure,[1] an action on which I dissented.  Bitnomial, a self-described small start-up,[2] applied to be a clearinghouse with a bespoke market structure—with the same parent company owning a CFTC-registered broker (futures commission merchant (FCM)) and exchange (DCM), as well as a trading firm that acts as a market maker and settlement facility that are not registered with the CFTC.[3]

After the Commission voted on Bitnomial’s application, Bitnomial trumpeted their status as the CFTC’s “first and only crypto-native exchange with a full set of US derivatives exchange, clearinghouse, and broker licenses.”[4]  Bitnomial noted that its clearinghouse license “was a rare achievement … allowing Bitnomial to cater to the unique needs of digital asset traders, brokers, and dealers across the entire derivatives industry, all under the federal oversight of the [CFTC].”  Further, Bitnomial claimed that their derivative trading platform would include “digital assets as collateral [and that this] change is not intended just for crypto trading but also for a broad spectrum of physical and digital commodities.”  And, “Now that the licensing process is complete” they are “shift[ing] focus to expanding Bitnomial’s product offering and customer base.”

Although this vertically integrated market structure is how the cryptocurrency industry operates in the unregulated space, the Commodity Exchange Act and Commission regulations do not contemplate such a novel integrated market structure.  Bitnomial does not need this bespoke market structure to clear Bitcoin derivatives as it has access to clearing services from the Minneapolis Grain Exchange.  Presumably, clearing through their own affiliate could save Bitnomial money, but the question for us is at what cost to customers, competition and financial stability.

I first voted internally to deny this application in May of this year on the basis that before we take such an action, the CFTC needed to analyze the risks of vertically integrated market structures, particularly in digital assets, as features of those markets could amplify risk.  By then, 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,[5] the Financial Stability Oversight Council (FSOC),[6] Treasury Secretary Janet Yellen,[7] then-Federal Reserve Vice Chair Lael Brainard,[8] and Acting Comptroller of the Currency Michael Hsu:[9]

• The March 2023 Economic Report of the President states, “there can be conflicts of interest at crypto asset platforms. For example, some crypto asset platforms combine exchange, 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.”[10]  This report cites FTX as an example.[11]
• FSOC’s October 2022 Report on Digital Asset Financial Stability Risks and Regulation discusses financial stability and investor protection implications that may arise from vertically integrated services.
• Treasury Secretary Janet Yellen said, “[W]e are also working to address risks specific to digital assets.  This includes risks associated with vertical integration of crypto-trading platforms….”
• Then-Federal Reserve Board Vice Chair Lael Brainard said, “Since trading platforms play a critical role in crypto-asset markets, it is important to address noncompliance and any gaps that may exist.  We have seen crypto-trading platforms and crypto-lending firms not only engage in activities similar to those in traditional financial without comparable regulatory compliance, but also combine activities that are required to be separated in traditional financial markets.”
• Acting Comptroller of the Currency Michael Hsu said, “Even integration within the crypto industry itself warrants attention from financial stability regulators.  The largest crypto players today want to provide an increasingly broad range of services seamlessly under one roof for their customers….While commingling these activities may offer convenience for consumers and cost savings for crypto firms, conflicts abound and the riskiest activity threatens the whole bundle.”

I was pleased in June that we started studying vertical integration through public consultation.[12]  At that time, I said, “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.”[13]  I said then that if the Commission wished to consider approving this type of integrated market structure, we should first engage in a comprehensive study of the risks, particularly to customers and financial stability, a study that should also include unregulated affiliates like market makers and settlement facilities.

Despite receiving 166 comments just 2 ½ months ago, including more than 100 comments expressing serious concern over vertically integrated market structures and the additional risks they pose, Bitnomial’s application was put before us this week to approve.  The stakes are high in this decision.  Commenters raised serious concerns over conflicts of interest risk, clearing system risk, contagion risk, risk of customer harm, anti-competitive risks, risk of eroding market transparency, financial stability risks, and systemic risk.  As the Futures Industry Association (FIA) commented:

FIA highlights the checks and balances that already exist by having a tiered system of separate registrants.  The self-regulatory privileges afforded to, and responsibilities imposed on, registered entities under the Commodity Exchange Act and Commission regulations presuppose that registered entities have sufficiently differing interests from those of intermediary registrants so that the registered entities themselves are able to hold the intermediaries active in their marketplaces accountable for their compliance with laws, rules, and regulations on a fair and impartial basis.  This tiered and interdependent scheme of rules distribution is a critical feature of the U.S.’s well-regulated derivatives markets.  FIA is concerned that collapsing this existing multi-tiered ecosystem—with its inherent checks and balances—without proper analysis could undo the foundation on which the self-regulatory structure is premised.

Similarly, the International Swaps and Derivatives Association (ISDA) commented, “It should be pointed out that the current regulatory landscape is an ecosystem of checks and balances that should not be undervalued or discarded without careful consideration.”  Better Markets commented that it “holds a general stance against vertical integration within derivatives markets, citing the inherent risks and potential adverse impacts it may impose on both the market itself and market participants.”  Better Markets commented that vertical integration “poses significant challenges to maintaining a level playing field and ensuring the fair and efficient operation of our financial markets.  These affiliations can give rise to conflicts of interest, distort competition, and compromise the integrity of regulatory oversight.”

It is unclear why we would risk upending the CFTC’s regulatory ecosystem of checks and balances for one crypto company that already has access to clearing before we have analyzed all of the risks discussed in the comments and determined the appropriate regulatory framework to address those risks.  The commenters in some cases said that some of the risks could not be mitigated.  This included some members of ISDA as well as Public Citizen.  In other cases, the commenters recommended specific Commission action including new rules, or new requirements on FCMs, exchanges and clearinghouses—including requirements that were not under Commission consideration.  ISDA called for the CFTC to provide new principles-based rules to address conflicts, with granular guidance, including on governance controls and separation of roles.  Better Markets called for the CFTC to conduct a comprehensive study to examine the broader implications and potential consequences to market stability and fairness.

Following a same risk, same regulatory outcome approach means that additional risk requires additional regulatory response.  But here, there is only a proposed two-page order approving Bitnomial as a CFTC-registered clearinghouse—an order that has zero conditions—no checks and balances to substitute for those present in the traditional market structure of separate entities.  Even if I were open to approving an application before the CFTC completes that analysis, I would not consider an order that includes no conditions to replace the checks and balances present in the traditional market structure.  A condition-less order provides no mechanism to hold Bitnomial accountable to any conditions agreed to in conversations with CFTC staff or put in their rulebook that they could later change, and provides no regulatory clarity publicly about how the CFTC sought to address serious risks in vertically integrated market structures.

We should learn the lesson from our consideration of FTX’s application that also sought to change the traditional market structure, in that case, collapsing the market structure by removing the FCM (a disintermediated model).  At that time, we received many comments against straying from the traditional market structure.  Weeks before FTX collapsed, I warned:[14]

Crypto companies seeking to come within the CFTC-regulated derivatives markets should expect the application of our existing regulatory framework because it has a proven record of reducing financial stability risk.  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.  Crypto companies set up for an unregulated environment will need to change to look more like a regulated entity.  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.

Being careful means that we should not approve Bitnomial’s application for bespoke treatment before the CFTC determines the appropriate and necessary regulatory action needed for vertically integrated market structures.  It would not be responsible innovation, but instead could have unintended consequences that undermine our rules, and harm customers, competition, and financial stability.  Therefore, I am compelled to dissent.

Additionally, while there are many concerns raised by commenters over vertical integration, I want to raise a few key concerns that are relevant to the application before us.

Risks Arising from Bitnomial’s Existing Vertical Integration Should be Addressed Before Adding to Those Risks with a Clearinghouse

Because the Bitnomial parent company already owns a CFTC-registered FCM and exchange as well as the trading firm that serves as a market maker, it is already vertically integrated, and there is already risk.  The CFTC should address this existing risk before doubling down on risk by adding an additional affiliated clearinghouse.  Bitnomial became vertically integrated when the National Futures Association approved its FCM’s application on September 12, 2022, while knowing that Bitnomial already had an exchange, and a trading firm.  This decision did not come before the Commission, nor was I made aware of it.  Several commenters raised concerns over vertical integration that involved an exchange, particularly given the role of exchanges as self-regulatory organizations (SROs).[15]  Several commenters also raised FTX as an example.[16]  The CFTC should address the existing risks before compounding that by approving an affiliated CFTC-registered clearinghouse, which would add new risk.

Systemic Risk and Customer Harm Concerns Over A Clearinghouse’s Affiliation with a Clearing Member (FCM)

Clearinghouses play an important public interest role—they are critical market infrastructure intended to foster financial stability, trust, and confidence in U.S. markets.  Dodd-Frank Act reforms increased central clearing, thereby increasing financial stability.  Those reforms also concentrated risk in clearinghouses.  With that concentrated risk, it is critical that the Commission maintain vigilance in its oversight over clearinghouses to identify and monitor risk and promote financial stability.  This is most important for the CFTC’s monitoring of systemic risk.

Under the Commodity Exchange Act, clearinghouses bear significant responsibilities for overseeing their members.  Because the clearinghouse “supervisory structure includes a number of discretionary decisions,” FIA in its comment urged “the Commission to carefully consider the full range of DCO [clearinghouse] functions and whether they can be impacted by owned affiliates.”  As Better Markets commented, “The looming specter of conflicts of interest, potential compromises in regulatory impartiality, and compromised oversight due to these affiliations presents formidable challenges.”

Better Markets commented that the tailoring of margin requirements can be influenced by a clearinghouse’s affiliation with an FCM, and there can be risks of conflicts of interest and preferential treatment.  Better Markets recommended specific measures to mitigate these risks.  FIA also raised concerns that a clearinghouse may exercise its discretion “in ways related to initial margin levels and margin calculations that are biased in favor of the affiliated FCMs and/or against unaffiliated FCMs, especially where there is lack of transparency in the process.”  ISDA also raised conflicts of interest where the clearinghouse has discretion, “such as setting margin requirements, tailoring margin to special portfolios, calibrating margin add-ons, especially for large positions (concentration margin, stress loss margin, credit margin), credit review, managing a default event, liquidating a portfolio and rule enforcement.”  ISDA raised concerns that the clearinghouse could apply a lower margin requirement for the affiliated FCM, which could give its affiliate a competitive advantage.

FIA also pointed to discretionary supervision including investigating a member for compliance with its rules, and bringing a disciplinary action.  Better Markets similarly raised concerns over a clearinghouse’s enforcement of its rules.  FIA said that one of the most important responsibilities of a clearinghouse is determining whether a member is in default, which invariably occurs in crisis situations.  FIA expressed concern that, “Common ownership may incentivize a DCO to delay defaulting its affiliated FCM, which raises a number of serious systemic risk and customer protection issues…. a DCO’s delay in declaring its affiliate intermediary in default could threaten the integrity of the entire marketplace, from clearing members to end customers.”  ISDA also raised concerns that the clearinghouse might delay a default.  FIA commented, “Indeed, systemic risk could result from a DCO considering the impact to its affiliated entity in making any decisions concerning default.”

Contagion Risk

Better Markets, FIA and ISDA raised concerns over the risk of contagion stemming from an affiliated entity’s failure.  FIA raised the possibility of market participants perceiving a higher level of contagion risk when a clearinghouse is affiliated with a defaulting affiliated FCM, “making runs on the DCO more likely.”  ISDA also raised concerns over run risks.

Better Markets recommended contingency planning to manage contagion risk, including liquidity management, risk mitigation strategies, and transparency (communication with customers, counterparties and clearing members).  Better Markets also recommended that the CFTC consider enhancing risk management and reporting standards for affiliated entities, and stress test and scenario analysis to identify the potential impact of an affiliated entity’s failure.

Multiple comments were made about the need for heightened scrutiny of a clearinghouse’s and affiliated intermediary’s financial resources to understand the level of interconnectedness of capital structures.  FIA recommended the CFTC consider whether the affiliated intermediary and clearinghouse should be subject to heightened capital requirements.  ISDA recommended increasing the clearinghouse’s skin-in-the-game in the default waterfall, and requiring robust capital and liquidity resources at the affiliated FCM.

Concerns Over Anti-Competitive Implications of a Clearinghouse’s Affiliation with a Clearing Member

The Biden Administration has taken a position of promoting competition.  However, several commenters raised anti-competitive concerns with vertically integrated market structures.  FIA commented that a clearinghouse with an affiliated FCM “would open the door to the appearance of unfair or unjustified favoritism in the DCO’s supervision of the affiliate.  Such perception could have untoward effects on competition.”  FIA called for a robust, regulatory framework, saying, “Existing requirements for compliance, enterprise risk and risk management staff at a DCO would not mitigate the potential appearance of favoritism.”  Several commenters raised concerns about the CFTC requiring information barriers and organizational separation.  The CFTC received multiple comments over concerns that affiliates would share resources.  ISDA commented that information barriers are not possible if personnel are shared, and that sharing resources could also pose competition concerns.  Further, Bitnomial’s investors who are also competitors presents additional conflicts of interest and risks.  The action the CFTC has taken to approve Bitnomial’s vertically integrated structure, despite all of the comments warning that these market structures are anti-competitive seems inconsistent with the Biden Administration’s position of promoting competition.

We should not take all of these comments lightly or ignore them.  However, that is exactly what the Commission would be doing by approving Bitnomial’s application.  I respectfully dissent.