This week, the Commission in a split vote, on which I dissented, approved the first proposed rule related to FTX’s bespoke direct-to-retail market structure. That structure removed the intermediary (known as a futures commission merchant or FCM) where the CFTC’s customer protection and anti-money laundering regimes sit.  I believe that before my tenure, the Commission made a mistake in approving two clearinghouses (LedgerX owned by FTX before FTX’s bankruptcy, and Nadex, which is now Crypto.com) for this direct-to-retail market structure before analyzing and addressing the risks of a lack of AML requirements, customer protections, and other checks and balances.

After FTX’s bankruptcy, the CFTC is now trying to remedy the consequences of its mistake, one of which is that retail participants do not have customer protections under this model because they lose their status as “customers,” instead becoming “clearing members.”  In the open meeting, the CFTC staff said that the proposed rule was an attempt to provide parallel protections to those individuals who we would normally consider to be “customers,” but who now are “members.”  But it fails to provide parallel protections to retail participants.  The proposed rule attempts to port over to this direct-to-retail model one protection (segregation of funds, which I support) without the other protections, or checks and balances present in an intermediated model with an FCM.

I do not know if it is even possible for the CFTC to give parallel protections to retail participants under a direct-to-retail model, because the Commodity Exchange Act and Commission rules contemplate the presence of an FCM.  Additionally, anti-money laundering controls sit with the FCM, and clearinghouses have no AML requirements.  AML is a critical guardrail for national security and customer protection.  The Financial Stability Oversight Council’s (FSOC) 2023 Annual Report says, “Crypto-assets remain susceptible to misuse by terrorist organizations and other sanctioned individuals’ efforts to move funds in support of illicit activities.”[1]

I do not believe that the rule, which was rushed in three weeks at the end of the year, is sufficient to remedy that earlier mistake. The rule would benefit from more time than three weeks.[2] We should step back and assess the impact of changing the tried and true market structure by removing the FCM. Without addressing a number of serious issues, the rule may give a false sense of security about the safety of a direct-to-retail model, while hiding the threats. The CFTC staff in the open meeting said that there are a number of applications pending for this model and they expect more.

Such an assessment would implement a recommendation from the FSOC. In its October 2022 Report on Digital Asset Financial Stability Risks and Regulation, the FSOC recommended that member agencies (including the CFTC) “assess the impact of vertical integration (i.e., direct access to markets by retail customers) on conflicts of interest and market volatility, and whether vertically integrated market structures can or should be accommodated under existing laws and regulations.” The CFTC has not conducted this analysis, leaving the CFTC out of step with FSOC’s recommendation.

I invite the public to watch this week’s CFTC public meeting, which showed that there are serious issues that the CFTC should assess and address before accommodating this crypto industry model.[3] The first is whether the CFTC can impose AML requirements on clearinghouses to prevent retail funds from being commingled with funds belonging to terrorists, cyber criminals and drug cartels— a question on which the CFTC is in the middle of its analysis.[4] This rule also does not require disclosures to inform retail participants that they are giving up customer protections and bankruptcy customer priority, instead taking the status of “clearing members,” similar to the roles and duties that normally falls to an FCM such as a large bank.[5] The rule also would not limit clearinghouses to depositing these “member” funds in only banks or trusts, as FCMs are required, which would allow the clearinghouse to deposit funds with an unregulated affiliate.[6]

Instead of learning the lessons of FTX, I worry that rushing to approve this proposal leaves the Commission out of step with other federal financial regulators that are asking whether a direct-to-retail model can or should be accommodated under current law, and assessing its implications. I also worry that this proposed rule will form the basis for the CFTC to approve more crypto companies for this direct-to-retail model under the false impression that this model is safe. I am concerned about rushing this rule through at the end of the year in three weeks’ time, when these are critical post-FTX issues.

The CFTC’s Laws and Regulations Protect Customers and Guard Against Illicit Finance through a Market Structure that has Stood the Test of Time

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.

FCMs also play an important role. First, they stand as a shock absorber, providing additional financial support to the clearinghouse to safeguard the financial system. Second, because they are customer-facing, they are responsible for providing customer protections. The customer protection regime under the Commodity Exchange Act and CFTC rules are found in requirements for FCMs. In its October 2022 report, the FSOC discussed:[7]

The current framework of markets regulation is generally structured around the requirement or presumption that markets are accessed by retail customers through intermediaries such as broker-dealers or future commission merchants (FCMs). Those intermediaries perform many important functions, such as processing transactions, acting as agent and obtaining best execution for customers, extending credit, managing custody of customer assets, ensuring compliance with federal regulations, and guaranteeing performance of contracts. As a result of the special role these intermediaries play in traditional market structures, they are subject to unique regulations often focused on customer protections, such as regulations around conflicts of interest, suitability, best execution, segregation of funds, disclosures, and fitness standards for employees.

Upending this traditional market structure, without analysis, can have unintended consequences.

There Are No Customers or Customer Protections in a Direct-to-Retail Model

The CFTC does not require disclosures to retail participants about the consequences of participating in this model. In the direct-to-retail model, customers lose their status as “customers,” thereby losing all of the customer protections in the CFTC’s regulatory framework, and instead take the status of “clearing members,” raising a host of issues. It is unlikely that retail customers know and understand that they gave up all of their customer protections. It is also unlikely that retail customers know and understand that in the event of a bankruptcy, they lose their “customer” priority in a distribution. It is also a question whether these retail customers would have to take on the FCM’s shock absorbing role.

When FTX’s application for authority to issue margined crypto products[8] was pending before us, on May 25, 2022, the CFTC held a roundtable on the disintermediated model. We heard then and later received comments from many stakeholders expressing serious concerns over this model.

The FSOC also expressed concerns over direct-to-retail models, warning in its October 2022 report:

Financial stability implications may arise from vertically integrated platforms’ approaches to managing risk…Direct exposure by retail investors to rapid liquidations of this kind also raises investor and consumer protection issues. Platforms dealing directly with retail investors would need to ensure the provision of adequate disclosures, responsibilities otherwise taken on by intermediaries. The vertically integrated model presents conflict of interest….[9]

The CFTC has not conducted the assessment that FSOC recommended more than one year ago. It is an open question of whether the CFTC should accommodate these direct-to-retail models given how much is lost, including the loss of the CFTC’s customer protection regime and AML regime.

This Rushed Proposed Rule Does Not Replace Customer Protections, AML, and Other Checks and Balances, Lost by Removing the FCM

The CFTC has had a year to learn the lessons from FTX’s application and assess direct-to-retail models as FSOC recommended. I am strongly in favor of strengthening customer protections, particularly for retail, including banning commingling of customer funds,[10] but this proposal is not about “customer” funds. In a direct-to-retail model, legally, there are no customers. I am not in favor of retail losing their status as customers and losing customer protections.[11] The proposed rule would be the first post-FTX rule on this model, but it was rushed and as a result, lacks sufficient analysis.

The question raised by the FSOC of whether we should accommodate this market structure from crypto is a critical one to answer. The deliberations at last week’s open meeting confirmed that it may not be possible to give retail participants the same protections in a disintermediated model as in the intermediated model. And just last week, the FSOC Annual Report again warned about the vulnerabilities arising from collapsing regulatory functions into a single entity, including “conflicts of interest, inappropriate use of clients’ funds, and market manipulation.”[12]

This rule would not resolve the FSOC’s concerns. It does not contain the assessment needed as to risk and what regulatory requirements would be required in a direct-to-retail model to meet a “same risk, same regulatory outcome approach” that makes up for the checks and balances lost from removing the FCM. That would require establishing the basic foundation of customer protections and guardrails (including against illicit finance). Without that analysis, this proposal puts the CFTC out of step with other federal financial regulators.

The Direct to Retail Model Raises Many Questions the CFTC Has Not Adequately Considered

My concerns about a direct-to-retail model include:

1. Losing status of “customer”: Regular people lose their protections as “customer” under the law in the direct-to-retail model. Instead, they are treated as clearinghouse “members,” a role that traditionally has been reserved for FCMs, which include the largest financial institutions. The regular person trading in bitcoin futures or event contracts is not the same as J.P. Morgan or Wells Fargo. Clearing members have obligations to the clearinghouse to stave off clearinghouse failure. This presumably would also be the case for retail acting as members. I have serious concerns about whether retail participants understand what they are giving up and that this is the role they are taking on. The CFTC should consider requiring plain English disclosures delivered in a manner that actually informs people of their rights and risks, as opposed to a click-wrap agreement or lengthy legal document.
    
2. No AML/CTF/KYC: Because the Commodity Exchange Act envisions the presence of an FCM that has significant responsibilities, including anti-money laundering/Know Your Customer requirements, clearinghouses do not have currently have any obligation to implement Anti-Money Laundering, Countering Terrorist Financing or Know Your Customer safeguards, opening up our market to illicit finance.The Commission staff are still analyzing what safeguards the CFTC can require.
    
3. No requirements to deposit funds in a regulated entity: FCMs are required to hold customer funds at a bank, trust or a CFTC-regulated entity. That requirement is absent for member funds and is not added in this rule, allowing clearinghouses to place the funds anywhere, even an affiliate. That means that FTX’s registered clearinghouse LedgerX could have deposited retail “member” funds with Alameda, the trading firm involved in the loss of billions of customer funds.
    
4. No checks and balances: FCMs who interface with customers have regulatory requirements for customer protections, and have incentives to monitor the clearinghouse to make sure it is not misusing customer funds. This role sits empty in a direct-to-retail model.
    
5. No customer bankruptcy priority: In the case of the clearinghouse bankruptcy under this model, the bankruptcy code would not consider retail participants to be “customers,” and they would not receive the customer priority in any distribution.

More Time is Needed to Analyze New AML Requirements for Clearinghouses

I want to call special attention to the proposal’s lack of anti-money laundering (AML) and know your customer (KYC) requirements for clearinghouses. Without these protections, retail funds may be at serious risk of seizure if they are commingled with funds of terrorist organizations, drug cartels, or other illicit actors. It is well known that cryptocurrency transactions are used to finance cybercrime, terrorism, sanctions avoidance, and the drug trade.[13] News reports suggest that Hamas used cryptocurrency to receive significant funding preceding its October 7^th attacks.[14]

FCMs have regulatory responsibilities to implement AML and KYC procedures, to perform standardized diligence, to verify customer identify and to assess whether customers may be known or suspected terrorists or sanctioned individuals. That AML/CTF/KYC responsibility puts them at the front lines of combating illicit finance. The legal requirement also means the CFTC and the National Futures Association can examine how FCMs are implementing required anti-money laundering controls. That makes it more likely we will identify material weaknesses before an FCM becomes a conduit for illicit funds. Reporting requirements also may make it easier for law enforcement to identify suspicious patterns and investigate them.

The proposed rule would not impose any AML responsibilities for clearinghouses. Under the proposal, retail participants could have their funds commingled with those deposited by terrorist or cybercriminals, including state-sponsored cybercrime gangs. In a seizure, the FBI, other law enforcement or Treasury would seize all of the funds. I would consider that a very serious risk to member funds, one that the proposal does not address.

At the open meeting, when I asked whether the CFTC could impose AML requirements on clearinghouses, the CFTC’s General Counsel said that they had not completed their analysis, but had not foreclosed the possibility that the CFTC has authority to impose AML requirements on clearinghouses and that “it has some promise.”[15] The proposed rule contained no analysis of this issue. That was one of the reasons why I asked that this proposed rule be pulled off of the meeting, so that the CFTC could continue to work on that analysis and include AML requirements. My request was denied. At the open meeting, the Office of the General Counsel said that while the analysis was ongoing, “it was decided on a policy basis that we save that for another day.”[16] That was not a policy decision made by a majority of the Commission as that was never before us.

More Analysis is Needed to Determine Whether Other Customer Protections and Other Checks and Balances Can Be Provided to Clearinghouses in the Direct-to-Retail Model

This proposal would impose some safeguards for member funds held at a disintermediated clearinghouse by banning commingling and imposing certain limits on how funds can be used.[17] But it is narrowly targeted, and serious gaps remain, leaving the proposed requirements far from the same regulatory outcome as the traditional model.

Location of Deposits

FCMs and clearinghouses in the traditional model are only permitted to deposit customer funds with regulated entities—a bank or trust, a clearinghouse, or another FCM—giving the CFTC visibility into customer funds, and layering customer protections. This proposal would not have the same limitation because these would not be “customer” funds. This proposed rule could benefit from adding in the same requirement. Otherwise, member funds could be deposited with an unregulated entity, including an unregulated affiliate with conflicts of interest, that introduces more risk, leaving the CFTC blind to risk.[18] At the meeting, the Commission heard from staff that they were concerned about whether the current requirement for where FCM’s can deposit funds provided sufficient protections for customers.[19] The proposal does not have any analysis of these concerns, likely because it was rushed.

Oversight from Checks and Balances

The proposal also does not replicate another important guardrail of traditional market structure: checks and balances. Separate clearinghouses and brokers (FCMs) create natural bumper guards not present in the direct-to-retail model. However, the proposed rule contains no analysis of the impacts of moving forward with this non-traditional model. Instead, at the open meeting, comments were made to the effect about how certain companies have determined that they prefer this market structure, and the staff expect there to be more applications for this model. It is concerning to me that this rushed rule may be used to facilitate expanding the use of this model, which is not responsible without further assessment

Bankruptcy Priority for Customers

The failures of FTX and Celsius show bankruptcy priority is a serious issue, especially in the retail space. Retail participants do not have the same ability as institutions to withstand losses or delay. Existing bankruptcy law assumes a traditional market structure.[20] Customers take priority over FCMs in distributions.[21] Retail participants in a disintermediated clearing model may not realize that they are losing bankruptcy priority as customers because the CFTC requires no disclosures. This loss of priority is not discussed in the proposal. We should consider requiring clear disclosures.

Conclusion

It is not responsible to rush our first post-FTX rule on direct-to-retail models in three weeks at the end of the year, without conducting the necessary assessment of the impact of this model as FSOC recommended more than one year ago. I asked for this proposed rule to be pulled off this open meeting. I am concerned about the lack of that assessment, including but not limited to specific analysis of: (1) whether the CFTC should require disclosures to inform retail participants that they are losing their customer status in this direct-to-retail model, disclosures that describes their rights and risks; (2) whether it is possible to take a same risk, same regulatory outcome approach on issues such as where funds can be deposited and other concerns raised in comments to the FTX application about these models; and (3) whether the CFTC can require clearinghouses to conduct AML/CTF/KYC. Although there are some existing retail participants currently in this model, at the open meeting, the staff said that they were already ensuring that the two crypto direct-to-retail clearing houses were taking steps aligned with the proposed rule.

Thirteen months after the collapse of FTX, I am glad that we are starting to address the direct-to-retail model as I have serious concerns about it, and remain concerned about any expansion of that model. However, the risks to retail, financial stability, market integrity and our national security, are too great to rush this in three weeks without analysis as FSOC recommended. Therefore, I must dissent.

[3] See CFTC to Hold and Open Commission Meeting on December 13 (December 13, 2023) at 2:12:00.

[4] See Id. at 3:07:40 – 3:08:40; 3:16:52 – 3:17:40.

[5] See Id. at 2:37:45 – 2:39:10.

[6] See Id. at 2:44:20 – 2:44:55.

[7] See Financial Stability Oversight Council, Report on Digital Asset Financial Stability Risks and Regulation (October 3, 2022).

[8]Financial Stability Risks of Crypto Assets: Remarks before the International Swaps and Derivatives Association’s Crypto Forum 2022 (Oct. 26, 2022).

[9] See Financial Stability Oversight Council, Report on Digital Asset Financial Stability Risks and Regulation (October 3, 2022).

[10] See CFTC Commissioner Christy Goldsmith Romero, Crypto’s Crisis of Trust: Lessons Learned from the FTX’s Collapse (Jan 18, 2023) (I warned in the aftermath of FTX’s collapse about how commingling presents “a significant threat to customers that can leave customers in a musical chairs dilemma.”)

[11] All participants, retail or institutional, are considered clearinghouse members.  This is not some technical, legalistic distinction.  Our laws will treat those retail participants the same as the largest financial institution.

[12] See Financial Stability Oversight Council, Annual Report 2023, (December 14, 2023).

[13] See Attorney General, U.S. Department of Justice, The Role of Law Enforcement in Detecting, Investigating, and Prosecuting Criminal Activity Related to Digital Assets, (Sept. 6, 2022).

[14] Wall Street Journal, “Hamas Needed a New Way to Get Money From Iran. It Turned to Crypto,” (Nov. 12, 2023). The CFTC has brought enforcement actions against two spot crypto exchanges, BitMEX and Binance, for failing to follow AML controls.  Our action against Binance found that instead of implementing those controls, Binance turned a blind eye and even advised users to circumvent the superficial controls it claimed to have.

[15]CFTC to Hold and Open Commission Meeting on December 13 (December 13, 2023) at 3:16:20 – 3:17:50.

[16] Id.

[17] It would require direct clearing customer funds to be held in a separate account from the clearinghouse’s funds, in an account identifying them as belonging to the customers. Those funds could only be used on behalf of the customer, not on behalf of the company or its affiliates. The funds would need to be accounted for daily, and reconciled with the total amount the clearinghouse owes its customers. It would also limit what clearinghouses can invest those funds in, with the same limits that apply to brokers today under Commission Regulation 1.25. These protections are largely in line with the representations made by FTX about LedgerX’s rules in its application.

[18] See Commissioner Christy Goldsmith Romero, Crypto’s Crisis of Trust: Lessons Learned from the FTX’s Collapse (Jan 18, 2023).

[19] CFTC to Hold and Open Commission Meeting on December 13 (December 13, 2023) at 2:42:40 – 2:46:08.

[20] Called “customer funds other than member property.”  See CFTC, Bankruptcy Regulations, 86 Fed. Reg. 19324 at 19365 (April 13, 2021).

[21] Id. at 19378. There are also rules allocating customer property among account classes.