Bitnomial Clearinghouse, LLC (Bitnomial Clearinghouse) seeks to register as a derivatives clearing organization (DCO) pursuant to Section 5b of the Commodity Exchange Act (CEA) and Part 39 of the Commodity Futures Trading Commission’s (Commission or CFTC) regulations (Part 39). Long before the Commission began deliberation on this application, I advocated for the Commission to initiate a rulemaking process directly addressing the concerns arising due to vertically-integrated market structures.[1]

In discussions and deliberations over the course of the last eighteen months, I have strongly indicated to my fellow Commissioners that I believe that the Commission must take a holistic approach to regulatory reforms concerning conflicts of interest that arise in vertically-integrated market structures. Instead, the Commission has continued to adopt an application-by-application approach with all attendant risks for the markets, customers, and Commission. It is deeply disappointing that the Commission has elected to proceed with granting additional applications that adopt this market structure before initiating a formal rulemaking to establish effective conflicts rules.

While I vote to approve the application before the Commission today, I believe that it is imperative and incumbent upon the Commission to begin a contemporaneous rulemaking process to establish regulations that would apply fairly, uniformly, and comprehensively to this applicant and all applicants seeking to adopt this market structure. I believe that the need for this rulemaking is all the more urgent as an increasing number of market participants, particularly market participants in the crypto-asset ecosystem, seek to adopt this opaque model inherently riddled by conflicts of interest and in light of the colossal financial failures and bankruptcies witnessed by markets over the last year associated with crypto-asset firms that adopted this market structure.

Background Leading to Bitnomial Clearinghouse’s Application

On May 30, 2023, the Commission’s Division of Clearing and Risk (DCR), underscoring the need for market participants to consider risks associated with evolving market structures, issued a staff advisory.[2] The advisory aimed to “remind[] registrants and applicants that when expanding lines of business, changing business models, or offering new and novel products, DCR will remain focused on the potentially heightened risks that may be associated with certain of those clearing activities. DCR expects DCOs and applicants to actively identify new, evolving, or unique risks and implement risk mitigation measures tailored to the risks that these products or clearing-structure changes may present.”[3]

In a public statement published the same day, I applauded the staff’s advisory and immediately encouraged the Commission to begin a formal rulemaking process to establish a universally enforceable set of regulations governing vertically integrated models. In my statement, I emphasized the increasing number of digital asset platforms that adopt this market structure model and the need to address and ensure transparency with respect to “[c]onflicts of interest arising from vertical integration of activities and functions.”[4]

A month later, on June 27, 2023, the Commission released a Request for Comment on the Impact of Affiliations of Certain CFTC-Regulated Entities (RFC on Affiliated Entities), seeking comments on potential issues that may arise where affiliated CFTC-registered entities that share a common parent company operate as part of a single integrated services platform.[5] The request inquires about affiliations between DCOs, designated contract markets (DCMs), or swap execution facilities (SEFs) with intermediaries, such as futures commission merchants (FCMs), or other market participants. The RFC on Affiliated Entities notes that under the CEA and CFTC regulations, DCOs, DCMs, and SEFs have responsibilities for supervising their participants, and an affiliation with an intermediary or other market participant raises questions as to how these supervisory responsibilities will be carried out.[6]

While we received valuable comments to the RFC on Affiliated Entities,[7] these comments are not a substitute for the formal notice and comment rulemaking process. For six months, my fellow Commissioner, Christy Goldsmith Romero, and I have continued to raise concerns that the Commission is failing in its duty to protect customers and market integrity and stability by not initiating a rulemaking process that directly addresses market structures marked by a single parent company operating with an affiliated market-maker, exchange, and clearinghouse.[8]

On Monday, December 11, the Market Risk Advisory Committee—the advisory committee that I sponsor—held its third meeting of the year. In my opening statement, I once again noted:

Vertical integration is not new, nor is it unique to digital asset markets. Traditional financial markets, with proper oversight, have identified significant advantages to vertical integration, such as greater efficiencies, reduced costs, and more control along the manufacturing or distribution process.

CFTC regulations impose myriad obligations on firms that adopt vertical integration—such as capital requirements, systems safeguards, know-your-customer procedures, and segregation of customer funds—that have been refined over the course of decades. Without regulation or registration, however, there are notable risks in permitting unsupervised adoption of vertical integration. In fact, vertical integration without proper oversight arguably contributed significantly to customer losses resulting from the collapse and bankruptcy of digital asset derivative platform FTX.com.[9]

Where a DCO exercises discretion, a vertically integrated structure creates concerns around a DCO’s general risk management procedures, transparency and the sharing of necessary information by clearing members with the DCO, the sharing of resources between the DCO and its affiliates and potential preferential treatment, the risk of contagion spreading from an affiliate to the DCO, and conflicts of interest concerns. These issues pose a risk to the integrity and stability of our markets, and it is imperative that the Commission carry out its mission to ensure the financial integrity of all transactions subject to the CEA and the avoidance of systemic risk.[10]

Other federal market and prudential regulators and international standard-setting authorities agree. It is time to immediately begin to address the potential market integrity, stability and systemic risk threats that this market structure poses for derivatives and other financial services markets.

In the fall of 2022, the Financial Stability Oversight Council (FSOC) issued a call to action asking regulatory agencies to thoroughly analyze the impact of vertical integration and determine whether it is a model that is sufficiently supported by existing laws and regulations.[11] Specifically, FSOC recommended that “member agencies 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 and should be accommodated under existing laws and regulations.”[12]

In May of this year, the International Organization of Securities Commissions published formal guidance with recommendations on conflicts of interest and vertical integration in the crypto market, setting forth principles that emphasize the importance of accurate and transparent disclosure by crypto-asset service providers about their roles and capacities to their clients, prospective clients, the general public and regulators across jurisdictions.[13]

Increased Focus on Vertical Integration

Vertical integration between an exchange and a DCO is a traditional futures market structure. The integration of an affiliated FCM with an exchange or DCO is, however, a novel and evolving market structure that may create additional risks in the absence of adequate supervision, oversight, and guardrails. We must ensure that customers using affiliated services are not disadvantaged. In the absence of conflict-of-interest protections, customers may be exceptionally vulnerable.

Futures contracts have long traded on DCMs while being cleared on DCOs where that DCM and DCO are affiliated entities. This structure can be valuable as it allows for straight-through processing, reduced breakage, and shorter turnaround times, all of which reduce transactional risk. As derivatives markets have evolved, new vertically integrated structures among affiliated entities are being introduced, both in the futures context and in the more nascent digital asset and cryptocurrency markets.

The collapse of FTX and other crypto finance companies cast a spotlight on the ways that this market structure may lead to catastrophic compliance failures. FTX.com, a centralized digital asset derivative platform, and Alameda, a digital asset trading firm that operated as a primary market maker on FTX, present a prime example of a vertically-integrated market structure.[14] Among other things, FTX promised that customers would control access to the assets in their accounts and that those assets were “appropriately safeguarded and segregated” from FTX’s own funds.[15] But an FTX affiliate, Alameda, and its executives were able to misappropriate customers’ funds. The FTX bankruptcy and other crypto-firm insolvencies have exposed weaknesses in the operational structures of certain crypto firms, particularly with respect to vertical integration.

Risk Management, Disclosure, and Transparency Are Among The Critical Issues Arising in Vertically-Integrated Market Structures

The risk management concerns that arise due to the adoption of a vertically-integrated market structure are plural, endemic, and present imminent threats to the enterprise risk of a firm, preservation of customer assets, and ability of an entity to comply with Commission regulations, and core principles that impose fairness obligations. These risks threaten to undermine confidence in the integrity of our markets.

In a vertically-integrated market structure, the threat of the failure of an affiliated FCM of a DCO could trigger contagion. If an affiliated FCM should fail or may be perceived as likely to fail, market participants may initiate a “run” on the affiliated DCO with potential catastrophic consequences. DCOs are critical to the safety and soundness of the derivatives markets.

Permitting affiliated entities to operate as part of a vertically-integrated market structure may impact competition, which has the potential to undermine the Commission’s mandate to promote responsible innovation and fair competition among boards of trade, other markets and market participants.[16]

The RFC on Affiliated Entities posed a broad range of scenarios and issues for consideration in the context of affiliated entities. Commonly raised issues that highlight key conflicts of interest risks in the context of a DCO with an affiliated DCM include general risk management, information sharing, and resource sharing.

General Risk Management

Commenters raised general concerns that a DCO’s discretion relating to the calculation of margin, determination of a clearing member default, and enforcement of rules for purposes of examination or disciplinary action may be exercised by a DCO in ways that demonstrate preference or bias in favor of the affiliated FCM or against the interests of unaffiliated FCMs, particularly in instances in which the decision-making process lacks transparency. At the very least, a DCO with an affiliated FCM may create the appearance of preferential treatment in the DCO’s supervision of its affiliate.

Information Sharing

If a DCO is affiliated with an FCM, other members may be less willing to provide information to the DCO if the members view the DCO as likely to demonstrate a preference in favor of the affiliated DCO. Such perceptions may stymie the affiliated DCO’s ability to obtain information required to effectively manage risks. Industry commenters agreed that additional efforts to ensure transparency would be needed in the context of affiliated entities to mitigate concerns regarding information sharing and other potential biases.

Better Markets, Inc. (Better Markets) perceived the risk as follows: “When a DCO is affiliated with an FCM, it can raise concerns about the DCO's ability to obtain information from other clearing members and whether other members might perceive the DCO as something other than market neutral. These concerns can potentially impact information sharing and trust within the clearing community.”[17]

CME Group Inc. (CME) urged the Commission “to consider requiring a DCO and its affiliated FCM to develop and implement appropriate information barriers and separate staffing” to address concerns around the negative impact of affiliation on the sharing of critical information.[18]

Resource Sharing

The sharing of resources, including personnel and technology, is a common practice between affiliated entities, such as a DCO and DCM. But overlapping resources could potentially result in an unfair advantage to the affiliated FCM of a DCO or could exacerbate an impression of bias among other clearing members. While many commenters acknowledged that this practice is somewhat common, they agreed that in this context resource sharing would be concerning.

Many commenters viewed these concerns as manageable with the creation of strict rules governing appropriate separation. The International Swaps and Derivatives Association, Inc. (ISDA), for instance, felt that resource sharing would pose such great risks and require such extreme mitigation measures that “[i]t is difficult to see how sharing of staff would be compatible with appropriate information barriers, whereas sharing of other resources might pose less of a problem.”[19]

Coinbase Global, Inc. (Coinbase), agreeing with the Commission, noted that “information barriers, disclosures, and controls with respect to shared resources between a DCM and affiliated FCM are powerful tools that can be used to mitigate or even prevent certain conflicts of interest from arising.”[20]

CME noted that the Commission “could, in a targeted way, require effective operational separation, including resource and information sharing limitations or barriers, between a DCO and an affiliated FCM.”[21]

As nearly every commenter suggested, there is urgent need for Commission action. Intercontinental Exchange Inc. (ICE), for example, noted:

ICE believes that recent developments whereby a group owns a futures commission merchant (FCM) and DCO, DCM, and/or SEF suggest that the Commission could consider taking additional steps to confirm that conflicts of interests continue to be managed effectively. Furthermore, recent events in the cryptocurrency and digital asset markets reinforce the critical need for effective management of conflicts of interest for new ownership models. Well-defined and robust policies, procedures, rules, and disclosures should be implemented at affiliated regulated entities to reduce the conflicts of interest risks.[22]

The Commission must consider proposing additional rules establishing expectations for the rules, policies, and procedures that the entities of such groups would be expected to maintain to comply with current applicable CFTC conflicts of interest regulations.

The CFTC Must Engage in a Rulemaking To Address Conflicts of Interest

Historically, CFTC regulations have consistently aimed to mitigate the harmful effects that conflicts of interest may present across all markets and products.

Within three months of Congress adopting the Dodd–Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act), in October of 2010, the Commission was among the first federal financial market regulators to initiate regulation addressing conflicts of interest.

Implementing the Dodd-Frank Act, the Commission proposed a rule to mitigate conflicts of interest in the operation of DCOs, DCMs, and SEFs. Specifically the Commission aimed to “improve the governance of certain DCOs, DCMs, or SEFs or to mitigate systemic risk, promote competition, or mitigate conflicts of interest in connection with the interaction between swap dealers and major swap participants, on the one hand, and such DCOs, DCMs, and SEFs.”[23]

The CFTC continued to carry out its mandates under the Dodd-Frank Act by adopting regulations imposing myriad obligations that may apply to firms that adopt vertical integration, but those obligations should be tightened.

DCO Core Principle P, SEF Core Principle12, and DCM Core Principle 16, for example, each impose conflicts of interest obligations on DCOs, SEFs, and DCMs, respectively. In addition, current Commission regulations require DCOs to affirmatively address conflicts of interest.

Specifically, DCO Core Principle P requires a DCO to establish and enforce rules to minimize conflicts of interest in the decision-making process, establish a process for resolving such conflicts of interest, and adopt procedures to identify, address, and manage conflicts of interest involving members of its board of directors.[24] In adopting CFTC Regulation 39.25, the Commission stated that the “change benefits markets and market participants by improving the governance fitness standards and avoiding conflicts of interest for DCOs operating in those markets.”[25]

The adopting release goes further to highlight the Commission’s expectation that “the adoption of … [CFTC Regulation 39.25] … would improve DCO risk management practices by promoting transparency of governance arrangements and making sure that the interests of a DCO’s clearing members and, where relevant, their customers are taken into account … [to] further enhance the protection of market participants and the public and the financial integrity of the derivatives markets.”[26]

SEF Core Principle 12 imposes broadly similar conflicts of interest requirements on SEFs relating to the SEF’s decision-making process.[27] In the release adopting the proposed rule for SEF Core Principles, the Commission advanced that because a SEF has self-regulatory obligations, it “is not simply a corporation, but a corporation charged with the public trust,” and the CEA confers on the Commission the responsibility to ensure that such entities do not “prioritize commercial interests over self-regulatory responsibilities.”[28] Guidance and acceptable practices, to the extent adopted, in Appendix B provide additional sources for compliance.[29]

Similar to SEFs, Core Principle 16 requires a DCM to minimize and resolve conflicts of interest in its decision-making process.[30] DCMs can also refer to the guidance and acceptable practices in Appendix B to demonstrate to the Commission compliance with the conflicts of interest requirements,[31] which provide contextual information regarding the core principles and detailed examples of how a DCM must satisfy a core principle.

These core principles are broad, dynamic, and adaptable. They focus on effective governance, risk-management, transparency, fairness, and impartiality in the decision-making of the registrant but provide significant flexibility to address concerns that may arise when a DCO, SEF or DCM is empowered with discretion to make decisions that might affect their affiliated entities and potentially their commercial interests. The Commission should bolster its regulatory requirements, including with respect the DCO, SEF, and DCM Core Principles, to address urgent concerns related to conflicts of interest with respect to vertically integrated structures in our markets, including, but in no way limited to, risk management, information sharing, and resource sharing.

The Commission should be guided by its more prescriptive conflicts of interest rules, which may be instructive for market infrastructures.

CFTC Regulation 1.71, for example, was adopted pursuant to Section 4d(c) of the CEA,[32] as amended by the Dodd-Frank Act, and requires FCMs and introducing brokers (IBs) to implement internal conflicts of interest policies and procedures.[33] Market participants must implement written policies and procedures mandating disclosure to customers of material incentives and material conflicts of interest regarding the execution and clearing of a derivatives transaction, and they are also required to establish informational partitions and ensure the separateness and independence of legal entities, business units, services, and employees.

These requirements generally parallel the conflicts of interest obligations on swap dealers.[34] CFTC Regulation 23.605, under Section 4s(j) of the CEA, as added by the Dodd-Frank Act, requires swap dealers to implement conflict of interest systems and procedures that “establish structural and institutional safeguards.”[35] These requirements cover, in detail, research conflicts, clearing conflicts, and undue influence on counterparties. Additionally, swap dealers are required to disclose material incentives and conflicts of interest that they may have in connection with a particular swap, including relating to the price of the swap, the price of the swap and the mid-market mark of the swap, and any compensation or other incentive from any source other than the counterparty that the swap dealer may receive in connection with the swap.[36]

In addressing concerns about conflicts of interest in the context of vertically integrated structures, as noted by a commenter, the Commission should consider providing a list of tools that entities may use to mitigate these conflicts such as establishing appropriate disclosures, incentives, internal controls, information barriers, separate legal entities, and operational separateness. The Commission must also give due consideration to those scenarios for which conflicts of interest may not be adequately managed or mitigated.[37]

The existing regulations provide a helpful, but inadequate, framework. A robust regulatory and disclosure framework subject to Commission supervision must be implemented to foster the integrity of our markets and protect customers.

A Rising Tide of Vertical Integration in the Crypto-Ecosystem

Increasing reliance on vertically-integrated market structures coupled with the significant interconnectedness of the crypto-ecosystem and regulators’ persistent lack of visibility in the underlying spot market may create a perfect storm for devastating customer protection and market integrity outcomes. 

Bitnomial Clearinghouse has several times applied for Commission permission to operate in crypto-derivatives markets. In connection with this series of applications, Bitnomial, Inc. (Bitnomial), the parent company, has adopted a vertically integrated organizational structure. Bitnomial’s business model aggregates execution, clearing, intermediary, and settlement services through a network of commonly-owned, affiliated entities.

Bitnomial Clearinghouse will clear physically-delivered Bitcoin futures contracts and options on Bitcoin futures contracts listed on Bitnomial Exchange, LLC (Bitnomial Exchange). Bitnomial Exchange, which directly owns Bitnomial Clearinghouse, has been registered with the CFTC as a DCM since 2020 and began operations in 2021. Bitnomial Exchange currently clears its Bitcoin futures contracts through Minneapolis Grain Exchange, LLC. Bitnomial Exchange services several FCMs.

Bitnomial Clearing LLC, an FCM, has been registered with the CFTC since 2022, and is a member of NFA. Bitnomial Clearing may seek to operate as a clearing member alongside other FCMs currently serviced by Bitnomial Clearinghouse.

Bitnomial Settlement, LLC is authorized as a digital asset settlement facility by the Exchange and is not licensed or registered with the CFTC.

To obtain and maintain registration as a DCO, a clearinghouse must demonstrate compliance with the DCO Core Principles set forth in Section 5b(c)(2) of the CEA and the regulations implementing the Core Principles set forth in Part 39 of the CFTC’s regulations. These Core Principles include principles to assure adequate financial, operational, and managerial resources; appropriate risk management capabilities; and standards and procedures to protect member and participant funds, among others.

Bitnomial Clearinghouse submitted an application for DCO registration on April 26, 2022, including the exhibits and information required by Form DCO. As an initial matter, Commission staff, including staff in DCR and the Office of the General Counsel, engaged in the review of Bitnomial Clearinghouse’s application over many months. The careful and detailed review involved numerous rounds of written questions and answers and requests for additional documentation. It included a review of rules; policies, procedures, and controls; financials; corporate formation documents; and information technology systems information, to name a few areas. DCR staff’s review was extensive and in-depth, and sought to ensure that Bitnomial Clearinghouse, at launch, would be able to comply with the relevant requirements under the CEA and Commission regulations, and would be able to sustain such compliance.

Bitnomial Clearinghouse discloses its affiliated entities, sets out policies relating to its affiliated entities to mitigate the effects of any conflicts of interest, and adopts rules regarding its affiliate clearing member. Bitnomial Clearinghouse will also disclose its affiliated FCM members to customers as part of a particularized disclosure at the outset of the clearing relationship, and this agreement is an important step in reducing conflict of interest concerns.

As a DCO registered with the Commission, Bitnomial Clearinghouse will be subject to existing Commission regulatory, supervisory, and examination requirements that are designed to ensure that they are fair, effective and efficient and that they reduce systemic risk.

Finally, to the extent the Commission imposes additional regulations to address concerns around the aggregation of services offered to a customer under the same corporate group, Bitnomial Clearinghouse will be required to comply with those requirements as and when they are adopted, as stipulated in Bitnomial Clearinghouse’s registration order.

Consistent Application of the CEA And CFTC Regulations

I have grave concerns about the risks posed by vertically-integrated structures in our markets and expect the Commission to immediately begin to address these concerns in a forthcoming rulemaking.[38] Today, we apply the currently applicable provisions of the CEA and our rules in the context of our deliberations. Our deliberations benefit from DCR’s rigorous review of the application and its conclusion that Bitnomial Clearinghouse complies with the current statutory and regulatory requirements under the CEA and Part 39 for registration as a DCO.

However, we approach this application with full knowledge from our own deliberations, discussions with this applicant, public comment at a day-long roundtable in May 2022 on non-intermediation and the many substantive responses to the RFC on Affiliated Entities that the current rules must be subject to immediate review and revision to address the evolving vertically-integrated market structures being adopted in crypto-derivatives markets. The Commission must introduce heightened obligations to address the conflicts apparent in this market structure. Failure to do so would be a dereliction of duty.

Reviewing the perspectives of the Commissioners on this matter, it appears that the Commission has a coalition of the willing with voices from diverse perspectives echoing the same concerns and demonstrating a willingness to respond to this call for action. A majority of voices on the Commission support a proposed rulemaking on vertically-integrated market structures.

The Commission must begin to adapt and tailor our regulatory structure to address the precise risk of vertical integration. The Commission would benefit from a rulemaking process—involving a notice and comment period—to address broader concerns that arise in the context of vertically integrated services in our markets, as the Commission expects to see more vertically integrated structures in our markets.

Conclusion

I strongly advocate for the Commission to initiate a rulemaking. More market participants are adopting a vertically-integrated market structure, and the Commission must ensure that such structure does not raise systemic risk or financial stability concerns.

I would like to thank the DCR staff—Eileen Donovan, Parisa Nouri, August Imholtz, Daniel O’Connell, Julie Mohr, Malcolm Alexander-Neal, Aimee Wilson, David Grzesiak, Shallom Moses, and Hong Sherwin—for their tremendous efforts.