In the mid-1800s, my family migrated to a small town in the Midwest and founded businesses, acquired real estate and originated small loans to support entrepreneurs and businesses in the community.[1] As is true for all businesses, relationships and trust were key elements in the success of these businesses. Trust is the core issue that motivates today’s notice of proposed rulemaking (Proposed Rule) regarding the protection of clearing member funds held by derivatives clearing organizations (DCOs) advanced by the Division of Clearing and Risk.
On March 30, 2022, I commenced service as a Commissioner of the Commodity Futures Trading Commission (Commission or CFTC). In a hearing before the Senate Agriculture, Nutrition, and Forestry Committee a few weeks earlier, I committed to promote the integrity and stability of our markets and protect customers, particularly vulnerable and marginalized individual retail customers who participate in our markets. This commitment is among the most compelling reasons for my public service.
Since the earliest days of federal prudential and market regulation in our nation, thought leaders have advocated for regulation that preserves customer assets held by others. In his book published in 1914—Other People’s Money—former Supreme Court Justice Louis Brandeis advocated for similar reforms that safeguard the assets of financial markets customers. Over the last few decades, the Commission has adopted and refined such protections for customers of intermediaries in our markets, namely by imposing rigorous obligations on intermediaries to segregate the funds of their customers, designating specific authorized depositories, and outlining permitted investments of customer funds.
Over the course of my tenure as a Commissioner, in numerous public speeches, statements, and interviews, I have called on the Commission to advance parallel customer protections for direct participants of non-intermediated clearinghouses registered with the Commission as DCOs.[2]
Today’s Proposed Rule takes the first steps to close this gap. I support this Proposed Rule that advances the protection of clearing member proprietary funds held by a DCO. Specifically, the Proposed Rule:
- requires a DCO to segregate clearing member proprietary funds from the DCO’s own funds, hold such funds in an account labeled as proprietary funds, and obtain a written acknowledgment letter from a depository;
- requires a DCO to treat clearing member proprietary funds as belonging to the clearing member while permitting the DCO to use clearing member proprietary funds as part of the DCO’s default waterfall, consistent with the DCO’s rules and agreement with its clearing members;
- permits the DCO to commingle proprietary funds of multiple clearing members in a single omnibus account for convenience while prohibiting the commingling of proprietary funds with the DCO’s own funds or futures commission merchant (FCM) customer funds;
- permits the DCO to invest clearing member proprietary funds in highly liquid financial instruments pursuant to CFTC Regulation 1.25 and requires DCOs to be responsible for investment losses; and
- requires the daily reconciliation of balances of FCM customers and clearing members and segregated funds and the reporting of any discrepancies.
In my capacity as a Commissioner at the CFTC, I have strongly advocated for the development of these important regulatory protections that parallel existing protections in intermediated market structures. This Proposed Rule reflects the tremendous efforts of coordination among the Division of Clearing and Risk, the office of the Chairman, my office, and my fellow Commissioners’ offices and their staff. Our collective engagement reflects years of dialogue with market participants, CFTC staff, other market and prudential regulators and engagement with the U.S. Department of the Treasury, members of Congress, academics, and public interest advocates.
This Proposed Rule offers a transformational reform that brings to markets in which clients may interact directly with a DCO foundational protections currently established in CFTC regulations and enforced in markets that rely on intermediaries.[3]
In a direct clearing model (non-intermediated market structure), clearing members are not customers of intermediaries,[4] and therefore, do not qualify for the regulatory protections available under Part 1 of the Commission’s regulations, including the requirement to separately account for and segregate customer funds as belonging to customers, deposit customer funds in specific locations, obtain written acknowledgment letters from depositories, and use customer funds as belonging to such customers.[5] The Proposed Rule reflects the historic development and evolution of markets and refers to the assets or funds on deposit from a customer of an intermediary as “customer funds.” The Proposed Rule adopts the term “clearing member” to describe those directly interacting with the clearinghouse and “ proprietary funds” to describe clearing members’ assets or funds on deposit.
The Commission acts to ensure parallel protections in the market for every asset class, adopting and seeking to implement the existing, well-tested, and effective regulatory framework under certain provisions of Part 1 of the CFTC’s regulation to the preservation of clearing member proprietary funds. This may be increasingly important as the Commission anticipates market participants’ introduction of novel financial products.
In adopting the Proposed Rule, the Commission seeks to ensure that clearing member proprietary funds are easily identified and receive the proper treatment in the event the DCO enters an insolvency or bankruptcy proceeding.
Today, the Commission takes a first step to ensure that there are parallel protections for both the “customers” of intermediaries, and the “clearing members” of DCOs who may include (in a direct clearing model) individual retail market participants.
Regulatory Gap For Direct Participants in Non-Intermediated Clearing Models
Section 4d of the Commodity Exchange Act (CEA) and Parts 1, 22 and 30 of the Commission’s regulations establish a comprehensive regime to safeguard the funds belonging to customers of FCMs in the context of intermediated DCOs.
The customer protection regime requires FCMs to segregate customer funds from their own funds, deposit customer funds under an account name that clearly identifies them as customer funds, and obtain a written acknowledgment from each depository that holds customer funds. The customer protection regime does not apply to the funds of a person that clears trades directly through a DCO and is a “clearing member” because such market participants do not meet the legal and regulatory definition of the term “customer.”
Therefore, direct participants that are not “customers” of intermediaries may not benefit from the Commission’s well-established customer protection regime.
The Commission seeks to offer parallel customer protections to direct participants in non-intermediated DCOs—clearing members—to preserve the value of their proprietary funds, mitigate the risk of loss, and improve the availability of those funds for return to the clearing member should the DCO fail. Section 5b(c)(2)(F) of the CEA (Core Principle F) and CFTC Regulation 39.15 apply to the treatment of clearing members’ funds and assets held by a DCO.
CFTC regulations require DCOs to establish standards and procedures designed to protect and ensure the safety of proprietary funds and require DCOs to hold proprietary funds in a manner that will minimize the risk of loss or delay in access by the DCO to the proprietary funds. Section 8a(5) of the CEA grants the Commission authority to adopt rules it determines are reasonably necessary to effectuate the DCO core principles.[6] The safeguards in this Proposed Rule are indeed reasonably necessary to effectuate DCO Core Principle F.[7]
In light of the lack of parallel protections for “clearing members” who directly interface with DCOs, there is a significant gap in the Commission’s ability to ensure the protection and preservation of funds or assets of direct participants. This Proposed Rule closes the gap.
The Collapse of the FTX Complex
The bankruptcy of FTX illustrates the magnitude of the losses that customers may experience in the absence of regulation that prohibits commingling of client assets or imposes obligations to segregate client assets for the benefit of customers.
In November 2022, FTX Trading Ltd. d/b/a/ FTX.com (FTX), Alameda Research LLC (Alameda) and approximately one hundred and thirty FTX-affiliated entities filed for bankruptcy in the United States. Contemporaneous with the bankruptcy filing, the Department of Justice (DOJ), Commission, and other federal regulators began to investigate claims that FTX employed omnibus accounts that commingled customer funds with the FTX enterprise resources, allegedly misappropriating more than $10 billion in client assets.[8]
In December 2022, in coordination with the DOJ, U.S. Attorney’s Office for the Southern District of New York and the Securities and Exchange Commission, the CFTC charged Sam Bankman-Fried, FTX and Alameda with fraud and material misrepresentations in connection with the sale of digital commodities in interstate commerce and the misappropriation of its customers’ assets.[9]
Earlier this fall, in a federal courtroom in the Southern District of New York, jurors found Sam Bankman-Fried, former chief executive officer of FTX, guilty of misappropriating billions of dollars in customer funds and assets deposited with and held in the custody by FTX.
In a parallel action, the CFTC has alleged that Mr. Bankman-Fried and FTX solicited customers on the premise that the FTX platform could be trusted.[10] FTX claimed that customer assets were “appropriately safeguarded and segregated” from FTX’s own assets. The CFTC’s complaint alleges that despite these statements, FTX permitted Alameda to access customer deposits and commingle customer assets with Alameda’s proprietary assets, which were used for Alameda’s and its executives’ own business operations, personal purchases, acquisitions of other businesses, and risky investments.
While soliciting customers to trust in the integrity of its business, FTX is alleged to have siphoned off billions in customer deposits.
The Benefits and Limits of Alternatives to Regulation: LedgerX
LedgerX, a non-intermediated clearinghouse registered with the Commission as a DCO and owned by parent company FTX, illustrates the importance of the protections advanced in the proposed rulemaking.
On October 25, 2021, FTX.US acquired LedgerX through a Delaware company doing business as West Realm Shires Services Inc. (West Realm Shires). When parent company FTX filed a petition seeking bankruptcy protection on November 11, 2022, the bankruptcy court declared LedgerX a non-debtor entity. LedgerX was one of the few assets within the network of FTX-affiliated companies that remained solvent. More than 100 FTX affiliates filed for bankruptcy protection.
In 2017, years before the acquisition by West Realm Shires, LedgerX submitted an application with the Commission seeking authorization to register as a DCO offering fully-collateralized (crypto) derivatives contracts. The Commission’s order, amended in September 2020, imposed a number of important conditions, including a condition requiring LedgerX to “at all times maintain funds of its clearing members separate and distinct from its own funds.”[11]
When FTX filed for bankruptcy protection, the conditions in the LedgerX order and Commission staff’s enforcement of compliance with the conditions contributed significantly to the preservation of LedgerX’s customer property.[12] The LedgerX order serves as an important precedent for the framework the Commission must consider when adopting parallel protections for DCO direct clients, particularly retail clients, in the non-intermediated context.
In 2022, LedgerX applied to amend its order of registration as a DCO to allow it to modify its existing non-intermediated model to clear margined products for retail participants while continuing with a non-intermediated model.
In May of 2022, the Commission held a convening to examine the implications of a derivatives clearing market structure that offers direct-to-client services. The convening outlined important issues addressed in this Proposed Rule.
The Rise of Non-Intermediated DCOs
DCOs play an increasingly important role in the financial markets, though DCOs have been central to facilitating access to the derivatives market since the founding of our nation and the futures market. The Dodd-Frank Act introduced a framework for the regulation of swaps that imposed central clearing and trade execution requirements, registration and comprehensive regulation of swap dealers, and recordkeeping and real-time reporting requirements.
The clearing market structure has evolved from a traditional clearing model, where an FCM served as an intermediary in transactions between a customer and a DCO, to a direct clearing model, where the transactions are between the customer and the DCO directly.[13] As I have previously stated:
FCMs solicit and accept orders for derivatives transactions on behalf of customers and receive customer funds to margin, guarantee, or secure derivatives transactions. FCMs are subject to significant regulatory requirements, including customer protection safeguards, safety and soundness capital requirements, risk management, conflicts of interest requirements, and anti-money laundering and know-your-customer programs.[14]
At the core, in a traditional, intermediated model, customer protection rules apply to FCMs and require FCMs to segregate customer funds, including when such funds are held at a DCO, among other safekeeping measures.
In newly emerging disintermediated market structures, the absence of an intermediary creates a gap in the application of the CFTC’s customer protection rules because key customer protections are triggered by the presence of a “customer,” as defined by the CFTC, and an FCM that facilitates the clearing of a customer’s derivatives transactions at the DCO.[15]
The Proposed Rule achieves parallel protections by applying key aspects of the customer protection regime to proprietary funds of clearing members and imposing parallel asset protection requirements on DCOs—both in intermediated and non-intermediated clearing models.
In addition, the Proposed Rule contains important requests for comments, soliciting feedback and engagement from the industry on a number of potential future actions.
Future Rulemaking: Anti-Money Laundering Requirements for DCOs
Anti-money laundering (AML) regulations ensure that all transactions in our markets are subject to identification verification standards and prevent illicit activity in our markets.
It is imperative that the Commission continue to engage with the U.S. Department of Treasury to ensure that AML regulations apply to all applicable market structures involving activities that create obligations to comply with AML regulations.
The Proposed Rule includes a request for comment that asks:
[h]ow might the Commission ensure AML and KYC compliance for DCOs that offer direct clearing services (a market structure that would not include FCMs or other intermediaries that are typically directed to create Bank Secrecy Act compliance programs)? Should DCOs offering direct-to-customer services to non-eligible contract participants or retail customers be required to comply with AML and KYC requirements?
Following consultation with the U.S. Department of Treasury, the Commission may need to engage in a formal rulemaking that imposes AML requirements on DCOs.[16]
Technical Clarifications in CFTC Regulation 1.25
The Proposed Rule allows DCOs to invest proprietary funds in permitted investments pursuant to CFTC Regulation 1.25. The drafting cross-refers to CFTC Regulation 1.25; the Commission is currently engaged in a proposed rulemaking that amends CFTC Regulation 1.25. My supporting statements to amendments to CFTC Regulation 1.25 note that it is imperative that the Commission consider an equivalent application of CFTC Regulation 1.25 in the context of a DCO’s investment of member property of retail customers.[17]
Comments to the Proposed Rule should indicate how best to ensure equivalence.[18]
Periodic Reporting of Daily Reconciliation
The Proposed Rule requires a DCO to notify the CFTC of discrepancies in its daily calculations. The Commission exercises direct oversight with respect to DCOs, meaning DCOs are not supervised by self-regulatory organizations (SRO) or designated self-regulatory organizations (DSRO). The Commission performs the examination functions. DCOs may benefit from a similar oversight as FCMs, which involves a regular reporting of reconciliation and not just the reporting of discrepancies.[19]
History provides a cautionary tale. Even with regular oversight from SROs or DSROs, the Commission has witnessed significant FCM bankruptcies under then-existing rules that failed to prevent losses to customers.
As one example, MF Global, a prominent FCM and broker-dealer, Jon Corzine, Goldman Sachs alum and former Governor and Senator of New Jersey, adopted a proprietary trading strategy involving the investment in the sovereign debt (bonds) of certain European nations through repurchase-to-maturity transactions. A steep decline in sovereign debt markets triggered demands for increased margin, and MF Global had insufficient liquidity to maintain positions. In an attempt to prevent a “run on the bank” by customer withdrawals, creditors’ demands, efforts to unwind repo counterparty positions, and attempts to liquidate proprietary positions at fire sale prices, MF Global misappropriated customer funds in violation of the Commission’s customer segregation requirements.
Peregrine, a futures trading firm, lost millions in customer funds. Russell Wasendorf Sr., the founder and former CEO of Peregrine, was sentenced to 50 years in prison because he siphoned off more than $215 million from customers of Peregrine. The National Futures Association, the SRO, was heavily criticized for failing to catch the shortfall in customer funds, though it was the auditor of Peregrine.
DCOs are subject to robust Commission regulations, examinations, and oversight. It will be important to receive comments from all stakeholders regarding the reporting of DCO reconciliations.
Conclusion
It is my hope that this Proposed Rule will move forward so that we can begin to introduce greater protections for clearing members, including retail customers. I thank the Division of Clearing and Risk—Clark Hutchinson, Eileen Donovan, Theodore Polley, and Scott Sloan—for their tremendous efforts in advancing this very important, significant, and transformative Proposed Rule.
[1] IND. HIST. SOC’Y, EARLY BLACK SETTLEMENTS: Early Black Settlements By County (Miami County) https://indianahistory.org/research/research-materials/early-black-settlements/early-black-settlements-by-county/.
[2] Kristin N. Johnson, Commissioner, CFTC, Statement on Preserving Trust and Preventing the Erosion of Customer Protection Regulation (Nov. 3, 2023), https://www.cftc.gov/PressRoom/SpeechesTestimony/johnstatement110323; Kristin N. Johnson, Commissioner, CFTC, Keynote Address at the World Federation of Exchanges Annual Meeting: Creating Rules of the Road for (Dis)Intermediated and (De)Centralized Markets (Sept. 21, 2023), https://www.cftc.gov/PressRoom/SpeechesTestimony/opajohnson5; Kristin N. Jonson, Commissioner, CFTC, Keynote Address at Salzburg Global Finance Forum: Future-Proofing Financial Markets Regulation (June 29, 2023), https://www.cftc.gov/PressRoom/SpeechesTestimony/opajohnson4; Kristin N. Johnson, Commissioner, CFTC, Statement Calling for the CFTC to Initiate A Rulemaking Process for CFTC-Registered DCOs Engaged in Crypto or Digital Asset Clearing Activities (May 30, 2023), https://www.cftc.gov/PressRoom/SpeechesTestimony/johnsonstatement053023; Kristin N. Johnson, Commissioner, CFTC, Keynote Address at Digital Assets @ Duke Conference, Duke’s Pratt School of Engineering and Duke Financial Economics Center: Mitigating Crypto-Crises: Applying Lessons Learned in Governance, Risk Management, and Compliance (Jan. 26, 2023), https://www.cftc.gov/PressRoom/SpeechesTestimony/opajohnson2; Kristin N. Johnson, Commissioner, CFTC, Statement in Support of Notice of Proposed Amendments to Reporting and Information Requirements for Derivatives Clearing Organizations (November 10, 2022), https://www.cftc.gov/PressRoom/SpeechesTestimony/johnsonstatement111022b.
[3] Although the focus of my statement is on direct participants in the context of non-intermediated clearing models, the Proposed Rule has broader implications. It applies to the proprietary funds of FCMs in the context of an intermediated model as well.
[4] The term “customer” is generally reserved for the individuals or businesses that rely on an intermediary such as an FCM to facilitate a transaction. Where a DCO offers direct services, the individuals or businesses engaged with the clearinghouse are generally described as “members.”
[5] 17 C.F.R. § 1.20.
[6] 7 U.S.C. § 12a(5).
[7] 7 U.S.C. § 7a-1(c)(2)(F).
[8] FTX Demonstrates Need for More Oversight: CFTC's Johnson (Bloomberg TV Nov. 9, 2022), https://www.bloomberg.com/news/videos/2022-11-09/ftx-demonstrates-need-for-more-oversight-cftc-s-johnson.
[9] Press Release No. 8638-22, CFTC, CFTC Charges Sam Bankman-Fried, FTX Trading and Alameda with Fraud and Material Misrepresentations (Dec. 13, 2022), https://www.cftc.gov/PressRoom/PressReleases/8638-22; Kristin N. Johnson, Commissioner, CFTC, Statement on Preserving Trust and Preventing the Erosion of Customer Protection Regulation (Nov. 3, 2023), https://www.cftc.gov/PressRoom/SpeechesTestimony/johnstatement110323; Kristin N. Johnson, Commissioner, CFTC, Atlanta Economics Club Keynote Address At The Federal Reserve Bank of Atlanta: Policing the (Token) Economy: Introducing Corporate Governance and Market Structure Reforms in Crypto and Environmental Commodities Markets (Nov. 13, 2023), https://www.cftc.gov/PressRoom/SpeechesTestimony/opajohnson8#fnt7.
[10] See Commodity Futures Trading Commission v. Samuel Bankman-Fried, FTX Trading Ltd d/b/a FTX.com, and Alameda Research LLC (S.D.N.Y. 2022) (Compl.).
[11] Press Release No. 8230-20, CFTC, CFTC Approves LedgerX, LLC to Clear Fully-Collateralized Futures and Options on Futures (Sept. 2, 2020), https://www.cftc.gov/PressRoom/PressReleases/8230-20.
[12] LedgerX’s “customers” are clearing members as described above and would not otherwise qualify for protections under Parts 1 and 22 of the Commission’s regulations.
[13] Currently, CBOE Clear Digital, LLC, CX Clearinghouse, L.P.; LedgerX, LLC, and North American Derivatives Exchange Inc. allow individuals to be direct clearing members. Additionally, ICE NGX Canada Inc. clears physically delivered energy contracts directly for clearing members with a net worth exceeding CAD $5,000,000 or assets exceeding CAD $25,000,000.
[14] Kristin N. Johnson, Commissioner, CFTC, Keynote Address at the World Federation of Exchanges Annual Meeting: Creating Rules of the Road for (Dis)Intermediated and (De)Centralized Markets (Sept. 21, 2023), https://www.cftc.gov/PressRoom/SpeechesTestimony/opajohnson5.
[15] See supra note 2.
[16] I note that the Commission has negotiated the inclusion of AML requirements in the registration order for several DCOs, including CBOE Clear Digital, LLC and LedgerX LLC. I commend DCOs that have implemented these conditions.
[17] Kristin N. Johnson, Commissioner, CFTC, Statement on Preserving Trust and Preventing the Erosion of Customer Protection Regulation (Nov. 3, 2023), https://www.cftc.gov/PressRoom/SpeechesTestimony/johnstatement110323.
[18] In footnote 45 in the Proposed Rule, the Commission notes: Proposed § 39.15(e) cross-references § 1.25, which provides that an FCM or DCO may invest “customer money” in certain instruments. The regulatory text of § 1.25, however, does not refer to “proprietary funds.” The Commission recently approved proposed amendments to § 1.25. Based on comments received on those proposed amendments, if appropriate, the Commission may consider further amending § 1.25 either in the final rule or as a re-proposed rule to ensure that the regulatory text provides clarity on the application of § 1.25 to a DCO’s investment of “proprietary funds,” as permitted under § 39.15(e).
[19] See supra note 17.
