MRAC Meeting

On July 10, the Commodity Futures Trading Commission (CFTC) Market Risk Advisory Committee (MRAC) held a public meeting.  The meeting agenda included sections on CCP risk and governance, interest rate benchmark reform, market structure, the future of finance, and climate-related market risk. 

Below is a summary of the meeting prepared by Delta Strategy Group. 

Speakers: 

Alessandro Cocco, Vice President and Head of Financial Markets Group, Federal Reserve Bank of Chicago

Alicia Crighton, Chair of the Board of Directors, Futures Industry Association

Chris Edmonds, Chief Development Officer, ICE 

• Workstreams: 
  • Margin and Collateral Activity 
    • We are discussing model transparency for initial margin, margin period of risk, model responsiveness for cleared and non-cleared initial margin models to market shocks, back-testing, and price volatility control.  We will be investigating whether there is a need for regulators to have a more comprehensive picture of market participants’ preparedness for market requirements.  We are also looking into the liquidity implications of collateral calls for clearing members, clients, and the broader financial system. 
  • Recovery and Resolution Action Plan 
    • The Subcommittee will discuss key issues raised in public comments on DCO recovery and orderly wind down plans.  We will work to examine the similarities and differences with resolution of financial entities that are not CCPs and consider lessons learned from those frameworks based on the understanding of the unique role of DCOs.  We will also survey other national and international frameworks for the recovery and resolution of CCPs and consider opportunities for further international harmonization where necessary. 
  • Technology & Operations Action Plan 
    • The Subcommittee will investigate current regulations and paths of direct or indirect oversight of critical third parties.  A key aspect of this will be determining which Core Principles may be impacted by oversight of third parties.  We will identify where the use of cloud technologies might impact current CFTC regulations and seek to identify potential enhancements. 

• This Subcommittee has worked to ensure that we avoid any regulatory obstacles to a smooth transition away from LIBOR to SOFR.  We believe that this transition has been successful in no small part due to the work carried out by the CFTC.  The CFTC worked to provide vital recommendations, including SOFR First, that allowed for this transition to occur successfully.  We have seen trading activity in SOFR rise in accordance with our expectations in this transition. 

CFTC Commissioner Kristin Johnson 

• This work should be a model for public-private partnerships going into the future.  The work to have a successful transition from LIBOR to SOFR has been extensive and is exceptional. 

Speaker: 

Biswarup Chatterjee, Managing Director and Head of Innovation for the Global Markets Division, Citigroup 

• Workstreams: 
  • Block Implementation Rules 
    • Block sizes that are not appropriately calibrated may adversely impact market participants’ ability to execute certain swaps and may impact the liquidity of OTC markets.  We are considering a near-term analysis of new CFTC thresholds for block trades which may involve analysis of data from SEFs and other market participants.  We may also analyze the impact of reporting delays and the time it takes for market participants to execute hedges.  We may consider long-term block recommendations for the new SOFR swap trading markets. 
  • FCM Concentration and Capacity 
    • The number of FCMs offering their services has significantly decreased over the last decade coinciding with the move to mandatory clearing for most OTC derivatives and the need to clear a larger number of products and volume.  We are examining barriers to entry such as capital requirements, customer account requirements, and technology requirements.  The Subcommittee may consider recommendations within the existing FCM models and other possible longer-term recommendations to enhance these models. 
  • Treasury Market Reform 
    •  Last September, the SEC proposed rules that would require members of clearing agencies to clear all Treasury bond trades.  Currently, the only registered clearing agency for these transactions if FICC.  While more must be done to narrow this workstreams focus, we expect to analyze how these requirements on clearing may impact CFTC-regulated markets. 
  • Post-Trade Risk Reduction 
    • PTRR services play a critical role in elimination of various aspects of credit, counterparty, and operational risks from trades that have been previously executed.  Market participants in the UK and EU are discussing exemptions from clearing and trading requirements that may incentivize additional risk and liquidity management using PTRR services.  We will seek to analyze similar exceptions from the CFTC, and the impact this would have on market integrity. 

Moderator: Alessandro Cocco, Vice President and Head of Financial Markets Group, Federal Reserve Bank of Chicago 

• The digital asset industry has the potential to lower costs and improve the efficiency of transferring assets.  This new economy offers the opportunity for wealth creation for new groups, but there are concerns over illicit activities and the protection of customer assets.  Many of the rules that ensure the security of derivatives markets would work well to improve customer protections and market integrity in digital asset markets.  Non-intermediated structures have created vertically integrated market structures that present unique challenges for regulation in these markets.  The CFTC should lead in ensuring that new rules are implemented to foster innovation in these markets while protecting investors from unscrupulous actors or market manipulation. 

Rebecca Rettig, Chief Policy Officer, Polygon Labs 

• The tried and trusted rules for derivatives markets arose as a reaction to the construction of the market itself, not the other way around.  We should not conflate existing frameworks with a deliberate policy choice to create markets.  These rules have also been modified over time to reflect changes in these markets.  We could use existing laws for digital asset markets, or we could tailor existing structures over time to the nature of digital asset markets.  It is important to underscore that we are in a critical moment for these markets, and we must look at what we can implement today to protect consumers.  These markets continue to grow despite setbacks.   
• Some of the greatest failures we have seen in these markets have nothing to do with digital assets.  Instead, they were the result of the same kinds of fraud and illicit activities that existing regulations are designed to prevent.  The greatest place for conflicts of interest in these markets are exchanges that are also operating trading platforms.  There are also examples of customer facing brokerage activities being integrated with trading platforms. 

Yesha Yadav, Vanderbilt University Law School 

• We are dealing with serious issues for unsecured depositors in failed entities.  This is a strange set of affairs given the decentralized nature of cryptocurrency and the extremely centralized nature of digital asset intermediaries.  This model has made these intermediaries successful, but it comes with significant investor concerns.  Also, the average retail investors in cryptocurrency are not comfortable with self-custody or interacting directly with blockchains, leading to many transactions taking place off-chain within an intermediary.  The unique structure of these markets makes it difficult to just uniformly apply existing market structure regulation.   
• There is a need for urgent reform in this space to provide necessary customer protections.  We need to get custodial rules in place as quickly as possible to protect investor funds.  Workable disclosure rules are also vital in this space. 

Steven Schwarcz, Duke University Law School 

• Vertical integration in crypto markets can have advantages such as informational efficiencies, but the disadvantages far outweigh the advantages.  We saw the deep risks that vertical integration can cause with events such as the FTX collapse.  It seems that conflicts of interest also increase the incentives for vertically integrated firms to work against consumer interests to minimize losses.  Over time, vertical integration is likely to naturally diminish.  Currently the firms that are involved in the space are more likely to engage in vertical integration due to their information asymmetry and hope to capitalize on as many aspects of the market as possible, but, over time, as information becomes more available to others, there will be more specialist forms as intermediaries. 

Jason Allegrante, Chief Legal and Compliance Officer, Fireblocks 

• The adoption of self-custodial practices provides additional protections against risks for investors, and it can help meet many market objectives such as market transparency and oversight.  There are risks in integrating self-custodial models into systems, but these are not structural problems that constitute significant conflicts of interest that put customers at risk.  On-chain solutions and self-custody offer retail customers an opportunity for fund segregation at the blockchain-level.  We urge this Committee to work to ensure that the U.S. remains a leader in global financial market standard setting. 

Chen Arad, Chief External Affairs Officer, Solidus Labs 

• Vertical integration can naturally lead to market manipulation, front-running, and insider trading.  These factors can directly contradict with the decentralized purpose of the cryptocurrency space.  The nature of a decentralized market can also make it harder to prevent or monitor markets for things like insider trading and information asymmetries.  Where Solidus labs saw insider trading, we almost always have found it originally purchased on decentralized exchanges.  Despite these issues, crypto’s market structure also provides the perfect path to preventing these activities.  The same transparency that can enable insider trading can also be used to track transactions for illicit activities. 

Discussion: 

Dick Berner:  We have identified several regulatory practices that we might borrow from traditional finance that would apply well to digital assets.  We believe that governance best practices would be beneficial for these markets.  There should also be high standards for transparency and global coordination between standard setters. 

Kevin Webach, University of Pennsylvania:  How should we think about the significance of DeFi from a risk management perspective?  Rettig:  There are certain times where there are points of centralization even within DeFi.  When you get to a truly decentralized state.  We need to ensure that there is not some central party that is controlling or guiding the public in the decisions they are making on a DeFi protocol;  Schwarcz:  There is an issue knowing exactly who should be regulated when it comes to DeFi. 

Tyson Slocum, Director, Public Citizen Energy Program 

• It was once common for corporations to make sustainability pledges primarily based on their plans to engage in voluntary carbon markets.  More recently, however, these markets have been exposed as deeply flawed and rife with bad actors.  There are deep underlying credibility problems in these markets.  I question whether these markets can be an effective tool to address climate concerns.  I support efforts to impose strong regulatory standards for these markets, and I agree with the CFTC’s work to encourage whistleblowers to come forward and expose fraud in these markets.  MRAC should consider a heightened self-certification process for carbon offset products.   

Peter Malyshev, Partner, Wickersham & Taft LLP 

• Unlike traditional physical commodities, the underlying commodities in a carbon offset futures product is just a contract relating to carbon instead of actual tangible products.  Jurisdictionally, the CFTC is limited with what it can do relating to environmental commodities given that it only has enforcement authority in these markets.  Having said this, a spot market can be set up on a DCM platform which would be fully regulated at the entity level.  The CFTC can also act as a thought leader outside of its jurisdictional reach over spot markets and can steer participants towards market mechanisms that have worked well in regulated markets (e.g., reporting, verifying deliverable supply, trading on organized platforms, registering intermediaries, clearing, and prevention of market abuse). 
• We have seen that there is an interest in fractionalizing larger carbon contracts to make them more attractive for retail participants.  We are also starting to see the use of carbon contracts in project financing and a greater interest in hedging and speculation of listed futures based on environmental commodities.  We believe that a greater appreciation that climate change is real, and we must focus on mitigation.  Despite this, there is still limited trading volume in voluntary carbon markets due to concerns over reliability and greenwashing.  A lot can be done to police these markets for fraud and ensure that they have appropriate integrity.