On January 13, 2022, CFTC Commissioner Dawn D. Stump delivered remarks at the Chamber of Digital Commerce. Commissioner Stump acknowledged that: (1) market regulators must avoid stifling beneficial market innovations by rigidly clinging to past regulatory approaches that do not fit the current paradigm of products and services offered to the public; and (2) infrastructure providers must accept regulatory oversight to assure market integrity and consumer protection.
Commission Stump recognizes that balancing these two positions requires hard work but rejected the CFTC’s current approach of “relying primarily on enforcement actions to impose penalties on those with novel products and markets for their failure to register with the agency is… an insufficient response.” Commissioner Stump encouraged the CFTC to use the principles-based authority granted by Congress to set clear regulatory expectations for new, innovative applications in the derivatives market rather than being mere bystanders who tell infrastructure providers “It’s not our job to tell you how to meet our rules, just figure it out.”
Commissioner Stump’s remarks identified three areas of concern where CFTC guidance is strongly encouraged:
1. Trading Platforms (Designated Contract Markets and Swap Execution Facilities). Polymarket is an unregistered DCM and SEF online trading platform that uses blockchain technology to offer event-driven binary options to users. The CFTC’s rules governing traditional DCMs and SEFs were fundamentally different from Polymarket’s services and the recent enforcement action against Polymarket is an issue of first impression for the agency because the CFTC has not offered any guidance regarding how Polymarket’s platform would be expected to operate under its existing rules. Instead of issuing guidance for market innovators to comply with the Polymarket Order is an avoidable example of regulation by enforcement. (See Polymarket Order).
2. Clearinghouses (Derivatives Clearing Organizations). Traditionally, intermediaries exist between clearinghouses and clients, who are usually institutional investors accustomed to using leverage and managing risks. New technologies now enable retail investors to abandon the intermediary model and still gain exposure to the derivatives market. The CFTC has required products to be fully collateralized when offered to retail investors seeking exposure to the derivatives market, but certain DCOs now seek to offer leveraged clearing to retail participants who may be unaccustomed to managing risk associated with increased leverage. Commissioner Stump continues to press for the CFTC to set clear regulatory expectations to ensure the safety and soundness of DCOs while enabling retail access to clearing infrastructure.
3. Brokers and Counterparties (Future Commission Merchants). In re Payward Ventures, Inc. (“Kraken”) highlights why updated regulatory parameters are required when new products and services do not fit existing rules. The CFTC penalized Kraken for operating an unregistered futures commission merchant which allowed Kraken’s customers to engage in online retail commodity transactions in digital assets, such as Bitcoin. (See Kraken Order). The CFTC has not comprehensively addressed how it regulates retail commodity transactions, and more importantly, many of the rules for traditional FCMs do not fit Kraken’s role as an exchange.
Lack of registration is low hanging fruit that market regulators have traditionally relied on to bring enforcement actions against infrastructure providers. This approach stifles innovation and is inefficient. Although Congressional interest around regulating digital assets has increased, we do not envision legislation soon. A two-track approach whereby infrastructure providers affirmatively seek out regulators and educate them about projects, use cases, and risks while products are being developed, and pushing regulators for additional industry guidance appear to be the best course. A timely agency review process is not novel as regulators, such as the SEC and CFTC, have processes to comment on certain corporate documents before they become effective. (See CFTC Staff Letters)
Bradford Edwards & Varlack LLP is closely following regulatory developments around digital assets and is ready to advise clients on implications for their operations as well as to aid with risk assessments to address areas of regulatory concern.
