Dissenting Commissioner Christy Goldsmith Romero, meanwhile, warned that the agency’s approval of a vertically integrated crypto market threatens to open a Pandora’s box.
Last Wednesday was a consequential day for the U.S. Commodity Futures Trading Commission and the cryptocurrency industry. The importance of the agency’s open meeting on December 13 is heightened by the fact that, as my colleague Henry Burke and I wrote recently in The American Prospect, CFTC Chair Rostin Behnam may be looking to revolve into one of the industries he’s currently tasked with regulating. While federal officials’ actions are always a matter of public concern, government ethics advisors have acknowledged that even greater scrutiny is warranted if and when executive branch personnel are pursuing outside employment.
That’s why the Revolving Door Project has filed a FOIA request seeking records of communications between Behnam and the CFTC Acting Inspector General or CFTC Designated Agency Ethics Officials to monitor any disclosures on his potential future employment—and will continue to submit updated requests in the coming months. If the CFTC waits until after a departure has been announced to disclose any potential conflicts of interest related to Behnam’s job prospects, the public would rightly question the reasoning behind months of agency decisions.
So what happened at last Wednesday’s meeting? For starters, the CFTC voted to advance two rulemaking proposals with major implications for the crypto industry. The first would require futures commission merchants (FCMs), swap dealers, and major swap participants to establish an operational resilience framework to thwart cyber attacks. The second purports to protect clearing member funds and property held by derivatives clearing organizations (DCOs).
Democratic Commissioner Christy Goldsmith Romero argued in a dissenting statement that the latter proposal is problematic because in a disintermediated environment (i.e., the crypto industry’s desired model in which ordinary customers are treated as sophisticated players capable of fending for themselves without the aid of brokers who are subject to public oversight), people are more vulnerable to being swindled. She noted that customers would unknowingly “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.’” Moreover, DCOs are not currently required to comply with anti-money laundering or know your customer safeguards. As a result, Goldsmith Romero explained, “retail funds may be at serious risk of seizure if they are commingled with funds of terrorist organizations, drug cartels, or other illicit actors”—a likely scenario given the frequency with which crypto transactions are used to finance criminal activities. In addition, unlike FCMs, DCOs are not required to deposit funds in banks and trusts, meaning assets could be funneled to unregulated entities, including affiliates.
“Instead of learning the lessons of FTX,” said Goldsmith Romero, “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.” Without fully examining “the impact of changing the tried and true market structure by removing the FCM,” she continued, “we may just move risk around the system.” Goldsmith Romero further warned 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.”
This brings us to another concerning development that transpired last Wednesday: the agency’s 4-1 approval of Bitnomial’s application to register as a DCO. Behnam joined fellow Democratic Commissioner Kristin Johnson in voting for Bitnomial’s precedent-setting DCO bid while Republican Commissioners Summer Mersinger and Caroline Pham concurred, thus supporting the majority. Goldsmith Romero was the lone dissenter.
Bitnomial, a Chicago-based crypto derivatives dealer founded in 2014, already had permission to operate as a designated contract market (DCM), which allowed it to list crypto futures and options contracts, and as an FCM, which enabled it to trade with customers. The one thing the firm couldn’t yet do was settle margined (i.e., debt-leveraged) futures and options contracts. But with its successful DCO registration, Bitnomial can now operate not only as a crypto exchange (DCM) and brokerage (FCM), but also as a clearinghouse. As Crypto News reported, this makes Bitnomial the “the sole exchange in the U.S. offering margined, physically delivered digital asset derivatives,” which “enables customers to obtain actual ownership of digital assets on a leveraged basis, a shift from the typical cash settlement approach.”
Bitnomial founder and CEO Luke Hoersten welcomed the CFTC’s decision. “Now that the licensing process is complete, we can shift our focus to expanding Bitnomial’s product offering and customer base,” he said in a statement released after the vote. “Our aim is to introduce a global derivative trading platform, regulated in the U.S., that marks a pivotal shift from traditional USD and Treasury margin collateral to incorporating digital assets as collateral as well. This change is intended not just for crypto trading but also for a broad spectrum of physical and digital commodities,” he added.
Many regulators, by contrast, have long expressed concerns about vertical integration in the digital asset sector, warning that it creates potential conflicts of interest and increases the chances of market volatility. Before votes were cast at last week’s meeting, Goldsmith Romero noted that she first voted internally to deny Bitnomial’s DCO application in May on the grounds that the CFTC needed to assess the risks of vertically integrated crypto market structures and then propose new rules accordingly. By that time, she remarked, the White House, the Financial Stability Oversight Council, Treasury Secretary Janet Yellen, then-Federal Reserve Vice Chair Lael Brainard, and Acting Comptroller of the Currency Michael Hsu had already sounded the alarm about the dangers associated with allowing digital asset platforms to combine exchange, brokerage, market-making, and clearing agency functions, with some officials alluding to the historic collapse of FTX as a cautionary tale.
Behnam, for his part, asked staff members from the CFTC’s Division of Clearing and Risk what Bitnomial has done to address conflicts of interest it may have as the first digital asset DCO. In response, agency official Daniel O’Connell said that Bitnomial’s DCO rulebook “includes rules designed to ensure that members of boards, panels, and committees do not knowingly participate in deliberations and voting on matters where they’re named parties of interest or have a family relationship with such a party or have related direct and substantial financial interests.” According to O’Connell, Bitnomial also has “rules that would serve to disclose the relationship between the DCO and its affiliated FCM.”
This company-authored rulebook hardly sounds sufficient. Perhaps that’s why O’Connell added that CFTC staff have “also reviewed rules and procedures designed to ensure affiliates do not receive preferential treatment and to mitigate potential conflicts related to affiliates more generally.” Reviewing procedures is one thing, but what about implementing and enforcing them?
Commissioner Johnson acknowledged that if Bitnomial were permitted to register as a DCO, it would be vertically integrated and therefore in need of more stringent oversight from the CFTC. But she also argued that “in the absence of a formal rulemaking that imposes certain structures in terms of conflicts of interest,” the agency should engage with “market participants who are seeking to bring novel structures or novel financial products into our markets.” To that end, Johnson urged Bitnomial to “adopt mitigating procedures to address conflicts of interest” and other concerns while it awaits a “formal rulemaking process that would advance precise regulatory text and clearly articulate regulatory expectations.” In other words, the company should self-regulate until the agency finalizes new requirements.
Commissioners Mersinger, Pham, and Behnam similarly expressed the need for the CFTC to establish stronger regulatory policies in this arena. By proceeding to greenlight Bitnomial’s DCO application, however, all four officials made clear that they think new rules can come after vertical integration has already gained momentum.
That begs the question: Why not complete vertical integration-related risk assessment and rulemaking prior to making a final decision with regard to Bitnomial’s DCO application? In Goldsmith Romero’s words, Bitnomial “does not need” to operate as a clearinghouse since it already has an agreement to clear crypto futures and options contracts through the Minneapolis Grain Exchange. “Presumably it could save money,” the commissioner observed, “but at what cost to customers, competition, and financial stability?”
“It is unclear why we would risk upending [the current] ecosystem of checks and balances for one crypto company before we have… determined the appropriate regulatory response,” Goldsmith Romero lamented. “Major concerns were raised about the many discretionary decisions that clearinghouses make,” including decisions about margins, defaults, and how/when to enforce self-imposed rules, all of which could “pose systemic risk and hurt customers.” Moreover, there are “anti-competitive concerns, including views of favoritism that could lead to run risk,” she added, “and much concern over contagion risk.”
To highlight one example of a potential conflict of interest, Coinbase Ventures—the investment arm of Coinbase, the largest crypto exchange in the U.S. by trading volume (and a chronic money launderer)—is among Bitnomial’s current financial backers. It’s worrisome, to say the least, that Coinbase stands to benefit directly from Bitnomial’s licensing coup. Additional Bitnomial investors include Electric Capital, Franklin Templeton, Belvedere Strategic Capital, Jump Trading, DV Chain, Consolidated Trading, RRE Ventures, Collab+Currency, and O’Brien Investment Group.
Hoersten’s celebratory remarks made clear that he sees the CFTC’s approval of Bitnomial’s DCO application as a victory for an environmentally disastrous industry reeling from a series of ethical scandals. Binance, which remains the world’s largest crypto exchange by market volume, recently pled guilty to violating federal laws designed to prevent illicit financial activities and agreed to pay a $4.3 billion fine. As part of the deal, former Binance CEO Changpeng Zhao, who is facing a potential prison sentence, was forced to resign. Meanwhile, FTX founder Sam Bankman-Fried is also facing jail time after a jury convicted him of fraud. Ultimately, what the crypto industry fears more than multibillion-dollar settlements is being required to comply with robust rules, as my colleague Julian Scoffield pointed out recently.
This is an industry ripe for a regulatory crackdown. Instead, Hoersten went out of his way to thank Behnam as well as other CFTC commissioners and staff members for “their coordination and hard work throughout the licensing process.” The crypto CEO stressed that “the CFTC is vital to the growth of the digital asset industry globally and we look forward to continuing our collaboration as we build a safe, transparent, and innovative digital asset derivatives market in the U.S.”
Collaboration? Regulators have an obligation to reign in polluters and financial scam artists, not work with them to expand their reach. The worldwide “growth of the digital asset industry” is not an inevitability. And it’s certainly not a goal that should be embraced by the federal government.
The above photo of the CFTC building in Washington, D.C. is a work of the U.S. federal government and in the public domain.