January 31, 2018

Commodity Futures Trading Commission Market Risk Advisory Committee Meeting

Key Topics & Takeaways

Bitcoin Futures: CFTC Chairman Giancarlo acknowledged concerns raised by some market participants that the CFTC did not hold public hearings prior to the self-certification of bitcoin futures. He explained, however, that “there is no avenue for public input” into CFTC staff review of product self-certifications in the Commodity Exchange Act (CEA) or Commission regulations.
Clearing of New Virtual Currency Products: Giancarlo stated that he has asked CFTC staff to consider requiring designated contract markets (DCMs) and swaps execution facilities (SEFs) to disclose to CFTC staff what steps they have taken to gather and accommodate input from key participants, and further for staff to review DCO governance around the clearing of new virtual currency products and provide recommendations for possible further action.

Speakers

Daniel J. Davis, General Counsel, Office of the General Counsel, CFTC
Amir Zaidi, Director, Division of Market Oversight, CFTC
Brian Bussey, Director, Division of Clearing and Risk, CFTC
William Heitner, Acting Deputy Director, Division of Clearing and Risk, CFTC
Matthew Kulkin, Director, Division of Swap Dealer and Intermediary Oversight, CFTC
James McDonald, Director, Division of Enforcement, CFTC
Julie Winkler, Chief Commercial Officer, CME Group
Chris Concannon, President and COO, Cboe Futures Exchange, LLC and Cboe Global Markets, Inc.
Trabue Bland, President, ICE Futures U.S., Inc.
Dale Michaels, Executive Vice President, Financial Risk Management, The Options Clearing Corporation
Albert S. Kyle, Charles E. Smith Chair Professor of Finance, University of Maryland Robert H. Smith School of Business
Edward Pla, Futures Industry Association Member Representative, Manager Director, Head of Clearing and Execution, UBS
Kari. S. Larsen, Counsel, Reed Smith LLP

Opening Statements

Chairman J. Christopher Giancarlo, CFTC

In his opening remarks, Chairman Giancarlo provided an overview of the day’s agenda, explaining discussion would focus on the product self-certification process under Part 40 of the Commission’s regulations. Giancarlo referenced his previous remarks at the ABA Section on Derivatives and Futures Law annual conference, in which he discussed derivatives of virtual currencies and the appropriateness of CFTC review of such products. Giancarlo highlighted that CFTC staff follows a “review and compliance checklist” in this regard, that seeks to ensure that 1.) self-certified virtual currency futures products and their cash-settlement processes are not readily susceptible to manipulation and 2.) that virtual currency derivatives products are sufficiently margined.

Giancarlo explained he is “neither an apologist nor an opponent of the current process of self-certification.” He further stated that the self-certification process was designed by Congress to give DCMs the ability to facilitate new product development and not be hampered by the political concerns of regulators that might slow down innovation. Giancarlo noted, however, that the Commission must still look to strike the right balances of interests for this process consider the impact of virtual currencies. He further acknowledged concerns raised by some market participants that the CFTC did not hold public hearings prior to the self-certification of Bitcoin futures. He explained, however, that “there is no avenue for public input” into CFTC staff review of product self-certifications in the CEA or Commission regulations – different from the rule self-certification process which does provide for such public comment. Rather, Giancarlo said, it is DCMs and DCOs that should be soliciting and addressing stakeholder concerns.

Giancarlo explained that he has asked CFTC staff to consider requiring DCMs and swaps execution facilities (SEFs) to disclose to CFTC staff what steps they have taken to gather and accommodate input from key participants, and further for staff to review DCO governance around the clearing of new virtual currency products and provide recommendations for possible further action.

Commissioner Brian D. Quintenz, CFTC

Commissioner Quintenz, in his opening statement, supported Chairman Giancarlo’s view that regulations should not impeded financial market innovation, acknowledging the import role self-certification can play in this regard. Commissioner Quintenz further pointed out that a new products life only begins upon self-certification, noting the ongoing CFTC surveillance efforts and oversight by the exchanges in ensuring the CEA and CFTC regulations are being followed.

Commissioner Rostin Behnam, MRAC Sponsor, CFTC

In his opening statement Commissioner Behnam expressed that meaningful dialogue on the self-certification and oversight of bitcoin futures must continue. Behnam further stated that as new products and technologies are adopted, the CFTC must ensure dialogue occurs on appropriately addressing risks, providing legal certainty to markets, educating the general public and reviewing the status quo.

Behnam said that while the process for self-certification of products does not expressly provide for public input, that does not mean public input is not vital. He further stated that the “heightened review” the Chairman referenced for virtual currencies may indicated the need for the CFTC to reconsider its approach to the self-certification of products.

Panel 1: Overview of Self-Certification for Products

Speakers

Paul Architzel, Partner, WilmerHale LLP (Facilitator)
Daniel J. Davis, General Counsel, Office of the General Counsel, CFTC
Amir Zaidi, Director, Division of Market Oversight, CFTC
Brian Bussey, Director, Division of Clearing and Risk, CFTC

Davis began with a historic overview of the CFTC’s approach to product certification. Prior to the Commodity Futures Modernization Act (CFMA), he explained, the Commission did not provide for self-certification, instead reviewing every product brought before it for approval. The CFMA, however, provided for a self-certification process, allowing registered entities to make initial determinations.

Zaidi next provided an overview of the Division of Market Oversight’s (DMO’s) role in the self-certification process. He explained DMO’s traditional role in the self-certification process has been to monitor DCM’s ongoing compliance with CEA Section 5, including whether new products are “readily susceptible to manipulation” (Core Principle 3), prevention of market disruption (Core Principle 4) and ensure DCMs adopt positions limits or accountability levels (Core Principle 5).

Bussey explained that the Division of Clearing and Risk (DCR) frequently has informal discussions with DCOs in the event new, complex products are being cleared. He caveated, however, that most new products do not require formal filings, as those situations are limited to circumstances where DCO rule changes are necessary.

Kathleen Cronin, CME Group, expressed the view that the current self-certification process has worked well, which includes constructive dialogue with the Commission and market participants, voicing concern that the imposition of a more formal process could create unnecessary administrative burdens.

Kristen Walters, BlackRock, highlighted that the cryptocurrency space is rapidly evolving, and asked at what point a more formal process around certification of these products might bee needed. Zaidi explained that the DMO has not traditionally considered the risks and valuations of products for the futures contract listing process. Bussey stated that DCR is monitoring the growth and associated issues around virtual currencies, but noted a more formal process might require statutory changes.

Marcus Stanley, Americans for Financial Reform, questioned whether DMO considers the underlying when considered whether a contract is susceptible to manipulation. Zaidi explained that per its statutory mandate and historical practice, DMO focuses on the settlement process and how a product is constructed, noting that broadening its purview and jurisdiction to cash markets should be carefully considered.

Dale Michaels, The Options Clearing Corporation, stressed that one should not confuse “informal” conversations between DCOs, DCMs and the CFTC as “shallow”, and that conversations are very thorough, with a great deal of information sharing and open dialogue.

Cronin expressed the view that while there is increased focused on virtual currencies, listings have regulatory protections in place and the contracts are not that different from others that have been listed that demonstrated volatility.

Panel 2: New Products from a Risk Perspective

Speakers

Brian Bussey, Director, DCR, CFTC
William Heitner, Acting Deputy Director, DCR, CFTC
Matthew Kulkin, Director, Division of Swap Dealer and Intermediary Oversight, CFTC
James McDonald, Director, Division of Enforcement, CFTC

Bussey opened the panel with an overview of the range of risk management and surveillance tools DCR uses to monitor DCOs and clearing members, including margin requirements and models, stress testing and back testing and initial and variation margin requirements, among others. Bussey stressed that certification of a product is just the beginning of the process, with significant efforts towards risk monitoring starting thereafter. He again noted that even where not required, DCR will engage in robust informal dialogue with market participants prior to the certification of a new product, which is followed by robust DCO oversight post-launch.

William Heitner next pointed out that since the launch of new Bitcoin futures products, DCR has been receiving data from DCOs, including positions, cash flows and margins, net positions, total longs and total shorts across all DCOs. He further explained that DCR also calculates and reviews market erosion, looks for margin breaches and monitors for consistently high prices fluctuations relative to margin. Heitner started that weekly reports are then prepared and provided to the Commission and other divisions summarizing surveillance findings. In the event of a risk concern, Heitner said that DCR would reach out to a DCO to discuss potential changes – though that has not been necessary to date.

Matthew Kulkin explained that the Division of Swap Dealer and Intermediary Oversight (DSIO) focuses on swap dealer (SD) and future commission merchant (FCM) oversight. Kulkin explained that DSIO coordinates closely with intermediaries and the National Futures Association (NFA) to ensure members are complying with the CEA and other necessary rules and requirements.

James McDonald highlighted that the structure of the Division of Enforcement recently changed to incorporate surveillance functions. He explained that this change has allowed for greater coordination, as surveillance functions allow for the identification of issues which may lead to enforcement activity. McDonald explained that surveillance relies on staff expertise and data analysis, which at times requires specific focus when dealing with new products. McDonald said staff also relies on intelligence from market participants, exchanges and other sources. He further noted that dialogue occurs both pre- and post-launch for a new product.

Architzel asked how the CFTC balances pre- and post-launch oversight. Bussey and McDonaled stated that pre- and post-launch are not treated in isolation, and that oversight is an ongoing process. Kulkin expressed that the divisions coordinate closely through all parts of the process.

Walters asked when the spot market and the attributes of the underlying assets on which the futures are traded are considered in the surveillance process. McDonald answered that the Division of Enforcement’s jurisdiction includes monitoring and enforcement of manipulation of underlying cash markets.

Rana Yared, Goldman Sachs, asked what work should be done by applicants submitting products for self-certification to ensure the market is ready to receive the risk once the contract is launched. Bussey referenced Chairman Giancarlo’s previous comments which called for consideration of DCO governance in relation to the launching of a new product.

Jerry Jeske, Commodity Markets Council, pointed out that many contract launches have successfully occurred via the self-certification process as it stands, and careful consideration should be given to whether something more formal would be beneficial.

Biswarp Chaterjee, Citigroup, asked whether consideration was given to DCO safety and resources beyond margin testing. Bussey explained that the stress testing done utilizes extreme shocks (i.e., 100 percent moves up and down). Heitner added that testing is done both pre- and post-launch.

Panel 3: Futures Exchanges and New Products

Speakers

Julie Winkler, Chief Commercial Officer, CME Group
Chris Concannon, President and Chief Operating Officer, Cboe Futures Exchange, LLC and Cboe Global Markets, Inc.
Trabue Bland, President, ICE Futures U.S., Inc.
Dale Michaels, Executive Vice President, Financial Risk Management, The Options Clearing Corporation (OCC)

Winkler stated the importance of examining and assessing existing processes surrounding the introduction of new products. She then explained the approaches to the product development and the risk management processes CME Group has in place to ensure products are effectively monitored and surveilled.

Concannon then discussed the analyses conducted at Cboe based on feedback received for new product ideas, and the discussions surrounding the benefits and concerns around such products. He continued that the self-certification process is a “suitable” mechanism, and that while there are many concerns raised when it comes to Bitcoin futures, it has “little to do with” self-certification.

Michaels explained that the OCC looks at risk management around new products to ensure there are proper controls in place, as well as asking whether there is anything new or novel around the product which would then lead to considerations on internal and external government risk management governance.

When asked about the extent exchanges and clearinghouses provide for input from risk committees and larger stakeholder audiences, Concannon replied that Cboe spends months with market participants asking for input, and that many times it is a solution created by their clients. He continued that there is an internal analysis of a product, then it moves onto a client interface stage. Concannon added that with the Bitcoin futures contract, Cboe announced their interest early on due to being a public company, allowing for a formal engagement with their clients. Winkler noted that CME Group had hundreds of meetings and conversations with clients regarding the product, which helped them modify and create the contract CME Group ultimately launched. He went on to add that client validation and demand is why CME Group launches new products. Michaels stated that the OCC’s risk committee is kept abreast of the products, as is a financial risk advisory group, and that any changes go through the risk committee to determine whether appropriate to move forward with a product.

When asked if there is a role for the CFTC regarding structure and formality for stakeholder validation of new products before being submitted to the CFTC for self-certification, Concannon replied that the obligation sits with the exchanges to submit feedback received during the process and prior to self-certification. Bland noted that the current process works well and allows for flexibility.

When asked if stakeholders who are clearing members should have a separate clearing fund, Michaels explained that it was discussed in the OCC’s risk committee, but that they went with a single clearing fund when launched. Winkler echoed Michaels response, adding that a lot of analyses were conducted around the risk profile of the contracts.

Regarding convergence and the different metrics used, Winkler described the difference in how a review of physically-derived contracts work and how index-based cash settled products work. She continued that with Bitcoin futures, the market surveillance team is watching daily and collecting data for the reference price, and that it is made clear which types of trades will be included as part of the reference price. Concannon stated that his process is slightly different, in that they monitor the Bitcoin market and have information sharing agreements where you can see the behavior in markets and settle against an auction event.

Regarding the concerns with the self-certification of products, Concannon noted his surprise at the reaction to self-certification of Bitcoin futures, adding that it is identical to the SEC’s process. He expressed the view that the concern may be due to increased media coverage and treating the product as a “toxic instrument.” Michaels stressed that no other product has been looked at more than Bitcoin, and explained the strong efforts to engage in dialogue with different clearing members to ensure the right people are participating in discussions.

Panel 4: Policy & Regulatory Approach for Novel Products

Speakers

Albert S. Kyle, Charles E. Smith Chair Professor of Finance, University of Maryland Robert H. Smith School of Business
Edward Pla, Futures Industry Association, Managing Director, Head of Clearing and Execution- UBS
Kari S. Larsen, Counsel, Reed Smith LLP

Kyle discussed silver futures trading and compared it to bitcoin, noting that the difference is that bitcoin is a cash settlement, and also novel due to the lack of fundamentals of supply and demand and its nature as a purely speculative type of commodity.

Pla applauded Giancarlo’s decision to consider improvements to the self-certification process to ensure the community is consulted prior to launching new products, and that it has to be more than a check-the-box exercise, ensuring exchanges and CCPs are involved, which would add accountability to the self-certification process. He continued that cryptocurrencies are not the only novel product class that could benefit from rule changes.

Larsen explained that the OTC market is important in the beginning stages of novel products, adding that they require additional CFTC meetings and connections to new participants. She continued that while cryptocurrencies have unique characteristics, but that they trade like other commodities.

When asked if the current self-certification process is appropriate for novel contracts, Larsen replied that most people are comfortable with the current process in place, but that it does not mean improvements cannot be made.

Regarding determining what products are novel and complex, Pla listed limited price history, possible unique settlement risks and whether there are niche clients. Larsen noted that many products are volatile, and that if products operate differently or calculations need to be changed, it is worth considering. Kyle added one more indicator – whether the CFTC staff would have the ability to sort out a “mess” due to something going wrong with the product.

For more information on this meeting, please click here.