Conor O'Hanlon, Deborah North and David Lucking are lawyers based in Allen & Overy's New York office, where they focus on matters relating to fintech, derivatives and international capital markets.
In this opinion piece, the authors explain the significance of a recent CFTC approval of a cryptocurrency derivatives platform and its potential impact on the market.
In what was a bustling month in crypto-land, one of the more important industry events may have been lost in the news flow.
We're talking about LedgerX, a startup whose board members include, among others, Mark Wetjen, a former Commodity Futures Trading Commission (CFTC) commissioner, and its successful registration as a derivatives clearing organization (DCO) with the CFTC – the primary U.S. derivatives regulator.
While the first registration of a DCO intending to offer cryptocurrency-linked derivatives is significant in and of itself, the approval was granted alongside a letter providing LedgerX exemptive relief from some of the onerous requirements that (justifiably) apply to DCOs.
This article discusses those details, as well as what impact the registration might have more broadly.
1. Clearing derivatives: an overview
First, let's clear up clearing.
"Clearing" a contract (or "swap") as opposed to a security, means that a transaction, which may be entered into bilaterally or an exchange or other trading platform, is then legally transferred to a central counterparty (a CCP, or in the CFTC's nomenclature, a DCO).
This is in comparison to an uncleared swap, which remains bilateral between the buyer and seller (which means they remain exposed to each other's credit risk). In a cleared swap, the CCP acts as a central counterparty for each buyer and seller, and effectively "guarantees" performance (to the extent it has the resources to do so).
CCPs are beneficial because, among other things, they ameliorate default risk and allow participants to offset transactions entered into with multiple counterparties. But if there's one thing that Satoshi taught us, it's that centralization carries its own systemic risks – that's why CCPs are subject to significant regulatory requirements and oversight.
It's worth pausing at this point to note that earlier in July, LedgerX also registered as a swap execution facility (SEF). This is a separate regulatory designation. An SEF is a trading platform through which users can view indicative pricing and quotations, and trade and transact in derivative products.
Unlike a CCP, an SEF does not stand between buyer and seller. SEFs were introduced following the financial crisis and the major U.S. legislative efforts that followed (the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act and its related regulations).
The purpose of SEFs include providing greater transparency in pricing, business conduct, execution and reporting of derivative products. Currently LedgerX is one of two SEFs offerings cryptocurrency-linked products, the other being TeraExchange.
To round out this whistle-stop tour, it is worth mentioning that some existing cryptocurrency exchanges do offer margin trading (which is a form of derivative). However those exchanges have generally relied on an exemption from being regulated with the CFTC as an SEF that permits margin trading so long as it results in the "actual delivery" of bitcoins within 28 days (rather than deferred delivery, or a claim against an account with bitcoins).
2. What about securities and the SEC?
In the U.S., the regulation of swaps and securities is overseen by separate regulators, respectively, the CFTC and the Securities and Exchange Commission (SEC).
The SEC's recent determination that DAO tokens were securities does not by itself impact LedgerX or the CFTC's regulation of swaps. It does, however, mention that some cryptocurrency exchanges that traded DAO tokens should have been registered as national securities exchanges or received an appropriate exemption.
To clarify, what the SEC is talking about here is securities exchanges, not necessarily exchanges or trading platforms on which trades in commodities or swaps are executed (which the CFTC regulates). For the moment, the only proposed crypto-derivatives relate to bitcoin, and so the SEC's wider role in regulating some security related elements of the derivatives market (like security-based swaps) has yet to be addressed.
3. How LedgerX compares to other DCOs and SEFs
While the CFTC's order approved LedgerX's registration as a DCO, such a designation comes with significant regulatory requirements and oversight.
That part of the equation was addressed in a CFTC letter issued at the same time. The letter outlined the exemptive relief being granted to LedgerX from some of those regulations. The relief included regulations pertaining to financial resources and related requirements of risk management, participant eligibility and management of funds.
LedgerX managed to avoid many of these requirements because of two primary differences between it and other established DCOs.
First, it is using a fully collateralized clearing model (buyer and seller must provide the full amount of their potential future obligations up front) so many of the regulations, which are aimed at protecting the CCP against defaults from its participants, are addressed by the fact that 100% of the collateral is already in place.
Second, LedgerX will only initially clear trades from LedgerX's own SEF, meaning it already has vetted the relevant participants.
In addition, the initial product being offered looks to be a simple bitcoin swap and the CFTC has already determined bitcoin is a commodity. Given these factors, the CFTC granted the above relief to LedgerX. However, as LedgerX expands both its client and product base, it will likely have to engage with the broader array of CFTC regulations applicable to DCOs.
4. What does this mean for cryptocurrencies?
This registration represents a small but significant step forward for bitcoin, and cryptocurrency more generally, as an asset class.
Although LedgerX's initial launch will be relatively limited, it signifies a growing interest from institutional investors who are keen to gain exposure to cryptocurrency risk.
For example, given the relative lack of regulated bitcoin-based investment vehicles, the LedgerX DCO now provides another possible avenue for such investors.
Secondly, the SEC's order rejecting the Winklevoss Bitcoin ETF in March mentioned, in pertinent part, that there was an absence of a significant regulated derivatives market for bitcoin which contributed to the SEC's determination that there wasn't sufficient transparency in bitcoin markets.
That decision is currently under review, and the LedgerX DCO approval may impact that analysis.
Third, the LedgerX approval and relief is the latest in a number of CFTC actions and initiatives with cryptocurrencies and blockchain. The regulator, and its current chairman Christopher Giancarlo, seem particularly focused on fintech and cryptocurrency-related issues, such as the establishment of LabCFTC.
The CFTC appears to developing into a particularly forward-looking regulator in the cryptocurrency space.
The order stated that LedgerX must have a cryptocurrency audit performed by an independent certified public accountant. No further detail is given on this requirement, and it comes at a time when the Financial Accounting Standards Board is considering best practices for cryptocurrency accounting.
Lastly, the order didn't mandate any particular cryptocurrency storage method (such as cold storage). This is perhaps unsurprising, given the evolving nature of the technology and industry.
While certain cryptocurrency derivatives already exist in jurisdictions around the world (Bitcoin Cash futures anyone?), LedgerX's registration as a DCO represents a noteworthy development the U.S.
As interest in cryptocurrencies continues to grow, "crypto-derivatives" may begin to find a place alongside other more established elements of the crypto economy, such as payments and securities tokens.
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