In May 2023, the Division of Clearing and Risk ("DCR") of the Commodity Futures Trading Commission ("CFTC") issued two Staff Advisory letters addressing areas of regulatory focus related to Derivatives Clearing Organizations ("DCOs," also known more broadly as central counterparties or "CCPs"). The first Advisory, CFTC Letter No. 23-06 (issued May 17, 2023) addresses the potential need for DCO registration of prime brokerage arrangements, and the second, CFTC Letter No. 23-07 (issued May 30, 2023) addresses risk related to clearing digital assets.

Both Advisories are remarkable for their brevity, considering the breadth of activity they encompass. In this article, we discuss the issues addressed by DCR, and consider the ramifications for market participants who engage in the activities addressed in the Staff Advisory letters.

Prime Brokerage Arrangements Requiring DCO Registration (Advisory 23-06)

In Advisory 23-06, DCR observed that in situations where derivatives transactions are cleared through prime brokerage arrangements,[1] the intermediaries may need to register with the CFTC as DCOs. DCR referred to recent situations it has encountered involving prime brokerage arrangements used by swap execution facilities ("SEFs")[2] in which a single prime broker would provide "centralized credit substitution" to all SEF participants.

In characterizing the type of activity necessitating DCO registration, DCR staff referenced the definition of DCO in the Commodity Exchange Act ("CEA"), 7 U.S.C. § 1a(15), focusing on subparagraph (A)(i) of the definition, which describes "an entity, facility, system, or organization that, with respect to an agreement, contract, or transaction . . . enables each party to the agreement, contract, or transaction to substitute, through novation or otherwise, the credit of the [DCO] for the credit of the parties." DCR stated that it will "look to the substance of the relevant arrangement" rather than "only its form" in determining what qualifies as requiring DCO registration.

While the Advisory focuses on the issue as it has arisen in the SEF context, the staff's guidance is not limited to SEFs.[3] As such, any market participant that is or uses an arrangement with a prime broker to provide "centralized credit substitution" should be mindful of DCR's focus on how the CEA's definition of "DCO" relates to such arrangements with prime brokers. Note, however, that the summary nature of this Advisory leaves market participants without much to guide their interpretation of the CFTC's views – for instance, it does not define what the agency considers to be a "credit substitution." It also does not purport to have Division of Market Oversight ("DMO") staff listed on the Advisory, and contacts with DMO about SEFs/SEF applications or examinations with respect to prime brokerage activity may also be more complicated given this Advisory. Market participants will need to carefully evaluate their own practices, and seek guidance of legal counsel in that effort, to ensure their activities do not require DCO registration. They should also be mindful of this Advisory if engaging with DMO staff.

Risks Associated With Clearing Digital Assets (Advisory 23-07)

In Advisory 23-07, DCR stated that it "has observed increased interest by DCOs and DCO applicants in expanding the types of products cleared and business lines, clearing models, and services offered by DCOs, including related to digital assets." DCR further "reminds" registrants and applicants that it will "remain focused on potentially heightened risks" associated with certain clearing activities (i.e., those related to digital assets), and "expects DCOs and applicants to actively identify new, evolving, or unique risks and implement risk mitigation measures tailored to the risks that these products or clearing-structure changes may present."

In the Advisory, DCR staff describes the "heightened cyber and other operational risks" potentially associated with digital assets, and states that DCR "will emphasize compliance with the systems safeguards requirements under the CEA and Part 39 of the Commission's regulations." The Advisory also identifies the following concerns:

  • For DCOs with dependencies on affiliated entities and services (e.g., "dual hatted executives" and shared systems), DCR "will emphasize reviews of DCOs' establishment and enforcement of rules to minimize conflicts of interest."
  • For DCOs that clear contracts involving physical delivery of digital assets, DCR (working with other CFTC staff) will emphasize review of physical settlement arrangements.

The Advisory contains little else in the way of guidance as to the specific actions DCR intends to take, but it affirms that DCR will act though its "general supervisory authority, application review authority, and examination authority" and states that "DCO registrants and applicants should expect that DCR will be placing emphasis on the potential risks and DCO core principles related to system safeguards, physical settlement procedures, and conflicts of interest."

The Advisory also does not offer an opinion as to what digital assets constitute commodities or securities, or whether having CFTC-registered DCO clear digital asset derivatives gives the CFTC different or exclusive authority over those products.

Statement by Commissioner Kristin N. Johnson Accompanying Digital Assets Advisory

Commissioner Kristin N. Johnson issued a statement in conjunction with Advisory 23-07, supporting the Advisory but also observing that "the rationale for such a notice indicates the increasingly urgent need for the Commission to initiate a formal rulemaking process that invites a comprehensive evaluation of 'heightened' risks associated with certain crypto clearing activities, particularly clearing activities in digital assets or cryptocurrency markets."

Commissioner Johnson's statement proposes that the Commission initiate an Advanced Notice of Proposed Rulemaking ("ANPRM") on Crypto or Digital Commodity DCO Clearing Activities, which she says should address the following issues:

  • Conflicts of interest arising from vertical integration of activities and functions;
  • Custody and client asset protection;
  • Operational and technological risk, specifically cyber-risks (which the Commissioner addresses at length in her statement); and
  • Market manipulation and fraud.

The Commissioner's statement suggests that engaging in an ANPRM for digital assets may enable a "multi-faceted and highly-collaborative process that includes diverse stakeholders influencing regulation through Requests for Information, formal Roundtables, and the development of Guidance from the Commission" in advance of drafting formal regulations.

Considerations for Market Participants

As an initial matter, it is worth noting that both Advisories are exceptionally terse, each containing about three short paragraphs of substantive guidance. It is unusual for such policy observations to be announced in this manner – and one can speculate that this approach is the result of the five commissioners finding difficulty in reaching consensus (or even a bare majority) for action. Furthermore, the absence of detail in this guidance requires market participants to engage in their own interpretation of the scope of the CFTC's stated general areas of focus.

Regardless of the agency's reasoning in issuing these Advisories in this form, both documents send an important message to market participants, indicating that the agency is closely focused on these issues; and we can expect this scrutiny to lead to more informal inquires and data requests, examinations, and potential enforcement actions. Market participants engaged in credit substitution through the use of prime brokers, SEFs and SEF applicants, and DCOs (existing and applicants) engaging in clearing activities in digital assets or cryptocurrency markets should work with legal counsel to consider how to best ensure compliance in light of these Advisories.

[1] Prime brokers, with respect to SEFs, are typically swap dealers/eligible contract participants who engage and transact on the SEF and then do off-SEF offsetting transactions.

[2] SEFs are CFTC-registered entities that provide a trading facility for certain types of swaps and are regulated under 17 CFR Part 37 and primarily overseen by the Division of Market Oversight ("DMO").

[3] Note that in March 2019, CFTC staff (now called the Markets Participant Division) granted no-action relief to swap dealers who are prime brokers facilitating prime brokerage activities and liquidity for SEFs. As noted by that relief, the prime broker "performs a credit intermediation role in the transaction."