FIA warns CFTC against hasty introduction of leveraged disintermediated clearing models

Rick Steves

“We should not jeopardize the standing of these markets, much less the safeguarding of customer property, in the rush of new and untested models to market.”

The Futures Industry Association (FIA) has voiced concerns to the Commodity Futures Trading Commission (CFTC) regarding its proposed regulatory changes aimed at enhancing the protection of funds held by clearing members at designated clearing organizations (DCOs).

In its commentary, the FIA supports the establishment of more stringent segregation and protection measures for clearing member assets, similar to those currently implemented at leading clearinghouses. Nonetheless, the FIA warns that the proposed regulations do not provide an adequate basis for the CFTC to greenlight new direct clearing methodologies, notably the leveraged disintermediated model initially advocated by FTX.

While supporting the adoption of the newly proposed CFTC rules, the FIA urges the regulator to delay the approval of any DCO clearing under the “leveraged disintermediated model” until the CFTC has proposed and adopted regulations establishing an asset protection regime for members clearing on such DCOs that is substantively equivalent to the asset protection regime for customers clearing under the traditional model.

Non-traditional models are not as safe

Walt Lukken, FIA President and CEO, articulated in the submission that while the CFTC’s initiative is a positive step toward narrowing the protection disparity between customer and clearing member assets, it should be considered just the beginning.

Lukken pointed out the risk of market participants, particularly retail customers, being misled into believing that their funds committed to clearinghouses under newly licensed, non-traditional models would enjoy the same level of protection as those cleared through futures commission merchants (FCMs).

The commentary identifies several shortcomings in the proposed rule that would leave customers clearing directly with clearinghouses less protected than those using an FCM. Such customers would not benefit from the robust risk management frameworks that arise from the interplay between registered intermediaries, exchanges, and clearinghouses. Additionally, they would miss out on the protections provided by FCMs, including disclosures, anti-money laundering protocols, customer due diligence, and regulatory oversight concerning customer interactions.

Highlighting the critical role of regulatory protections in the foundation of the U.S. futures and derivatives markets, Lukken’s letter emphasizes the risk of compromising these standards and the safeguarding of customer assets in the rush to market new and unverified models.

The FIA is urging the CFTC to undertake a comprehensive evaluation of its legal authority, regulatory framework, and self-regulatory environment to determine the necessary actions to extend robust protections to customers across all clearing models. The association argues that the CFTC should only consider endorsing new models after ensuring that such protections are firmly in place.

FIA President and CEO Walt Lukken said: “The Commission’s action is a constructive first step to close the gap between the protections available to customer property and those available to clearing member property. But it is only a first step. Finalizing the [proposed rule] in a vacuum may give market participants – and, in particular, retail customers – the mistaken impression that when they commit funds to a [clearinghouse] clearing under the non-traditional models that the CFTC has begun to license, they will receive the same protections as customers of [futures commission merchants].

“We should not jeopardize the standing of these markets, much less the safeguarding of customer property, in the rush of new and untested models to market.”

What is Leveraged Disintermediated Clearing

In its letter to the CFTC, the FIA understands “leveraged disintermediated clearing” to involve four elements:

  •  registered DCO that solicits and offers clearing services;
  • directly (rather than intermediated through an affiliated or unaffiliated FCM clearing member);
  • to retail participants (that is, persons who are not eligible contract participants under Section 1a(18) of the Commodity Exchange Act);
  • for futures contracts and options on futures that are margined (as distinct from fully collateralized). To date, the Commission has not authorized any DCO to offer leveraged disintermediated clearing.

Why is FIA concerned with the CFTC’s Segregation Mandate

The FIA’s letter expresses significant concerns about the CFTC’s adoption of the Segregation Mandate within leveraged disintermediated clearing models. It cautions that this might give the false impression that customer asset protections equivalent to those under the traditional FCM clearing model are provided. However, the FIA believes that, even with the Segregation Mandate, clearing members utilizing leveraged disintermediated clearing would still face considerable disadvantages compared to customers of FCMs under traditional models. Key concerns include:

  • Lack of Minimum Financial Resources: The mandate does not require leveraged disintermediated DCOs to maintain adequate financial resources or capital to support proprietary fund obligations to clearing members, nor does it address the sizing of guaranty funds in a manner that would protect clearing members.
  • Fellow Clearing Member Risk: The co-existence of leveraged disintermediated clearing with intermediated clearing on the same platform could lead to risks where thinly capitalized clearing members could affect the financial stability of FCM clearing members through a cascading effect of defaults.
  • No Prohibition on Encumbering Proprietary Funds: Unlike the traditional model, there’s no rule preventing DCOs in leveraged disintermediated models from granting security interests or liens on clearing member funds.
  • Lack of AML/KYC Diligence: Disintermediated DCOs are not bound by the same anti-money laundering and know-your-customer obligations as FCMs, posing risks of commingling with illicit funds.
  • No Minimum Standards for Depositories: The proposal does not set forth requirements for the safekeeping of proprietary funds in depositories, unlike the stringent criteria applied to FCMs.
  • Absence of Required Customer Disclosures: DCOs are not obligated to disclose comprehensive information about their operations to their members, which FCMs must do under CFTC regulations.
  • Diminished Risk Management Checks and Balances: The consolidation of roles in leveraged disintermediated clearing models could weaken the established system of risk management obligations and oversight among exchanges, clearinghouses, and intermediaries.
  • No Registration for Sales Personnel and Supervisory Obligations: There’s no requirement for DCOs to register sales personnel or provide specific disclosures and privacy notices, reducing oversight and consumer protection.

The FIA is cautioning against the quick adoption of these models without fully addressing these significant gaps in protection and oversight that currently exist under traditional clearing models.

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