Introduction and summary
The Commodity Futures Trading Commission (CFTC) is one of the least known but most important financial regulatory agencies in the United States. It is responsible for ensuring the efficiency and stability of large sections of the nation’s derivatives markets, valued at more than $350 trillion in December 2021.1 Derivatives are financial contracts between two parties in which “prices are determined by, or ‘derived’ from, the value of some underlying asset, rate, index, or event.”2 They allow entities in the financial and real economies to manage their financial risks and plan for the future.3
What are derivatives?
Derivatives are financial contracts between two parties with prices derived from the value of some reference item. Two of the most common types of derivatives transactions are futures and swaps.
Futures: Contracts between two parties in which the parties agree to buy and sell assets for a specific price at a particular time in the future. For example, a farmer planting corn wants to ensure that she gets at least $5 per bushel when it is time to sell. She can use a futures contract to lock in that price. While the farmer loses the possibility that her corn could sell for more than $5 at harvest time, she avoids the risk that the market price for corn will be less than $5.
Swaps: Contracts in which two parties agree to make specified payments based on the occurrence or nonoccurrence of an event or contingency, such as to exchange a fixed cash flow for a variable or floating cash flow for a specified period of time, in the case of a fixed-for-floating interest rate swap, or for payment in connection with a “credit event”—such as borrower default—in the case of a credit default swap. For example, an exporter who sells U.S. goods in Europe wants to ensure that she always has enough dollars to buy the next shipment. She can use a currency swap to lock in a set euro-to-U.S. dollar exchange rate. While the exporter loses the possibility that her euros will appreciate against the dollar, she avoids the risk that her euros will fall before she buys the next shipment.
Derivatives will no doubt play a large role in helping companies adapt to a carbon-neutral or carbon-negative economy, known as “net zero,” which is necessary to limit global warming to 1.5 degrees Celsius. As the climate warms, and as policymakers enact laws to reduce greenhouse gas emissions, this transition has the potential to be jarring to the economy. Private sector enterprises face not only the consequences of harsher and more frequent fires, droughts, floods, and other physical disasters but also potential disruptions from other companies along supply chains that fail to prepare effectively for the phase-out of fossil fuels for green alternatives. Because derivatives markets can help private companies hedge their risk exposures—including risks from energy price swings—firms can use them to hedge potential losses from the physical risks of climate change and smooth the path to net zero.
Although derivatives can produce material social and economic benefits, derivatives trading can also cause significant harms to the real economy in the absence of strong regulations—as seen with the 2007-08 global financial crisis. In 2000, Congress enacted a law that prohibited the CFTC from regulating “credit risk” and other similar derivative contracts.4 As a result, in the years preceding the crisis, the insurance company AIG “accumulate[d] a one-half trillion dollar position in credit risk [derivatives] without being required to post one dollar’s worth of initial collateral or making any other provision for loss,”5 including a “$79 billion derivatives exposure to mortgage-related securities.”6 When the economy soured and borrowers defaulted on their credit in droves, AIG could not pay its counterparties. Taxpayers ultimately paid $182 billion in the form of a bailout7 to backstop the economic fallout. Of course, AIG was not the only company to default: “The value of the underlying assets for [credit default swaps] outstanding worldwide grew from $6.4 trillion at the end of 2004 to a peak of $58.2 trillion at the end of 2007.”8
Following the financial crisis, Congress recognized that strong derivatives regulation is necessary to ensure a sound financial system, and it reinvigorated the CFTC’s jurisdiction over these contracts as part of the Dodd-Frank Wall Street Reform and Consumer Protection Act.9 Thanks to the CFTC’s years of work to put in place a new regulatory structure, the nation’s derivatives markets are much stronger today than they were before the financial crisis.
However, there is still more to be done.
Recently, President Joe Biden nominated five individuals to serve as CFTC commissioners, including recently confirmed Chairman Rostin Behnam.10 Now is the appropriate time to develop a strong and effective agenda that the CFTC can implement over the next several years. Although the commission must address many challenges, this report outlines the top five reforms that would make sure derivatives markets can withstand risks from climate change; are transparent and equitable; and provide for a resilient and stable market structure that ensures counterparty risks are handled within the financial system without harming the real economy. The author also details 14 specific recommendations to accomplish these priorities.
The CFTC’s five priorities should be to:
- Facilitate the transition to a net-zero economy.
- Stress-test central counterparties for climate risks.
- Ensure competition between traders and between the platforms that enable the derivatives markets to operate.
- Increase trading transparency and real-time data reporting requirements.
- Impose meaningful regulations on the parts of digital asset markets that are within the commission’s jurisdiction.
1. The CFTC should facilitate the transition to net zero
The CFTC should encourage more standardized carbon accounting by compelling futures exchanges to quantify the carbon emissions associated with a commodity contract, such as scope 1, 2, and 3 emissions.
The CFTC should undertake a full economic analysis of the systemic impact of speculative passive investments.
The CFTC should facilitate the development of new financial products that help the private sector mitigate its climate-related risks. It should conduct research into instruments that could be useful and should work with exchanges to ensure that they offer appropriate products.
The CFTC should ensure that products actually provide the benefits they claim and block products that would harm net-zero efforts, such as carbon offsets with insufficient verification. It must hold offset issuers accountable if they promise carbon reductions that do not or simply cannot occur—such as those relating to forest preservation—and should reject derivatives of carbon offsets unless and until the agency can ensure that the offsets upon which the derivatives are based are not fraudulent.
As explained above, derivatives markets can ease the transition to a carbon-neutral or carbon-negative economy. While the CFTC cannot require reductions in carbon emissions, it can ensure that derivatives markets allow companies that use swaps, futures, and other financial products to hedge against the physical risks of climate change and smooth the transition from fossil fuels. As such, the CFTC must understand the myriad ways companies are using derivatives in their climate efforts and help swaps dealers develop products to help address climate risks. The CFTC must also ensure that the derivatives markets are not working at cross-purposes with other efforts to address climate change and investigate fraud in the market for carbon offsets.
The CFTC has begun outlining a plan for action. In March 2021, Chair Behnam established a Climate Risk Unit “to support the agency’s mission by focusing on the role of derivatives in understanding, pricing, and addressing climate-related risk and transitioning to a low-carbon economy.”11 This is an important step, but the public has yet to see significant action from it.
So far, the extent of the CFTC’s work on climate has been studying how the agency can help address climate-related risks in the derivatives market. In September 2020, the CFTC’s Climate-Related Market Risk Subcommittee released a report detailing actions the agency and other financial regulators could take to begin addressing climate change, including the recommendation that the CFTC “[s]urvey market participants about their use of climate-related derivatives, the adequacy of product availability and market infrastructure, and the availability of data to incorporate climate impacts into existing and new instruments.”12 Similarly, the CFTC’s Energy and Environmental Markets Advisory Committee has hosted public meetings to learn from industry about ways the agency can improve its efforts. Last year, for example, it held a meeting to examine the “status of carbon reduction through cap-and-trade and other carbon trading market mechanisms.”13 Also last year, then-CFTC Commissioner Dan Berkovitz gave a speech in which he acknowledged that “the CFTC must be aware of how the various primary, secondary, and derivative carbon markets are interacting and how companies use these markets to meet their compliance obligations, manage risks, and discover prices.”14 While there is certainly value in further study, there are concrete actions the CFTC could take now to help market participants address and adapt to climate change.
A common challenge for companies seeking to measure their carbon emissions is the lack of standards around carbon accounting across a commodity supply chain. The CFTC should encourage more standardized carbon accounting by compelling futures exchanges to benchmark the carbon emissions associated with a commodity contract to determine its emissions footprint, including scope 1, 2, and 3 emissions.15 Just as liquid commodity future contracts are used to benchmark pricing and related risks for commodity market participants,16 they could also be used to benchmark carbon emissions.
The CFTC should also address the increased commodity volatility that results from climate change. Recent research has found that a warming climate will result in “dramatic increases in the variability of corn yields from one year to the next…which could lead to price hikes and global shortages.”17 Similarly, there is evidence that “extreme weather events and unusual seasonal patterns [impact] both gas demand and supply,” again causing price volatility from one season to the next and making pricing predictions difficult.18 This volatility will harm commodity end users—regular customers who rely on corn for sustenance or on gas for heating. To that end, the CFTC should undertake a full economic analysis of the systemic impact of speculation in the form of passive investments, including the so-called massive passives that have the potential to raise commodity prices on American consumers.19 The CFTC should consider whether its current position-limits regulations adequately achieve a balance between the risks to the economy from this kind of passive speculation and any possible benefits. These risks have been particularly pronounced during the COVID-19 pandemic due to heightened costs across the supply chain.
Perhaps more importantly, the CFTC should facilitate the development of new financial products that help the private sector mitigate its climate-related risks20 while keeping products that do not deliver on their carbon-reduction claims out of the market. Other regulators are undertaking efforts to ensure that companies understand the risks that climate change poses to their businesses—including heightened physical risks of fire, drought, flood, and other natural disasters, as well as risks from business partners that are not taking similar steps to adapt. The latter category is known as counterparty risks. As companies come to understand all of these risks and look to derivatives markets to hedge their exposures, the CFTC can help ensure that exchanges are offering products to do just that.
At the same time, the CFTC must ensure that products are providing the benefits they claim and block products that would harm net-zero efforts, such as carbon offsets with insufficient verification. The MIT Climate Portal defines carbon offsets as “tradable ‘rights’ or certificates linked to activities that lower the amount of carbon dioxide in the atmosphere”; companies purchase these certificates to theoretically offset their own carbon emissions.21 Essentially, offsets are meant to “allow companies to pollute at home in exchange for investing in greener projects elsewhere.”22
Many economists and industry experts argue that carbon offsets are one of the best ways for companies to meet their carbon-neutral objectives,23 and companies have invested in any number of different projects to offset their emissions, including through forest preservation or reforestation, construction of renewable energy sources, increased waste management, and carbon sequestration.24 Many businesses and economists are especially excited about voluntary carbon offset markets, which allow companies to more easily buy and sell offsets than if they were to negotiate bespoke offsetting contracts individually. The Yale School of the Environment notes that “offset markets could take their place alongside government programs to move the world toward a low-carbon future,”25 and former Bank of England Governor Mark Carney has predicted that the market for carbon offsets “could be worth $100 billion by the end of the decade.”26
Yet there is deep concern—backed by significant evidence—that carbon offsets, as currently designed, do not work. One study considered a Brazilian rainforest preservation project that sold credits in 2013 and found that “[f]our years later, only half the project areas were forested.”27 Another study of the United Nations-run Clean Development Mechanism found that “85% of the covered projects…have a low likelihood of ensuring environmental integrity” and “[o]nly 2% of the projects…have a high likelihood of ensuring environmental integrity.”28 A third study found that 82 percent of credits issued by the California Air Resources Board “likely do not represent true emissions reductions due to the protocol’s use of lenient leakage accounting methods”—that is, protecting trees under the board’s offsetting program resulted in additional logging elsewhere.29 One survey of studies offered this conclusion: “If the world were graded on the historic reliability of carbon offsets, the result would be a solid F.”30
The CFTC has jurisdiction over carbon offsets through its authority to address fraud and market manipulation in spot commodity markets—contracts for immediate delivery31—as well as its authority to require listing standards for derivatives contracts,32 and it can hold offset issuers accountable if they promise carbon reductions that do not, or simply cannot, occur. For example, it is clear that offsets relating to forest preservation do not work: For a forest preservation investment to be an effective carbon offset, the forest remain a forest forever, and future logging or even wildfires that result in deforestation will negate offsets that were paid for and counted years in the past. Therefore, offset providers’ claims that their forest preservation or reforestation efforts are net-negative likely misrepresent the actual amount of carbon offset. The CFTC could—and should—bring rigorous enforcement actions against sellers of such offsets for fraud. It could even write a regulation that provides for a rebuttable presumption that forest-based carbon offsets are fraudulent. The agency should also reject derivatives of carbon offsets unless and until it can ensure that the offsets upon which the derivatives are based are not fraudulent.
Moreover, carbon offset markets suffer from challenges relating to double claiming, double counting, and double use,33 which include claiming as an offset emission reduction activity that would have occurred even without the offset’s investment. The CFTC should use its authority to set standards and police the carbon markets to reduce the risk of fraudulent or manipulative activity that could blunt the impact of climate risk mitigation efforts, as well as to encourage the integrity of cash carbon-credit markets.
The CFTC must not allow carbon offset spot and derivative markets to develop unless issuers can demonstrate that offsets lead to permanent and additional carbon reductions.
2. The CFTC should stress-test central counterparties for climate risks
The CFTC should use its stress tests of derivative clearing organizations (DCO) to examine the climate risks that each DCO faces from its counterparties. It should ensure that DCO counterparties supply sufficient margin—taking climate change into consideration—to cover their potential default.
The CFTC should use its stress tests of DCOs to ensure that their operations are capable of withstanding climate-related physical risks and that they have contingency plans in place in the event of a climate disaster.
Derivatives markets are extraordinarily resilient due to the fact that nearly 70 percent of swaps are conducted through derivatives clearing organizations (DCOs).34 DCOs, also known as central clearinghouses or central counterparties, sit between a contract’s two parties (known as novation) and assume the counterparty risk originally held by the traders—in effect, DCOs centrally clear trades. If one party is unable to uphold their end of a contract, perhaps because they have gone bankrupt in the interim, the DCO will step in to fulfill it. This arrangement provides the CFTC better transparency into derivatives markets and reduces counterparty risk by centralizing risk within DCOs and facilitating margin netting. Central clearing represents a significant step toward ensuring a safe and stable financial system.
The systemic risk reduction benefit of central clearing directly proportionate to the resilience of the central clearing infrastructure to financial shocks. If DCOs are fragile and susceptible to financial contagion, then they will not be able to contain future financial crises, threatening the U.S. economy and millions of American jobs. DCOs are so important that the Financial Stability Oversight Council designated several of the largest DCOs as systemically important financial market utilities, subjecting them to increased risk management standards and oversight. The financial markets simply will not work without them.35
Each DCO funds its operations and the payments it makes on behalf of its counterparties through the collection of collateral, known as margin. Each time a DCO steps between two parties, each party is required to provide the DCO with initial margin that is expected to be sufficient to address the price volatility of the contract. As a contract becomes more volatile, the parties may be required to provide additional margin, known as variation margin. Beyond collecting margin, each DCO has a “waterfall” it goes through—as it needs capital to continue its operations—which includes asking members to provide capital in times of crisis and haircutting member gains.36
Despite their ability to collect capital through this waterfall, DCOs’ importance means that they are routinely stress-tested to ensure that they will survive in times of crisis.37 These stress tests examine DCOs’ likelihood of fulfilling their responsibilities in the event that many of their counterparties fail and DCOs are required to use their own reserves to fulfill their contracts. Stress tests look at, among other things, whether DCOs are collecting sufficient margin from their counterparties to cover expected losses; whether the reserves DCOs have on hand are sufficient; and whether they have the capacity to collect new capital from their members if their reserves would not cover their needs.
Finally, regulators should recognize that DCOs’ survival is threatened not just by financial crises but also by climate change. The CFTC must acknowledge its responsibility to “ensure appropriate management and disclosure of climate-related risks”38 by undertaking two new stress-testing activities to ensure DCOs’ operational resiliency in the face of climate change.
First, stress tests should examine the climate risks that a DCO’s counterparties face to ensure that they supply sufficient margin to cover their potential default resulting from climate change. Initial margin requirements today are based on the expected volatility of the contract, but even if a contract is not volatile, a party can still collapse due to its other activities. DCOs must know whether their members’ operations face climate risk that is not reflected in the initial margin. Similarly, DCOs should similarly know whether their counterparties’ transactions are so concentrated in one instrument subject to climate risk, such as corn futures, that climate-caused natural disasters would threaten the parties’ solvency. The CFTC must ensure that DCOs are capable of learning the current climate risk of their counterparties—perhaps through required disclosures—and that DCOs adjust their collected margin accordingly in light of changed conditions.
Second, stress tests must ensure that DCOs’ operations are capable of withstanding climate-related physical risks and that they have contingency plans in place in the event of a climate disaster. Like most financial markets today, DCOs’ operations are on computer servers, and the buildings in which these servers are located must be able to withstand fires, floods, or other climate-caused natural disasters. According to the CFTC’s Subcommittee on Climate-Related Market Risk, the agency should ensure that its stress tests “cover the operational continuity and organizational resilience of [DCOs], including organizational resilience of operations, contingency planning, and engineering resilience for facilities exposed to climate-related physical risks.”39
3. The CFTC should ensure competition between traders and between the platforms that enable the derivatives markets to operate
The CFTC should rewrite its position limits rule to ensure a competitive marketplace by capping a trader’s individual market share for any of 25 different commodity derivatives at 15 percent.
The CFTC should prohibit derivative market platforms—including designated contract markets, swap execution facilities, and DCOs—from purchasing other existing platforms where the market for services would be reduced to an anti-competitive level.
The CFTC should request that the Federal Trade Commission and U.S. Department of Justice use their authorities to stop anti-competitive mergers between derivative market platforms.
The CFTC should enact new regulations to encourage competition between platforms such that new platforms can enter the market. Some examples include implementing regulatory changes to allow exchanges to freely compete against each other, limiting the percentage of total exchange volume that any particular swap execution facility or designated contract market may handle, imposing notional size limits on DCOs, or setting transaction fee caps so that a monopolistic platform cannot abuse its market power.
Financial markets work most fairly and efficiently when there is competition, and derivatives are no exception. Without a functioning derivatives market that allows all who wish to participate to do so, end users in the real economy who rely on derivatives contracts to hedge their risk will be left to shoulder risk that speculators would gladly have shouldered themselves. Similarly, traders who corner a derivatives market can push spot prices in one direction or another, and market concentration can cause “sudden or unreasonable fluctuations or unwarranted changes in the price of an underlying commodity.”40
The Dodd-Frank Act allowed the CFTC to set limits on the number of derivative contracts into which any one speculator can enter, and in 2020, the CFTC finalized position limits for 25 physically settled commodities, providing that no trader may maintain contracts exceeding 25 percent of the estimated spot market supply.41 Unfortunately, limiting traders to 25 percent of spot market supply still allows for an unnecessarily concentrated market, and the CFTC should rewrite this rule to further reduce position limits to ensure a competitive marketplace.
The most common metric for determining market concentration is the Herfindahl-Hirschman Index (HHI). According to the Federal Trade Commission and U.S. Department of Justice Antitrust Division’s horizontal merger guidelines, a market with an HHI score less than 1,500 is deemed competitive, or technically “unconcentrated”; a score of 1,500 to 2,500 is moderately concentrated; and a score greater than 2,500 is highly concentrated.42
The maximum HHI score possible under the CFTC’s position limits rule is 2,500, meaning that the CFTC is implicitly permitting a market on the cusp of being highly concentrated—and therefore, is implicitly permitting the heightened volatility that comes with concentration, as speculators may be required to exit their contracts at whatever price the other party demands. The CFTC should amend the position limits for energy futures so that the highest possible HHI score is one in the competitive range—capping a trader’s individual market share at roughly 15 percent, which would allow six traders to each have 15 percent market share while maintaining a competitive market.
However, competition involves more than just competition between market participants; there also must be competition between the platforms that enable the derivatives markets to operate. The Commodity Exchange Act recognizes this: Congress enacted the statute to “promote responsible innovation and fair competition” among the trading platforms.43
Three types of platforms ensure the smooth operation of the derivatives markets. Designated contract markets (DCMs) and swap execution facilities (SEFs) are exchanges on which derivatives are traded, and DCOs, as described above, centrally clear derivatives contracts. End users rely on these platforms for efficient and safe access to the derivatives markets, but the market for services these platforms operate is highly concentrated—potentially leading to higher prices, worse services, and increased systemic risk than under a more competitive market.
Although the CFTC listed 16 operational DCMs and 20 operational SEFs as of January 2022,44 these numbers are illusory because most instruments or classes of instruments trade on only one or two exchanges.45 This is because there is a tendency toward natural monopoly on exchanges as they “exhibit particularly strong network effects: traders value liquidity in financial markets and this creates a tendency for trading to concentrate on a single exchange” where the other traders are.46 Nearly 15 years ago, the U.S. Department of Justice noted:
The introduction of a new contract by one futures exchange frequently prompts another exchange to offer a similar contract, and a battle to garner all the liquidity in the contract ensues. After one exchange wins most of the liquidity in the contract, the other exchange usually exits.47
For example, although the Chicago Board Options Exchange (Cboe) was the first exchange to offer Bitcoin futures, CME’s Bitcoin futures product has gained increased traction and Cboe recently announced the delisting of its product.48 Although the Dodd-Frank Act made efforts to improve competition, such as by permitting any SEF to make any swap available for trade,49 such concentration is poised to continue: In August 2021, news reports indicated that CME was interested in purchasing Cboe, its rival,50 which would reduce the number of major competitors to CME in various markets from two to one, or from one to none.
The DCO market is similarly concentrated. The largest SEFs and DCMs—such as CME and ICE—are vertically integrated with their own DCOs, requiring instruments traded on their exchanges to be cleared by their clearinghouses. Other exchanges, such as Cboe and OCC, partner with a particular DCO to clear the vast majority of their instruments. Like exchanges, clearinghouses tend toward natural monopoly, as traders wish to limit their membership to only one DCO in order to comply with a single entity’s membership requirements and to hold their capital in a single institution. This, combined with the power of individual exchanges, results in two significant problems. The first issue—lock-in effects—is endemic to any monopoly or duopoly; because traders to a contract must agree to use the same DCO, all trades on an exchange end up clearing on one DCO. In turn, a DCM may refuse to clear instruments traded on exchanges that compete with the one that provides it the most business. This lock-out effect means that new DCMs have extremely limited opportunities to gain market share.
Perhaps most importantly, the lack of competition between DCOs concentrates counterparty risk in a small number of them. As a DCO grows bigger in terms of total notional value of cleared instruments or as a share of total transaction volume, it becomes more systemically important. The failure of a DCO that clears all or nearly all of a highly traded instrument could ripple to other parts of the financial system, causing severe damage to the DCO’s counterparties and the entities in the financial and real economy with which they transact. Such a DCO may require a government bailout to ensure the survival of its counterparties. A concentrated DCO market also deters financial innovation and discourages competition upstream and downstream from a DCO in the derivatives trading value chain.
The CFTC should take three actions to ensure long-term competition in the derivatives market. First, the CFTC must enact regulations to inhibit anti-competitive mergers between platforms. The Commodity Exchange Act requires the CFTC to “take into consideration the public interest to be protected by the antitrust laws” in all its actions51 and explicitly provides that DCMs, SEFs, and DCOs “shall not adopt any rule or take any action that results in any unreasonable restraint of trade; or impose any material anticompetitive burden” on the market.52 The agency should prohibit these platforms from purchasing other existing platforms when it would reduce the market for exchange or clearing services of any one instrument to an anti-competitive level.
The CFTC does not appear to have the authority to block platforms from merging absent new regulations. Therefore, when the CFTC observes a platform attempting an anti-competitive horizontal or vertical merger, it should refer the transaction to the U.S. Department of Justice and the Federal Trade Commission to consider whether the merger violates federal antitrust laws and use their authorities to the extent legally permissible.
Finally, the CFTC should enact new regulations to promote competition between platforms and encourage new platforms to enter the market. The Securities and Exchange Commission’s Regulation National Market System (NMS), which “linked together” disparate securities exchanges into one national market, could be a model.53 Regulation NMS required brokers and dealers to ensure that investor trades execute at prices at least as good as the best bid or best offer (NBBO) on any trading platform; it does so by requiring those trades to be either internalized or traded on a platform with the NBBO. The regulation also established a process for collecting those bids and offers from trading platforms. While there are concerns surrounding Regulation NMS and not all of its provisions would translate to the derivatives markets, creating a system in which exchanges can freely compete against each other would be beneficial. Alternatively, the CFTC could limit the percentage of total market exchange volume that any particular SEF or DCM may handle or impose notional size limits on DCOs. The CFTC could also set transaction fee caps so that a monopolistic platform cannot abuse its market power.
4. The CFTC should increase trading transparency
The CFTC should require all swap execution facilities and designated contract markets to exclusively use central limit order book systems. Absent that, the CFTC should require that all requested quotes be made publicly available.
The CFTC should impose transparency requirements for pre-trade data, including ensuring equitable access to data in terms of both cost and latency, that is at least as robust as requirements for post-trade data.
The CFTC should improve the rules governing the availability of post-trade data, including by providing a maximum time by which SEFs must report trade execution information to SDRs, measured in seconds or less, and by requiring SDRs to make historical data available to the public.
Timely access to essential market information is crucial to competition, as market participants can only engage in effective price discovery if they have up-to-date information about market prices. To trade effectively, market participants need information about current bids and offers, as well as prior transactions; in other words, they need to be able to see where the market is and where the market has been, respectively. Unfortunately, the CFTC’s trading transparency and real-time data reporting requirements are insufficient in several areas. It should apply existing regulations, and issue new ones, to ensure timely access to essential market information at a reasonable and nondiscriminatory cost.
First, in the dealer-to-customer market for swaps, most transactions occur on a request for quote (RFQ) trading system rather than a central limit order book (CLOB) trading system.54 Exchanges, including SEFs, use either an RFQ or CLOB system. Under an RFQ model, customers must request quotes from dealers in order to learn the bids or offers available, then choose one to trade with. Under a CLOB model, exchanges collect bids and offers from customers and dealers and execute trades when two match. CLOBs are the more transparent and equitable system: While RFQs require customers to alert dealers of their interest in trading, CLOBs require all dealers and all customers to provide their best bids and offers and usually allow parties to trade anonymously. All parties involved with a CLOB also have symmetrical information, as dealers and customers can see other traders’ best bids and offers.
Full information of the type that CLOBs offer is necessary for customers to obtain the best prices, and the asymmetry offered by RFQ systems is shown to result in higher prices for customers. RFQ systems, by definition, require customers to request information from dealers, which provides dealers with the knowledge of what customers are looking to trade—in other words, the volume of demand. Customers, however, are unable to see that demand, which puts them at a disadvantage in negotiations. The difference between the two types of systems is readily apparent: Recent research shows that transaction costs are “several times larger” for customers in RFQ-based markets than in CLOB-based markets.55
CFTC regulations require SEFs to offer either an RFQ system in conjunction with a CLOB or a CLOB alone.56 Although all major dealer-to-customer SEFs—including CME, ICE, and Bloomberg57—offer trades on both RFQ and CLOB systems, the latter is rarely used except for the most liquid of instruments because dealers do not proactively post their bids and offers to the CLOB. To address this, the CFTC should require all SEFs and DCMs to use CLOB systems alone or, at minimum, require that all requested quotes be made publicly available for all traders to see. Doing so would provide much-needed transparency to the swaps markets, decreasing costs for customers and end users.
Second, regardless of the format in which quotations are provided, the CFTC should ensure real-time, machine-readable, public dissemination of pre-trade data on both SEFs and DCMs. CFTC regulations do not govern the publication of bids and offers in either CLOB or RFQ systems, meaning that exchanges can charge whatever they wish for pre-trade data feeds so long as they self-certify their compliance with the Commodity Exchange Act and CFTC regulations. They may also individually negotiate contracts. For-profit enterprises do not seem well-positioned to pass independent judgment on their own compliance with the law:58 In 2020, one exchange used the lack of regulations governing pre-trade data to increase the cost of obtaining historical data from five exchanges from $0 to $135,000 annually.59 This not only differs from the CFTC’s rules governing the availability of post-trade derivatives data (see Recommendation 4.3) but also from the rules governing securities exchanges’ data, which prohibit charges that are contrary to the public interest or are anti-competitive.60 The CFTC should impose transparency requirements for pre-trade data that are at least as robust as requirements for post-trade data. These should ensure equitable access to data in terms of both cost and latency, as well as dictate that the information is provided in a machine-readable format.
Third, the CFTC’s rules governing the availability of post-trade data should also be improved. The CFTC requires that swaps transactions be reported to swaps data repositories (SDRs) for public availability once they have been completed but has no such public reporting requirement for other non-swaps derivatives.61 For those swaps that are publicly reported, the CFTC requires information to be transmitted “as soon as technologically practicable” after execution, but there is no other hard-and-fast rule to which SEFs are held.62 Moreover, SDRs have limited the availability of historical data, making SDR data useful only if a researcher or market participant scrapes it off an SDR’s data feed or uses a vendor that performs the scraping.
Traders need information about recent transactions in order to understand where the market has been and where the market is going. Buying or selling without historic trade information—including information about trades executed hours, minutes, or even fractions of a second prior—can result in receiving a suboptimal price. In some markets, even millisecond-delayed information can mean the difference between profit and loss. Importantly, when the reporting of post-trade data is delayed, dealers—who know the details of trades they made between execution and reporting—are in possession of and can trade on material, nonpublic information. In the swaps market, “prices can move rapidly, and gaps can appear. A difference of a few minutes can see the price shift dramatically.”63 The CFTC should, through regulation, provide a maximum time by which SEFs must report trade execution information to SDRs, measured in seconds or less, and should update that number periodically as technology improves so that SEFs may be held to account. Similarly, SDRs should be required to make historical data available to the public in an easily accessible, machine-readable format. The CFTC should also make sure that similar DCM requirements are updated to be consistent with the refreshed requirements for SEFs and SDRs.
5. The CFTC should impose meaningful regulations on the parts of digital asset markets that are within its jurisdiction
The CFTC should think critically about how it can use its existing authorities to improve digital asset spot markets. Some options include only approving derivatives contracts that base their price on spot exchanges that work with a third party to custody assets and assist with settlement and comport with minimum requirements provided by the CFTC.
The CFTC has an important role to play in regulating the market for digital assets such as cryptocurrencies, as it has sole jurisdiction over nearly 60 percent of the market by capitalization.64 Digital assets exist as entries on ledgers known as blockchains, which themselves consist of records of when assets were bought and sold and to whom. (For a more fulsome description of digital assets and related technologies, see the recent CAP report, “The SEC’s Regulatory Role in the Digital Asset Markets.”)65 Computers around the globe known as “miners” or “validator pools” then conduct cryptographic calculations to ensure that assets cannot be counterfeited or double-spent. The CFTC has anti-fraud and anti-market manipulation jurisdiction over digital assets that are commodities66 as well as full regulatory authority over their derivatives, including futures, options, and swaps.67 It lacks jurisdiction over digital assets that are securities.68
To understand the breadth of the CFTC’s jurisdiction, it is necessary to delineate which digital assets are commodities and which are securities.69 Commodities are generally defined as “goods sold in the market with a quality and value uniform throughout the world.”70 As explained in a 2021 CAP report, many digital assets are securities because they fit the test that the Supreme Court developed to determine whether something is a security.71 Under the Howey test, a security is “a contract, transaction, or scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party.”72 Courts have generally struggled to determine whether something is a commodity and have not developed a test; nevertheless, things that are intangible can still be commodities.73 It is generally presumed that the CFTC has jurisdiction over digital assets that are uniform and interchangeable, and courts have approved of the CFTC’s claim that Bitcoin is a commodity and that its $1.16 trillion market falls within the agency’s jurisdiction.74 The commission does not, however, have authority over digital assets that are not interchangeable, such as nonfungible tokens.
With jurisdiction over digital asset commodities, the CFTC has a number of authorities to protect the general public and ensure the integrity of the markets. First, the CFTC has anti-fraud and anti-manipulation authority over digital asset commodities’ spot market, enabling it to bring enforcement actions against buyers and sellers who make false statements or, more importantly, engage in market manipulation.75 This is not an idle fear: A bare majority of miners on any one blockchain can “rewrite the blockchain and reverse transactions that are considered settled,”76 and one recent report found that the number of bitcoin miners necessary to reach a majority is frequently fewer than 50.77 The CFTC may also address issues with digital asset wash trades—trades in which two traders, or even one trader with multiple wallets, trade assets back and forth to increase an asset’s purported price or trade volume in order to make the asset look more valuable than it really is.78
Additionally, the CFTC has broad authority over other markets, including registration requirements for platforms, dealers, and major market participants. These additional markets include those for the sale of assets on margin that do not result in actual delivery79—which includes most margin sales on digital asset exchanges, as they engage in only book-entry settlement and not actual delivery—and those for derivatives of digital asset commodities.80 The importance of this authority cannot be overstated: Because traders use derivatives to speculate on whether the price of the underlying asset will rise or fall, these instruments are used to take larger risks than otherwise possible, making investor protections all the more necessary.
The CFTC also likely has regulatory authority over a growing segment of the digital asset industry known as decentralized finance (DeFi). DeFi is “an umbrella term for a variety of financial applications,” including many in which “smart contracts… automatically execute transactions if certain conditions are met.”81 Some of the most popular smart contracts allow digital asset holders to swap assets with others, lend and borrow digital assets from other asset holders, make predictions using digital assets as collateral, automatically rebalance digital asset portfolios, and more.82 However, each of these uses makes the smart contract a derivative that is therefore regulated by the CFTC—whether swaps, margining agreements, or futures—and the agency can require registration and regulation of DeFi platforms as introducing brokers, trading facilities such as SEFs or DCMs, or some other regulated entity as applicable.83
Fortunately, most of the regulations necessary for the CFTC to address digital asset markets are currently in place, and it is already enforcing many of them. It has, for example, sued market participants for “engag[ing] in illegal, off-exchange retail commodity transactions in digital assets…and operat[ing] as a futures commission merchant without registering,”84 trading platforms for failing to register with the commission and “failing to implement an adequate Anti-Money Laundering program,”85 and digital asset issuers for “making untrue or misleading statements” about their digital assets.86
Yet the CFTC’s continued enforcement of the law is necessary but insufficient to protect investors in the digital asset markets, and it must think critically about how it can use its existing authorities to improve markets. For example, the price of a given digital asset on various spot exchanges frequently diverges. Not only is there no effective way for traders to arbitrage away this difference—given that exchanges custody clients’ digital assets, as opposed to a third party87—but the price of a given digital asset on an exchange can be manipulated much more easily than the global price. The CFTC can help address this by only approving derivatives contracts that comport with minimum requirements and base their price on spot exchanges that work with a third party to custody assets and assist with settlement. This way, although the CFTC could not directly regulate the spot market for digital assets, it could incentivize the creation of a market that has the qualities of a regulated market.
The safety and efficacy of the derivatives markets are vital to modern finance. When they operate effectively, they are practically invisible, but they have the capacity to help companies adapt to a carbon-neutral or carbon-negative economy. Yet this importance means that the derivatives markets can cause catastrophe if they fail, as they did in the run up to the global financial crisis. The CFTC must take steps to ensure that derivatives markets facilitate the transition to net zero; are capable of withstanding climate risks; and are competitive, transparent, and safe for all market participants in every asset class under the commission’s jurisdiction.