CFTC enforcement and Staff Advisory
On Sept. 29, 2021, the CFTC issued an order filing (and simultaneously settling) charges brought against a California entity that offers finance and trading-related electronic communication services for failing to register as a swap execution facility (SEF). The CFTC described the defendant as providing “a technological tool for automated request for quote (RFQ) workflow for interest rate and cross currency swaps,” and enabling “multiple swap market participants to select swap product parameters, such as swap type, clearing preference, tenor, and notional size to populate RFQs.”1
The CFTC’s Division of Market Oversight (DMO) seems to have anticipated that this order’s adoption of a novel SEF definition would be viewed as a significant departure from the SEF definition established in the original SEF rule.2 As a result, DMO concurrently issued a Staff Advisory clarifying that “certain trading activities may trigger compliance with the SEF registration requirement in the Commodity Exchange Act (CEA) and CFTC regulations.”3
The CFTC Staff Advisory is considered controversial from an Administrative Procedure Act perspective, given that in 2018, the CFTC proposed but never finalized a rule that would have expanded the scope of the SEF registration requirement – and thus, in practice, what constitutes an SEF.4 The CFTC Staff Advisory arguably accomplished the result that the CFTC sought through the 2018 proposed rulemaking by the simple expedience of staff action. The CFTC Staff Advisory indicates that entities “may need to register as a SEF” when:
(1) facilitating trading or execution of swaps through one-to-many or bilateral communications; (2) facilitating trading or execution of swaps not subject to the trade execution requirement in CEA section 2(h)(8); (3) providing non-electronic means for the execution of swaps; or (4) currently registered with the CFTC in some other capacity, such as a commodity trading advisor or an introducing broker, if its facility falls within the SEF definition.5
Of particular note for unregistered platforms, and specifically for those in the DeFi space, is DMO’s admonition that “facilitating trading or execution of swaps through one-to-many or bi-lateral communications” falls within category of activities that could require SEF registration. This “clarification” was likely intended to cast doubt on the notion that certain platforms, including DeFi platforms are not subject to SEF registration (or any other CFTC regulations) because their protocols do not allow multiple participants to “simultaneously request, make, or accept bids and offers from multiple participants” or because their platforms act as a single liquidity provider (i.e., one-to-many) and thus do not satisfy the “multiple-to-multiple prong” of CEA § 1a(50).6 On the latter point, the CFTC Staff Advisory specifically asserts that “a facility meets the multiple-to-multiple prong if multiple participants simply have the “ability [sic] to execute or trade swaps” with multiple participants.”7 The emphasis on “ability” drastically broadens the scope of the SEF definition.
As clearly stated in the CFTC Staff Advisory, and evidenced by the CFTC’s concurrently announced charges and settlement in September 2021, the agency is looking closely at platforms offering “chat” functions that enable communications in a way that appears to give buyers and sellers the ability to execute derivative transactions (i.e., swap trades). This broad interpretation could pull in any number of DeFi platforms, as well as more traditional financial services providers and potentially even other social and business digital communications platforms that offer capabilities related to or involving derivatives trading.
Importantly, because the CFTC Staff Advisory, from DMO’s perspective, is merely a clarification of what the SEF definition has been since the original 2013 SEF rule, it will have retroactive application, meaning that the CFTC’s Division of Enforcement could bring enforcement actions against facilities that believed they were in compliance with the 2013 SEF registration rule but would now fall within the definition of a SEF as provided in the recent CFTC Staff Advisory.
On Jan. 3, 2022, the CFTC made clear that CFTC regulations applicable to SEFs and designated contract markets (DCMs)8 apply in equal measure to DeFi platforms by filing and settling charges against an event-based binary options exchange that was not registered as either a SEF or a DCM.9 Given the number of unregistered platforms similarly offering derivatives in the market, many more actions of this nature are likely to ensue. CFTC Chairman Behnam specifically noted in his Congressional testimony of Feb. 9, 2022, that the CFTC will focus oversight on platforms where digital assets are traded.10
SEC’s proposed ATS rule
On Jan. 26, 2022, the SEC released a proposal to amend Rule 3b-16 of the Securities Exchange Act of 1934 (Exchange Act) with respect to alternative trading systems (ATSs) (SEC ATS proposed rule). Although the focus of the SEC ATS proposed rule is on the definition of “exchange” under Section 3(a)(1) of the Exchange Act as it relates to U.S. government and treasury securities, that focus should not obscure the proposal’s additional aim of expanding the exchange concept “to include systems that offer the use of non-firm trading interest and communication protocols to bring together buyers and sellers of securities.” In practice, this proposed amendment would broaden the scope of the definition of “exchange” to capture not only actual orders placed on securities exchanges, but also “non-firm trading interests,” including conditional offers and exploratory solicitations for securities trades. The amendment would also provide the SEC with newly codified authority to oversee and regulate communication protocol systems (CPSs).11
SEC Commissioner Caroline Crenshaw described the proposed expansion of SEC authority over platforms on which solely “non-firm trading interests” are exchanged as the long-needed removal of a “loophole” used to evade SEC rules.12 Specifically, to capture CPSs, the SEC proposes amending the term “exchange” to include any “organization, association, or group of persons” that is not otherwise subject to an exemption if it:
(1) brings together buyers and sellers of securities using trading interest; and (2) makes available established, non-discretionary methods (whether by providing a trading facility or communication protocols, or by setting rules) under which buyers and sellers can interact and agree to the terms of a trade.13
The SEC ATS proposed rule provides a non-exhaustive list of CPSs that would be subject to registration and oversight, including RFQ systems, so-called “stream axes,” which electronically provide a continuous flow of firm and non-firm trading offers on a security to those on the platform, some conditional order systems, and negotiation systems that bring together buyers and sellers via a “bilateral negotiation protocol.”
The SEC provided 30 days after the publication in the Federal Register to file comments to the SEC ATS proposed rule.14 In her dissenting statement on the proposal, SEC Commissioner Hester Peirce stated that, “[w]e face no emergency in these markets that compels us to limit comments to 30 days; indeed, the Commission’s precipitous rush to plow through the comment period—almost as if it were a mere formality in our process—presents a greater immediate risk to the market than any of the issues that have led to this recommendation.” The SEC could extend the comment period or reopen it once the 30-day period has lapsed, if it were inclined to do so.
Although SEC Chair Gary Gensler described these amendments as necessary to adapt the agency’s regulations to a world in which exchange platforms are “increasingly electronified,”15 this action by the SEC is also a shot across the bow for DeFi platforms offering blockchain-based, algorithmically-facilitated platforms on which securities trades are facilitated or communicated. Some would argue that the DeFi platforms currently operating autonomous or semi-autonomous protocols that provide communications functions or other related services to potential buyers and sellers of securities are not covered by the Exchange Act’s current definition of “exchange.” These amendments would, at least in some instances, bring those platforms more clearly under the SEC’s jurisdiction, first and foremost by requiring them to register with the agency as an exchange or as a broker-dealer or an ATS.
ESMA’s consultation paper
Two days after the release of the SEC ATS proposed rule, the ESMA published a consultation paper (CP) setting forth “ESMA’s Opinion on the trading venue perimeter.” ESMA’s paper seeks to further “clarify … the definition of multilateral systems and provid[e] guidance on when systems should be considered as multilateral systems and, as consequence, seek for authorization as trading venues.”16
Very similarly to the CFTC Staff Advisory and SEC ATS proposed rule, ESMA’s CP aims to clarify when a trading venue becomes subject to the authorization requirement as either an organized trading facility (OTF) or a multilateral trading facility (MTF). “In particular, the CP looks at [RFQ] systems and new technology providers that may, in some instances, operate de facto a multilateral system without proper authorization.”17
ESMA’s CP reminds entities that under MiFID II a multilateral system is one in which: there is a system or a facility, there are multiple third parties buying and selling interests, those trading interests need to be able to interact, and trading interests need to be in financial instruments.18 The CP also looks at recent technology and market developments, including bilateral negotiation and communication protocols, as well as RFQ and order management and execution systems. Comments on the ESMA consultation paper are due by April 29, 2022, and it is expected that eventually a lot more entities and platforms will be required to register as OTFs and MTFs in the EU.
Other developments
On Oct. 28, 2021, the Financial Action Task Force (FATF), the global standard-setter for anti-money laundering and countering-the-financing-of-terrorism (AML/CFT) efforts, released its updated guidance for a risk-based approach on virtual assets and virtual asset service providers (VASPs). The updated guidance is not legally binding on FATF member countries, but AML/CFT frameworks in these countries are now likely to converge with it over time.
Under the FATF guidance, creators, owners, operators or other persons who: (1) maintain control or sufficient influence in DeFi platforms (for example, decentralized applications or decentralized exchanges); and (2) provide or actively facilitate VASP services, may be considered VASPs, even if those arrangements seem decentralized or portions of the processes are automated. Non-exhaustive factors to be considered include whether the relevant person has control or sufficient influence over assets or over aspects of the service’s protocol, the existence of any ongoing business relationship with users (even if this is exercised through a smart contract or voting protocols), the fact that the person profits from the service, and/or the person’s ability to set or change the parameters of the service’s protocol.
In relation to DeFi operators that are deemed VASPs, measures which FATF member countries can adopt include requiring the VASP to facilitate transactions only to/from addresses or sources that are acceptable based on a risk assessment or to/from VASPs and other regulated entities, requiring the VASP to file reports on user transactions with unhosted wallets, and applying enhanced regulatory scrutiny of VASPs that enable users to transact with unhosted wallets.
At the national level, jurisdictions other than the United States and European Union also have taken steps to expand the scope of regulation of digital asset platforms. In Singapore for example, the regulatory licensing regime governing digital payment token (DPT) services is due to be expanded (likely with effect from later this year) to capture any service of inducing or attempting to induce DPT buy and sell transactions. The Monetary Authority of Singapore has explained that this licensing requirement will capture, for example, “an entity which carries on a business of providing brokerage or exchange services, or software applications, which enable users to find counterparties, and actively match orders for buyers and sellers of the DPTs, without taking possession of the moneys or DPTs.” It remains to be seen to what extent this captures DeFi protocols, but it may do so in cases where the activities of the protocol have a requisite Singapore nexus and accountability for complying with the licensing requirement can be attributed to a person who controls or operates the protocol.
Conclusion
DeFi platforms and businesses collaborating with them, including companies providing digital communications services in the financial services sector, should closely analyze the CFTC’s, SEC’s, and ESMA’s recent actions. Even if these regulators did not formally coordinate their approach, the substance of the CFTC, the purpose of the SEC ATS proposed rule, as well as the scope of ESMA’s consultation paper, all indicate that the regulators are attempting to do the same thing – scope the outside boundaries of what constitutes a regulated trading facility.
These developments not only foreshadow increased regulatory scrutiny and compliance costs for the derivatives, commodity and digital asset industry but also send the signal that the CFTC, the SEC, the ESMA and other regulators, at times in either an actual or seemingly coordinated manner, will be looking for ways to extend and apply their authorities to the rapid technological changes that are fundamentally altering the structure of the financial markets.
- cftc.gov/.
- cftc.gov/.
- cftc.gov/.
- cftc.gov/.
- cftc.gov/.
- Id. (emphasis original).
- Id. (emphasis original).
- Note that SEFs can only give access to their trading platforms to eligible contract participants (“ECPs”); while non-ECPs (i.e., retail participants) can only trade on DCMs.
- cftc.gov/.
- cftc.gov/.
- Additionally, as part of this amendment package, the SEC proposed to remove an exemption under Regulation ATS for alternative trading systems (ATSs) that facilitate trading of U.S. Treasury securities and other government securities, in order to bring them “under the regulatory umbrella.”
- sec.gov/.
- sec.gov/.
- As of the date of this paper, the SEC ATS Proposed Rule has not been published yet.
- sec.gov/.
- esma.europa.eu/.
- Id.
- Id at 10.
In-depth 2022-042
