Reed Smith In-depth

Financial regulators in the United States and Europe continue to search for ways to bring the burgeoning decentralized finance (DeFi) industry, including companies and autonomous protocols that provide capabilities for trading digital assets, into the regulatory fold. Doing so is a complex undertaking because the DeFi business model does not fit neatly into the traditional corporate structures for which the existing U.S. and European regulatory schemes were designed. This complexity is compounded by the reality that many DeFi platforms will not have a controlling central authority for regulators to target. To that end, the U.S. Commodity Futures Trading Commission (CFTC) and the U.S. Securities and Exchange Commission (SEC) recently took steps to broaden the scope of their respective regulatory and enforcement authorities. These actions appear to be directly aimed at DeFi platforms and foretell increased scrutiny and likely additional compliance costs for such platforms, and where applicable, those that facilitate them. Simultaneously, the EU’s European Securities and Markets Authority (ESMA) also published its consultation paper addressing non-traditional trading venues.
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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