In a recent development, causing some ripples in financial circles, the U.S. Commodity Futures Trading Commission (CFTC) has proposed a new rule, titled “Protection of Clearing Member Funds Held by Derivatives Clearing Organizations.”
At its core, the rule targets derivatives clearing organizations (DCOs), the behind-the-scenes market participant in the financial drama. The rule’s standout feature: The insistence that proprietary funds held by DCOs must be segregated, a move aimed at creating a robust financial buffer that encompasses margins from retail investors.
CFTC Commissioner Kristin Johnson introduced the initiative. Commissioner Johnson and Chair Rostin Behnam voted to adopt the proposed rule, while Commissioners Summer Mersinger and Christy Goldsmith Romero voted “no” and Commissioner Caroline Pham concurred.
The proposed rule is designed to prevent a DCO from tampering with funds belonging to their direct clients. In the meeting, Commissioner Johnson called for the Commission to adopt AML requirements for DCOs. or to engage with Treasury on FinCen.
The proposed rules states as follows:
(1) require clearing member property be segregated from a DCO’s own funds and be acknowledged as separate in writing;
(2) require clearing member property to be treated as belonging to the clearing member while permitting the use of it as part of the DCO’s default waterfall, consistent with the DCO’s rules and agreements with clearing members;
(3) permit the commingling of clearing member property in a single omnibus account for convenience;
(4) permit the investment of clearing member property pursuant to CFTC Regulation 1.25; and
(5) require the daily reconciliation of balances owed to customers and clearing members against the amount actually held in segregation.
The need for the proposed rule was underscored by the collapse of the FTX crypto exchange. FTX exchange mixed customer funds, and later, its CEO, Sam Bankman-Fried, was found guilty of misappropriating billions in customer funds. Remember that FTX wasn’t registered with the CFTC. FTX’s former affiliate, LedgerX, attempted to pioneer a direct path at the CFTC by clearing margin customer transactions without intermediaries. Commissioner Johnson made a call that rejecting the proposed rule would leave retail customers without protection or recourse. Although, the separation of member property is a condition in DCO registration orders, adopting a rule strengthens this requirement.
If a rule had applied to FTX, then FTX could not have mixed customer funds and allowed Sam Bankman-Fried to move funds out of the company for his own ulterior motives. Commissioner Johnson states that FTX is an example for “the magnitude of losses that customers may experience in the absence of regulation that prohibits commingling of customer funds or member property.”
The CFTC commissioners approved the publication of the proposal for public feedback. This is a crucial step in the process to establish a rule applicable to any DCOs falling under the commodities regulator’s purview.
It is now open for public comments—let ‘em know what you think.
Thank you to my research fellow, John Livingstone. If you have any comments, suggestions or feedback, please send them to John Livingstone john.livingstone@case.edu or to me anat.beck@case.edu.