The health of our financial system and the integrity of our markets rests on the ability of customers to entrust their assets and property to custodians. Consequently, enhancing the protection of customer funds and assets and preventing the erosion of regulation that preserves customer assets is critical to the success of our economy.
For thousands of years, customers have entrusted custodians to safeguard their hard-earned money. Trust is the hallmark of custodial relationships. From Greek scripts in ancient civilizations recounting evidence of Phoenician custody banking to modern banking, securities, and derivatives transactions, the obligation of custodians to preserve customer funds has served as a cornerstone of market transactions.
The Commodity Exchange Act (CEA) tasks the Commodity Futures Trading Commission (CFTC or Commission) with developing, adopting, and implementing rules that effectively protect customer funds or property held by market participants that serve as custodians. Preserving the value of customer funds and property held by a third-party is a central, critical, and foundational role of the CFTC.
Retail participation in our markets is growing. The regulation advanced today is only part of our broader framework to preserve customer assets.
As we examine the matter before us today, I strongly advocate for the Commission to carefully consider (among other issues outlined below) and implement:
- appropriate parallel rules to protect retail customer assets, funds, and property across our markets;
- a regulatory metric that acknowledges the challenges of relying on credit default swap (CDS) spreads calculated by an increasingly concentrated market to inform our understanding of the likelihood of foreign sovereign debt default risk; and
- forthcoming rules governing the clearing of U.S. treasuries.
Preserving Customer Assets Is Our Mission
Successful preservation of customer assets directly impacts transaction costs and, in periods marked by significant losses of customer funds, may impact market integrity.
For decades, the CFTC and other market and prudential regulators have introduced and enforced important rules governing the preservation of customer funds and property. Notwithstanding prudential and market regulators’ best efforts, markets and customers have experienced remarkable losses. Markets have witnessed customer losses in heavily regulated markets as well as markets where there are regulatory gaps and regulators may have limited visibility.
FTX and Billions in Missing Customer Funds
Last year, we witnessed a series of bankruptcies in the $1 trillion cryptocurrency markets. Several of the failed firms were among the largest global retail customer trading platforms in the digital asset marketplace.
A year ago today, media accounts began reporting that FTX Trading or FTX.com (FTX) could not account for more than $10 billion in customer funds. Yesterday, in a federal courtroom in the Southern District of New York, jurors found Sam Bankman-Fried, former chief executive officer (CEO) of FTX, guilty of misappropriating and embezzling billions of dollars in customer funds deposited with and held in the custody by FTX in connection with crypto-trading transactions at FTX.
Preserving Customer Assets
An ounce of prevention is worth a pound of cure. When customers entrust their resources and assets to registered participants in our markets, regulation offers the first-best method of preserving customers funds or property. Consequently, creating and enforcing effective, well-tailored rules governing the custody, investment, and preservation of customer funds must be among the Commission’s highest priorities. Without these rules and rigorous enforcement, our markets would lack the foundation of trust upon which every transaction is built.
A recent report indicates that futures commission merchants (FCMs) may hold approximately $500 billion of customer funds in segregated accounts—a number that is the equivalent of the gross domestic product of certain medium-sized countries.
Today, the Commission seeks to refine a foundational rule governing the investment of funds by FCMs and derivatives clearing organizations (DCOs) in our markets. FCMs, alongside several other registered futures and swaps market participants, are entrusted with customer funds.
I commend the Market Participants Division (Division) for its willingness to incorporate comments from my office in the Proposed Rule. I applaud the effort of the proposed amendments to Regulation 1.25 and related matters (Proposed Rule) advanced today, which seeks to introduce greater protections for customer funds, yet, regrettably I find that the Commission has missed an important opportunity.
Over the term of my service as a Commissioner, I have continuously advocated for enhanced protection of customer funds. While I support the adoption of the Proposed Rule, I find that the Commission has missed an opportunity to effectively address gaps in a parallel market that has had exponential growth in recent years due, in part, to the introduction of cryptocurrency or digital assets.
Understanding and Applying our Regulatory Authority
Before reaching the impact of the Proposed Rule, it is important to consider the scope of the Commission’s authority to act to refine existing rules governing the investment of customer funds as well as a broader intervention that addresses evolving market structures. I have advocated, formally and informally, for the Commission to revisit custody rules as part of our customer protection framework since the beginning of my tenure as a Commissioner.
The Commission is proposing to amend Regulation 1.25 pursuant to its public interest exemptive authority under Section 4(c) of the CEA. The Commission may exercise this power to provide certain exemptions from the requirements of the CEA and regulations promulgated thereunder, if the Commission determines that such an exemption would be consistent with the public interest.
The Commission may opt to grant a public interest exemption by way of a rule or regulation. I commend the Commission for electing to start a rulemaking process in the context of the Proposed Rule. In a formal rulemaking process, we benefit from proposed rule text and regulatory expectations and the heightened discourse and public exchanges that are characteristic of the notice and comment period. As a financial market regulator, the Commission must continuously engage in careful and deliberative analyses to ensure the adoption and implementation of robust regulatory processes. Our efforts to achieve these goals ensure the continued stability and integrity of our derivatives markets.
However, as noted in the legislative history of Section 4(c) of the CEA, the Commission must be vigilant to ensure that the exercise of its exemptive power does not “prompt a wide-scale deregulation of markets falling within the ambit of the [CEA].”
Origins of the Commission’s 4(c) Authority
Section 4(c) of the CEA was adopted in the context of the evolution of the derivatives market from traditional agricultural derivatives to financial derivatives. In the 1980s, market participants developed a new OTC derivatives or swaps market featuring instruments that shared characteristics with existing futures contracts and had similar economic purposes. While some questioned the CFTC’s jurisdiction over the novel swap agreements, the Commission’s jurisdiction over futures contracts was clearly established. Congress has long concluded that the CFTC has jurisdiction over contracts that are “in the character of” futures contracts.
In 1992, in response to regulatory uncertainty, Congress adopted Section 4(c) of the CEA – codified in the Futures Trading Practices Act (1992 Act). Rather than resolving the appropriate classification for OTC swap agreements, Congress deferred to the Commission to exempt exchange-traded and OTC derivatives instruments from the CEA where such exemptions are consistent with the public interest. Congress granted the CFTC this exemptive authority to ensure “certainty and stability” for “existing and emerging markets” and to enable “financial innovation and market development” and competition.
Roughly a year later, consistent with the authority granted by Congress in the 1992 Act, the CFTC adopted an exemptive regulation (1993 Exemptive Regulation). Relying on Section 4(c)(3)(K) of the CEA, the Commission limited the market participants permitted to trade in these products to “eligible swap participants,” a group that includes sophisticated individuals with assets over $10 million. As a further customer protection guardrail, the CFTC mandated that an eligible swap participant could only trade unregulated swaps on its own behalf or on behalf of another eligible swap participant.
Seven years later as the swaps market grew exponentially, Congress enacted the Commodity Futures Modernization Act and addressed the product classification issue head-on. By law, Congress exempted financial OTC derivatives from the scope of the CEA, subject to certain conditions that generally excluded small businesses and individual investors from participating in the unregulated swaps market.
The deregulation of the swaps market directly and markedly contributed to the global financial crisis, which caused significant stress and contagion in global financial markets. Certain of the proposed amendments will weaken many of the regulations adopted pursuant to the Dodd-Frank Act, and it is imperative that we do not make the same mistake as the Commission amends its customer protection regime.
Explanation of the Customer Protection Framework
Pursuant to its authority under Section 4(c) of the CEA, the Commission proposes to expand the range of instruments in which FCMs and DCOs may invest customer funds beyond those specifically enumerated in the CEA. The stated benefit is to enhance the yield available to FCMs, DCOs and their customers, without compromising the safety of customer funds.
The Commission has established a comprehensive customer protection regime, designed to ensure that customer funds are segregated from the proprietary funds of FCMs and DCOs, used only to support customer positions, and available for return to customers in the event of the insolvency of the FCM or DCO. Customer funds are classified into one of three account classes based on the specific type of customer position. The categories are futures customer funds, cleared swaps collateral, or 30.7 customer funds in respect of domestic futures, cleared swaps, and foreign futures, respectively.
The CEA and Commission Regulation 1.25 are foundational provisions that set the framework and scope for FCMs’ and DCOs’ investment of customer funds and are fundamentally interconnected with the requirements to segregate customer funds. The CEA permits FCMs to invest futures customer funds in a prescribed list of instruments—obligations of U.S. government, obligations fully guaranteed as to principal and interest by the U.S., and general obligations of any State or any political subdivision. The regulation permits FCMs and DCOs to invest customer funds in each account class in a limited set of permitted investments consistent with the prudential objectives of preserving customer funds and mitigating credit risk, market risk, and liquidity risk. The CEA and Regulation 1.25 reinforce the long-held view of the Commission that customer funds, entrusted to an FCM or a DCO, must be invested in a manner that preserves the availability to customers of FCMs and DCOs.
However, the investment of customer funds may threaten the preservation of such funds, and I have diligently and consistently called for Commission regulation to protect the funds of retail clients that might not fall within the definition of “customer funds.” Some DCOs do not have an intermediated market structure.
Contextualization of the Proposed Amendments
Since the Commission first authorized FCMs and DCOs to invest futures customer funds in these limited permitted instruments in 1968, the Commission has engaged in a series of critical expansions and subsequent restrictions of the provisions of Commission Regulation 1.25. This evolution is largely in response to failures of large FCMs and major financial crises and economic stresses.
In its current form, Commission Regulation 1.25 applies to all three account classes and lists seven categories of investments that qualify as permitted investments—obligations of the U.S. and obligations fully guaranteed as to principal and interest by the U.S.; general obligations of any State or political subdivision of a State; obligations of any U.S. government corporation or enterprise sponsored by the U.S.; certificates of deposit issued by a bank; commercial paper fully guaranteed by the U.S. under the Temporary Liquidity Guarantee Program (TLGP) as administered by the Federal Deposit Insurance Corporation; corporate notes and bonds fully guaranteed as to principal and interest by the U.S. under the TLGP; and interests in money market mutual funds (MMFs).
The Commission’s authority to introduce and enforce regulations that ensure the preservation of customers’ assets, particularly in instances where FCMs and DCOs may experience liquidity crises, is foundational to protecting market participants from fraudulent and other abusive conduct and the misuse of customer assets. Effectively exercising this authority is equally central to the Commission’s role in supporting sound risk management practices and ensuring the stability of the broader financial system.
In the Proposed Rule, the Commission proposes to take several significant actions: add specified foreign sovereign debt to the list of permitted investments; add short-term U.S. treasury exchange-traded funds (ETF) to the list of permitted investments; limit the scope of MMF whose interest qualify as permitted investments; eliminate commercial paper and corporate notes and bonds as permitted investments; request comment on the potential elimination of certificates of deposit issued by banks; replace the London Interbank Offered Rate (LIBOR) with the Secured Overnight Financing Rate (SOFR) as a permitted benchmark for adjustable rate securities; revise concentration limits for certain permitted investments; establish capital charges for specified foreign sovereign debt and qualified ETFs; propose to eliminate the read-only, access provisions; and clarify that DCOs are financially responsible for any losses resulting from investments of cleared swap customer collateral in permitted investments.
I appreciate the importance of the Commission’s engagement in the continual reassessment of Regulation 1.25 and related matters and revising regulatory requirements as and when appropriate. In this case, the proposed amendments are in response to specific petitions by market participants; but the Commission must ensure that its regulations are robust and responsive to our evolving market structure.
Regulatory Gap for Non-intermediated DCOs
The Proposed Rule does not consider the prudential principles of Regulation 1.25 in the context of a non-intermediated clearing model where the DCO offers direct client access to its clearing services, without the FCM as an intermediary. The derivatives market structure is significantly evolving, and it is imperative that the Commission’s regulations evolve in parallel.
Formal Rules Governing Custody for Retail Investors Across our Markets
In 2022, the Commission received a request from LedgerX, which was withdrawn last year when LedgerX’s parent company, FTX, filed for bankruptcy protection. The request aimed to amend its order of registration as a non-intermediated DCO to clear margined products for retail participants.
Five years earlier, LedgerX solicited and the Commission granted an order permitting the firm to offer fully-collateralized derivatives contracts as a DCO. The Commission’s order, amended in September 2020, imposed a number of important conditions, including requiring LedgerX to “at all times maintain funds of its clearing members separate and distinct from its own funds.” The conditions were necessary and important for the preservation of customer property.
Our current regulations do not reach the issues addressed by the conditions in the LedgerX order. The Commission should consider regulation that closes this gap and ensures parallel retail customer protection for trading through intermediaries and non-intermediated DCOs.
LedgerX’s obligation to comply with the Commission’s conditions contributed to the preservation of customer property after FTX acquired LedgerX. When FTX, filed for bankruptcy, LedgerX remained solvent, a non-debtor. The LedgerX order serves as an important precedent for the framework the Commission should consider when adopting parallel protections for direct clients, particularly retail clients, in the non-intermediated context.
It is imperative that the Commission consider an equivalent application of Regulation 1.25 in the context of DCO reinvestment of member property of retail customers.
Earlier Evidence of the Need to Enhance Customer Protections Rules
Long before crypto markets, however, we witnessed significant FCM bankruptcies under then-existing rules that failed to prevent losses to customers. Refco collapsed in 2005; Sentinel Management Group shuttered its doors in 2007; MF Global failed in 2012; and Peregrine Financial Group filed for bankruptcy protection in 2012. The substantial amount of customer funds entrusted to FCMs and the long history of FCM failures underscore the critical relationships between FCMs and customers as well as the FCM’s role, responsibility, and accountability in serving as a custodian of customer funds.
Elimination of Read-Only, Electronic Access to Customer Accounts
As historic and current events demonstrate, the Commission’s customer protection framework, though exceptionally consequential and significant, does not guarantee against losses of customer funds. Following several infamous bankruptcies, the Commission tightened existing regulations including to improve oversight of FCM activities and verify customer funds. The Commission is reevaluating certain aspects of those regulations, which is important. But we should be careful not to forget the unprecedented events that led to the implementation of more stringent oversight of FCMs and necessitate the extension of strict oversight to non-intermediated DCOs.
The Failure of MF Global and Peregrine
MF Global, a prominent FCM and broker-dealer, is an example of a firm that unraveled during the financial crisis. Jon Corzine, Goldman Sachs alum and former Governor and Senator of New Jersey, adopted a proprietary trading strategy involving the investment in the sovereign debt (bonds) of certain European nations through repurchase-to-maturity transactions. MF Global structured a portfolio of “repurchase to maturity” bonds, bonds that paid large coupon rates. Later the bonds were posted as “collateral for short-term borrowing” and purportedly delayed any risk to the firm’s balance sheet until maturity.
A steep decline in sovereign debt markets triggered demands for increased margin, and MF Global had insufficient liquidity to maintain positions. In an attempt to stave off a “run on the bank” by customer withdrawals, creditors’ demands, efforts to unwind repo counterparty positions, and attempts to liquidate proprietary positions at fire sale prices, MF Global made the unacceptable and catastrophic decision to misappropriate customer funds in violation of the Commission’s customer segregation requirements.
The failure of futures trading firm Peregrine also created a need for stronger customer protection mechanisms. Russell Wasendorf Sr. was the founder and former CEO of Peregrine, and he was sentenced to 50 years in prison because he siphoned off more than $215 million from customers of Peregrine. The National Futures Association (NFA), the self-regulatory organization (SROs), was heavily criticized for failing to catch the shortfall in customer funds, though it was the auditor of Peregrine.
After the collapse of MF Global and Peregrine Financial Group, the Commission thoughtfully and meticulously supplemented the protections embedded in Commission regulations to enhance customer protections and transparency at the FCM level.
Dated Efforts to Enhance Customer Protection
In November 2013, the Commission adopted a rule that afforded greater assurances to market participants that the auditing and examination programs of the Commission and SROs are monitoring the activities of FCMs in a prudent and thorough manner. The Commission required depositories holding customer funds for FCMs to provide the Commission with direct, read-only electronic access to customer fund accounts while acknowledging that the Commission did not intend to access FCM accounts on a regular basis to monitor account activity but would use that information when necessary to obtain account balance and other information that staff could not obtain via the designated auditors, either CME Group Inc. (CME) or NFA.
The Commission and depositories are experiencing significant operational and resource-intensive challenges in implementing and administering the provision and the CME and NFA have provided alternative means of obtaining transaction and account balance information.
Although the Commission is proposing to remove the “direct access” requirement, the Commission should be confident that the private sector auditing features that exist at the relevant designated self-regulatory organization (DSRO) are considered in the context of non-intermediated DCOs where there is an absence of an FCM.
Whether it is a traditional market structure or new market structure, the Commission needs to be comfortable that liabilities to customers will be satisfied. I also expect that the Commission and relevant DSRO would impose on non-intermediated market infrastructures the same segregation investment reporting obligations imposed on traditional infrastructure. There is a continuous need to revisit whether measures to protect customer funds are adequate.
Consideration of Other Important Factors
Although I support the Proposed Rule, a few discrete aspects of the Proposed Rule merit additional discussion
- Inclusion of Foreign Sovereign Debt as Permitted Investments
The Commission plans to use the CDS spread to determine whether certain permitted foreign sovereign debt should qualify as “permitted investments.” The Commission needs to carefully consider the conditions that apply to each permitted foreign sovereign debt by establishing strong guardrails so that history does not repeat itself.
On August 15, 2023, FCMs held the U.S. dollar equivalent of $51 billion of customer funds denominated in Canadian, European, Japanese, and UK currencies. Given the significant non-U.S. dollar customer transactions intermediated by FCMs, the Commission’s proposal expands the list of permissible investments to add the debt of countries that represent the largest economies, are members of the Group of 7, and a money center country—Canada, France, Germany, Japan, and the UK.
De-Regulatory Decisions and the Recent Financial Crisis
The recent global financial crisis is a cautionary tale. A series of deregulatory decisions created significant vulnerabilities in financial markets. More specifically, an exemption from regulation for bespoke over-the-counter (OTC) swaps trading in bilateral markets obscured excessive risk-taking and undermined the integrity of global markets. According to the U.S. Government Accountability Office, the 2007-2009 financial crisis, which threatened the stability of the U.S. financial system and the health of the U.S. economy, may have led to $10 trillion in losses, including large declines in employment and household wealth, reduced tax revenues from lower economic activity, and lost output (value of goods and services).
Traditionally, customer funds have been invested in U.S. treasury securities to generate interest income, which is shared between the customer and the FCM. The Commission amended Regulation 1.25 in 2000 to expand the list of investments to include all foreign sovereign debt, subject to a ratings requirement. Following the 2007-2009 global financial crisis, in December 2011, the Commission unanimously approved a final rule amending Regulation 1.25 to eliminate all foreign sovereign debt as permitted investments in light of the economic crisis but remained open to the possibility of reintroducing specific foreign debt. The Commission tightened the definition of permissible investments.
History has demonstrated that certain sovereign debt instruments may be risky. The financial crisis was closely intertwined with the sovereign debt crisis, which is characterized by the economic collapse in—and a deterioration in the credit quality of—Iceland, Portugal, Italy, Ireland, Greece, and Spain. It is helpful that sovereign debt from those countries are not proposed to be permitted sovereign debt.
The Commission should reintroduce foreign sovereign debt as a permitted investment with caution and sufficient guardrails. The Commission is using the CDS spread of the sovereign issuer as a proxy for default risk, such that the relevant sovereign is disqualified if the issuer’s two-year credit default spread exceeds 45 BPs. The CDS spread is the spread on protection pursuant to a CDS against the default of the issuer of a debt instrument, and an increase in the spread reflects a market perception that the creditworthiness of the issuer has deteriorated, implying an increased risk of non-payment on the debt investment.
We must not forget that the CDS market came under heavy scrutiny during the financial crisis, and Warren Buffett infamously called CDS the “financial weapons of mass destruction.” Since the adoption of the Dodd-Frank Act, there has been significant contraction in a number of important segments of the CDS market.
Given the nature of this specific market-based metric, I encourage market participants, in responding to the request for comment, to consider whether the use of the CDS spread, which is dependent on a functioning CDS market, is (and the circumstances under which it would be) an appropriate indicator of whether a foreign sovereign debt is “consistent with the objectives of preserving principal and maintaining liquidity and according to the following specific requirements.”
- Interaction with Proposed U.S. Treasury Clearing Requirement
Financial markets are closely interconnected and correlated. Consequently, we need a comprehensive and holistic approach to U.S. treasury obligations. The SEC has proposed a rule that will require the clearing of certain repurchase or reverse repurchase agreements involving U.S. treasury securities.
Our registrants, FCMs and DCOs, may buy and sell permitted investments, including U.S. treasury obligations, pursuant to repurchase and reverse repurchase transactions with permitted counterparties, subject to certain conditions.
Upon the finalization of the proposed rule, the Commission may need to revisit Regulation 1.25 accordingly.
For the reasons above, I support the adoption of the Proposed Rule. I look forward to the thoughtful contributions of market participants.