In contrast to the “regulation by enforcement” theme to which those in the digital assets community have become accustomed, the Commodity Futures Trading Commission (CFTC or Commission) has been active in issuing guidance to the industry. Recently, CFTC staff issued an advisory on digital asset–related risks and the Commission issued an amended Order of Derivatives Clearing Organization (DCO) Registration to Cboe Clear Digital, LLC (Cboe Clear Digital), allowing it to clear margined futures on digital assets.

Risks Related to Clearing Digital Asset Products

On May 30, 2023, the CFTC’s Division of Clearing and Risk (DCR) issued a staff advisory on the risks associated with the clearing of digital assets (the Advisory). The Advisory emphasizes the need for registered DCOs and DCO applicants to exercise caution in light of the increased operational and cybersecurity risks related to clearing digital assets. In its one-page Advisory, CFTC staff highlights the importance of specific DCO Core Principles, including system safeguards, conflicts of interest, and physical settlement procedures:

• DCOs should ensure that their compliance with system safeguard requirements incorporate safeguards for any heightened cybersecurity and other operational risks to which they are exposed by virtue of clearing digital assets.
• When a DCO relies on affiliates, whether for dual-hatted executives or the sharing of systems or other resources, DCR will review the DCO’s rules (and its enforcement of these rules) that mitigate conflicts of interest, as well as the DCO’s processes to resolve conflicts of interest when they arise.
• When clearing involves the physical delivery of digital assets, DCOs need to effectively identify and manage risks associated with digital assets and establish rules that explicitly state a DCO’s duties concerning such deliveries.

Although Commissioner Kristin Johnson supported the Advisory, she urged the CFTC to establish a formal rulemaking procedure. In light of her concerns that investors are exposed to “platforms with the higher risk management exposures and lower customer protections,” Commissioner Johnson proposed that the CFTC initiate an advance notice of proposed rulemaking on DCO clearing activities to thoroughly review potential risks related to clearing digital assets.

She also suggested creating a proposed rule that addresses these risks, citing to the conditions in LedgerX’s DCO Order of Registration as potential requirements the CFTC should make standard by regulation for all DCOs involved in certain products under the existing regulatory framework.

CFTC Issues Amended Order of DCO Registration to Cboe Clear Digital

Shortly after DCR issued the Advisory, on June 5, 2023, the CFTC issued an Amended Order of DCO Registration to Cboe Clear Digital (the Amended Order), expanding Cboe Clear Digital’s existing order to permit it to clear futures on a margined basis, in addition to products for which it is already permitted to clear (i.e., fully collateralized futures and fully collateralized swaps).

Commissioner Christy Goldsmith Romero, the sole commissioner to issue a statement with the Commission’s announcement of the Amended Order, explained that she worked with Cboe Clear Digital to enhance its risk mitigation measures during the Commission’s review process. (Cboe Clear Digital requested the amendment on March 15, 2022).

For example, Cboe Clear Digital took measures to strengthen its cybersecurity and operational risk protections for itself and third parties, amended its vendor management program to improve risk management of custodians and wallet providers, and revised eligibility standards to disqualify any applicant for clearing membership if it, any affiliate, or any associated principal is subject to any statutory disqualification under Section 8a(2) of the Commodity Exchange Act.

In her statement on the Amended Order, Commissioner Goldsmith Romero highlights that Cboe Clear Digital would list and clear digital asset futures under the traditional broker-intermediated model and regulatory framework, in contrast to FTX’s application for non-intermediated clearing (which has since been withdrawn).

The Amended Order incorporates conditions to which the Commission requires Cboe Clear Digital to adhere, including

• treating funds held in member property accounts as “member property” as defined in the Bankruptcy Code,
• maintaining commercially reasonable insurance coverage for the loss or theft of digital asset collateral of participants,
• disclosing material risks associated with clearing digital asset contracts,
• engaging an independent certified public accountant to annually audit digital asset balances and issuing an opinion on Cboe Clear Digital’s accounting treatment of digital assets that it holds,
• obtaining and providing to DCR a copy of any System and Organization Controls (SOC) report of third-party service providers that Cboe Clear Digital uses in the custody or storage of digital assets held on behalf of clearing members, and
• complying with certain statutes (i.e., the Bank Secrecy Act and the Trading with the Enemy Act), regulations, and Executive Orders as if it were a covered “financial institution” as defined in 31 CFR § 1010, et seq.

What’s Next?

Risk management and customer protection are two of the CFTC’s core tenants, so it is no surprise that the Advisory and Amended Order focus on these topics. The Advisory and Amended Order reflect the CFTC’s efforts to foster innovation while protecting customers and other market participants from the types of risks to which digital assets are most susceptible.

Market participants that are considering reviewing their digital asset activities for best practices should consider whether they satisfy relevant conditions in digital asset clearinghouse registration orders, and if not, consider adopting them.