Against a backdrop of changing markets, rapidly evolving technology and increased jurisdiction, the U.S. Commodity Futures Trading Commission (CFTC) – the regulatory agency with responsibility for oversight of the U.S. exchange-traded and over-the-counter (OTC) derivatives markets – has recently amended its recordkeeping rules to modernize them, and has announced two initiatives to help modernize its operations and reduce regulatory burdens on market participants.
The CFTC’s jurisdiction covers regulation of commodity interest contracts (futures, options on futures, and swaps), exchanges and clearinghouses, and market intermediaries such as commodity pool operators (CPOs) and commodity trading advisors (CTAs). When the CFTC was established in 1974, most derivatives trading was in the form of exchange-traded futures in the U.S. domestic agricultural sector. Over the decades, derivatives trading has become more diverse and complex, as well as internationalized and more technical. Almost all of the trading pits at U.S. futures exchanges in which commodity interests were once traded by traders in person have closed. Sophisticated digital technology now gives traders worldwide electronic access to U.S. markets, and U.S. traders access to markets elsewhere. Since the enactment of the Dodd-Frank Act, the CFTC’s purview has exploded to include OTC derivatives markets, including OTC derivatives trading activity with a U.S. nexus (such as swaps where one counterparty is a U.S. person), and to coordinate its regulation with other member countries of the International Organization of Securities Commissions (IOSCO) in an effort to prevent another economic meltdown like the financial crisis of 2008. In addition, as the result of amendments to its rules governing CPO and CTA activity in 2012, many more asset managers are now subject to registration with the CFTC and compliance with its rules.
CFTC Modernizes its Recordkeeping Rules
On May 23, 2017, the CFTC unanimously approved a final rule amending CFTC Rule 1.31, which governs the CFTC’s recordkeeping requirements. The amendments changed the CFTC recordkeeping rule from an out-of-date set of prescriptive requirements to a principles-based approach with the goal being to “modernize and make technology neutral the form and manner in which regulatory records must be kept.” Specifically, the amendments removed the requirements that: (1) all U.S. Commodity Exchange Act (CEA)-required books and records be kept by in their original form (for paper records) or native file format (for electronic records); (2) all electronic records be kept in a “non-rewritable, non-erasable format (i.e., the ‘write once, read many’ or ‘WORM’ requirement);” and (3) covered entities retain a third-party technical consultant to make certain representations in CFTC filings regarding access to the entity’s electronic regulatory records. Going forward, regulated entities subject to the CEA and their designated service providers must retain records “in a form and manner that ensures the authenticity and reliability of such regulatory records in accordance with the [CEA] and [CFTC] regulations ….”1
Asset managers that are registered CPOs and CTAs should find the CFTC’s amendments to the recordkeeping rule a welcome modernization. Many asset managers rely on third-party service providers (such as custodians, transfer agents, administrators and subadvisors) to maintain records of the commodity pools and accounts for which they provide services (third-party recordkeepers). In recognition of this fact, in its 2012 rulemaking amending the CPO rules, the CFTC permitted CPOs to delegate recordkeeping responsibilities to an enumerated list of entities (e.g., a commodity pool’s administrator, distributor or custodian).2 In September 2014, the CFTC expanded the types of service providers that may act as third-party recordkeepers for CPOs.3 In April 2017, the CFTC staff provided industry-wide exemptive relief to permit registered CTAs to use third-party recordkeepers.4
However, the ability of a CPO to use any third-party recordkeeper is conditioned on the third-party recordkeeper making certain affirmative representations in writing to the CFTC regarding the services. One of those conditions is that the third-party recordkeeper is responsible for ensuring that all books and records are kept in accordance with CFTC Rule 1.31.5 While CFTC Rule 1.31 contained such outdated requirements as the retention of third-party technical consultants, some third-party recordkeepers for CPOs were unable or unwilling to make the necessary representations to the CFTC, and as a result the relief built into the CPO Recordkeeping Rules was of limited use. Furthermore, prior to the CFTC Rule 1.31 amendments, registered CPOs and CTAs were uneasy about making their own required representations to the CFTC regarding CFTC Rule 1.31 compliance.
The effective date for the rule amendments is August 28, 2017.
CFTC Announces LabCFTC as a Major FinTech Initiative
On May 17, 2017, the CFTC announced the approval of “LabCFTC” – an initiative “aimed at promoting responsible FinTech [financial technology] innovation to improve the quality, resiliency, and competitiveness” of the various derivatives markets over which the CFTC has jurisdiction. The CFTC has recognized that its regulation and operations have not kept pace with the digitalization of the derivatives trading markets.6 With LabCFTC, the CFTC would like to achieve two goals: (1) “to provide greater regulatory certainty that encourages market-enhancing FinTech innovation to improve the quality, resiliency, and competitiveness of our markets,” and (2) “to identify and utilize emerging technologies that can enable the CFTC to carry out its mission more effectively and efficiently in the new digital world.”7
To that end, the CFTC plans to make a point of contact at the CFTC available to FinTech innovators in order to foster technology ideas that will benefit the markets (GuidePoint). Through this point of contact, the CFTC plans to offer timely and useful feedback to innovators who engage with the CFTC, in order to save those innovators time and effort. Feedback might include information about the CEA and CFTC regulation, CFTC organization, the CFTC approach to market oversight, and publicly available information about current proposals and initiatives at the CFTC.
The CFTC also plans to initiate the adoption of new technology in the CFTC’s regulatory operations (CFTC 2.0). In order to facilitate this portion of the initiative, the CFTC plans to run its own innovation lab to study new technologies and collaborate with other regulatory authorities. The CFTC may also establish competitions under the America Competes Act, participate in an annual conference on FinTech, and engage with academia.
One type of trading technology that has caught regulators’ attention as a direction in which the markets may be going – and one with which regulation needs to catch up – is distributed ledger technology, also known as “blockchain.”8 Blockchain is the peer-to-peer maintained transaction ledger that underpins Bitcoin trading, but the technology could be used for just about any transaction without the need for a trusted intermediary. The ledger can be used for the trading, processing and clearing of derivatives trades, and can incorporate smart contracts that can automatically initiate future events and transactions. Some markets (e.g., the Australian Stock Exchange and NASDAQ) are already using blockchain in some aspects of their operations.9
Finally, the CFTC plans to use its engagement with the FinTech sector to review where its existing regulations may need to be updated in order to reduce friction and reflect the current state of the trading markets.10
CFTC Announces Initiative to Reduce Regulatory Burdens, Dubbed “Project KISS”
On May 3, 2017, the CFTC announced an initiative to request public input on how the CFTC might simplify its rules to make them less costly and burdensome. The endeavor is called Project KISS, or “keep it simple, stupid.” Acting Chairman J. Christopher Giancarlo has recognized that “at times the CFTC rules are unnecessarily complex, and the harder they are to understand and costly to follow, the less dynamic and vibrant these markets become.” Costs incurred in the derivatives markets can affect cash markets for commodities such as gasoline and groceries. The initiative is in the spirit of President Donald Trump’s executive order directing federal agencies to designate a Regulatory Reform Officer and establish a Regulatory Reform Task Force.11 As an independent agency, the CFTC is not required to comply with the order, but the CFTC is nevertheless interested in reviewing its regulations.12
As part of the U.S. Administrative Procedures Act process for agency rulemakings, industry participants have the opportunity to comment on proposed CFTC rules prior to finalization and implementation. However, the manner in which a regulation (or other CFTC action such as no-action or exemptive relief) will work in practice is often not known until compliance begins. And since several different regulatory agencies, both in and outside the United States, have been writing regulations at the same time as the CFTC has been implementing its Dodd-Frank Act related regulations, there may be previously unanticipated overlap and duplication. Asset managers subject to the CEA and CFTC rules are encouraged to file a submission with the CFTC describing their experiences with burdensome regulation and setting forth their recommendations.
The comment period for Project KISS closes on September 30, 2017.