Proposed Rule2026-15948
Conflicts and Affiliations
Primary source
Metadata and text below are from the Federal Register, a public-domain U.S. government work. Always verify the official published version before relying on it for any legal matter.
Published
August 6, 2026
Issuing agencies
Commodity Futures Trading Commission
Abstract
The Commodity Futures Trading Commission ("CFTC" or "Commission") is proposing new rules and amendments to its existing regulations for futures commission merchants ("FCMs"), swap execution facilities ("SEFs"), designated contract markets ("DCMs"), and derivatives clearing organizations ("DCOs") (the "Proposal"). The Proposal addresses requirements relating to financial oversight of FCMs by self-regulatory organizations ("SROs") and designated self- regulatory organizations ("DSROs"), as well as disclosure requirements by FCMs regarding affiliate relationships that an FCM has with a SEF, DCM, or DCO. For SEFs, DCMs, and DCOs, the Proposal would also establish requirements, including conflicts of interest rules, to address those registered entities' relationships with certain affiliates, such as FCM affiliates and affiliated principal trading firms. The Proposal includes guidance regarding the implementation of safeguards to protect the impartiality of SEFs, DCMs, and DCOs, including where applicable in their role as SROs or performing SRO functions with respect to certain affiliates. The guidance addresses the sharing of resources including staffing, technology, and office space, and limitations on the sharing of non-public information.
Full Text
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[Federal Register Volume 91, Number 150 (Thursday, August 6, 2026)]
[Proposed Rules]
[Pages 50926-50995]
From the Federal Register Online via the Government Publishing Office [<a href="http://www.gpo.gov">www.gpo.gov</a>]
[FR Doc No: 2026-15948]
[[Page 50925]]
Vol. 91
Thursday,
No. 150
August 6, 2026
Part II
Commodity Futures Trading Commission
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17 CFR Parts 1, 37, 38, et al.
Conflicts and Affiliations; Proposed Rule
Federal Register / Vol. 91, No. 150 / Thursday, August 6, 2026 /
Proposed Rules
[[Page 50926]]
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COMMODITY FUTURES TRADING COMMISSION
17 CFR Parts 1, 37, 38, and 39
RIN 3038-AF76
Conflicts and Affiliations
AGENCY: Commodity Futures Trading Commission.
ACTION: Notice of proposed rulemaking.
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SUMMARY: The Commodity Futures Trading Commission (``CFTC'' or
``Commission'') is proposing new rules and amendments to its existing
regulations for futures commission merchants (``FCMs''), swap execution
facilities (``SEFs''), designated contract markets (``DCMs''), and
derivatives clearing organizations (``DCOs'') (the ``Proposal''). The
Proposal addresses requirements relating to financial oversight of FCMs
by self-regulatory organizations (``SROs'') and designated self-
regulatory organizations (``DSROs''), as well as disclosure
requirements by FCMs regarding affiliate relationships that an FCM has
with a SEF, DCM, or DCO. For SEFs, DCMs, and DCOs, the Proposal would
also establish requirements, including conflicts of interest rules, to
address those registered entities' relationships with certain
affiliates, such as FCM affiliates and affiliated principal trading
firms. The Proposal includes guidance regarding the implementation of
safeguards to protect the impartiality of SEFs, DCMs, and DCOs,
including where applicable in their role as SROs or performing SRO
functions with respect to certain affiliates. The guidance addresses
the sharing of resources including staffing, technology, and office
space, and limitations on the sharing of non-public information.
DATES: Comments must be in writing and received by October 5, 2026.
ADDRESSES: You may submit comments, identified by ``Conflicts and
Affiliations'' and RIN 3038-AF76, by any of the following methods:
<bullet> <a href="http://Regulations.gov">Regulations.gov</a>: Go to <a href="https://www.regulations.gov">https://www.regulations.gov</a> and
press the ``Search'' button, then proceed as follows:
1. Under Refine Documents Results--check the box to ``Only show
documents open for comment'';
2. Under Agency--select ``See More'' and check the box for
``Commodity Futures Trading Commission,'' then press the Apply button;
3. Identify this proposal in the list of CFTC documents open for
comment, press the ``Comment'' button to open the submission form, and
follow the instructions on the form.
Alternatively, if you are viewing this proposal on
<a href="http://www.federalregister.gov">www.federalregister.gov</a>, click the ``Submit A Public Comment'' button
at the top of the page to open the comment form. Follow the
instructions on the form to submit your comment to <a href="http://Regulations.gov">Regulations.gov</a>.
<bullet> Mail: Send to Christopher Kirkpatrick, Secretary of the
Commission, Commodity Futures Trading Commission, Three Lafayette
Centre, 1155 21st Street NW, Washington, DC 20581.
<bullet> Hand Delivery/Courier: Address to--CFTC Comment
Submission, Attn: Christopher Kirkpatrick, Secretary of the Commission,
Commodity Futures Trading Commission, Three Lafayette Centre, 1155 21st
Street NW, Washington, DC 20581.
Please submit your comments using only one of these methods. To
avoid possible delays with mail or in-person deliveries, submissions
through <a href="http://Regulations.gov">Regulations.gov</a> are encouraged.
All comments must be submitted in English, or if not, accompanied
by an English translation. Do not include in your comment text or
attachments any personal identifying information or business
information that you do not want published online. Comments (regardless
of submission method) will be published without review for, and without
removal of, any personal identifying information or information your
business may consider confidential.
If you wish to submit confidential information for the Commission's
consideration, please contact the CFTC personnel listed in this Notice
under FOR FURTHER INFORMATION CONTACT before making any submission.
Please also carefully review the Commission's procedures in 17 CFR
145.9 for requesting confidential treatment under the Freedom of
Information Act (``FOIA'') of information submitted to the Commission.
The CFTC reserves the right, but shall have no obligation, to
review, pre-screen, filter, or redact all or any part of your comment
submission. The CFTC also reserves the right, without further
notification, to refuse to publish or to remove from public view all or
any part of your submission to the extent it contains content
inappropriate for publication in a comment file, such as--without
limitation--obscene language, threats of violence, solicitations for
commercial sales or illegal activity, or obvious spam. If a submission
that is refused for or withdrawn from publication because of
inappropriate content also contains comments on the merits of this
proposal, such submission will be retained in the record for the matter
and will be considered as required under the Administrative Procedure
Act (``APA'') and other applicable laws, and may be accessible under
the FOIA.
Pursuant to the APA at 5 U.S.C. 553(b)(4), a plain language summary
of the proposed rule is available at <a href="http://Regulations.gov">Regulations.gov</a>.
FOR FURTHER INFORMATION CONTACT: Stephen Andrews, Deputy General
Counsel for Regulation, <a href="/cdn-cgi/l/email-protection#8efdeaefe0eafcebf9fdceede8faeda0e9e1f8"><span class="__cf_email__" data-cfemail="2f5c4b4e414b5d4a585c6f4c495b4c01484059">[email protected]</span></a>, 202-418-5000, Office of the
General Counsel, Commodity Futures Trading Commission, Three Lafayette
Centre, 1155 21st Street NW, Washington, DC 20581; Aaron Levine,
<a href="/cdn-cgi/l/email-protection#26474a43504f4843664540524508414950"><span class="__cf_email__" data-cfemail="a7c6cbc2d1cec9c2e7c4c1d3c489c0c8d1">[email protected]</span></a>, 646-746-9700, Office of the General Counsel,
Commodity Futures Trading Commission, 290 Broadway, New York, NY 10007.
SUPPLEMENTARY INFORMATION:
Table of Contents
I. Introduction
A. Background
B. Regulatory Background
C. SEF and DCM Statutory and Regulatory Requirements
D. FCM Statutory and Regulatory Requirements
E. DCO Statutory and Regulatory Requirements
F. Current Affiliated Relationships
II. DCM Obligations--Proposed Amendments to Commission Regulations
1.52, 38.604, and 38.606
A. Proposed Amendments to Commission Regulation 1.52--SRO
Surveillance of Financial Requirements for Affiliate FCMs
B. Proposed Amendments to Commission Regulations 38.604 and
38.606--DCM Financial Surveillance of Members and Third-Party
Regulatory Service Providers
III. Exchange-Related Conflicts Mitigation
A. Proposed New Commission Regulations 38.852 and 37.1201--
Conflicts of Interest Involving an Affiliate Market Participant
B. Proposed New Commission Regulations 38.852(b) and (c)--
Prohibition on Affiliate Principal Trading Firms and Conditional
Affiliate Market Maker Exception
C. Proposed New Commission Regulation 38.853--Board Composition,
Regulatory Oversight Committee, and Disciplinary Panels
IV. DCO-Affiliate Clearing Member--Proposed Amendments to Commission
Regulations 39.2, 39.21, and 39.25
A. Background
B. Comments on the Affiliations RFC
C. Identified Concerns
D. Proposed Amendments
E. Statutory Authority
F. Alternatives Considered
G. Request for Comment
V. Public Disclosures by FCMs--Proposed Amendment to Commission
Regulation 1.55
A. Background
B. Comments on the Affiliations RFC
[[Page 50927]]
C. Proposed Amendments
D. Statutory Authority
E. Alternatives Considered
F. Request for Comment
VI. Compliance Responsibility
VII. Related Matters
A. Regulatory Flexibility Act
B. Paperwork Reduction Act
C. Consideration of Costs and Benefits
D. Antitrust Considerations
E. Executive Orders 12866, 13563, and 14192
List of Subjects
I. Introduction
A. Background
The Commission proposes new rules and amendments to its existing
regulations for SEFs, DCMs, DCOs, and FCMs that would further establish
requirements and guidance applicable to those entities' relationships
with certain affiliated entities. Exchanges, DCOs, and intermediaries
are already subject to requirements addressing conflicts of interest,
reporting, and disclosure. However, the Commission preliminarily
believes that the regulated entities would benefit from new regulations
and amendments to increase the detail and specificity of the existing
regulations in order to mitigate potential risks particularly given the
increasing number of affiliate relationships among market participants.
In 2023, Commission staff published a request for comment in part
in response to growing interest among market participants in affiliated
structures (the ``Affiliations RFC'').\1\ From the comments it
received, and through its experience, the Commission has observed
applicants for SEF, DCM, and DCO registration or designation and
existing registered entities changing the traditional market structure
of a separately-owned and independently operated exchange, market
participant, and clearinghouse to an ``affiliated'' market structure in
which these distinct entities share common ownership. Some forms of
affiliate relationships have a long history, such as those between DCMs
and DCOs, while other forms of affiliate relationships, such as those
between a DCM and an affiliate market maker, are comparatively new.
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\1\ See CFTC Staff of the Divisions of Market Oversight,
Clearing and Risk, and Market Participants, ``Request for Comment on
the Impact of Affiliations on Certain CFTC-Regulated Entities''
(Jun. 27, 2023) (``Affiliations RFC'').
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The Commission preliminarily believes that this market structure
may provide benefits to the derivatives markets and market
participants. In this regard, the Commission believes that facilitating
market structure innovation and competition, subject to appropriate
safeguards, advances the Commission's mission of promoting the
integrity, resilience, and vibrancy of the U.S. derivatives markets.\2\
The Commission recognizes, however, that there may be risks as well,
including to unaffiliated market participants such as retail customers.
One risk that this Proposal seeks to address is conflicts of interest
arising in an affiliated market structure. For example, a situation in
which an exchange and a market participant (such as a market maker) on
that exchange share common ownership presents conflict of interest
concerns regarding an exchange's enforcement of its rules for the
affiliated participant. Similar concerns arise regarding the oversight
and enforcement functions of a clearinghouse that shares common
ownership with a clearing member. This Proposal would require
registered entities to have procedures in place to mitigate such
potential conflicts of interest, including specifically regarding
systems, personnel, and office space, and provides guidance regarding
appropriate practices in connection with such procedures. This Proposal
also would subject DCMs with affiliate principal trading firms to
additional requirements, given the heightened conflicts of interest
concerns that may arise in that context.
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\2\ CFTC Mission Statement, https://www.cftc.gov/About/
AboutTheCommission#:~:text=The%20mission%20of%20the%20C.
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The financial oversight of FCMs is governed by the longstanding
principle of self-regulation, in which DCMs and registered futures
associations are responsible, in their capacity as SROs, to adopt
financial and related reporting requirements for member FCMs, and to
periodically examine FCMs for compliance with such requirements. The
Commission also permits two or more SROs to enter into an agreement to
assign to one of the SROs (the DSRO) the function of examining member
FCMs for compliance with minimum capital and related financial
reporting obligations. Given the inherent potential conflict of
interest that exists when an SRO or a DSRO surveils their affiliate
FCM, the Proposal comprises requirements designed to minimize potential
risks resulting from the conflict, including a requirement for an SRO
with an affiliate FCM to establish a separate reporting line for staff
performing self-regulatory functions and a prohibition against an SRO
acting as the DSRO for its affiliate FCM. The Proposal also strengthens
the disclosure requirements imposed on FCMs pursuant to Regulation 1.55
with respect to such affiliate relationships. Additionally, the
Proposal would allow an FCM to select its DSRO, subject to certain
requirements.
In this Proposal, the Commission is drawing on comments from the
Commission staff-issued Affiliations RFC, Commission staff's other
discussions with market participants (including DCMs, DCOs, FCMs, and
market makers), Commission staff's experience in conducting its routine
oversight of SEFs, DCMs, and DCOs, including SEF application
registration reviews, DCM designation application reviews, SEF and DCM
rule enforcement reviews, DCO applications for registration, and
regular engagement with SEFs, DCMs, and DCOs. The Commission has also
consulted with DCMs and the National Futures Association (``NFA''),\3\
in their role as SROs and DSROs, and reviewed market practices
concerning affiliate relationships between DCMs and FCMs.
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\3\ NFA is currently the only registered futures association.
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In developing the Proposal, the Commission has consulted with the
Securities and Exchange Commission (``SEC'') and the prudential
regulators, pursuant to section 712(a)(1) of the Dodd-Frank Act.\4\
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\4\ 15 U.S.C. 8302 (``Before commencing any rulemaking or
issuing an order regarding swaps, swap dealers, major swap
participants, swap data repositories, derivatives clearing
organizations with regard to swaps, persons associated with a swap
dealer or major swap participant, eligible contract participants, or
swap execution facilities pursuant to this subtitle, the Commodity
Futures Trading Commission shall consult and coordinate to the
extent possible with the Securities and Exchange Commission and the
prudential regulators for the purposes of assuring regulatory
consistency and comparability, to the extent possible.'').
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B. Regulatory Background
Section 8a(5) of the Commodity Exchange Act (``CEA'' or the
``Act'') \5\ authorizes the Commission ``to make and promulgate such
rules and regulation as, in the judgment of the Commission, are
reasonably necessary to effectuate any of the provisions, or to
accomplish any of the purposes, of'' the CEA. The Commission
preliminarily believes that the Proposal is reasonably necessary to
accomplish the purposes of section 3(b) of the CEA which states ``[i]t
is the purpose of this Act to serve the public interests . . . through
a system of effective self-regulation of trading facilities, clearing
systems [and] market participants . . . .'' \6\ This
[[Page 50928]]
Proposal addresses critical issues that the Commission believes are
necessary for effective self-regulation that have been raised because
of affiliations between trading facilities and/or clearing systems and
participants in those facilities and/or systems. This Proposal sets out
rules and guidance for SEFs and DCMs, which are trading facilities,
DCOs, which are clearing systems, and FCMs, which are market
participants. In each instance, SEFs, DCMs, and DCOs have self-
regulatory obligations.\7\ An affiliation between a SEF, DCM, or DCO
and an FCM or other market participant raises questions about the (a)
quality of oversight of self-regulation, (b) discretionary decision-
making by the DCO, DCM, or SEF, and (c) potential conflicts of
interest. The Commission has observed increasing numbers of
affiliations in ``affiliated'' corporate structures of SEFs, DCMs, and
DCOs, so the Commission believes it is reasonably necessary to issue
this Proposal to specifically address these market structures.
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\5\ 7 U.S.C. 12a(5).
\6\ 7 U.S.C. 5(b) (emphasis added). As noted above, section
8a(5) of the CEA authorizes the Commission to make and promulgate
such rules and regulation as in the Commission's judgment are
reasonably necessary to effectuate any of the provisions, or to
accomplish any of the purposes, of the CEA. The Commission is of the
view that the best interpretation of section 8a(5) of the CEA is
that it delegates to the Commission discretionary authority to
establish the proposed rules.
\7\ See 17 CFR 1.3 (definition of ``self-regulatory
organization'') and CEA sections 5b(c)(2)(A)-(R), 7 U.S.C. 7a-
1(c)(2)(A)-(R) (DCO Core Principles). Also, for purposes of section
1.52 of the CEA, only DCMs and registered futures associations are
included in the definition of SRO because only DCMs and registered
futures associations are required to adopt minimum capital and
financial reporting requirements for their member firms. SEFs, DCMs,
and DCOs are all subject to requirements under the Act and the
Commission's regulations to supervise the conduct of their members
and participants.
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In addition, the Commission, pursuant to section 8a(5) of the CEA,
is proposing rules applicable to SEFs, DCMs, DCOs, and FCMs, in order
to effectuate the relevant Core Principles and/or provisions of the
CEA, as appropriate, for each particular entity. For SEFs, the
Commission believes that the Proposal is reasonably necessary to
effectuate the Core Principles set out in section 5h(f)(2) (impartial
access),\8\ section 5h(f)(10) (reporting),\9\ 5h(f)(12) (conflicts of
interest),\10\ and section 5h(f)(13) (adequate financial, operational,
and managerial resources).\11\
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\8\ CEA 5h(f)(2), 7 U.S.C. 7b-3(f)(2).
\9\ CEA 5h(f)(10), 7 U.S.C. 7b-3(f)(10).
\10\ CEA 5h(f)(12), 7 U.S.C. 7b-3(f)(12).
\11\ CEA 5h(f)(13), 7 U.S.C. 7b-3(f)(13).
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For DCMs, the Commission believes that the Proposal is reasonably
necessary to effectuate the Core Principles in section 5(d)(2) (access
requirements),\12\ section 5(d)(11) (rules to ensure the financial
integrity of any FCM and the protection of customer funds),\13\ section
5(d)(12) (promote fair and equitable trading),\14\ section 5d(16)
(conflicts of interest),\15\ and section 5(d)(21) (adequate financial,
operational and managerial resources).\16\
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\12\ CEA 5(d)(2), 7 U.S.C. 7(d)(2).
\13\ CEA 5(d)(11), 7 U.S.C. 7(d)(11).
\14\ CEA 5(d)(12), 7 U.S.C. 7(d)(12).
\15\ CEA 5(d)(16), 7 U.S.C. 7(d)(16).
\16\ CEA 5(d)(21), 7 U.S.C. 7(d)(21).
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For DCOs, the Commission believes that the Proposal is reasonably
necessary to effectuate the Core Principles in CEA section 5b(c)(2)(C)
(participant and product eligibility),\17\ section 5b(c)(2)(D) (risk
management),\18\ section 5b(c)(2)(J) (reporting),\19\ section
5b(c)(2)(L) (public information),\20\ and section 5b(c)(2)(P)
(conflicts of interest).\21\
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\17\ CEA 5b(c)(2)(C), 7 U.S.C. 7a-1(c)(2)(C).
\18\ CEA 5b(c)(2)(D), 7 U.S.C. 7a-1(c)(2)(D).
\19\ CEA 5b(c)(2)(J), 7 U.S.C. 7a-1(c)(2)(J).
\20\ CEA 5b(c)(2)(L), 7 U.S.C. 7a-1(c)(2)(L).
\21\ CEA 5b(c)(2)(P), 7 U.S.C. 7a-1(c)(2)(P).
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With respect to FCMs, the Proposal includes rules for those FCMs
that are affiliated with an exchange or DCO. The Commission believes
that these rules are reasonably necessary to effectuate Section 4f(b)
(Commission authority to adopt regulations imposing minimum financial
requirements).\22\
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\22\ CEA 4f(b), 7 U.S.C. 6f(b).
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Accordingly, the Commission believes that the amendments in this
Proposal relating to affiliations of SEFs, DCOs, DCMs, and FCMs are
reasonably necessary to implement the purposes and provisions of the
CEA. The application of these statutory provisions for each proposed
amendment to current Commission regulations is described in detail
below.
C. SEF and DCM Statutory and Regulatory Requirements
The Core Principles in parts 37 and 38, and corresponding
regulations, are relevant to the proposed regulations in this Proposal.
Their applicability is addressed in more detail with respect to each
proposed regulation. Below is a summary of relevant Core Principles and
regulations.
SEF Core Principle 12 requires a SEF to (a) establish and enforce
rules to minimize conflicts of interest in its decision-making process
and (b) establish a process for resolving the conflicts of
interest.\23\ DCM Core Principle 16 likewise provides that a board of
trade shall establish and enforce rules: (a) to minimize conflicts of
interest in the decision-making process of the contract market and (b)
to establish a process for resolving conflicts of interest described in
paragraph (a) of this section.\24\ Commission Regulation 38.851 refers
to the guidance and/or Acceptable Practices in appendix B of part 38 to
advise on how DCMs may comply with the Core Principle and implementing
regulations.
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\23\ 17 CFR 37.1200.
\24\ 17 CFR 38.850.
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The part 38 Guidance to Core Principle 16 provides that the means
to address conflicts of interest in the DCM's decision-making should
include methods to ascertain the presence of conflicts of interest and
to make decisions in the event of such a conflict.\25\ In addition, the
DCM should provide for appropriate limitations on the use or disclosure
of material non-public information gained through the performance of
official duties by board members, committee members, and contract
market employees or gained through an ownership interest in the
contract market.\26\
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\25\ See 17 CFR part 38, app. B--Guidance on, and Acceptable
Practices in, Compliance with Core Principles, Core Principle 16,
sec. (B)(a).
\26\ See id.
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The Core Principle 16 Acceptable Practices provide additional
details to assist DCMs in demonstrating compliance with the Core
Principle by outlining specific compliance practices. Among other
things, they provide that DCMs ``bear special responsibility to
regulate effectively, impartially, and with due consideration of the
public interest, as provided for in section 3 of the Act.'' \27\ The
Acceptable Practices also state that DCMs ``should be particularly
vigilant for such conflicts between and among any of their self-
regulatory responsibilities, their commercial interests, and the
several interests of their management, members, owners, customers and
market participants, other industry participants, and other
constituencies.'' \28\ Additionally, the Acceptable Practices provide
several key provisions relating to board composition, the regulatory
oversight committee (``ROC''), and disciplinary panels.\29\
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\27\ See id.
\28\ See id.
\29\ See id.
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The Commission's parts 37 and 38 regulations also provide impartial
access requirements, which highlight the importance of a SEF's and a
DCM's responsibility to treat its market participants fairly.
Commission Regulation 37.202 requires that a SEF shall provide any
eligible contract participant (``ECP'') and any independent software
vendor with impartial access to its market(s) and market services,
including any indicative quote screens or any similar
[[Page 50929]]
pricing data displays, provided that the facility has: (1) criteria
governing such access that are impartial, transparent, and applied in a
fair and nondiscriminatory manner; (2) procedures whereby ECPs provide
the SEF with written or electronic confirmation of their status as
ECPs; and (3) comparable fee structures for ECPs and independent
software vendors receiving comparable access to, or services from, the
SEF.\30\
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\30\ 17 CFR 37.202.
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Similarly, Commission Regulation 38.151 provides that a DCM must
provide its members, persons with trading privileges, and independent
software vendors with impartial access to its markets and services,
including: (1) access criteria that are impartial, transparent, and
applied in a non-discriminatory manner; and (2) comparable fee
structures for members, persons with trading privileges and independent
software vendors receiving equal access to, or services from, the
DCM.\31\
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\31\ 17 CFR 38.151.
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Parts 37 and 38 of the Commission's regulations also require SEFs
and DCMs to maintain adequate financial, operational, and managerial
resources. SEF Core Principle 13 (Financial Resources) provides that a
SEF shall have adequate financial, operational, and managerial
resources to discharge each responsibility of the SEF.\32\ It further
provides that the financial resources of a SEF shall be considered to
be adequate if the value of the financial resources exceeds the total
amount that would enable the SEF to cover the operating costs of the
SEF for a one-year period, as calculated on a rolling basis.\33\ DCM
Core Principle 21 (Financial Resources) provides similar requirements,
requiring that a DCM shall have adequate financial, operational, and
managerial resources to discharge each of its responsibilities.\34\ In
addition, a DCM's financial resources shall be considered to be
adequate if the value of the financial resources exceeds the total
amount that would enable the contract market to cover the operating
costs of the contract market for a 1-year period, as calculated on a
rolling basis.\35\
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\32\ 17 CFR 37.1300(a).
\33\ 17 CFR 37.1300(b).
\34\ 17 CFR 38.1100.
\35\ 17 CFR 38.1100(b).
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Finally, pursuant to DCM Core Principle 11 (Financial Integrity of
Transactions), DCMs are required to establish and enforce rules to: (a)
ensure the financial integrity of transactions entered into on or
through the facilities of the contract market and (b) ensure the
financial integrity of any FCM or IB.\36\ In this connection,
Commission Regulation 38.602 provides that a DCM must provide for the
financial integrity of its transactions by establishing and maintaining
appropriate minimum financial standards for its members and non-
intermediated market participants.\37\ In addition, Commission
Regulation 38.604 provides that a DCM must monitor its members'
compliance with the DCM's minimum financial standards, and therefore,
must routinely receive and promptly review financial and related
information from its members, as well as continuously monitor the
positions of its members and their customers.\38\
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\36\ 17 CFR 38.600.
\37\ 17 CFR 38.602.
\38\ 17 CFR 38.604.
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D. FCM Statutory and Regulatory Requirements
One of the chief functions of DCMs and registered futures
associations is the financial oversight of their member FCMs. FCMs
perform critical functions to facilitate the efficient operation of
Commission-regulated exchange-traded derivatives markets.\39\ In
addition to trading for their own accounts and carrying the accounts of
their affiliates, FCMs act as market intermediaries, standing between
customers trading futures and swaps on one side and DCMs and DCOs on
the other side. As market intermediaries, FCMs carry customer accounts
and hold customer funds to margin futures and cleared swap
transactions. Additionally, FCMs fulfill daily settlement obligations
on behalf of customers by posting sufficient funds to DCOs to support
their customers' futures and swap positions, including paying mark-to-
market losses associated with such positions. FCMs are also essential
to the efficient operation of Commission-regulated markets in that they
guarantee each customer's financial performance for futures and swap
positions to DCOs by agreeing to use their own financial resources to
cover any shortfall resulting from a customer default.\40\
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\39\ An FCM is defined in 17 CFR 1.3, in relevant part, as: (i)
an entity that is engaged in soliciting or accepting orders for the
purchase or sale of any commodity for future delivery or a swap and,
in connection with the solicitation and acceptance of such orders,
accepts money, securities or property (or extends credit in lieu
thereof) to margin, guarantee or secure futures or swaps
transactions, or (ii) an entity registered as an FCM.
\40\ 17 CFR 39.16(c)(2)(vi).
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The Act established the critical role performed by FCMs and
authorizes the Commission to adopt regulations to help ensure that they
maintain the necessary financial resources to properly perform such
duties. Section 4f(b) of the CEA authorizes the Commission to adopt
regulations imposing minimum capital and financial reporting
requirements on FCMs to help ensure that they maintain adequate
financial resources to fulfill their obligations.\41\ Under this
statutory authorization, the Commission adopted regulations requiring
FCMs to, among other requirements, maintain a minimum level of
regulatory capital,\42\ segregate customer funds from their own funds
in specially designated customer accounts,\43\ and maintain appropriate
risk management programs to monitor and manage the risks associated
with their activities as FCMs.\44\ FCMs are also required to provide a
notice if they experience certain events that could impact their
financial condition.\45\ In addition, FCMs are bound by specific public
disclosure requirements to promote the protection of customer funds and
to minimize the systemic risk posed by certain actions of market
participants.\46\
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\41\ Section 4f(b) of the Act provides, in relevant part, that
no person shall be registered as an FCM unless such person meets the
minimum financial requirements that the Commission may prescribe by
regulation as necessary to insure such person meets its obligations
as a registrant, and each person registered as an FCM shall at all
times continue to meet such prescribed minimum financial
requirements. 7 U.S.C. 6f(b).
\42\ 17 CFR 1.17.
\43\ 17 CFR 1.20; 17 CFR 22.2; 17 CFR 30.7.
\44\ 17 CFR 1.11. FCMs are also subject to a requirement to
address certain conflicts of interest within the firm. Specifically,
pursuant to section 4d(c) of the Act, the Commission adopted
Commission Regulation 1.71, which requires FCMs to adopt and
implement written conflicts of interest policies and procedures. 7
U.S.C. 6d(c) and 17 CFR 1.71. Commission Regulation 1.71 focuses on
the potential conflicts that could arise between individuals
conducting research and analysis, on the one hand, and individuals
involved in trading and clearing, on the other hand. The regulation,
however, does not more broadly address the sharing of non-public
information between FCMs and their affiliates. Id.; see also Swap
Dealer and Major Swap Participant Recordkeeping, Reporting, and
Duties Rules; Futures Commission Merchant and Introducing Broker
Conflicts of Interest Rules; and Chief Compliance Officer Rules for
Swap Dealers, Major Swap Participants, and Futures Commission
Merchants, 77 FR 20120 at 20144-20146 (Apr. 3, 2012) and
Implementation of Conflicts of Interest Policies and Procedures by
Futures Commission Merchants and Introducing Brokers, 75 FR 70152
(Nov. 17, 2010).
\45\ 17 CFR 1.12.
\46\ 17 CFR 1.55.
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The financial oversight of FCMs and other market intermediaries is
primarily performed by the respective DCMs and registered futures
associations \47\ in their role as SROs.\48\ In 2000, Congress
[[Page 50930]]
affirmed this regulatory structure of industry self-regulation by
amending section 3 of the CEA to state: ``It is the purpose of this Act
to serve the public interests . . . through a system of effective self-
regulation of trading facilities, clearing systems, market
participants, and market professionals under the oversight of the
Commission.'' \49\ Pursuant to such objective, the Act, as further
implemented through Commission regulations, requires SROs to adopt
financial and related reporting requirements for member FCMs, and to
periodically examine FCMs for compliance with such requirements.
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\47\ NFA's financial requirements for FCMs are available at its
website, <a href="http://www.nfa.futures.org">www.nfa.futures.org</a>.
\48\ Section 3(b) of the Act. Commission Regulation 1.3 defines
an SRO as a DCM, a registered futures association, or a SEF. For
purposes of Commission Regulation 1.52, however, SEFs are excluded
from the SRO definition. SEFs are not required to adopt minimum
capital and financial reporting requirements for their member firms
and, as a result, the oversight program required under Commission
Regulation 1.52 is not applicable to SEFs. With respect to the SEF's
obligation to monitor its members for financial soundness, the
obligation extends only to a requirement to ensure that the members
continue to qualify as ECPs as defined in section 1a(18) of the Act.
See 78 FR 68506 at 68560.
\49\ Commodity Futures Modernization Act of 2000, Sec. 108,
Public Law 106-554, 114 Stat. 2763 (2000).
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Specifically, section 17(p) of the CEA requires a registered
futures association to establish and submit for Commission approval
rules imposing minimum capital, segregation, and other financial
requirements applicable to its members for which such requirements are
imposed by the Commission, which must be at least as stringent as those
set by the Act or Commission regulations.\50\ Section 17(p) further
provides that a registered futures association must implement a program
to audit and enforce compliance by its members with the registered
futures association's minimum financial requirements.\51\
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\50\ CEA 17(p)(2), 7 U.S.C. 21(p)(2).
\51\ See Id.
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Similarly, section 5(d)(11)(B) of the Act and Commission Regulation
38.600 require, in relevant part, each DCM to implement rules to ensure
the financial integrity of any member FCM and the protection of
customer funds.\52\ Pursuant to Commission Regulation 38.602, DCMs must
further establish and maintain appropriate minimum financial standards
for its members.\53\ Additionally, Commission Regulations 38.604 and
38.605 require each DCM to be responsible for the financial
surveillance of its FCM members. As discussed above, Commission
Regulation 38.604 requires each DCM to monitor the FCM members'
compliance with the DCM's minimum financial standards.\54\ To that
effect, a DCM must review financial and related information from its
FCM members and engage in intra-day surveillance by monitoring the
positions of its FCM members and their customers.\55\ In connection
with the intra-day surveillance requirement, Commission Regulation
38.604 specifies that each DCM must survey the obligations of each FCM
created by its customers' positions and compare such obligations to the
financial resources of the FCM.\56\ Pursuant to Commission Regulation
38.604(c), if a DCM, in its professional judgement, determines that the
obligations of an FCM member are excessive, the DCM must take
appropriate action to protect customer funds, including by contacting
the FCM or the FCM's DSRO.\57\ Commission Regulation 38.605 requires a
DCM, in its role as an SRO, to comply with the standards of Commission
Regulation 1.52 to ensure the financial integrity of its member FCMs by
establishing and carrying out a financial surveillance program.\58\ As
further discussed below, Commission Regulation 1.52 sets forth the
required elements of SRO supervisory programs and permits one or more
SROs to establish, subject to Commission approval, a Joint Audit Plan
to provide for the SRO supervision of members of more than one SRO.\59\
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\52\ CEA 5(d)(11)(B), 7 U.S.C. 7(d)(11)(B); 17 CFR 38.600.
\53\ 17 CFR 38.602.
\54\ 17 CFR 38.604.
\55\ Id. Specifically, Commission Regulation 38.604 further
provides that a DCM must: (a) continually surveil the obligations of
each FCM created by the positions of its customers, (b) compare
those obligations to the resources of the FCM, and (c) take
appropriate steps to use this information to protect customer funds.
\56\ 17 CFR 38.604(b).
\57\ Id. See also Core Principles and Other Requirements for
Designated Contract Markets, 77 FR 36612 at 36647 (Jun. 19, 2012).
\58\ 17 CFR 38.605. A DCM's financial surveillance program must
comply with Commission Regulation 1.52, which is discussed below.
\59\ 17 CFR 1.52.
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Pursuant to Commission Regulation 38.606, DCMs may, but are not
obligated to, satisfy their financial surveillance responsibilities
under Commission Regulations 38.604 and 38.605 by designating a
regulatory service provider (``RSP'') to conduct such financial
surveillance, provided that the RSP is a registered futures association
or a registered entity,\60\ the DCM ensures that the RSP has the
capacity and resources to conduct the necessary financial surveillance
and, notwithstanding the use of an RSP, the DCM remains responsible for
compliance with its financial surveillance obligations.\61\ Pursuant to
Commission Regulation 38.606, the appointment of an RSP must be
governed by a written agreement that specifically documents the
services to be performed as well as the capacity and resources of the
RSP with respect to the services performed.\62\
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\60\ 17 CFR 1.3.
\61\ 17 CFR 38.604 and 38.605. The term ``registered entity'' is
defined in section 1a(40) of the Act and includes DCMs, SEFs, and
DCOs. 7 U.S.C. 1a.
\62\ 17 CFR 38.606.
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Consistent with the CEA's purpose of serving the public interest
through a system of effective self-regulation, Commission Regulation
1.52 establishes the minimum standards that all SROs must satisfy in
conducting FCM financial oversight. Commission Regulation 1.52 directs
SROs to adopt rules prescribing minimum financial and related financial
reporting requirements for member FCMs that are the same as, or more
stringent, than the Commission's requirements.\63\ Commission
Regulation 1.52 also requires SROs to establish and operate a
supervisory program that includes examination of member FCMs to assess
whether such FCMs are in compliance with SRO rules and Commission
regulations governing, among other requirements, minimum net capital
and related financial requirements, the appropriate segregation of
customer funds, and financial reporting requirements.\64\ As part of
the supervisory program, an SRO must perform ongoing surveillance of
FCMs through, among other actions, review and analysis of financial
statements and regulatory notices, and must conduct routine periodic
on-site examinations.\65\
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\63\ 17 CFR 1.52(b)(1). NFA's FCM capital and financial
reporting requirements are set forth in section 1 of the NFA's
Financial Requirements section of its rulebook and may be accessed
at NFA's website: <a href="https://www.nfa.futures.org/rulebook/index.aspx">https://www.nfa.futures.org/rulebook/index.aspx</a>.
\64\ 17 CFR 1.52(c)(1).
\65\ 17 CFR 1.52(c)(1)(ii) and 17 CFR 1.52(c)(1)(iv)(A).
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Commission Regulation 1.52(d) also permits two or more SROs to
enter into an agreement to establish a Joint Audit Plan for the purpose
of assigning to one of the SROs (the ``DSRO'') of the Joint Audit Plan
the function of examining member FCMs for compliance with minimum
capital and related financial reporting obligations.\66\ The audit plan
[[Page 50931]]
must be submitted to the Commission for approval.\67\ Currently all
active SROs are members of a Joint Audit Plan that was approved by the
Commission on March 18, 2009.\68\ The delegation of primary
responsibility for monitoring and examining the financial condition of
FCMs that are members of two or more SROs to a DSRO under the Joint
Audit Plan allows for a more efficient use of SRO resources, while also
reducing burdens that would otherwise be imposed on an FCM from
duplicative supervision, including periodic on-site examinations from
multiple SROs.\69\
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\66\ The purpose of delegation of financial surveillance to
DSROs is to promote an effective and efficient market through
applying financial standards for FCMs that are often members of
multiple DCMs. The Commission has previously noted the
inefficiencies that may be caused by duplicative financial
surveillance amongst different SROs over the same FCM, stating that
``it may be advantageous for the contract markets to engage in a
joint enforcement or audit program to monitor compliance with such
uniform minimum financial and related reporting requirements.''
Futures Commission Merchants Financial and Reporting Requirements,
41 FR 45705 at 45706 (Oct. 15, 1976). In addition, the Commission,
in proposing to authorize the delegation of financial surveillance
responsibilities to DSROs, highlighted the efficiencies of such
delegation, noting that it would benefit both FCMs and SROs. Minimum
Financial Requirements, 42 FR 39032 at 39037 (Aug. 1, 1977).
\67\ 17 CFR 1.52(d)(3) and 1.52(h).
\68\ The original signatories of the Joint Audit Plan approved
on March 18, 2009 are as follows: Board of Trade of the City of
Chicago, Inc.; Board of Trade of Kansas City; CBOE Futures Exchange,
LLC; Chicago Climate Futures Exchange, L.L.C.; Chicago Mercantile
Exchange Inc.; Commodity Exchange, Inc.; ELX Futures, L.P.;
HedgeStreet, Inc.; ICE Futures U.S., Inc.; INET Futures Exchange,
L.L.C.; Minneapolis Grain Exchange; NASDAQ OMX Futures Exchange;
NFA; New York Mercantile Exchange, Inc.; NYSE Liffe US, L.L.C.; and
One Chicago, L.L.C. The Joint Audit Plan is available at <a href="https://www.cftc.gov/idc/groups/public/@lrfederalregister/documents/frcomment/08-007b001.pdf">https://www.cftc.gov/idc/groups/public/@lrfederalregister/documents/frcomment/08-007b001.pdf</a>. The current signatories (DCMs, and one
registered futures association) are listed on the JAC website,
available at: <a href="http://www.jacfutures.com/jac/default.aspx">http://www.jacfutures.com/jac/default.aspx</a>.
\69\ See Financial Surveillance Examination Program Requirements
for Self-Regulatory Organizations, 84 FR 12882 at 12883 (Apr. 3,
2019).
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Both SROs and DSROs are required to maintain adequate levels and
independence of examination staff.\70\ In this regard, Commission
Regulations 1.52(c) and 1.52(d), which govern SROs and DSROs
respectively, contain identical language that requires SROs and DSROs
to maintain staff of an adequate size, training, and experience to
effectively implement a supervisory program.\71\ In addition, staff
``must maintain independent judgment and its actions must not impair
its independence nor appear to impair its independence in matters
related to the supervisory program.'' \72\ This language is consistent
with the longstanding guidance to SROs contained in the Financial and
Segregation Interpretation No. 4-1 (Advisory Interpretation for Self-
Regulatory Organization Surveillance Over Members' Compliance with
Minimum Financial, Segregation, Reporting, and Related Recordkeeping
Requirements), and Addendums A and B to Financial and Segregation
Interpretation No. 4-1, and Financial and Segregation Interpretation
No. 4-2 (Risk-Based Auditing), which guided the practices of members of
the Joint Audit Committee (``JAC'') \73\ voluntarily operating a Joint
Audit Plan that had since been approved by the Commission.\74\
Commission Regulation 1.52 also provides that the members of the JAC
must establish, operate and maintain a joint audit program, meeting the
requirements specified in Commission Regulation 1.52(d)(2)(ii) (``Joint
Audit Program'').\75\ The Joint Audit Program sets forth the policies
and procedures to be followed by each DSRO in the conduct of
examinations and financial reviews of FCMs.\76\
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\70\ 17 CFR 1.52(c)(1)(i) and 1.52(d)(2)(ii)(C).
\71\ Id.
\72\ Id.
\73\ The JAC is a voluntary, cooperative organization comprised
of representatives of the financial surveillance staff of DCMs and
NFA, formed for the purpose of coordinating the monitoring and
examination of common FCM members of such entities.
\74\ See Joint Audit Committee Operating Agreement, 73 FR 52832
(Sept. 11, 2008) (requesting comments prior to the Commission's
approval of the most recent JAC agreement, which was granted on Mar.
18, 2009).
\75\ Commission staff letters are available on the Commission's
website, <a href="http://www.cftc.gov">www.cftc.gov</a>.
\76\ 17 CFR 1.52(d)(2)(i). See also Enhancing Protections
Afforded Customers and Customer Funds Held by Futures Commission
Merchants and Derivatives Clearing Organizations, 78 FR 68506 at
68580 (Nov. 14, 2013) and Enhancing Protections Afforded Customers
and Customer Funds Held by Futures Commission Merchants and
Derivatives Clearing Organizations, 77 FR 67866 at 67892 (Nov. 14,
2012).
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E. DCO Statutory and Regulatory Requirements
Section 5b(c)(2) of the CEA sets forth Core Principles with which a
DCO must comply to be registered and to maintain registration as a
DCO,\77\ and part 39 of the Commission's regulations implements the DCO
Core Principles. Under the DCO Core Principles and related Commission
regulations, a DCO has extensive responsibilities to manage its risks
and supervise the conduct of its members and participants. A DCO's
affiliation with a clearing member may raise questions regarding the
impartiality with which these responsibilities will be carried out. For
example, an affiliation between a clearing member and a DCO may
incentivize the DCO to act with partiality in favor of its affiliate
when making decisions regarding the treatment of non-public information
or the adequacy of applicable financial resources, with possible anti-
competitive effects.
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\77\ CEA 5b(c)(2), 7 U.S.C. 7a-1(c)(2).
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Several existing DCO Core Principles and related regulations target
potential risks posed by clearing members generally and partially
address some of the concerns and risks raised by affiliated
relationships in the clearing context. For example, Core Principle C
(Participant and Product Eligibility) requires a DCO to: (1) establish
appropriate admission and continuing eligibility standards (including
sufficient financial resources and operational capacity to meet
obligations arising from participation in the DCO) for members of, and
participants in, the DCO; (2) establish appropriate standards for
determining eligibility of agreements, contracts, or transactions
submitted to the DCO for clearing; and (3) establish and implement
procedures to verify, on an ongoing basis, compliance with the DCO's
participation and membership requirements, which must be objective, be
publicly disclosed, and permit fair and open access. Commission
Regulation 39.12 implements Core Principle C.
Core Principle D (Risk Management) requires a DCO to, among other
things: (1) measure and monitor its credit exposures to each clearing
member daily; (2) through margin requirements and other risk control
mechanisms, limit its exposure to potential losses from a clearing
member default; and (3) require sufficient margin from its clearing
members to cover potential exposures in normal market conditions.
Commission Regulation 39.13 implements Core Principle D and, among
other things, requires that a DCO: (1) have an appropriate risk
management framework that, at a minimum, clearly identifies and
documents the range of risks to which the DCO is exposed, addresses the
monitoring and management of the entirety of those risks, and provides
a mechanism for internal audits; (2) measure and monitor its credit
exposure to each clearing member on a daily basis; (3) limit its
exposure to potential losses from defaults by its clearing members; and
(4) have rules that require its clearing members to maintain current
written risk management policies and procedures, which address the
risks that such clearing members may pose to the DCO.
Furthermore, Core Principle L (Public Information) requires a DCO
to provide market participants with sufficient information to enable
them to identify and evaluate accurately the risks and costs associated
with using the DCO's services, and to publicly disclose, among other
items, any information relevant to participation in the DCO's
settlement and clearing activities. Commission Regulation 39.21
implements Core Principle L and, among other things, requires a DCO to
[[Page 50932]]
make certain information readily available to the general public by
posting it on its website. Core Principle N (Antitrust Considerations)
requires a DCO to avoid, unless necessary or appropriate to achieve the
purposes of the CEA, adopting any rule or taking any action that
results in any unreasonable restraint of trade, or imposing any
material anticompetitive burden. Commission Regulation 39.23 codifies
Core Principle N. Core Principle P (Conflicts of Interest) requires a
DCO to establish and enforce rules to minimize conflicts of interest in
the decision-making process of the DCO, and establish a process for
resolving such conflicts of interest. Commission Regulation 39.25
implements Core Principle P and further requires the DCO to describe
procedures for identifying, addressing, and managing conflicts of
interest involving members of the board of directors.
F. Current Affiliated Relationships
i. Current SEF and DCM Affiliated Relationships
Certain SEFs and DCMs have affiliated relationships, including with
entities that trade or facilitate trades on their own markets. The
Commission notes that there are 20 SEFs currently registered with the
Commission. Some of these SEFs have affiliated relationships with
market participants, such as IBs and CTAs, that execute, introduce, or
otherwise facilitate trades on the SEFs. Similarly, there are 27 DCMs
currently designated by the Commission. The Commission is aware that
certain DCMs have affiliated relationships including with market
makers, liquidity providers, FCMs, and IBs that execute, introduce,
intermediate, or otherwise facilitate trades on the DCMs.
The Commission acknowledges that some SEFs and DCMs already have
publicly available rules and disclosures regarding their affiliate
relationships. For example, certain SEFs acknowledge affiliate
relationships in their rulebooks. Among other things, some DCM
rulebooks provide conditions on affiliate participation, including that
the affiliate does not have access to the DCM's material non-public
information, that the DCM maintains operational independence from the
affiliate, and that the affiliate will not receive preferential
treatment. Some DCMs also provide website disclosures that identify the
affiliated market participant.
Finally, as discussed above, DCMs have self-regulatory
responsibilities with respect to their members. In this regard, while
Commission Regulation 1.52 does not expressly prohibit an SRO from
acting as a DSRO for its affiliated FCM, to date, no DCM with an
affiliate FCM has attempted to act as DSRO for its affiliate FCM.
Instead, CME or NFA, the two DSROs under the current Joint Audit Plan,
perform the periodic financial surveillance of FCMs that are affiliated
with a DCM.\78\
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\78\ A DCM may, in its capacity as an SRO, delegate primary
responsibility for monitoring and examining the financial condition
of member FCMs to a DSRO.
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ii. Current DCO Affiliated Relationships
The Commission has also observed various affiliated relationships
in the clearing context--historically, DCO-exchange affiliations, and
more recently, DCO-clearing member affiliations. There are 24 DCOs
currently registered with the Commission; approximately 5 of those DCOs
have an affiliated clearing member. The Commission notes that the DCOs
with affiliated clearing members have implemented a variety of measures
to address potential concerns regarding these relationships. For
example, certain of these DCOs provide public disclosure of the
affiliated relationships and have rules which prohibit access to non-
public information by the affiliated clearing member.
iii. Current Affiliated Market Makers
The Commission has more recently observed a growing number of
registered entities, including DCMs, that have affiliated market makers
trading on the exchange. There are approximately eight DCMs with
affiliated market makers. The Commission understands that this market
structure is particularly prominent in prediction markets and that the
operators of such markets believe that an affiliated market maker can
be especially important in the creation and maintenance of new markets.
The Commission notes that the exchanges with affiliated market makers
have implemented a variety of measures to address potential concerns
regarding these relationships. For example, these measures include
public disclosure of affiliate relationships, rules to prohibit access
to non-public information by the affiliated market maker, and
adjustments to the traditional price-time priority execution method on
central limit order books.
As the preceding discussion reflects, a number of SEFs, DCMs, and
DCOs have voluntarily adopted measures designed to identify and address
the potential conflicts of interest associated with affiliated
relationships--including public disclosure of affiliations, information
barriers limiting affiliate access to material non-public information,
and requirements that affiliated participants receive no preferential
treatment. The Commission recognizes the value of these measures and
preliminarily believes that they have contributed to the integrity of
these markets and to the confidence of market participants in their
fairness.
At the same time, the Commission preliminarily believes that the
existing framework of voluntary practices, however constructive, is
uneven. As described above and below, various measures have been
adopted to differing degrees and stringency, and they are memorialized
in disparate forms. Because each measure is adopted at the discretion
of the individual entity, it may be narrowed, modified, or
discontinued, and such voluntary undertakings are not uniformly subject
to the Commission's examination and enforcement processes. Market
participants who transact across multiple registered entities therefore
cannot presently rely on a consistent baseline of protections, and the
public may find it difficult to identify, compare, or verify the
safeguards that apply to any particular affiliated relationship.
The Commission preliminarily believes that establishing a
consistent regulatory baseline--one that draws on the sound practices
responsible registered entities have already developed--would promote
the consistency, clarity, and transparency that voluntary measures
alone have not achieved. A codified framework would afford registered
entities and market participants predictable expectations; help ensure
that comparable conflicts are subject to comparable safeguards
regardless of the venue on which they arise; and render those
safeguards durable and subject to Commission oversight. The Commission
preliminarily believes that such a framework would advance the
conflict-of-interest, customer-protection, and market-integrity
objectives reflected in the Core Principles applicable to SEFs, DCMs,
and DCOs discussed above, and that, by doing so, it would reinforce--
rather than displace--the practices registered entities have adopted
and the confidence those practices have helped to build. The proposed
amendments set forth in the following sections are intended to
establish that framework.
[[Page 50933]]
II. DCM Obligations--Proposed Amendments to Commission Regulations
1.52, 38.604, and 38.606
A. Proposed Amendments to Commission Regulation 1.52--SRO Surveillance
of Financial Requirements for Affiliate FCMs
i. Background
DCMs and registered futures associations play a foundational role
in the surveillance of FCM's compliance with Commission and SRO
financial requirements. Section 5(d)(11)(B) of the CEA requires each
DCM to establish and enforce rules to ensure the financial integrity of
any FCM that is a member of the contract market and to ensure the
protection of customer funds.\79\ Section 17(p) of the CEA imposes
parallel obligations on registered futures associations, requiring
NFA--the sole such association--to establish, subject to Commission
approval, minimum financial requirements applicable to its FCM members
and a program to audit and enforce compliance with those
requirements.\80\
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\79\ CEA 5(d)(11)(B), 7 U.S.C. 7(d)(11)(B).
\80\ CEA 17(p), 7 U.S.C. 21(p).
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Commission Regulation 1.52 establishes the minimum standards that
all SROs must satisfy in carrying out their financial supervisory
programs. Commission Regulation 1.52(c) requires each SRO to establish
and operate a supervisory program--including written policies and
procedures--for examining its member FCMs for compliance with
applicable SRO rules and Commission regulations governing minimum net
capital, segregation of customer funds, risk management, financial
reporting, recordkeeping, and sales-practice requirements.\81\
Commission Regulations 1.52(c)(2)(i) and (d)(2)(ii)(C)(1) further
require SROs and DSROs to maintain examination staff of ``adequate
size, training, and experience'' to effectively implement the
supervisory program and the Joint Audit Program, respectively, and
provide that such staff ``must maintain independent judgment'' and that
their ``actions must not impair its independence nor appear to impair
its independence in matters related to'' those programs.\82\ These
existing independence requirements are important, but they do not
specifically address the concerns presented when an SRO has an
affiliate FCM.
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\81\ 17 CFR 1.52(c)(1).
\82\ 17 CFR 1.52(c)(2)(i), (d)(2)(ii)(C)(1).
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As described above, Commission Regulation 1.52 permits two or more
SROs to file with the Commission a plan for delegating to a DSRO, for
any FCM that is a member of more than one such SRO, the function of
monitoring and examining that FCM for compliance with minimum financial
and related reporting requirements.\83\ The SROs participating in such
a plan form a JAC which establishes and operates a Commission-approved
Joint Audit Program and designates the DSRO responsible for the
examination of each FCM.\84\ Under this framework, the assignment of a
particular FCM to a particular DSRO is made by the JAC pursuant to the
plan; the FCM itself plays no role in selecting its DSRO and is
notified of the DSRO to which it has been assigned.\85\
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\83\ 17 CFR 1.52(d)(1).
\84\ 17 CFR 1.52(d)(2)(i).
\85\ See 17 CFR 1.52(i)(2).
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There is currently one Joint Audit Program, which has its origins
in a Joint Audit Agreement entered into in 1984 by a number of futures
exchanges and NFA, under which an FCM that is a member of more than one
SRO is assigned a single DSRO primarily responsible for conducting
periodic financial examinations, the results of which are shared with
the FCM's other SROs.\86\ Although the 1984 Agreement was entered into
by NFA and numerous independent futures exchanges, consolidation among
the exchanges in the intervening decades has substantially reduced the
number of SROs that serve as DSROs.\87\ Today, as a result of the
delegations elected by SROs under the Joint Audit Program, CME serves
as the DSRO for FCMs that are clearing members of CME, and NFA serves
as the DSRO for FCMs that are not CME clearing members.\88\
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\86\ See Joint Audit Plan, 49 FR 28906 (July 17, 1984) (approved
by Commission letter dated Oct. 10, 1984); 73 FR 52832 (Sept. 11,
2008) (describing the 1984 Agreement and a proposed replacement
addressing JAC governance, voting rights, membership criteria,
information-sharing arrangements, and DSRO designation criteria);
and 78 FR 65806 at 68559 (Nov. 14, 2013) (noting that the Commission
approved the Joint Audit Plan on March 18, 2009). The current
version of the Joint Audit Agreement, which has been shared with
Commission staff and is unchanged in all material respects from the
2009 Joint Audit Agreement, was entered into on September 1, 2017
and is available at: <a href="https://www.cftc.gov/media/11981/JACagreement_2017/download">https://www.cftc.gov/media/11981/JACagreement_2017/download</a>.
\87\ The current signatories to the Joint Audit Agreement are
listed on the JAC website, available at: <a href="http://www.jacfutures.com/jac/default.aspx">http://www.jacfutures.com/jac/default.aspx</a>.
\88\ See Financial Surveillance Examination Program Requirements
for Self-Regulatory Organizations, 84 FR 12882, 12884 & n.22 (Apr.
3, 2019).
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In October 2024, NFA approved the FCM application of F&O Financial
LLC, an FCM jointly owned by CME and an unaffiliated firm.\89\
Accordingly, CME--which serves as the DSRO for all FCMs that are
clearing members of CME--is now affiliated with an FCM, while
continuing to serve as the DSRO for FCMs that may compete with that
affiliate.\90\
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\89\ See Press Release, CME Group, CME Group Receives Approval
to Establish Futures Commission Merchant (Oct. 29, 2024), <a href="https://www.cmegroup.com/media-room/press-releases/2024/10/29/cme_group_receivesapprovaltoestablishfuturescommissionmerchant.html">https://www.cmegroup.com/media-room/press-releases/2024/10/29/cme_group_receivesapprovaltoestablishfuturescommissionmerchant.html</a>.
\90\ CME delegated the DSRO function of its affiliated FCM to
NFA to mitigate the potential conflict of interest associated with
acting as DSRO for an affiliated FCM.
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Commission Regulation 1.52(b) requires each SRO to adopt rules
prescribing minimum financial and related reporting requirements for
its member FCMs that are the same as, or more stringent than, the
Commission's requirements.\91\ Commission Regulations 1.52(c) and
1.52(d) require an SRO and, where applicable, a DSRO to operate a
financial supervisory program that includes routine surveillance
through the review and analysis of financial statements and regulatory
notices, and periodic on-site examinations of member FCMs.\92\ Both
regulations require that examination staff be of adequate size,
training, and experience to effectively implement the program, and that
such staff ``maintain independent judgment'' such that the staff's
``actions must not impair its independence nor appear to impair its
independence in matters related to the supervisory program.'' \93\
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\91\ 17 CFR 1.52(b).
\92\ 17 CFR 1.52(c), (d).
\93\ 17 CFR 1.52(c)(1)(i), (d)(2)(ii)(C)(1).
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Because NFA is the only futures association registered under
section 17 of the Act,\94\ and a registered futures association is an
SRO for purposes of Commission Regulation 1.52,\95\ every FCM is a
member of NFA. NFA does not operate a market, does not trade, and has
no affiliate FCMs or other market participants.\96\ Consequently, NFA
is, for every FCM, an SRO with no commercial interest in the FCM's
trading activity and, but for the current Joint Audit Program and any
resource constraints, is available to serve as that FCM's DSRO.
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\94\ See 7 U.S.C. 21.
\95\ See 17 CFR 1.52(a)(2).
\96\ See Letter from Carol Wooding, SVP, General Counsel and
Secretary, on behalf of the NFA to Christopher Kirkpatrick, Sec'y,
CFTC at 1 (Sept. 26, 2023) (hereinafter ``NFA Comment''). The letter
is available on the Commission's website.
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Commission Regulation 1.52 does not currently address SRO oversight
of an affiliate FCM expressly, nor does it prohibit an SRO from acting
as DSRO for its own affiliate FCM. To date, however, no DCM with an
affiliate FCM has acted as DSRO for that affiliate FCM. Instead, in
each such case, the
[[Page 50934]]
DCM has voluntarily requested that NFA perform the DSRO function for
the affiliate FCM.\97\
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\97\ See NFA Comment, supra note 96, at 4-5.
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ii. Comments on the Affiliations RFC
The Commission received substantial comment on DSRO oversight of
FCMs in response to the 2023 Affiliations RFC.\98\ The relevant
comments addressed three distinct questions: (1) whether a DCM should
be permitted to serve as the DSRO for its own affiliate FCM; (2)
whether a DCM with an affiliate FCM should serve as the DSRO for non-
affiliate FCMs that may compete with that affiliate; and (3) what
information barriers and structural safeguards should apply to a DSRO's
oversight of FCMs. The Commission addresses each in turn.
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\98\ See Affiliations RFC, supra note 1.
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A DCM serving as DSRO for its own affiliate FCM. The Commission
received six comment letters related to the conflicts of interest
implications for the self-regulatory framework of SROs and DSROs having
an affiliate FCM. All six commenters agreed that a DCM should not act
as the DSRO for its affiliate FCM.\99\
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\99\ Letter from Jonathan Marcus, Senior Managing Director and
General Counsel, on behalf of CME Group Inc., to Christopher
Kirkpatrick, Sec'y, CFTC at 14 (Sept. 20, 2023) (hereinafter ``CME
Comment''); Letter from Kara Dutta, Assistant General Counsel, on
behalf of Intercontinental Exchange, Inc., to Christopher
Kirkpatrick, Sec'y, CFTC at 2 (Sept. 28, 2023) (hereinafter ``ICE
Comment''); Letter from Patrick Sexton, EVP, General Counsel &
Corporate Secretary, on behalf of Cboe Global Markets, Inc. to
Christopher Kirkpatrick, Sec'y, CFTC at 3 (Sept. 28, 2023)
(hereinafter ``Cboe Comment''); Letter from Ronald H. Filler,
Professor Emeritus, New York Law School, to Office of the Secretary,
CFTC at 8 (Nov. 3, 2023) (hereinafter ``Filler Comment''); See
Letter from Allison Lurton, General Counsel & Chief Legal Officer,
on behalf of the Futures Industry Association, to Christopher
Kirkpatrick, Sec'y, CFTC at 9-10 (Sept. 28, 2023) (hereinafter ``FIA
Comment''); NFA Comment, supra note 96, at 4.
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NFA--the DSRO for FCMs that are not CME clearing members under the
current Joint Audit Plan--observed that although each DCM with an
affiliate FCM has to date voluntarily requested that NFA perform the
DSRO function, the Commission should nonetheless amend Commission
Regulation 1.52 to ensure that a DCM could not be the DSRO for its
affiliate FCM in the future.\100\ The Futures Industry Association
(``FIA'') and Professor Ronald Filler emphasized the centrality of DSRO
examination to FCM financial surveillance and the risk of impartial
treatment if a DSRO oversees its own affiliate FCM.\101\ The Global
Association of Central Counterparties (``CCP Global'') expressed
support for the existing Commission Regulation 1.52 framework while
emphasizing the importance of explicit rules and procedures to ensure
that affiliated FCMs are not afforded preferential treatment relative
to non-affiliate FCMs.\102\
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\100\ NFA Comment, supra note 96, at 4-5.
\101\ FIA Comment, supra note 99, at 9; Filler Comment, at 8.
\102\ Letter from The Global Association of Central
Counterparties at 2-3 (Sept. 28, 2023) (hereinafter ``CCP Global
Comment'').
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A DCM with an affiliate FCM serving as DSRO for non-affiliate FCMs.
Several commenters separately addressed whether a DCM that has an
affiliate FCM should be able to serve as the DSRO for non-affiliate
FCMs--that is, the FCMs that may compete with the DCM's own affiliate.
Commenters identified this relationship as raising distinct conflict-
of-interest and competition concerns arising from the DSRO's access to
the confidential information of the FCMs it examines.
NFA characterized this as an issue that SROs and DSROs ``have not
previously faced'' and explained that a DCM with an affiliate FCM
serving as DSRO for its non-affiliate FCM members ``may raise conflicts
and competitive issues that may be heightened by the DSRO's access to
its non-affiliate FCMs' confidential information and a perception that
actions taken in overseeing its unaffiliated FCM members benefit its
affiliate FCM.'' \103\ ICE Futures U.S., Inc. (``ICE'') likewise urged
the Commission to ``consider whether it is appropriate for an entity to
be tasked with auditing entities with which it competes'' and stated
that, at a minimum, robust information barriers should be required ``to
ensure that information derived from an examination does not flow to
the affiliated entity that competes with the firms being audited.''
\104\ Professor Filler questioned whether a DCM with an affiliate FCM
should ``even serve as a DSRO . . . for another FCM given the
confidential information that each DSRO obtains from the other FCMs''
and suggested that ``[o]ne possible model would only allow [NFA] . . .
to serve as the DSRO for all FCMs, even [CME] clearing member firms, if
a DCM becomes affiliated with an FCM.'' \105\
---------------------------------------------------------------------------
\103\ NFA Comment, supra note 96, at 4.
\104\ ICE Comment, supra note 99, at 2-3.
\105\ Filler Comment, supra note 99, at 8.
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CME recommended that persons affiliated with an FCM not be
permitted to participate in or receive reports from the JAC, ``which
could include sensitive information pertaining to other unaffiliated
FCMs.'' \106\
---------------------------------------------------------------------------
\106\ CME Comment, supra note 99, at 14.
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Information barriers and structural safeguards. Commenters were
broadly supportive of information barriers and confidentiality
safeguards to govern a DSRO's access to and handling of the non-public
information of the FCMs it examines. CME, NFA, ICE, and Professor
Filler each agreed that appropriate firewalls and information barriers
should be in place.\107\ NFA emphasized the importance of separate
boards of directors, separate key management personnel, information-
sharing barriers, and conflicts-of-interest policies.\108\ ICE, while
supportive of information barriers generally, separately cautioned that
information barriers alone ``will not mitigate the conflicts of
interest'' presented by a DSRO's oversight of an affiliate FCM.\109\
---------------------------------------------------------------------------
\107\ CME Comment, supra note 99, at 14-15; NFA Comment, supra
note 96, at 3; ICE Comment, supra note 99 at 3; Filler Comment,
supra note 99, at 5.
\108\ NFA Comment, supra note 96, at 3.
\109\ ICE Comment, supra note 99, at 2.
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Commenters that operate affiliated structures described their
existing safeguards. MIAX described its rule providing that its
affiliate FCM ``will not receive preferential treatment in any
respect,'' a company-wide information-barrier policy, and a
representation that affiliates do not share senior compliance and risk-
management personnel, such as the CRO or CCO, or physical office space,
although certain functions such as cybersecurity and internal audit may
be shared.\110\
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\110\ See Letter from Thomas F. Gallagher, Chairman and CEO, on
behalf of Miami International Holdings, Inc. and Mark G. Bagan,
President and CEO, on behalf of Minneapolis Grain Exchange, LLC, to
Christopher Kirkpatrick, Sec'y, CFTC at 4-7 (Sept. 26, 2023)
(hereinafter ``MIAX/MGEX Comment'').
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Views supporting the existing framework or a principles-based
approach. CME, ICE, CCP Global, Cboe, and the World Federation of
Exchanges (``WFE'') urged the Commission to retain its principles-based
regulatory approach and cautioned against prescriptive structural
requirements, even while several of them supported particular targeted
measures.\111\
---------------------------------------------------------------------------
\111\ CME Comment, supra note 99, at 1-2, 16-17 (cautioning
against ``comprehensive and prescriptive rules'' while supporting a
prohibition on an SRO serving as DSRO for its own affiliate); CCP
Global Comment, supra note 102, at 2 (the Commission should not
``deviate from its principles-based approach''); ICE Comment, supra
note 99, at 1 (expressing support for ``the CFTC's principles-based
approach); Cboe Comment, supra note 99, at 3; Letter from Charlie
Ryder, Regulatory Affairs Manager, on behalf of World Federation of
Exchanges, to the CFTC at 3-4 (Sept. 28, 2023) (hereinafter ``WFE
Comment'').
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iii. Identified Concerns
After considering these comments, the Commission has identified
four sets of concerns regarding SRO and DSRO oversight of FCMs that the
Commission
[[Page 50935]]
preliminarily believes the existing Commission Regulation 1.52
framework does not specifically address. The first three concern an
SRO's oversight of its own affiliate FCM. The fourth concerns the
position of non-affiliate FCMs that are examined by a DSRO whose
affiliate FCM competes with them, and the absence of any mechanism by
which such an unaffiliated FCM may be subject to examination by an SRO
that has no competing commercial interest in its activities.
Impartiality of supervision. An SRO with an affiliate FCM has a
commercial interest in that affiliate's success that does not exist
with respect to its other, unaffiliated member FCMs. That commercial
interest could affect, or appear to affect, the rigor with which the
SRO applies its supervisory program to the affiliate FCM, including the
timeliness and intensity of any enforcement response to identified
deficiencies. Commission Regulations 1.52(c)(2)(i) and (d)(2)(ii)(C)(1)
already require that examination staff maintain independent judgment
and avoid actions that ``impair . . . or appear to impair'' their
independence.\112\ The Commission preliminarily believes that, in the
affiliate FCM context, additional structural safeguards are warranted
to give effect to those existing independence requirements.
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\112\ 17 CFR 1.52(c)(1)(i), (d)(2)(ii)(C)(1).
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Use of non-public information. Through its supervisory program, an
SRO acquires non-public information concerning the financial condition,
customer activity, risk profile, and proprietary trading of its member
FCMs. Access to, or sharing with an affiliate FCM of, non-public
information of non-affiliate member FCMs could afford the affiliate FCM
a competitive advantage and could disadvantage non-affiliate member
FCMs that compete with the affiliate FCM. Reciprocally, the SRO's
access to its affiliate FCM's non-public information--outside of what
is necessary for the SRO's regulatory functions--could blur the
boundary between regulatory and commercial information flows within the
affiliated group.
Reporting lines for examination staff. SRO examination staff
implementing the supervisory program may report to SRO management that
also bears commercial responsibility for the affiliated enterprise.
Such reporting relationships could undermine, or appear to undermine,
the independent judgment that Commission Regulation 1.52 already
requires of supervisory staff.
Oversight of non-affiliate FCMs by a DSRO whose affiliate FCM
competes with them. The first three concerns address an SRO's oversight
of its own affiliate FCM. A distinct concern arises with respect to the
non-affiliate FCMs that a DSRO examines when that DSRO has an affiliate
FCM competing in the same markets. In conducting the supervisory
program and the on-site examinations required by Commission Regulation
1.52(c) and the Joint Audit Program, a DSRO obtains detailed non-public
information--including financial condition, customer activity,
positions, and risk profile--concerning each FCM it examines.\113\
Where the DSRO has an affiliate FCM, the DSRO acquires this information
about firms that compete with its affiliate, giving rise to both a
competitive concern--that such information could advantage the
affiliate FCM--and a concern that the DSRO's oversight decisions
affecting non-affiliate FCMs could be perceived as benefiting its
affiliate.
---------------------------------------------------------------------------
\113\ See 17 CFR 1.52(c)(1), (d)(2)(ii)(C).
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The Commission preliminarily believes that, although the
information-barrier and separation safeguards proposed herein mitigate
this concern by restricting the flow of non-affiliate FCMs' non-public
information to an affiliate FCM, those safeguards operate only as
constraints on the DSRO. They do not afford a non-affiliate FCM any
means of being subject to examination by an SRO that has no commercial
interest in the FCM's activities. Because NFA operates no market and
has no affiliate FCM, NFA is, for every FCM, such an SRO. The
Commission preliminarily believes that affording each FCM the option to
elect NFA as its DSRO would provide a direct, registrant-side response
to this concern, complementing the constraints imposed on the DSRO by
the safeguards described above.
iv. Proposed Amendments
The Commission preliminarily believes that targeted amendments to
Commission Regulation 1.52--calibrated to the specific circumstance of
an SRO with an affiliate FCM--would address the concerns identified
above while preserving the existing framework for SROs and DSROs that
do not have an affiliate FCM. Each element of the proposed amendments
is discussed below.
Definitions--Proposed Commission Regulations 1.52(a)(3) and (a)(4).
The Commission proposes to add definitions of ``affiliate futures
commission merchant,'' ``control,'' and ``non-public information'' to
Commission Regulation 1.52(a) in order to effectuate the proposed
substantive revisions to Commission Regulation 1.52.
Proposed Commission Regulation 1.52(a)(3) would define ``affiliate
futures commission merchant'' as an FCM (as defined in Commission
Regulation 1.3) that directly or indirectly controls, is controlled by,
or is under common control with an SRO. The same paragraph would define
``control''--including the terms ``controlled by'' and ``under common
control with''--to mean the possession, direct or indirect, of the
power to direct or cause the direction of the management and policies
of a person, whether through the ownership of voting securities, by
contract, or otherwise. This control formulation tracks well-
established usage under the federal securities laws \114\ and is
intended to capture the range of relationships that give rise to the
concerns identified above. The Commission preliminarily believes a
control-based definition (rather than a fixed ownership-percentage
threshold) is appropriate because the relevant concerns (i.e.,
commercial alignment, information flow, reporting-line pressure) turn
on the ability to direct management and policies rather than on any
particular equity stake.
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\114\ See, e.g., 17 CFR 230.405 (Securities Act); 17 CFR
240.12b-2 (Exchange Act).
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Proposed Commission Regulation 1.52(a)(4) would define ``non-public
information'' as information that has not been disseminated in a manner
which makes it generally available to the trading public. This
formulation reflects the existing concept of non-public information
used in Commission guidance and Acceptable Practices \115\ and is
intended to capture, for example, the categories of financial,
operational, customer-position, risk-management, and proprietary-
trading information that an SRO acquires through its supervisory
program.
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\115\ See, e.g., 17 CFR part 38, app. B, Core Principle 16(a).
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Reporting Lines for Examination Staff--Proposed Commission
Regulation 1.52(c)(1)(i)(B).
Proposed Commission Regulation 1.52(c)(1)(i)(B) would require that,
if an SRO has an affiliate FCM, the examination staff implementing the
supervisory program required by Commission Regulation 1.52(c) report
directly to the board of directors or other designated committee or
officer responsible for regulatory compliance of the SRO. The proposed
regulation would further require that, if examination staff report to
an officer
[[Page 50936]]
responsible for regulatory compliance of the self-regulatory
organization, such officer must, in turn, report directly to the board
of directors or other designated committee. The proposal would not
displace the existing Commission Regulation 1.52(c)(1)(i) requirement
that staff maintain independent judgment. Rather, it would supplement
that general independence standard with a specific reporting-line
safeguard for the circumstance the Commission has identified as
presenting heightened risk to that independence (i.e., the existence of
an affiliate relationship). The Commission preliminarily believes that
a reporting line that runs to the board (or to a designated committee
or officer with regulatory-compliance responsibility) rather than to
commercial management, would insulate examination staff from reporting
pressures that could affect their independent judgment given the
commercial interest at play with respect to an affiliate FCM.
In practice, the Commission preliminarily expects that most DCMs
would implement this requirement by having examination staff report
directly to its ROC \116\ or to a chief regulatory officer (``CRO'') or
similar officer who, in turn, reports to the ROC, thus preserving a
reporting line insulated from commercial pressures. The Commission
requests comment on existing SRO reporting lines and its understanding
of how SROs would comply with this proposed regulation.
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\116\ The Acceptable Practices in app. B to part 38 notes that a
ROC must consist only of public directors (i.e., those directors
that have no material relationship to the DCM that ``reasonably
could affect the independent judgment or decision-making of the
director'').
---------------------------------------------------------------------------
Mandatory Independent Third-Party SRO--Proposed Commission
Regulation 1.52(c)(1)(i)(C).
Proposed Commission Regulation 1.52(c)(1)(i)(C) would require an
SRO that has an affiliate FCM to designate an independent third-party
SRO to conduct the surveillance of the affiliate FCM otherwise required
of the SRO under existing Commission Regulation 1.52(c). The SRO with
the affiliate FCM would be required to ensure that the third-party SRO
implements a supervisory program that satisfies both Commission
Regulation 1.52(c) and the RSP requirements of Commission Regulation
38.606. The SRO would at all times remain responsible for compliance
with its obligations under the CEA and the Commission's regulations,
and for the third-party SRO's performance on its behalf--consistent
with the existing Commission Regulation 38.606 framework for RSP
arrangements.\117\ The Commission requests comment on whether it is
appropriate for the designating SRO to be responsible for the third-
party's performance on its behalf where such designation is mandatory
as opposed to voluntary, as in the Commission Regulation 38.606
circumstance. The Commission also requests comment on the appropriate
liability standard for the designating SRO.
---------------------------------------------------------------------------
\117\ See 17 CFR 38.606.
---------------------------------------------------------------------------
This proposal would codify--and extend across the full Commission
Regulation 1.52(c) supervisory function--the practice that the
Commission understands that DCMs with affiliate FCMs already follow on
a voluntary basis. The Commission preliminarily believes that
codification is appropriate to ensure the practice continues to make
the requirement transparent to FCMs and their customers, and to provide
an enforceable regulatory baseline against which the Commission can
monitor compliance. The Commission also preliminarily believes that
such codification would mitigate the inherent conflicts of interest
arising out of an SRO fulfilling its regulatory obligations in the
context of its affiliate FCM.
Restrictions on Access to and Sharing of Non-Public Information--
Proposed Commission Regulation 1.52(c)(1)(i)(D).
Proposed Commission Regulation Sec. 1.52(c)(1)(i)(D) would impose
two related restrictions on an SRO that has an affiliate FCM. First,
proposed Commission Regulation 1.52(c)(1)(i)(D)(1) would prohibit an
SRO from accessing the non-public information of its affiliate FCM,
except as necessary to comply with the SRO's responsibilities and
obligations as a DCM under part 38 of the Commission's Regulations.
Second, proposed Commission Regulation 1.52(c)(1)(i)(D)(2) would
prohibit an SRO from sharing, directly or indirectly, non-public
information obtained from its supervisory program of its non-affiliate
member FCMs with its affiliate FCM for any purpose, except as necessary
to comply with the SRO's responsibilities and obligations as an SRO
under Commission Regulation 1.52 or as a DCM under part 38 of the
Commission's regulations. The Commission preliminarily believes that an
SRO sharing such information with its affiliate FCM would be extremely
rare.
The Commission recognizes that a DCM's compliance with its part 38
obligations--including financial surveillance under Commission
Regulations 38.604 and 38.605 and the trade-practice surveillance and
audit-trail functions associated with DCM Core Principles 2, 4, and
11--necessarily entail receipt and use of information that is non-
public as to particular member FCMs, including an affiliate FCM. The
part 38 compliance carve-out preserves the SRO's ability to carry out
those required functions, while prohibiting the use, access, or sharing
of non-public information for any purpose outside those regulatory
responsibilities. The ``directly or indirectly'' language is intended
to prevent circumvention by routing non-public information to the
affiliate FCM via another affiliated entity. Indirect routing may
nevertheless occur--or, at least, appear to occur to market
participants. This fact informs the Commission's preliminary view, as
outlined below, that market participants should be able to elect a
neutral SRO.
Parallel Amendments to the Joint Audit Plan Provisions--Proposed
Commission Regulation 1.52(d)(2)(ii)(C)(1).
The Commission proposes parallel amendments to Commission
Regulation 1.52(d)(2)(ii)(C)(1), which governs DSROs operating under
the Joint Audit Plan.
Proposed Commission Regulation 1.52(d)(2)(ii)(C)(1)(ii) \118\ would
expressly require that a DSRO that has an affiliate FCM may not perform
the function of a DSRO for that affiliate FCM. This proposal codifies
the practices currently followed under the Joint Audit Plan, under
which NFA performs the DSRO function for an FCM affiliated with a DCM.
The Commission preliminarily believes that an express prohibition,
codified in the Commission's regulations, is preferable to continued
reliance on voluntary practice for the reasons described above (i.e.,
conflict of interest risk mitigation and enhanced market integrity),
including that, absent a regulatory prohibition, voluntary practice
could change thus allowing a surveillance structure that the Commission
preliminarily believes results in unmitigable conflicts of interest.
The Commission requests comment on whether this proposed regulation
should include a similar liability standard as proposed in proposed
Commission Regulation 1.52(c)(2)(i)(B).
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\118\ The text in current Commission Regulation 1.52(d)(2)(C)(1)
is proposed to be moved to proposed Commission Regulation
1.52(d)(2)(C)(1)(i) without any changes to the rule text.
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Proposed Commission Regulation 1.52(d)(2)(ii)(C)(1)(iii) would,
consistent with the proposed regulations
[[Page 50937]]
applicable to SROs, require that if a DSRO has an affiliate FCM, the
examination staff implementing the DSRO's supervisory program must
report directly to the board of directors or other designated committee
or officer responsible for regulatory compliance of the DSRO. Further,
the proposed regulation would require that, if such examination staff
report to an officer responsible for regulatory compliance of the DSRO,
such officer must, in turn, report directly to the board of directors
or other designated committee. The Commission's reasoning is consistent
with that provided above; namely, to insulate examination staff from
reporting pressures that could affect their independent judgment given
the commercial interest at play with respect to an affiliate FCM.
Proposed Commission Regulation 1.52(d)(2)(ii)(C)(1)(iv) would
impose on DSROs the same restrictions on access to and sharing of non-
public information that the Commission would impose on SROs more
generally, with the same carve-out for compliance with part 38
obligations. The Commission preliminarily believes that uniform
treatment is appropriate because the DSRO function under the Joint
Audit Plan and the broader supervisory program under Commission
Regulation 1.52(c) raises materially similar concerns when an affiliate
FCM is involved.
FCM Election of a Registered Futures Association as Designated
Self-Regulatory Organization--Proposed Commission Regulation
1.52(d)(2)(i)(A).
The safeguards described above operate as constraints on the SRO
and the DSRO. They do not, however, afford a non-affiliate FCM any
affirmative means of obtaining examination by an SRO that has no
commercial interest in its activities, including by virtue of that SRO
having an affiliate FCM. Proposed Commission Regulation
1.52(d)(2)(i)(A) would supply that means.\119\ It would permit an FCM
that is a member of a registered futures association to elect, in
writing to the JAC, to have such registered futures association serve
as its DSRO.\120\ Upon receipt of a valid election, the JAC would
designate NFA as that FCM's DSRO and reflect the designation in the
Joint Audit Program.\121\ In the absence of an election, the JAC would
designate the FCM's DSRO under the existing process. The Proposal would
provide expressly that an election does not alter the examination
standards applicable to the FCM under the Joint Audit Program and does
not relieve any SRO of the residual responsibility it retains under
Commission Regulations, including Commission Regulations 1.52(d)(1)(ii)
and (i)(2).
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\119\ The CEA authorizes a futures association to register with
the Commission pursuant to the terms and conditions set out in the
Act. CEA sec. 17. The Commission's rules regarding futures
associations require a registered futures association to, among
other things, demonstrate that it will be able to carry out the
purposes of section 17 of the Act. For example, a registered futures
association ``should be prepared to establish and maintain in
accordance with Sec. 1.52 of this chapter, a financial compliance
program for those members of the association who are futures
commission merchants.'' 17 CFR 170.1.
\120\ The Commission recognizes that there currently is only one
registered futures association--NFA--and so this proposed regulation
would function to allow FCMs that are NFA members to select NFA as
their DSRO. The Commission further recognizes that, while today
there is only one JAC, Commission Regulation 1.52(d) allows any two
(or more) SROs to form a JAC and there could be more than one in the
future. To the extent another JAC consistent with Commission
regulations, the Commission preliminarily believes that an FCM
subject to such JAC should, likewise, be able to elect a registered
futures association its DSRO, to the extent this proposal is adopted
as proposed.
\121\ Such DSRO designations are made public on a monthly basis
through the Commission's publication of selected FCM financial data.
See Financial Data for FCMs, <a href="https://www.cftc.gov/MarketReports/financialfcmdata/index.htm">https://www.cftc.gov/MarketReports/financialfcmdata/index.htm</a>.
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The Commission preliminarily believes that affording each FCM this
option is warranted for three reasons. First, the election provides the
option of a neutral examiner available to every FCM. The safeguards
described above reduce the risk that a DSRO's relationship to its
affiliate FCM affects its oversight of the non-affiliate FCMs it
examines, but they leave the non-affiliate FCMs dependent on the
efficacy of those constraints. A non-affiliate FCM that prefers
examination by an SRO with no commercial stake in its business has,
under the current framework, no means of established process to obtain
it (absent abstaining from trading on CME). Because NFA operates no
market and has no affiliate FCM or other affiliate market participant,
NFA is, for every FCM, an SRO without the same sort of commercial
interest in the FCM's trading activity. The election would allow any
FCM to obtain examination by such an organization directly, rather than
relying solely on constraints imposed on its assigned DSRO.
Second, the Commission preliminarily believes that the election
option would introduce a measure of market discipline that supplements,
but does not supplant, the Commission's oversight of the self-
regulatory framework. Under the current structure, an FCM has no
ability to decline examination by an assigned DSRO, so an FCM's
continued examination by a particular DSRO conveys no information about
whether the FCM regards that DSRO's oversight as impartial. By making
elections observable, the Proposal would allow the degree to which FCMs
elect or decline to elect away from a particular DSRO to serve as an
indicator--to the Commission and to other market participants--of
confidence in that DSRO's application of the Joint Audit Program. A
DSRO that retains Commission Regulation 1.52 authority over the FCMs it
examines after acquiring an affiliate FCM would have demonstrated such
confidence; a significant pattern of elections away from a DSRO would
identify a circumstance likely warranting the Commission's attention.
For example, this pattern may indicate a ``race to the bottom''--FCMs
may elect a DSRO based on the perceived ``difficulty'' of the DSRO's
supervisory program. The Commission emphasizes that the election would
not permit any FCM to alter the standards under which it is examined,
and that the election supplements rather than replaces the Commission's
independent supervisory judgment. The Commission further notes that the
notice period and minimum-duration provisions described below are
designed so that an election reflects a considered determination rather
than transient or strategic switching; the Commission preliminarily
believes these features would cause election activity to surface
durable, rather than ephemeral, assessments of a DSRO's oversight.
Third, the Commission preliminarily believes that a standing and
universally available election option would address the relevant
concerns without requiring the Commission or the JAC to make case-by-
case determinations and would accommodate future changes in market
structure. Conditioning the election on a finding that a particular
FCM's DSRO is affiliated with a competitor would require contestable
determinations regarding affiliation and competition of the kind that
may be difficult to draw. A universal election option available to
every FCM requires no such triggering determination. It also would
ensure that the option is available automatically as affiliate
relationships arise in the future--a consideration of practical
importance given both the consolidation of DSROs under the Joint Audit
Program over the past four decades and the recent emergence of an
affiliate FCM at a DSRO. The Commission recognizes that, for an FCM
whose DSRO has no affiliate FCM, the election's practical significance
is limited; the universal availability of the election rests on the
[[Page 50938]]
administrability and forward-looking considerations described here
rather than on a present benefit common to all FCMs.
The Commission recognizes that there may be potential drawbacks to
this approach. For example, the Commission understands that existing
DSROs, including CME, have experience and resources dedicated to
fulfilling their roles as DSROs. In this regard, a DSRO and its staff
likely have developed significant familiarity with the particular FCMs
that it examines, including historical records and observations that
may facilitate future examinations. An election option may disrupt this
historical knowledge and expertise. The Commission requests feedback
with respect to these observations and how they may affect any final
rule.
Membership Predicate--Proposed Commission Regulation
1.52(d)(2)(i)(B).
Proposed Commission Regulation 1.52(d)(2)(i)(B) would confirm that
no FCM may be designated to, and the JAC may not designate to an FCM,
an SRO of which the FCM is not a member, and that nothing in the
election provision requires any SRO other than a registered futures
association (i.e., NFA) to serve as the DSRO for an FCM that is not its
member. Because NFA membership is a practical prerequisite to FCM
registration, every FCM may make a valid election of NFA. The
membership predicate ensures that the election provision does not
disturb the existing arrangement under which an SRO other than NFA
serves as DSRO only for FCMs that are its members; the Proposal would
create no right to elect an exchange SRO, and any assignment of an FCM
to an SRO other than NFA would continue to occur through the JAC's
existing designation process and only as to FCMs that are members of
that SRO.
Notice Period and Effective Date of Election--Proposed Commission
Regulation 1.52(d)(2)(i)(C).
Proposed Commission Regulation 1.52(d)(2)(i)(C) would provide that
an election takes effect on the later of the first day of the next
examination cycle under Commission Regulation 1.52(d)(2)(ii)(C)(4) or
six months after the JAC's receipt of the election, and that an
election does not interrupt or shorten an examination then in progress.
The Proposal would further authorize the JAC, where it determines that
elections received within a common period would, if given immediate
effect, impair a DSRO's ability to maintain examination staff of
adequate size, training, and experience as required under Commission
Regulation 1.52(d)(2)(ii)(C)(1), to establish a reasonable schedule
phasing in the effective dates of such elections, provided that no
election is delayed beyond twelve months after its receipt.
The Commission preliminarily believes that a defined notice period,
together with the phasing authority, is necessary to ensure that a DSRO
receiving elected FCMs has sufficient time to recruit, train, and
deploy qualified examination staff, and to prevent a concentration of
elections within a short period from compromising examination quality.
Minimum Duration of Election--Proposed Commission Regulation
1.52(d)(2)(i)(D).
Proposed Commission Regulation 1.52(d)(2)(i)(D) would require an
FCM, following the effective date of an election, to retain its elected
DSRO for not fewer than three complete examination cycles under
Commission Regulation 1.52(d)(2)(ii)(C)(4) before electing a different
DSRO or revoking its election.
The Commission preliminarily believes a minimum-duration
requirement is warranted to prevent repeated switching that would
impose recurring transition burdens on DSROs and complicate continuity
of examination, and to support the staffing investment that a DSRO must
make to absorb electing FCMs. The proposed three-examination-cycle
period--corresponding to approximately four and one-half years--
reflects the Commission's preliminary judgment as to the period
necessary to balance these continuity and staffing interests against an
FCM's interest in its ability to revisit its election. In this regard,
the Commission preliminarily believes that a shorter period of time
would hinder a DSRO's ability to manage its resources effectively,
develop expertise and deepen its understanding of the FCMs it examines.
The minimum-duration requirement would not affect an FCM's obligations,
or any SRO's residual responsibilities, including under Commission
Regulations 1.52(d)(1)(ii) and (i)(2). As noted below, the Commission
requests comment on the appropriate length of these cycles.
Conforming Amendment to the Member-Notification Provision--Proposed
Commission Regulation 1.52(i)(2).
The Commission proposes a conforming amendment to Commission
Regulation 1.52(i)(2), which requires a delegating SRO to notify each
affected member of the identity of the DSRO to which the member has
been assigned. The amendment would provide that this notification
includes, where applicable, a registered futures association where the
member has elected such registered futures association as its DSRO
under proposed Commission Regulation 1.52(d)(2)(i)(A). This conforming
change ensures that the existing notification mechanism accurately
reflects an elected, rather than solely an assigned, DSRO.
v. Statutory Authority
The Commission proposes the amendments to Commission Regulation
1.52 pursuant to section 8a(5) of the Act, which authorizes the
Commission to promulgate such rules and regulations as, in its
judgment, are reasonably necessary to effectuate any of the provisions
or to accomplish any of the purposes of the Act.\122\ The Commission's
authority to prescribe minimum financial-surveillance standards for
SROs, and to establish the framework for delegated financial oversight
of FCMs through the Joint Audit Program, is longstanding: Commission
Regulation 1.52 has been in effect since 1978, and the Commission last
comprehensively revised the Commission Regulation 1.52 framework in
2013.\123\ The proposed amendments do not expand the scope of that
authority; rather, they calibrate the existing framework to address a
specific circumstance--an SRO's oversight of an affiliate FCM, and a
DSRO's oversight of non-affiliate FCMs that compete with its
affiliate--that the current framework does not address.
---------------------------------------------------------------------------
\122\ CEA 8a(5), 7 U.S.C. 12a(5).
\123\ Enhancing Protections Afforded Customers and Customer
Funds Held by Futures Commission Merchants and Derivatives Clearing
Organizations, 78 FR 68506 (Nov. 14, 2013).
---------------------------------------------------------------------------
The proposed FCM option to elect a registered futures association
as DSRO rests on the same section 8a(5) authority, supplemented by
section 17 of the Act, which vests the Commission with oversight
authority over registered futures associations,\124\ and section 4f(b)
of the Act, under which registered futures association membership is a
practical prerequisite to FCM registration.\125\ The Commission
preliminarily believes that section 8a(5)--read together with sections
17 and 4f(b)--and the Commission's existing approval-and-conditioning
authority over Joint Audit Plans under Sec. 1.52(d)(1) and (h)--
supplies sufficient authority to require a registered futures
association, including NFA, to accept an FCM's election in the
circumstance addressed by the proposal.
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\124\ CEA 17, 7 U.S.C. 21.
\125\ CEA 4f(b), 7 U.S.C. 6f(b).
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[[Page 50939]]
vi. Alternatives Considered
The Commission considered, and requests comment on, several
alternative approaches to the issues addressed by the proposed
amendments to Commission Regulation 1.52.
1. Reliance on Existing Voluntary Practice
The Commission considered relying on the current voluntary
practice--under which NFA performs DSRO functions for FCMs affiliated
with DCMs--without codification. The Commission preliminarily concluded
that relying on this voluntary practice is untenable, given the
increasing number of DCMs with affiliate FCMs and the possibility that
such voluntary practice could change. In this regard, the Commission
preliminarily determined that codification is preferable to ensure
continuity of that voluntary practice, to extend safeguards beyond the
DSRO context to the broader Commission Regulation 1.52(c) supervisory
function, and to make the requirements transparent to market
participants. The Commission requests comment on whether reliance on
existing voluntary practice is sufficient.
2. Independent DSRO for All Member FCMs
The Commission considered, as suggested by Professor Filler and
reflected in part in NFA's comment, requiring that NFA (or another
independent third-party SRO) serve as DSRO for all member FCMs of an
SRO that has an affiliate FCM--not only for the affiliate FCM
itself.\126\ The rationale for this alternative is that an SRO's access
to non-public information of non-affiliate FCMs--which may compete with
the affiliate FCM--raises competitive concerns even when the SRO does
not directly examine the affiliate FCM. The Commission preliminarily
declines to take this approach for two reasons. First, the Commission
understands that FCM examinations provide valuable information to DSROs
that also operate an exchange, and that such information may bear on
risk management decisions made by the exchange. In this regard,
removing FCM examination authority from such DSROs may result in blind
spots that increase systemic risk. Second, the Commission preliminarily
concludes that the proposed approach is sufficient to address the
relevant competitive concerns while enabling market forces to show
revealed preferences. The Commission requests comment on this
alternative, including whether the proposed access and sharing
restrictions adequately mitigate the competitive concerns that this
alternative would address.
---------------------------------------------------------------------------
\126\ Filler Comment, supra note 99, at 8; see also NFA Comment,
supra note 96, at 4-5.
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3. Prescriptive Separation Requirements
The Commission considered prescriptive separation requirements--
including physical office separation, technical specifications for
information barriers, and dual-hatting prohibitions for senior
officers--for SRO personnel involved in the supervisory program of an
affiliate FCM. The Commission notes that a DCM with an affiliate FCM
would be subject to the Commission's proposed conflicts-of-interest-
procedures rule described below, and that the Commission's proposed
acceptable practices in implementing such procedures likewise would
apply. As described below, the Commission preliminarily believes that a
principles-based rule, together with detailed acceptable practices,
provides the market with appropriate guidance regarding the
Commission's expectations, while allowing for some flexibility in
approaches. The Commission, therefore, preliminarily concludes that the
targeted requirements in the current proposal--combined with the
existing Commission Regulation 1.52 independence-of-staff standards and
the aforementioned proposed conflicts procedures rule--are sufficient
to address the concerns identified. The Commission requests comment on
this preliminary conclusion.
vii. Request for Comment
The Commission requests comment on all aspects of the proposed
amendments to Commission Regulation 1.52, including:
(1) Whether the proposed definition of ``affiliate futures
commission merchant''--and the related ``control'' formulation--
captures the appropriate scope of relationships. Should the definition
encompass partial ownership interests that do not rise to the level of
``control''? If so, at what threshold or under what criteria?
(2) Whether the proposed definition of ``non-public information''
is appropriately scoped. Should this concept be expressed in terms of
materiality, enumerated categories of information (e.g., customer
positions, financial condition, risk-management policies), as proposed,
or based on some other criteria?
(3) Whether the Commission should adopt the alternative under which
an SRO with an affiliate FCM would be required to designate an
independent third-party DSRO for examination of all of its member FCMs,
rather than only for the affiliate FCM.
(4) Whether, in circumstances where the Proposal would mandate
delegation of SRO or DSRO functions under Commission Regulations
1.52(c) or (d), it is reasonable for the delegating SRO to be
responsible and liable for the third-party's performance on its behalf.
Should the delegating SRO be subject to a strict liability standard
such that any examination failure on the part of the third-party SRO is
the responsibility of the delegating SRO, or, alternatively, should the
delegating SRO be liable only if it is negligent in its selection of
the third-party SRO?
(5) Whether the part 38 carve-out, which would allow an SRO or DSRO
to access or share certain non-public information to comply with part
38 obligations, is appropriately scoped, including whether additional
specificity is warranted regarding the categories of non-public
information access and sharing permitted under the carve-out.
(6) Whether the reporting-line requirements, which would require
examination staff to be insulated from commercial pressures, is
appropriately calibrated, including whether the Commission should
specify the level of the board or committee to which examination staff
must report.
(7) Whether the proposed Commission Regulation 1.52 amendments
should apply to SRO oversight of affiliated entities other than FCMs
(e.g., IBs or market makers).
(8) Whether the Commission should afford FCMs an election of a
registered futures association as DSRO at all, and whether the
information-access, reporting-line, and prohibition safeguards proposed
above--together with the conflicts-of-interest framework proposed
elsewhere in this Proposal--would adequately address the concerns
regarding a DSRO's oversight of non-affiliate FCMs that compete with
its affiliate, without an election option.
(9) Whether the election provision should be limited to a
registered futures association, as proposed, or should instead permit
an FCM to elect any SRO of which it is a member; and if an open
election was permitted, what conditions should apply, including how the
membership predicate and examination-standard consistency would be
preserved.
(10) Whether the proposed six-month minimum notice period provides
an appropriate balance between an electing FCM's interest in a timely
transition and a receiving DSRO's need to recruit, train, and deploy
qualified examination
[[Page 50940]]
staff; and whether a shorter or longer period would be preferable.
(11) Whether the authority of the JAC to phase in clustered
elections, subject to the proposed twelve-month outer limit, is
appropriately calibrated to protect examination quality and DSRO
staffing; whether the outer limit should be shorter or longer; and what
criteria the JAC should apply in determining that a phase-in schedule
is warranted.
(12) Whether the proposed three-cycle minimum-duration requirement
appropriately balances continuity of examination and DSRO staffing
stability against an FCM's interest in revisiting its election; and
whether a shorter or longer minimum duration would be preferable.
(13) Whether an FCM that has elected a registered futures
association should be permitted to revoke its election before the
minimum duration elapses in defined circumstances, for example, upon a
change in the FCM's clearing membership or upon a material change in
the circumstances that prompted the election, and, if so, what
circumstances should qualify.
(14) Whether the proposed election option could result in
unintended consequences to a DSRO that also operates an exchange
including, for example, with respect to risk management activities. For
example, could the election option result in a DSRO that loses the
ability to examine an FCM as a result of an election revising its DCM
or DCO rulebook to require similar examinations to ensure that it
receives risk management information regarding its member FCMs,
ultimately resulting in duplicative examinations and surveillance?
(15) Whether the proposed election option would have effects on the
resources, staffing, or funding of NFA or of any other DSRO that the
Commission should consider, including, whether a substantial volume of
elections could affect the cost or quality of examinations; and the
Commission specifically requests that NFA, CME, and any other SRO,
DSRO, FCM, or market participant with relevant information describe the
anticipated operational and cost effects of the proposed election
option.
(16) The Commission understands that DCOs conduct examinations of
their clearing members apart from the obligations imposed by Commission
Regulation 1.52. Will the election mechanism result in clearing members
becoming subject to duplicative examinations--one by the DCO and one by
a registered futures association?
The Commission specifically requests that SROs and DSROs with an
affiliate FCM--and any other SRO, DSRO, FCM, or market participant with
relevant information--describe:
(17) The arrangements currently in place for the financial
surveillance and DSRO oversight of any affiliate FCM, including the
identity of the third-party SRO performing those functions and the
terms (including cost) of the arrangement.
(18) The reporting lines through which examination staff
implementing the Commission Regulation 1.52(c) supervisory program
currently report, including the highest organizational level at which
that reporting line terminates and the independence of that level from
commercial management of the SRO and the affiliate FCM. Whether the
reporting-line requirements are consistent with existing reporting
structures at SROs and DSROs.
(19) The existing policies, procedures, information barriers, or
technological controls governing an SRO's access to non-public
information of an affiliate FCM and the SRO's sharing of non-public
information obtained from the Commission Regulation 1.52(c) supervisory
program with the affiliate FCM, including any exceptions for compliance
with part 38 obligations.
(20) The nature and estimated incremental cost of any change to
existing arrangements that would be required to comply with the
proposed Commission Regulation 1.52 amendments.
(21) Whether the proposed definitions of ``affiliate futures
commission merchant,'' ``control,'' and ``non-public information''
would capture relationships or categories of information that differ in
any material respect from those addressed by existing arrangements.
B. Proposed Amendments to Commission Regulations 38.604 and 38.606--DCM
Financial Surveillance of Members and Third-Party Regulatory Service
Providers
i. Background
DCMs bear responsibility for the financial surveillance of their
member FCMs under DCM Core Principle 11 (Financial Integrity of
Transactions) and Commission Regulations 38.602, 38.604, and
38.605.\127\ In particular, Commission Regulation 38.604 requires that
a DCM ``monitor members' compliance with the [DCM's] minimum financial
standards'' by, among other things, routinely receiving and promptly
reviewing financial and related information from its members,
``continuously monitor[ing] the positions of members and their
customers,'' \128\ continually surveying the obligations of each FCM
created by the positions of its customers, comparing those obligations
to the financial resources of the FCM as appropriate, and taking
appropriate steps to use this information to protect customer
funds.\129\ Commission Regulation 38.605 requires a DCM to comply with
the standards of Commission Regulation 1.52 in carrying out this
financial surveillance program.\130\
---------------------------------------------------------------------------
\127\ CEA 5(d)(11), 7 U.S.C. 7(d)(11); 17 CFR 38.602, 38.604,
38.605.
\128\ 17 CFR 38.604.
\129\ 17 CFR 38.604(a)-(c).
\130\ 17 CFR 38.605.
---------------------------------------------------------------------------
Commission Regulation 38.606 currently permits--but does not
require--a DCM to comply with the requirements of Commission
Regulations 38.604 and 38.605 through the regulatory services of an
RSP.\131\ Where a DCM elects to engage an RSP, Commission Regulation
38.606 requires the DCM to ensure that the RSP has the capacity and
resources necessary to provide timely and effective regulatory
services, including adequate staff and surveillance systems; to enter
into a written agreement that specifically documents the services to be
performed; and to retain ultimate responsibility for compliance with
its obligations under the CEA and the Commission's regulations.\132\
---------------------------------------------------------------------------
\131\ 17 CFR 38.606.
\132\ Id.
---------------------------------------------------------------------------
In administering Commission Regulation 38.604, Commission staff has
fielded interpretative questions regarding the frequency at which a DCM
must monitor positions and survey FCM obligations. The phrases
``continuously monitor the positions of members and their customers''
and ``continually survey the obligations of each [FCM]'' in current
Commission Regulation 38.604 could be read to require literal real-time
monitoring of trading activity. The Commission's intent in adopting
those phrases was to direct DCMs to perform risk-based, intra-day
assessments of the positions carried by each FCM throughout the trading
day--not to impose a continuous real-time monitoring obligation.\133\
---------------------------------------------------------------------------
\133\ See Core Principles and Other Requirements for Designated
Contract Markets, 77 FR 36612 (June 19, 2012) (adopting Commission
Regulation 38.604).
---------------------------------------------------------------------------
ii. Comments on the Affiliations RFC
The Commission sought comment on whether and how a DCM with an
affiliate FCM may carry out its financial surveillance obligations
under Commission Regulation 38.604
[[Page 50941]]
consistent with its impartiality responsibilities, what mitigants and
safeguards might be appropriate, and whether existing regulations are
sufficient.\134\ Commenters' views fell into three categories:
---------------------------------------------------------------------------
\134\ See Affiliations RFC, supra note 1.
---------------------------------------------------------------------------
Acknowledgment of potential conflicts. A number of commenters
acknowledged that a DCM's financial surveillance of an affiliate FCM
presents potential conflict-of-interest concerns. As described above,
CME, NFA, ICE, Cboe, FIA, and Professor Filler each indicated that a
DCM should not be permitted to act as DSRO for its affiliate FCM.\135\
Although these comments are most directly relevant to the proposed
Commission Regulation 1.52 amendments described above--which would
govern the periodic supervisory and examination program--the underlying
concern about partiality in supervision of an affiliated FCM applies as
well to the intra-day financial surveillance required by Commission
Regulation 38.604.
---------------------------------------------------------------------------
\135\ CME Comment, supra note 99, at 14; NFA Comment, supra note
96, at 4; ICE Comment, supra note 99, at 2-3; Cboe Comment, supra
note 99, at 3; FIA Comment, supra note 99, at 9-10; Filler Comment,
supra note 99, at 8.
---------------------------------------------------------------------------
Views on mitigants. Commenters offered a range of views on how
potential conflicts in DCM financial surveillance of an affiliate FCM
might be mitigated. Several commenters supported information barriers
and confidentiality controls. CME, NFA, ICE, and Professor Filler each
agreed that appropriate firewalls and information barriers should be in
place between a DCM and its affiliate FCM.\136\ NFA emphasized the
importance of separate boards of directors, separate key management
personnel, information-sharing barriers, and conflict-of-interest
policies.\137\
---------------------------------------------------------------------------
\136\ CME Comment, supra note 99, at 14-15; NFA Comment, supra
note 96, at 3; ICE Comment, supra note 99, at 3; Filler Comment,
supra note 99, at 5.
\137\ NFA Comment, supra note 96, at 3.
---------------------------------------------------------------------------
Other commenters addressed personnel and resource separations in
the surveillance context. CME stated that ``sufficient separation
between DCM or SEF personnel performing surveillance, investigation and
enforcement duties and an affiliated intermediary should be implemented
and conflicts of interest policies maintained,'' but cautioned against
``overly prescriptive rules'' given the obligations that DCMs already
have under the existing Core Principles to enforce rules, treat members
impartially, and minimize conflicts of interest in decision-
making.\138\ MIAX commented that DCM and SEF affiliates should not
share senior compliance and risk management personnel--including the
CRO and CCO--although certain functional roles, such as cybersecurity,
physical security, internal audit, and information security, present no
conflicts of interest and may be shared.\139\ AEGIS described its
existing approach, under which its SEF compliance and surveillance
staff are dedicated to the SEF and not shared with any affiliate, and
the SEF's staff is segregated into separate physical office space,
although certain marketing, treasury, and technology functions are
shared with affiliates pursuant to a shared-services agreement.\140\
CCP Global emphasized that there should be separation of resources,
including key personnel and offices, between affiliated entities.\141\
---------------------------------------------------------------------------
\138\ CME Comment, supra note 99, at 16-17.
\139\ MIAX/MGEX Comment, supra note 110, at 4, 7.
\140\ Letter from Andrew Furman, Chief Compliance Officer, on
behalf of AEGIS SEF, LLC, to CFTC at 3-4 (Sep. 28, 2023) (``AEGIS
Comment'').
\141\ CCP Global Comment, supra note 102, at 3.
---------------------------------------------------------------------------
Views supporting the existing framework. Several commenters viewed
the existing principles-based framework as sufficient to address
concerns about a DCM's financial surveillance of an affiliate FCM.
Coinbase did not believe that the affiliation between a DCM and an FCM
by itself would affect financial surveillance, citing the requirements
for the ROC under DCM Core Principle 16 and existing financial-
oversight regulations such as Commission Regulation 38.553 applicable
to FCMs and NFA.\142\ MIAX described its existing internal controls--
including a compliance manual that disallows treating affiliates
differently than other members and an Audits and Investigations
department that reports directly to the CRO, who in turn reports
directly to the ROC--as a means of ensuring equal treatment of
affiliated and unaffiliated participants.\143\ MGEX commented that, so
long as an affiliate FCM can demonstrate that it meets the applicable
regulatory financial-resources requirements without access to the
affiliated entity's funds, affiliation with a DCM should not pose a
problem.\144\ Cboe did not support new regulations limiting the sharing
of personnel or office space and encouraged the Commission to continue
a principles-based approach that allows for the flexibility necessary
to address particular facts and circumstances rather than developing an
entirely new framework.\145\
---------------------------------------------------------------------------
\142\ Letter from Faryar Shirzad, Chief Policy Officer, and
Gregory Compa, Senior Director, Head of Institutional Compliance, on
behalf of Coinbase Global, Inc., to CFTC, (Sep. 28, 2023) at 3, 7-8
(``Coinbase Comment'').
\143\ MIAX/MGEX Comment, supra note 110, at 5.
\144\ Id.
\145\ Cboe Comment, supra note 99, at 3.
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The Commission notes that none of the commenters specifically
recommended that the Commission mandate use of an RSP under Commission
Regulation 38.606 for a DCM's surveillance of its affiliate FCM.
Commenters who addressed mitigation generally emphasized information
barriers, personnel separations, and other structural safeguards as
appropriate means of addressing the potential conflict, rather than
mandatory third-party outsourcing of the intra-day financial
surveillance function.
iii. Identified Concerns
After considering the comments, the Commission preliminarily
believes that a DCM's financial surveillance of an affiliate FCM under
Commission Regulation 38.604 presents potential conflicts of interest
that warrant attention beyond those addressed by existing regulations.
Specifically, in monitoring the positions of an affiliate FCM,
comparing those positions to the FCM's financial resources, and
determining the appropriate steps to protect customer funds, a DCM
exercises judgment that may be influenced--or appear to be influenced--
by its commercial interest in the affiliate FCM. The decision to
escalate concerns regarding the affiliate FCM's financial condition
(including by contacting the FCM, the FCM's DSRO, or Commission staff
under Commission Regulation 38.604(c)) is similarly subject to
potential conflict or appearance of a conflict. Although the proposed
amendments to Commission Regulation 1.52 described above address the
periodic supervisory and examination program that an SRO conducts under
Commission Regulation 1.52(c) and the Joint Audit Plan under Commission
Regulation 1.52(d), the intra-day financial surveillance required by
Commission Regulation 38.604 is distinct as it involves the intraday
monitoring of positions and obligations and may require intraday
judgment calls about the financial integrity of FCMs and the protection
of customer funds that are not present in the Commission Regulation
1.52 context.
Separately, the Commission preliminarily believes that the existing
``continuously monitor'' and ``continually survey'' language in
Commission Regulation 38.604 would benefit from specifically reflecting
the
[[Page 50942]]
Commission's intent that the surveillance obligation is risk-based and
intra-day, not continuous in a literal real-time sense.
iv. Proposed Amendments
The Commission proposes two sets of amendments to address the
concerns identified above.
Clarifying Amendments to Commission Regulation 38.604.
The Commission proposes to amend Commission Regulation 38.604
regarding the frequency of the financial surveillance obligation. As
proposed, Commission Regulation 38.604(a) would retain the existing
requirement that a DCM monitor its members' compliance with the DCM's
minimum financial standards and routinely receive and promptly review
financial and related information from its members but would remove the
word ``continuously'' from the requirement to monitor the positions of
members and their customers. Instead, proposed Commission Regulation
38.604(a) would require the DCM to (1) monitor the obligations of each
FCM created by the positions of its customers ``throughout the day'';
(2) as appropriate, compare those obligations to the financial
resources of the FCM; and (3) take appropriate steps to use this
information to protect customer funds.
These amendments are intended to confirm that the surveillance
obligation requires intra-day, risk-based monitoring--taking into
account factors such as the size of an FCM and its customers'
positions, the margin required on open positions, market volatility,
the capital levels of an FCM, and the amount of excess segregated funds
held by the FCM--rather than literal real-time monitoring of every
trade. The Commission preliminarily believes that this clarification
codifies existing Commission expectations and market practices and is
appropriate independent of the affiliate-FCM context, although it has
practical importance for that context as well.
New Conflicts Procedures Requirements--Proposed amendments to
Commission Regulation 38.606.
The Commission proposes to amend Commission Regulation 38.606 to
add a new paragraph providing that a DCM that has an affiliate FCM (as
defined in proposed Commission Regulation 1.52(a)(3)) may comply with
the requirements of Commission Regulation 38.604 by designating an
independent third-party RSP, and that if such a DCM does not engage an
independent third-party RSP, the DCM must have procedures for
identifying, addressing, and managing conflicts of interests involving
its affiliate FCM that may arise in connection with the DCM's
obligations under Commission Regulation 38.604. The amendments would
further provide that such procedures must address, at a minimum: (1)
applications and systems, such that a DCM's applications and systems
are maintained and operated in a manner that prevents the sharing of
non-public information with any affiliate FCM; (2) personnel, such that
a DCM does not share staff with any affiliate FCM, except with respect
to administrative functions; (3) office space, such that a DCM
maintains office space for itself that is separate from the office
space of any affiliate FCM; (4) documentation, such that a DCM
documents all conflicts of interest that arise with respect to an
affiliate FCM and how any such conflict of interest is resolved; and
(5) disclosures, such that a DCM provides disclosure of the existence
of an affiliate FCM in its rulebook and in a clear, prominent, and
readily available manner on its website and any other application
portal or similar means through which a DCM directly or indirectly
connects electronically with its market participants.
This Proposal would not require a DCM with an affiliate FCM to
engage an RSP for Commission Regulation 38.604 purposes. The Commission
preliminarily believes--in part based on the comments described above--
that a principles-based conflicts mitigation requirement, leaving the
DCM with the choice between (i) outsourcing Commission regulation
38.604 surveillance to an independent third-party RSP and (ii)
implementing procedures to address the conflicts arising from in-house
Commission Regulation 38.604 surveillance of an affiliate FCM, would
appropriately accommodate the range of arrangements that DCMs may adopt
to satisfy DCM Core Principle 11 with respect to affiliated FCMs. This
approach is consistent with the principles-based posture recommended by
Cboe and is informed by the structural-safeguard recommendations of
CME, NFA, MIAX, AEGIS, and CCP Global.
The proposed approach is intended to operate alongside, rather than
duplicate, the proposed Commission Regulation 1.52 requirements
described above. The proposed Commission Regulation 1.52 changes would
require an SRO with an affiliate FCM to designate an independent third-
party SRO to conduct the periodic supervisory program and prohibit the
SRO from acting as DSRO for the affiliate FCM. The proposed Commission
Regulation 38.606 amendment, by contrast, would govern the distinct
intra-day financial surveillance function under Commission Regulation
38.604 and would leave the DCM with discretion to determine how best to
address the related conflicts.
The Commission also is proposing to amend Appendix B to part 38 to
provide DCMs with guidance regarding the Commission's views concerning
acceptable practices for conflict-of-interest procedures. The current
guidance provided with respect to Core Principle 16 (conflicts of
interest) in Appendix B to part 38 notes that DCMs ``bear special
responsibility to regulate effectively, impartially, and with due
consideration of the public interest'' and that they ``should be
particularly vigilant for such conflicts between and among any of their
self-regulatory responsibilities, their commercial interests, and the
several interests of their management, members, owners, customers and
market participants, other industry participants, and other
constituencies.'' \146\ The Appendix provides various acceptable
practices to manage conflicts of interest. This proposal would add
guidance regarding appropriate separations between a DCM and an
affiliate market participant (described below and including an
affiliate FCM) as follows:
---------------------------------------------------------------------------
\146\ CFR 17 part 38, app. B.
---------------------------------------------------------------------------
Separate systems. The guidance would provide that a DCM's
applications and systems should be maintained and operated in a manner
that prevents the sharing of non-public information with any affiliate
FCM, with a carveout to allow such sharing if the DCM shares such non-
public information with all of the DCM's market participants or if the
information relates only to the affiliate FCM or the affiliate FCM's
customers. The guidance would provide further color on appropriate
systems separations including that a DCM should: (1) keep logically
separate its trading platform, surveillance systems and recordkeeping
systems from an affiliate FCM's applications and systems; (2) apply
controls across all other applications, information and systems to
prevent improper sharing of non-public information with an affiliate
FCM; and (3) monitor for instances where an affiliate FCM has gained
access to the DCM's applications, information, or systems.
Separate personnel. The guidance would provide that a DCM should
not share staff with an affiliate FCM, with the exception of
administrative staff (for example, accounting, human resources
[[Page 50943]]
and payroll staff) and technology staff responsible for Core Principle
20 (Systems Safeguards) functions.
Separate office space. In order to prevent the inappropriate
sharing of non-public information, the guidance would provide that a
DCM should establish office space for itself that is separate from the
office space of any affiliate FCM, and that the separation should
include physical barriers and the ability of the DCM to monitor for any
instances where an affiliate FCM has gained physical access to the DCM.
The Commission preliminarily believes that this guidance sets out
best practices with respect to mitigating conflicts of interest between
affiliates. The core of the proposed guidance, together with the
proposed rule amendments, recommends physical separations between
affiliates' systems, personnel, and offices. The Commission
preliminarily believes that such separations will reduce the
possibility of affiliates and their personnel from inappropriately
sharing non-public information. Furthermore, the Commission
preliminarily believes that such separations will provide other market
participants with confidence regarding the DCM's ability to manage
conflicts.
The Commission requests comment on all aspects of the proposed
guidance. The Commission specifically requests comment on whether each
aspect of the proposed guidance is adequate or, instead, should be
modified or removed, and if the Commission should provide specific
guidance with respect to any other aspects of a conflicts of interest
program.
v. Statutory Authority
The Commission proposes the amendments to Commission Regulations
38.604 and 38.606 pursuant to section 8a(5) of the Act, which
authorizes the Commission to promulgate such rules and regulations as,
in its judgment, are reasonably necessary to effectuate any of the
provisions or to accomplish any of the purposes of the Act \147\ and
DCM Core Principles 11 (Financial Integrity of Transactions) and 16
(Conflicts of Interest). Core Principle 11 requires each DCM to
establish and enforce rules and procedures for ensuring the financial
integrity of transactions entered into on or through the facilities of
the contract market and for the protection of customer and member
property. Core Principle 16, in turn, requires each DCM to ``establish
and enforce rules to minimize conflicts of interest in the decision-
making process of the contract market and establish a process for
resolving [such] conflicts of interest.'' Under section 5(d)(1)(B) of
the Act, as amended by section 735(b) of the Dodd-Frank Act, a DCM has
reasonable discretion in establishing the manner in which it complies
with the Core Principles ``unless otherwise determined by the
Commission by rule or regulation.'' \148\ That reservation supplies the
affirmative authority for the Commission to specify particular means of
compliance where a specific circumstance not adequately addressed by
the general Core Principle formulation warrants targeted regulation.
Section 5c(a)(1) of the Act further authorizes the Commission to issue
interpretations of the DCM Core Principles to describe acceptable
business practices, on a non-exclusive basis.\149\
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\147\ CEA 8a(5), 7 U.S.C. 12a(5).
\148\ CEA 5(d)(1)(B), 7 U.S.C. 7(d)(1)(B).
\149\ CEA 5c(a)(1), 7 U.S.C. 7a-2(a)(1)-(2).
---------------------------------------------------------------------------
The proposed amendments exercise those authorities to address a
discrete conflict of interest--a DCM's financial surveillance of an
affiliate FCM--that the general Core Principle 11 framework, and the
current Sec. Sec. 38.604 and 38.606 implementing regulations, do not
specifically address. The Commission preliminarily believes that the
proposed amendments neither displace the DCM's reasonable discretion in
complying with the Core Principles nor exceed the Commission's
statutory authority under section 8a(5) and section 5(d).
vi. Alternatives Considered
The Commission considered, and requests comment on, two
alternatives to the proposed approach.
1. Mandatory Independent Third-Party RSP for Affiliated-FCM
Surveillance
The Commission considered requiring a DCM with an affiliate FCM to
designate an independent third-party RSP to perform Commission
Regulation 38.604 financial surveillance of that affiliate FCM. The
Commission preliminarily concluded that the principles-based approach
reflected in proposed amendments to Commission Regulation 38.606--
combined with the proposed Appendix B guidance--would be sufficient to
address the identified concerns at lower cost and is consistent with
the principles-based mitigation approach favored by many commenters.
The Commission requests comment on whether a mandatory independent
third-party RSP requirement for Commission Regulation 38.604 compliance
purposes is necessary or appropriate.
2. Prescriptive Separation Requirements in Rule Text
The Commission considered further codifying in rule text the
specific separations that the Commission considers appropriate for a
DCM that performs Commission Regulation 38.604 surveillance of an
affiliate FCM in-house. This approach would give effect to the
structural-separation recommendations of certain commenters,\150\ but
would not accommodate the principles-based flexibility favored by
others.\151\ The Commission preliminarily concluded that adding
Appendix B guidance, rather than new rule text, provides DCMs with
appropriate flexibility to design conflicts of interest procedures
suited to their specific organizational structures and operational
arrangements while providing market participants with information on
what the Commission considers to be appropriate conflicts of interest
procedures. The Commission requests comment on whether some or all of
the Appendix B content should be codified in rule text instead.
---------------------------------------------------------------------------
\150\ See, e.g., MIAX/MGEX Comment, supra note 110, at 4, 7 (no
shared senior compliance or risk personnel); AEGIS Comment, supra
note 140, at 3-4 (separate physical office space); CCP Global
Comment, supra note 102, at 3 (separation of resources including key
personnel and offices); NFA Comment, supra note 96, at 3 (separate
boards and key management personnel).
\151\ See, e.g., Cboe Comment, supra note 99, at 3; CME Comment,
supra note 99, at 16-17 (urging the Commission not to implement
overly prescriptive rules).
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vii. Request for Comment
The Commission requests comment on all aspects of the proposed
amendments to Commission Regulations 38.604 and 38.606 including:
(22) Whether the clarifying amendments to Commission Regulation
38.604--including the removal of the word ``continuously'' and the
substitution of ``throughout the day''--appropriately capture the
Commission's intent regarding the frequency and risk-based nature of
the intra-day financial surveillance requirement.
(23) Whether the principles-based approach in proposed Commission
Regulation 38.606 is appropriately calibrated, including whether the
proposed regulation should specify additional procedural elements that
a DCM electing to conduct in-house Commission Regulation 38.604
surveillance of an affiliate FCM must
[[Page 50944]]
include in its conflicts of interest procedures.
(24) Whether the Commission should adopt the alternative under
which a DCM with an affiliate FCM would be required to designate an
independent third-party RSP for Commission Regulation 38.604
surveillance of the affiliate FCM.
(25) Whether the Commission should adopt the alternative under
which additional separation requirements would be codified in the rule
text.
The Commission also specifically requests that DCMs with an
affiliate FCM--and any other DCM, FCM, or market participant with
relevant information--describe:
(26) Whether the DCM currently engages an RSP for Commission
Regulation 38.604 purposes (including for surveillance of an affiliate
FCM); and if so, the identity of the RSP and the terms (including cost)
of the arrangement;
(27) Where the DCM conducts Commission Regulation 38.604
surveillance in-house, the policies, procedures, organization
separations, and other measures currently in place to address potential
conflicts of interest arising from financial surveillance of an
affiliate FCM;
(28) The nature and estimated incremental cost of any change to
existing arrangements that would be required to comply with Commission
Regulation 38.606 as proposed; and
(29) The nature and estimated incremental cost of complying with
the mandatory independent third-party RSP alternative described above,
including any market-capacity considerations that would arise if
additional DCMs were required to engage NFA or another RSP for
Commission Regulation 38.604 surveillance of affiliate FCMs.
III. Exchange-Related Conflicts Mitigation
DCM Core Principle 16 and SEF Core Principle 12 each require an
exchange to establish and enforce rules to minimize conflicts of
interest in its decision-making process.\152\ This section of the
Proposal addresses conflicts of interest that arise when a DCM or SEF
is affiliated with a market participant that directly or indirectly
executes, introduces, or otherwise facilitates trades on that exchange.
Two distinct kinds of affiliation are at issue, and the distinction
between them is central to the regulatory approach the Commission
proposes. The first is an affiliation between an exchange and an
intermediary--such as an FCM or IB--that acts on behalf of customers.
The second is an affiliation between an exchange and a principal
trading firm, such as a hedge fund or market maker, that trades for its
own account on the exchange. As discussed below, an affiliated
intermediary acts as agent for customers, whereas an affiliate
principal trading firm trades as principal; every transaction the
latter executes against an unaffiliated participant implicates the
exchange's own economic interests directly. The Commission
preliminarily believes these two affiliations present conflicts that
differ in kind and proposes to address them through two distinct
mechanisms: a principles-based conflicts-of-interest framework
applicable to any affiliate market participant, and, for an affiliate
principal trading firm, a more prescriptive set of requirements. This
section of the Proposal also addresses conflicts of interest matters
related to DCM board composition, ROCs, and disciplinary panels.
---------------------------------------------------------------------------
\152\ CEA 5(d)(16), 7 U.S.C. 7(d)(16) (DCM Core Principle 16);
CEA 5h(f)(12), 7 U.S.C. 7b-3(f)(12) (SEF Core Principle 12).
---------------------------------------------------------------------------
A. Proposed New Commission Regulations 38.852 and 37.1201--Conflicts of
Interest Involving an Affiliate Market Participant
i. Background
DCM Core Principle 16 directs each DCM to establish and enforce
rules to minimize conflicts of interest in its decision-making process
and to establish a process for resolving such conflicts of
interest.\153\ The Commission's guidance and acceptable practices for
Core Principle 16 appear in Appendix B to part 38.\154\ SEF Core
Principle 12 imposes a parallel obligation on each SEF to minimize
conflicts of interest in its decision-making process and to establish a
process for resolving them.\155\ Both Core Principles are principles
based: the exchange must minimize conflicts in its decision-making and
have a process to resolve them, but the manner in which it does so is
left to the exchange's reasonable discretion, subject to the
Commission's rules and informed by Commission guidance and acceptable
practices.\156\
---------------------------------------------------------------------------
\153\ CEA 5(d)(16), 7 U.S.C. 7(d)(16) (DCM Core Principle 16).
\154\ 17 CFR part 38, app. B, Core Principle 16. app. B
currently does not provide any guidance with respect to compliance
with Core Principle 16.
\155\ CEA 5h(f)(12), 7 U.S.C. 7b-3(f)(12) (SEF Core Principle
12); 17 CFR part 37 2.
\156\ See CEA 5(d)(1)(B), 7 U.S.C. 7(d)(1)(B) (DCM reasonable
discretion); CEA 5h(f)(1)(B), 7 U.S.C. 7b-3(f)(1)(B) (SEF reasonable
discretion).
---------------------------------------------------------------------------
Neither Core Principle, however, specifically addresses the
conflicts of interest that arise when the exchange is affiliated with
one of its own market participants. Appendix B to part 38 speaks to
conflicts between a DCM's self-regulatory responsibilities and its
commercial interests generally, but neither the part 38 regulations nor
the part 38 guidance specifically addresses conflicts arising from an
exchange's affiliation with an FCM, IB, or principal trading firm
participating on its market.
ii. Comments on the Affiliations RFC
The Commission received substantial comment in response to the 2023
Affiliations RFC on conflicts arising from an exchange's affiliation
with a market participant.\157\ Commenters generally agreed that
affiliations between an exchange and a market participant can create
conflicts of interest warranting management, but a substantial majority
favored addressing those conflicts through a principles-based framework
rather than prescriptive structural requirements or an outright
prohibition.
---------------------------------------------------------------------------
\157\ Affiliations RFC, supra note 1.
---------------------------------------------------------------------------
Views supporting a principles-based framework. Commenters that
operate exchanges with affiliated intermediaries trading on their
markets and others urged the Commission to address potential conflicts
through a principles-based approach with accompanying guidance rather
than prescriptive rules. AEGIS, which operates a SEF affiliated with a
CTA and IB that executes transactions on the SEF, described the
existing combination of regulations and the registration process as
``effective in avoiding conflicts of interest.'' \158\ The Wholesale
Markets Brokers' Association, Americas (``WMBAA''), whose members
operate SEFs with affiliated IBs, similarly commented that the matters
raised in the RFC ``are addressed by current CFTC regulations and
current market practices'' and cautioned that an ``overly prescriptive
implementation of the Core Principles'' could ``dissuade future
entrants into the swaps market and reduce competition.'' \159\
---------------------------------------------------------------------------
\158\ AEGIS Comment, supra note 140, at 1.
\159\ Letter from Shawn Bernardo, on behalf of WMBAA, to CFTC at
2 (Sep. 28, 2023) (``WMBAA Comment'').
---------------------------------------------------------------------------
Cboe, which operates DCMs, a SEF, and DCO, commented that
``existing CFTC regulations provide an appropriate, principles-based
framework'' for evaluating and disclosing the risks associated with
intermediary affiliations and urged the Commission to ``continue
embracing a principles-based approach that allows for necessary
flexibility to address
[[Page 50945]]
particular facts and circumstances rather than develop an entirely new
framework.'' \160\ Coinbase observed that existing law and regulations
already ``prohibit DCMs from engaging in anticompetitive behavior and
require them to maintain impartial access to their market, enforce
their rulebooks consistently across participants, maintain adequate
staffing, safeguard confidential information and manage conflicts of
interest'' and encouraged the Commission to revise existing provisions
``only to the extent that'' a gap is identified, rather than adopt
``overly prescriptive regulations.'' \161\ CCP Global, while stating
that it ``does not believe that the CFTC should deviate from its
principles-based approach,'' suggested it ``could be beneficial'' for
the Commission to provide additional guidance--for example, ``an
illustrative list of conflicts to be mitigated, managed, and/or
disclosed and a list of tools that entities may use to mitigate these
conflicts.'' \162\ CME, while cautioning the Commission ``against
adopting comprehensive and prescriptive rules'' and emphasizing that
the existing principles-based approach ``has worked well'' supported
``requiring a marketplace SRO that is affiliate with an FCM (or other
CFTC registrant) to adopt and implement rules, policies, and/or
procedures to assure that its operations and those of the CFTC
registrant are sufficiently separated.'' \163\
---------------------------------------------------------------------------
\160\ Cboe Comment, supra note 99, at 2.
\161\ Coinbase Comment, supra note 142, at 2.
\162\ CCP Global, supra note 102, at 2.
\163\ CME Comment, supra note 99, at 1, 4.
---------------------------------------------------------------------------
Views on specific mitigants and disclosures. Some commenters
described the specific separations, safeguards, and disclosures they
viewed as appropriate, and many reported that such measures are already
standard market practice. AEGIS described an approach under which staff
responsible for compliance and surveillance are ``dedicated to the SEF
and not shared with any affiliate'' and are ``segregated into separate
physical'' office space, with certain marketing, treasury, and
technology functions shared with affiliates only pursuant to a CFTC-
reviewed shared-services agreement; it also described independent
governance through a SEF board and regulatory oversight committee with
public directors, the use of a third-party RSP for trade-practice
surveillance, and public disclosure of its affiliated broker firm.\164\
WMBAA reported that its members' SEFs manage affiliated-intermediary
conflicts through ``rulebooks, distinct and transparent governance
structures and operational policies,'' a third-party RSP, and ``data
separation barriers,'' while emphasizing the cost and efficiency
benefits of ``properly segmented'' shared resources.\165\ CCP Global
emphasized that an affiliate FCM should ``neither be afforded
preferential treatment, nor be disadvantaged or subject to more
restrictive treatment'' relative to unaffiliated FCMs, and should be
subject to the ``same access criteria and rules as non-affiliated''
members ``in areas including, but not limited to, fees, surveillance,
and disciplinary processes''; it further supported ``separation of
resources, including key personnel, offices, and information systems''
and robust information barriers.\166\
---------------------------------------------------------------------------
\164\ AEGIS Comment, supra note 140, at 1.
\165\ WMBAA Comment, supra note 159, at 4-5.
\166\ CCP Global Comment, supra note 102, at 3.
---------------------------------------------------------------------------
MIAX identified a ``well-conceived, thorough, and rigorously
enforced'' information-barrier policy; a prohibition on affiliates
sharing ``senior compliance and risk management personnel, such as the
Chief Risk Officer, the Chief Compliance Officer, and the Chief
Regulatory Officer''; physically and logically separate information-
technology systems and separate office space; and a public rule that
the affiliate ``will not receive preferential treatment in any
respect'' disclosed on its website.\167\ It identified cybersecurity,
physical security, internal audit, and information security as
functions that may be shared without conflict.\168\ CME recommended
that an affiliated registrant's operations be ``sufficiently
separated'' from the exchange's and agreed that the exchange should
adopt firewalls and internal procedures to prevent the affiliate from
accessing confidential information held by exchange staff.\169\
---------------------------------------------------------------------------
\167\ MIAX/MGEX Comment, supra note 110, at 4, 15.
\168\ Id.
\169\ CME Comment, supra note 99, at 4, 15.
---------------------------------------------------------------------------
Regarding disclosure, MIAX and AEGIS each described public
disclosure of the affiliate relationship as their existing practice,
and CCP Global, Cboe, and Coinbase each treated transparency regarding
the affiliation as an element of an adequate conflicts framework.\170\
---------------------------------------------------------------------------
\170\ MIAX/MGEX Comment, supra note 110, at 5 & n.13; AEGIS
Comment, supra note 140, at 1; CCP Global Comment, supra note 102,
at 2-3; Cboe Comment, supra note 99, at 2; Coinbase Comment, supra
note 142, at 2.
---------------------------------------------------------------------------
Views opposing affiliation. Public Citizen and Better Markets
opposed permitting exchange-affiliate relationships, with Public
Citizen taking the view that the conflicts ``cannot be successfully
mitigated'' and that the Commission ``must therefore establish rules
prohibiting'' such affiliations, and Better Markets opposing
affiliation structures generally while recommending robust disclosure
and conflicts-of-interest requirements if the Commission permits such
structures.\171\
---------------------------------------------------------------------------
\171\ See Letter from Tyson Slocum, Energy Program Director, on
behalf of Public Citizen, Inc., to the CFTC at 1-2 (Sep. 28, 2023)
(hereinafter ``Public Citizen Comment''); Letter from Cantrell
Dumas, Director of Derivatives Policy, on behalf of Better Markets,
Inc., to the CFTC at 1, 4 (Sep. 28, 2023) (hereinafter ``Better
Markets Comment'').
---------------------------------------------------------------------------
Views distinguishing agents from principals. Finally, several
commenters distinguished an affiliated intermediary that acts as an
agent for customers from an affiliated firm that trades on a
proprietary basis on the exchange. CME distinguished between an
affiliate FCM that ``acts solely on an agency basis'' and a trading
firm that ``trades on a proprietary basis on the DCM,'' observing that
the latter ``raises conflict of interest concerns of a very different
type and magnitude.'' \172\ Cboe questioned whether a DCM or SEF should
be permitted to have an affiliated liquidity provider trade on its
market.\173\ And Coinbase observed that the degree of conflict ``varies
depending on whether the trader is trading on behalf of others . . . or
whether the trader is solely trading for its own profit.'' \174\
---------------------------------------------------------------------------
\172\ CME Comment, supra note 99, at 3, 5.
\173\ Cboe Comment, supra note 99, at 3.
\174\ Coinbase Comment, supra note 142, at 7.
---------------------------------------------------------------------------
iii. Identified Concerns
After considering the comments described above, the Commission
preliminarily identifies the following concerns with respect to an
exchange's affiliation with a market participant.
First, an exchange exercises substantial discretion across
functions that bear directly on the competitive position of its market
participants. That discretion includes market and trade-practice
surveillance, investigations and rule enforcement, product listing
decisions, and fee and incentive arrangements. Where the exchange is
affiliated with a market participant, the structural incentive to
exercise that discretion in a manner that favors the affiliate, or that
disadvantages the affiliate's competitors, can compromise the
exchange's role as a neutral, self-regulatory operator of the market.
Second, an exchange acquires non-public information about its
market participants--including regarding order flow and positions, and,
through its surveillance and examination functions, financial and risk
information. Affiliation creates the risk that such
[[Page 50946]]
information could be shared with, or used to benefit, the exchange's
affiliate. As several commenters recognized, robust information
barriers between the exchange and its affiliate are a principal
safeguard against this risk; unaffiliated participants may be reluctant
to provide non-public information to an exchange if they perceive that
it could reach a competitor.
Third, even where an exchange in fact treats it affiliate on an
arms-length basis, the Commission believes that the perception of
preferential treatment can itself have anti-competitive effects and
understands that many market participants share this concern.
Unaffiliated participants may conclude that they are systematically
disadvantaged in surveillance, enforcement, listing, trading or fee
decisions, and may direct activity away from the venue, undermining the
integrity of the exchange as a market-neutral operator. It is possible
that unaffiliated participants may decide not to trade due to perceived
unfairness, which could have a negative impact on liquidity, or that
non-affiliate participants may have to trade on certain venues--in some
cases due to a lack of viable alternatives--despite these concerns.
The Commission preliminarily believes these concerns warrant
Commission action and that the Commission's existing regulations and
guidance are not sufficient. At the same time, the Commission is
preliminarily persuaded by the substantial body of comment indicating
that exchanges with affiliated market participants generally already
maintain the kinds of governance separations, information barriers, and
disclosures that mitigate these concerns. The Commission's proposed
approach, described below, is calibrated accordingly.\175\
---------------------------------------------------------------------------
\175\ The mission of the Commodity Futures Trading Commission is
to promote the integrity, resilience, and vibrancy of the U.S.
derivatives markets through sound regulation. See Mission Statement,
available at <a href="https://www.cftc.gov/About/AboutTheCommission">https://www.cftc.gov/About/AboutTheCommission</a>. See also
Chairman Michael Selig's April 1, 2026 public statement that
``regulators must be disciplined enough to administer the minimum
effective dose of regulation, otherwise innovation moves elsewhere
and our nation suffers the consequences,'' available at <a href="https://www.cftc.gov/PressRoom/SpeechesTestimony/seligstatement040126">https://www.cftc.gov/PressRoom/SpeechesTestimony/seligstatement040126</a>.
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iv. Proposed Amendments
The Commission proposes to add a new Commission Regulation 38.852
to part 38 and a parallel new Commission Regulation 37.1201 to part 37,
each establishing a principles-based requirement that an exchange with
an affiliate market participant maintain procedures to identify,
address, and manage the related conflicts of interest, together with
conforming acceptable practices in Appendix B to each part.
Definition of ``affiliate market participant''--Proposed Commission
Regulations 38.852(a), 37.1201(a).
Proposed Commission Regulation 38.852(a) would define ``affiliate
market participant'' as any person (including any affiliate FCM or
affiliate principal trading firm) that (i) directly or indirectly
executes, introduces, or otherwise facilitates trades on or subject to
the rules of the DCM, and (ii) directly or indirectly controls, is
controlled by, or is under common control with the DCM. Proposed
Commission Regulation 37.1201(a) would adopt a parallel definition for
SEFs that additionally enumerates an affiliate introducing broker,
reflecting the central role of introducing brokers in the SEF market
structure. Each definition uses the same ``control''-based formulation
the Commission proposes to use for the parallel definitions of
``affiliate futures commission merchant'' and ``affiliate clearing
member''.\176\
---------------------------------------------------------------------------
\176\ See supra Sec. II.A.iv.a, infra Sec. IV.D.
---------------------------------------------------------------------------
The Commission preliminarily believes that a control-based
definition, rather than a fixed ownership-percentage threshold, is
appropriate because the relevant conflicts turn on the power to direct
management and policies rather than on any particular equity stake, and
that consistency across the parallel definitions will promote clarity
and ease of compliance for corporate groups with multiple CFTC-
registered entities.\177\ The Commission solicits comment on the
proposed definition.
---------------------------------------------------------------------------
\177\ The terms ``affiliate'' and ``affiliated'' are consistent
with how the Commission has defined such terms elsewhere in its
regulations, including Commission Regulations 49.2 and 23.23(a)(1).
The Commission also believes that its definition is generally
consistent with how SEFs and DCMs have defined the term
``affiliate'' in their rulebooks. See, e.g., LedgerX LLC (d/b/a MIAX
Derivatives Exchange) (defining affiliate as ``a Person who,
directly or indirectly, controls, is controlled by, or is under
common control with another Person''); Kalshi LLC (defining
affiliate as, with respect to any Person, any Person who, directly
or indirectly, Controls, is Controlled by, or is under common
Control with, such other Person''); AEGIS SEF (defining affiliate as
``a Person who directly or indirectly, controls, is controlled by,
or is under common control with another Person''); BGC SEF (defining
Affiliate as any other Person which directly, or indirectly through
one or more intermediaries, controls, is controlled by, or is under
common control with, such Person.'').
---------------------------------------------------------------------------
Principles-based conflicts requirement--Proposed Commission
Regulations 38.852(b), 37.1201(b).
Proposed Commission Regulation 38.852(b)(1) would require that a
DCM have procedures for identifying, addressing, and managing conflicts
of interest involving an affiliate market participant. The proposed
regulation would further require that such procedures address, at a
minimum, applications and systems, personnel, office space,
documentation of conflicts, and disclosures. Proposed Commission
Regulation 37.1201(b) would impose the identical requirement on a SEF.
This formulation parallels the requirement the Commission proposes
below for DCOs in proposed Commission Regulation 39.25(d) and the
existing procedures-based formulation in Commission Regulation
39.25(c).\178\
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\178\ See infra Sec. IV.D.
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The Commission preliminarily believes a principles-based
requirement is preferable to prescriptive structural separation rules
in this context. Whether an exchange has an affiliate market
participant is an objective inquiry, as is whether the exchange
maintains procedures to identify, address, and manage the associated
conflicts, including with respect to the specifically enumerated
categories. The Commission can examine for compliance, and the
requirement places the burden on the exchange to design and implement
procedures suited to its particular structure and risk profile. This
approach is consistent with the principles-based posture favored by
most commenters and is informed by the specific safeguards that
exchanges with affiliated participants report already maintaining.
Acceptable practices--Appendix B to parts 37 and 38.
The Commission proposes to add conforming acceptable practices to
Appendix B of both parts 37 and 38, identifying the separations the
Commission would consider appropriate for an exchange with an affiliate
market participant. This Proposal would add guidance regarding
appropriate separations between a DCM or a SEF and an affiliate market
participant as follows:
Separate systems. The guidance would provide that a DCM's or SEF's
applications and systems should be maintained and operated in a manner
that prevents the sharing of non-public information with any affiliate
market participant, with a carveout to allow such sharing if the DCM or
SEF shares such non-public information with all of the DCM's or SEF's
market participants or if the information relates only to the affiliate
market participant or the affiliate market participants customer's. The
guidance would provide further color on appropriate systems separations
including that a DCM or
[[Page 50947]]
SEF should: (1) keep logically separate its trading platform,
surveillance systems and recordkeeping systems from an affiliate market
participant's applications and systems; (2) apply controls across all
other applications and systems to prevent improper sharing of non-
public information with an affiliate market participant; and (3)
monitor for instances where an affiliate market participant has gained
access to the DCM's applications, information, or systems.
Separate personnel. The guidance would provide that a DCM or SEF
should not share staff with an affiliate market participant, with the
exception of administrative staff (for example, accounting, human
resources, and payroll staff) and technology staff responsible for Core
Principle 20 (or 14, with respect to SEFs) (Systems Safeguards)
functions. The Commission preliminarily believes that legal and
compliance personnel do not constitute administrative staff for these
purposes, such that a DCM or a SEF would not be able to share such
personnel with an affiliate market participant. The Commission requests
comment on the appropriate classification of legal and compliance
staff.
Separate office space. In order to prevent the inappropriate
sharing of non-public information, the guidance would provide that a
DCM or SEF should establish office space for itself that is separate
from the office space of any affiliate market participant, and that the
separation should include physical barriers and the ability of the DCM
or SEF to monitor for any instances where an affiliate market
participant has gained physical access to the DCM or SEF.
As described above, the Commission preliminarily believes that this
guidance sets out best practices with respect to mitigating conflicts
of interest between an exchange and an affiliate market participant.
The core of the proposed guidance recommends physical separations
between affiliates' systems, personnel, and offices. The Commission
preliminarily believes that such separations will reduce the
possibility of affiliates and their personnel from inappropriately
sharing non-public information of an unaffiliated market participant,
which the Commission understands to be a core concern of such
unaffiliated market participants. Furthermore, the Commission
preliminarily believes that such separations will provide unaffiliated
market participants with confidence regarding a DCM's or SEF's ability
to manage conflicts.
The Commission preliminarily believes that placing these additional
details in acceptable practices, rather than in rule text, gives
exchanges clear notice of the Commission's expectations and appropriate
flexibility to design conflicts procedures suited to their own
structures.
v. Statutory Authority
The Commission proposes Commission Regulations 38.852 and 37.1201
pursuant to its authority under DCM Core Principle 16 and SEF Core
Principle 12, respectively--each of which directs the exchange to
``establish and enforce rules to minimize conflicts of interest in
[its] decision-making process'' and ``establish a process for resolving
such conflicts of interest''--and its general rulemaking authority
under CEA section 8a(5) to ``make and promulgate such rules and
regulations as, in the judgment of the Commission, are reasonably
necessary to effectuate any of the provisions or to accomplish any of
the purposes of this Act.'' \179\ The conflicts of interest addressed
by proposed Commission Regulations 38.852 and 37.1201 also implicate
additional Core Principle obligations under which the Commission has
authority to regulate: DCM Core Principle 12 and SEF Core Principle 3
direct exchanges to establish and enforce rules to protect markets and
market participants from abusive practices and to promote fair and
equitable trading, and DCM Core Principle 9 directs each contract
market to provide a competitive, open, and efficient market.\180\ The
exchange's exercise of surveillance, listing, and fee authority in a
manner that favors an affiliated intermediary bears directly on each of
these obligations, and the proposed conflicts framework supports the
exchange's compliance with all of them.
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\179\ CEA 5(d)(16), 7 U.S.C. 7(d)(16); CEA 5h(f)(12), 7 U.S.C.
7b-3(f)(12); CEA 8a(5), 7 U.S.C. 12a(5).
\180\ CEA 5(d)(12), 7 U.S.C. 7(d)(12); CEA 5(d)(9), 7 U.S.C.
7(d)(9); CEA 5h(f)(2), 7 U.S.C. 7b-3(f)(2).
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Additionally, the Core Principles establish that, ``[u]nless
otherwise determined by the Commission by rule or regulation,'' each
exchange has ``reasonable direction in establishing the manner'' in
which it complies.\181\ The reasonable-discretion clause expressly
contemplates that the Commission may specify the manner of compliance
by rule or regulation, and thereby authorizes proposed Commission
Regulations 38.852 and 37.1201, which require the exchange to maintain
conflicts procedures without dictating their content.
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\181\ CEA 5(d)(1)(B), 7 U.S.C. 7(d)(1)(B); CEA 5h(f)(1)(B), 7
U.S.C. 7b-3(f)(1)(B).
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vi. Alternatives Considered
The Commission considered, and requests comment on, several
alternatives to the proposed principles-based approach.
1. Additional Prescriptive Separation Requirements in Rule Text
The Commission considered codifying additional specific separation
requirements--including dedicated systems, dedicated staff, and
separate physical locations--in rule text rather than as guidance
regarding acceptable practices. The Commission preliminarily declines
to adopt it, principally because the record indicates that exchanges
with affiliated participants already maintain such separations and that
a prescriptive mandate could impose costs (such as restricting firms
from taking reasonable approaches that vary from those set out in the
acceptable practices) without corresponding benefit and deter entry and
competition. Moreover, the Commission understands that it regulates an
evolving industry with unique market structures and it wants to support
innovation. The Commission requests comment on whether some or all of
the acceptable practices should instead be codified in rule text.
2. Prohibition
The Commission considered, but preliminarily declines to propose, a
prohibition on exchange-affiliate relationships. The Commission
preliminarily concludes that affiliations involving an intermediary can
produce efficiencies and competitive benefits, including with respect
to market access and liquidity, that the CEA does not bar them, and
that conflicts procedures and disclosure as provided in the proposed
Acceptable Practices adequately mitigate the relevant risks. The
Commission requests comment on this alternative.
vii. Request for Comment
The Commission requests comment on all aspects of proposed
Commission Regulations 38.852 and 37.1201 and the conforming acceptable
practices, including:
(30) This Proposal generally applies to FCM and IB intermediaries,
as well as market participants such as principal trading firms, market
makers, and liquidity providers. Should the scope be expanded to
specifically refer to any other types of entities? If so, please
identify and explain.
[[Page 50948]]
(31) Whether the proposed definition of ``affiliate market
participant''--and the related ``control'' formulation--captures the
appropriate scope of relationships. Should the definition reach partial
ownership interests that do not rise to ``control''? Should the SEF
definition's express inclusion of an affiliate introducing broker be
mirrored in the DCM definition?
(32) Whether the principles-based formulation in proposed
Commission Regulations 38.852(b)(1) and 37.1201(b) is appropriately
calibrated, or whether the rule text should instead enumerate
additional specific procedures an exchange must adopt. If applicable,
please specify which Acceptable Practices should be moved to regulation
text.
(33) Whether the proposed Acceptable Practices are complete and
appropriately scoped.
(34) Whether DCMs and SEFs should be able to share legal and
compliance staff with an affiliate market participant.
(35) Whether any additional disclosures should be required. If so,
please specify the nature of such additional proposed disclosure.
(36) Whether the proposed approach should differ as between a DCM
and a SEF, and whether the SEF context in particular warrants any
distinct treatment given the nature of the market participants
typically active on a SEF versus those on a DCM. Conversely, given that
retail participation is prevalent on some DCMs, does the nature of such
participants warrant any distinct treatment?
(37) The Commission preliminarily understands that the proposed
requirements are consistent with existing practice at exchanges that
have an affiliate market participant. The Commission requests comment
on whether this understanding is correct, and requests that such
exchanges describe the policies, procedures, governance separations,
information barriers, and disclosures currently in place, and the
nature and estimated incremental cost of any change required to comply
with the Proposal as drafted.
(38) Are there benefits of affiliations between exchanges and
market participants, such as enhanced liquidity, broader market options
for customers, resource efficiencies, and increased competition and
innovation that the Commission has not described in this Proposal? If
so, please describe.
B. Proposed New Commission Regulations 38.852(b) and (c)--Prohibition
on Affiliate Principal Trading Firms and Conditional Affiliate Market
Maker Exception
i. Background
DCM Core Principle 16 requires each DCM to establish and enforce
rules to minimize conflicts of interest in its decision-making process
and to establish a process for resolving them.\182\ DCM Core Principle
12 separately requires a DCM to establish and enforce rules to protect
the market and market participants from abusive practices and to
promote fair and equitable trading.\183\ Each Core Principle is
principles-based, and a DCM ordinarily has reasonable discretion in
establishing the manner in which it complies.\184\ That discretion
applies, however, only ``[u]nless otherwise determined by the
Commission by rule or regulation.'' \185\ The Commission may therefore
prescribe by rule the manner in which a DCM complies with Core
Principles 12 and 16 where it determines that general exchange
discretion would not adequately address a particular conflict. \186\
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\182\ CEA 5(d)(16), 7 U.S.C. 7(d)(16).
\183\ CEA 5(d)(12), 7 U.S.C. 7(d)(12).
\184\ CEA 5(d)(1)(B), 7 U.S.C. 7(d)(1)(B).
\185\ CEA 5(d)(1)(A)-(B), 7 U.S.C. 7(d)(1)(A)-(B) (discretion
limited by Commission rule or regulation).
\186\ Part 38 already contains many implementing regulations.
See e.g. Commission Regulations 38.151-38.159, and 38.251-38.258.
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Section III.A addressed, through a principles-based framework, the
conflicts that arise when a DCM is affiliated with a market participant
generally. An affiliate that trades as principal for its own account on
an affiliated exchange presents a conflict that differs in kind. An
affiliated FCM or IB acts as agent and stands between the exchange and
its customers that trade on an exchange; an affiliate principal trading
firm is itself a trading counterparty on the exchange. Each transaction
it executes against an unaffiliated market participant situates the
exchange's own affiliate as a counterparty to a trade with a
participant the exchange is simultaneously obligated to, among other
things, treat impartially.
In the response to the Affiliations RFC, CME characterized an
exchange's affiliation with a proprietary trading firm as presenting
the ``most acute'' risks and as an ``inherent and stark conflict
arising from a firm trading its own account on its affiliated
exchange.'' \187\ CME accordingly urged the Commission to consider
``stringent restrictions and heightened supervisory obligations'' on a
DCM that permits an affiliate to trade for its own account.\188\ Cboe
questioned whether there is any need to permit an affiliate liquidity
provider to trade on an exchange on an ongoing basis, observing that an
exchange can instead incentivize unaffiliated liquidity providers
through incentive-program rule filings.\189\
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\187\ CME Comment, supra note 99, at 4, 12, 20.
\188\ Id. at 4, 12.
\189\ Cboe Comment, supra note 99, at 3.
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Neither Core Principles 12 and 16, nor the existing Acceptable
Practices in Appendix B to part 38, specifically address the conflict
presented by an affiliate that trades as principal on an affiliated
exchange.
This conflict has acquired practical significance with the
emergence of affiliated structures, particularly in prediction markets.
In these markets, the affiliate principal trading firm may serve as a
significant source of liquidity on the affiliated exchange. In such a
structure, the exchange's commercial dependence on its affiliate's
trading is structural rather than incidental, and unaffiliated
liquidity providers may decline to trade or quote on a venue where they
perceive that an affiliate trades on advantaged terms. The Commission
preliminarily understands that at least six DCMs currently permit an
affiliate to trade as principal on their markets, though due to
constantly evolving market structure, this estimation could change.
For the reasons set out in the Identified Concerns section below,
the Commission preliminarily determines that the principles-based
procedures proposed in Section III.A, while sufficient to address
conflicts arising from an affiliated intermediary, do not adequately
minimize the conflicts presented by an affiliate principal trading
firm. Exercising its authority to prescribe the manner of compliance
with Core Principles 12 and 16, and under its authority under Section
8a(5) of the Act, the Commission proposes in this section to allow an
affiliate principal trading firm to trade for its own account, subject
to certain safeguards to ensure the affiliated exchange treats such
firm on equal footing to non-affiliates. In this way, any benefits of
affiliation are preserved while striking a balance with goals of market
integrity and fairness.
The Commission notes that this section of the Proposal applies only
to DCMs, not to SEFs. It is the Commission's understanding that
[[Page 50949]]
market makers and liquidity providers are not as prevalent on SEFs, and
therefore the proposed requirements related to affiliate principal
trading should not apply to SEFs at this time. The Commission requests
comment on the scope limitation to DCMs.
ii. Identified Concerns
After considering the comments described above and the nature of
the affiliate principal trading relationship, the Commission
preliminarily identifies the following concerns, which it preliminarily
believes differ in kind from those presented by an affiliated
intermediary addressed in Section III.A. The defining feature of an
affiliate principal trading firm is that it trades as principal for its
own account, with the result that the exchange and its affiliate
through direct or indirect corporate affiliations, via a parent entity
or otherwise, may ultimately share the affiliate's profits from trading
on the exchange. The conflict therefore does not arise merely in the
exchange's decision-making process, where it might be managed through
procedures and disclosures; it inheres in the exchange's economic
position and persists, however scrupulously the exchange administers
its conflicts procedures.
First, an exchange controls the operational terms on which
participants trade--including ability to trade on the market,
generally, the latency and market-data access afforded to participants,
the priority accorded to competing orders at the same price, and the
fees and incentives available to liquidity providers. An affiliation
gives the exchange a direct financial incentive to set those terms to
advantage its affiliate. Because the affiliate trades as principal, any
such advantage converts directly into trading gains in which the
exchange ultimately could share, at the expense of the unaffiliated
market participants on the other side of those trades. Matching
priority, market-data and connectivity arrangements, and market-maker
incentive programs are ordinary features of exchange operation, and the
Commission preliminarily believes that an exchange administering them
for the benefit of an affiliate counterparty would compromise its
obligation under Core Principle 16 to minimize conflicts and its
obligation under Core Principle 12 to protect market participants from
unfair treatment.\190\
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\190\ CEA 5(d)(12), (16), 7 U.S.C. 7(d)(12), (16).
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Second, an exchange acquires non-public information about its
participants--for example, order flow and resting order-book
information--that would be of substantial value to a firm trading for
its own account. An affiliation creates both the means and the
incentive to share that information with, or exploit it for the benefit
of, the affiliate. The affiliate's status as a principal trader is what
makes the information particularly valuable: unlike an intermediary
executing customer orders, a principal trader can convert an
informational advantage directly into proprietary profit through its
own positions. The Commission preliminarily believes that the conflicts
of interest procedures, discussed in Section III.A, reduce this risk
but may not be sufficient in the context of an affiliate principal
trading firm because the exchange's incentive to tolerate leakage runs
in the same direction as the affiliate's incentive to exploit it.
Third, and most fundamentally, the exchange's self-regulatory
functions run directly against its commercial interest in the
affiliate's trading. A DCM is responsible for conducting market and
trade-practice surveillance of activity on its market and for
investigating and disciplining misconduct.\191\ Where the firm under
surveillance is the exchange's own affiliate and a potential profit
center, the exchange is asked to investigate and, if warranted,
discipline the source of its own revenue.\192\ The concern is
compounded in an affiliated structure in which the exchange is also
affiliated with the organization that clears its trades, which adds
discretion over margin, auto-liquidation, and default management that
could be exercised to favor the affiliate. The Commission is concerned
that an exchange cannot credibly perform these self-regulatory
functions in the context of an affiliate upon which it may be dependent
for profits, and that the mitigants cited by commenters--equal-
treatment and impartial-access requirements, ROC review, and Commission
examination--ultimately depend on the exchange's policing its own
conduct in the face of a significant conflict of interest. This concern
is most acute where the affiliate is the exchange's dominant or sole
source of liquidity, such that the exchange's continued viability
depends on the affiliate's activity precisely when impartial
enforcement matters most.
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\191\ See CEA 5(d)(2), 7 U.S.C. 7(d)(2) (Core Principle 2); CEA
5(d)(4), 7 U.S.C. 7(d)(4) (Core Principle 4).
\192\ The Commission recognizes that an affiliated FCM or IB
also could be a source of revenue for an affiliated exchange.
However, the Commission preliminarily understands that the value
proposition of an affiliated FCM or IB stems more from its ability
to connect customers to the exchange rather than through trading
profits. The Commission welcomes comment, including any relevant
data, on this understanding.
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Taken together, the Commission preliminarily concludes that the
conflicts presented by an affiliate principal trading firm are inherent
in the relationship and are not adequately minimized by conflicts
procedures and disclosure alone, as they would be for an affiliated
intermediary. Consistent with the comment record, the Commission views
this as the most acute of the affiliation conflicts.
The Commission does not, however, preliminarily propose to bar
affiliate principal trading altogether. Instead, the Commission
proposes to distinguish bona fide market making from directional
proprietary trading. Such a bona fide market maker would be a firm that
is contractually obligated to maintain continuous two-sided quotations,
that is filled only after unaffiliated members at every price level
(even where such affiliate placed its bids or offers prior to such
unaffiliated members), and that may not establish directional positions
other than in connection with its obligation to maintain two-sided
quotations. The harms identified above turn on the affiliate's ability
to convert operational and information advantages into proprietary
profit, and on the exchange's stake in the affiliate's directional
gains; the Commission preliminarily believes that confining such an
affiliate to bona fide market making removes the principal mechanisms
by which those harms are realized.
The Commission also preliminarily credits an affirmative rationale
for permitting a bona fide affiliate market maker. A new exchange faces
a coordination problem--unaffiliated market makers are reluctant to
commit capital and bear the fixed costs of participation until a market
demonstrates sufficient volume to make participation worthwhile, yet
volume is difficult to attract without quoted liquidity--and an
affiliate principal trading firm aligned with the venue's success may
supply that initial liquidity when independent firms will not. The
Commission preliminarily understands this dynamic to be especially
pronounced in prediction markets, which characteristically list a large
and continually refreshed population of individual small, short-lived,
and idiosyncratic contracts; unaffiliated market makers will rationally
concentrate on the few deepest contracts and decline to quote the long
tail, so that much of a venue's listed contracts may lack liquidity
unless an affiliate provides it. Because contracts of this
[[Page 50950]]
kind are listed continuously, the Commission preliminarily views the
need as recurring rather than confined to a venue's initial launch,
which informs its preliminary decision to propose a standing exception
rather than one-time accommodation. The Commission recognizes that an
exchange may instead seek to attract unaffiliated liquidity providers
through incentive-program rule filings \193\ but preliminarily believes
that incentive programs and affiliate market making are not perfect
substitutes for an unproven venue or across a broad and thin contract
universe.
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\193\ The Commission stated in the part 40 adopting release that
registered entities must submit all incenti
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