Towards Customer Protection: What the Futures Industry Can Teach Crypto
R Tamara de Silva
The Commodity Futures Trading Commission (CFTC) has established specific rules to ensure the protection of customer funds in the futures markets. Two key rules are CFTC Rule 1.20 and CFTC Rule 1.25. This article focuses on what the well run futures industry can teach centralized cryptocurrency exchanges. It also discusses what customers may want to consider in investing from a mature industry with separate silos that prioritize the protection of customer funds and the tremendous promise of cryptocurrency and blockchain technology.
CFTC Rule 1.20: Segregation of Customer Funds
CFTC Rule 1.20 mandates that futures commission merchants (FCMs) must segregate customer funds from their own operating funds. This means all customer funds received by the FCM must be deposited into separate accounts designated exclusively for the benefit of customers. The primary purpose of this rule is to ensure that customer assets are not used for the firm’s proprietary trading or other purposes. This segregation protects customers in the event of the FCM’s insolvency, ensuring that customer funds are not at risk.
CFTC Rule 1.25: Permissible Investments
CFTC Rule 1.25 outlines the types of instruments in which customer funds can be invested. This rule is designed to ensure that customer funds are invested in low-risk, highly liquid instruments to minimize the risk of loss. The investments are restricted to high-quality assets such as U.S. Treasury securities, ensuring that the principal is preserved and readily available when needed.
These rules collectively ensure that customer funds are protected and managed with a high degree of prudence, maintaining the integrity of the futures markets.
Centralized cryptocurrency exchanges can take several measures to align with CFTC rules. Establishing separate accounts specifically for customer funds, similar to FCMs under CFTC Rule 1.20, is crucial. These accounts should be designated for the exclusive benefit of customers, ensuring no commingling with the exchange’s operational funds. Secure custody solutions, including cold storage for cryptocurrencies, can further protect customer assets.
Performing daily calculations ensures adequate funds in segregated accounts to cover all customer obligations, mirroring FCM practices. Providing transparent reporting to regulators and customers about the status of segregated funds and daily calculations builds trust and accountability.
Restricting the investment of customer funds to low-risk, highly liquid instruments as outlined in CFTC Rule 1.25 minimizes the potential for loss and ensures the safety of customer funds. Regular internal and external audits verify compliance with segregation and investment rules. Active engagement with regulators helps exchanges stay updated on compliance requirements and best practices.
Enhanced security protocols protect customer funds from theft and fraud. Continuous assessment and mitigation of risks associated with holding and managing cryptocurrency assets are crucial. Utilizing blockchain technology provides transparency and traceability of customer funds, ensuring that segregation and proper management are easily verifiable. Implementing smart contracts to automate compliance checks and enforce segregation and investment rules programmatically adds an additional layer of security.
Future Regulations should aim to balance encouraging innovation in blockchain and not driving registrants outside the United States with the customer protection standards that are arguably the best in the financial world for customer asset segregation and protection.
The Nature of Decentralized Assets
Decentralized assets pose unique challenges for regulatory compliance. Their inherent nature can make it more difficult for exchanges to adhere to stringent customer protection rules like those set forth by the CFTC. Decentralized exchanges operate without a central authority, which complicates the implementation of uniform compliance standards. The anonymity associated with decentralized assets can hinder efforts to perform thorough AML and KYC checks, making it difficult to track the source of funds and ensure they are not used for illicit activities.
Decentralized finance (DeFi) is also susceptible to cyber-attacks, with a majority of crypto hacks targeting this sector. In 2023, cryptocurrency hacking incidents rose to 231 from 219 in 2022. However, the total value stolen dropped by 54.3%, from $3.7 billion in 2022 to $1.7 billion in 2023. This decrease was largely due to a significant reduction in DeFi hacks, which saw a 63.7% drop in stolen funds. Despite the reduction in stolen value, hacking remains a significant threat to the cryptocurrency industry. This is an important risk disclosure for customers to understand and acquiesce to.
Integrating blockchain technology and smart contracts for compliance purposes requires significant technical expertise and resources, which may not be readily available to all exchanges.
This also poses challenges for registrants in the crypto space because their universe of vendors for compliance, legal, fund administration and accounting is more limited. This poses a unique challenge for registered crypto entities in applying National Futures Association Rule (NFA) Compliance Rule 2-9. What I mean by this is that there are fewer vendors to choose from and the possibility of getting a subpar vendor may be greater. New registrants should be careful in choosing legal counsel to make sure they truly understand the compliance requirements and are not just registering entities without full and complete understanding of the futures regulatory regime. I have previously written about the auditor who gave an unqualified opinion of FTX, Prager Matis, and the other Armanino, who never looked at FTX’s internal controls to notice the lack of them. These were among the first to cater to an industry without understanding it better.
Despite all the aforementioned challenges and regulatory uncertainty is a substantial challenge- regulatory uncertainty is not an excuse for exchanges to not strive to offer similar protections for customers as are present in the well-run futures markets. The task is to aspire towards the same customer protection rules of the futures markets without destroying the technology behind crypto. Exchanges must strive to align with CFTC rules to enhance customer protection and market integrity.
Proof of Assets and Reserves: Current State and Adoption
In 2024, there is still no set standard for proof of assets or proof of reserves for cryptocurrency exchanges. Proof of assets involves demonstrating that an exchange holds the actual stated amounts of customer funds, ensuring transparency and trust. Proof of reserves, on the other hand, involves showing that an exchange has enough assets to operate and cover its liabilities.
Cryptocurrency exchanges need to provide verifiable evidence that they hold the actual amounts of customer funds they claim. This can be achieved through regular audits and transparent reporting practices, similar to the daily reconciliation required by CFTC Rule 1.20. Proof of reserves involves demonstrating that an exchange has sufficient assets to cover all customer liabilities and operate sustainably. However, adoption of standardized proof of reserves across the cryptocurrency industry is still lacking.
Risks Posed by Centralized Cryptocurrency Exchanges for Customer Protection
Centralized cryptocurrency exchanges are not as transparent or mature as well-run futures exchanges in offering stringent customer protection rules. Regulatory uncertainty is not an excuse for not being able to comply with the long-standing and well-established customer protection rules of the futures markets as set forth by the CFTC. While some exchanges like BitMEX, Coinbase, and Kraken are taking significant steps towards higher compliance standards, this relatively new industry is still evolving. By adopting practices that align more closely with CFTC rules and establishing proof of assets and reserves, cryptocurrency exchanges can enhance customer protection, improve market trust, and build a foundation for sustainable growth in the digital asset space.
There are inherent risks associated with centralized cryptocurrency exchanges. Custodial risks arise when exchanges hold users' funds, making them attractive targets for hackers. The lack of segregation of duties means trading, custody, and settlement functions are often intertwined, increasing operational risks and potential misuse of funds. In futures, the trading, custody, clearing and settlement function are each in different silos. This siloing provides customer protection that is not available in most centralized crypto exchanges even in 2024.
As the regulatory landscape continues to evolve, exchanges and registered entities that prioritize compliance and transparency will be better positioned to navigate the complexities of the market and gain a competitive edge. Following rules early can help businesses stand out, making people and institutional investors trust them more. This may ultimately give them a competitive advantage in the market. It is not always just about technology.
If you need assistance navigating the complexities of futures and derivatives law, including compliance with CFTC regulations, contact us. With extensive experience in regulatory and compliance practice within the financial industry, we provide tailored legal solutions to ensure your business meets the highest standards of customer protection and regulatory compliance.
Endnotes:
https://www.ecfr.gov/current/title-17/chapter-I/part-1/subject-group-ECFR0b7db1d7cacc538
https://www.law.cornell.edu/cfr/text/17/1.25
https://www.chainalysis.com/blog/crypto-hacking-stolen-funds-2024
Chainalysis Blog: https://www.chainalysis.com/blog/crypto-hacking-stolen-funds-2024/
https://www.desilvalawoffices.com/articles/blog/2022/december/ftxs-auditors-and-proof-of-reserves/
NB This information is provided as a service to clients and friends for educational purposes. It should not be construed or relied on as legal advice or to create a lawyer-client relationship. Readers should not act upon this information without seeking advice from a legal professional.