Last month marked the latest chapter in the long, strange saga of Bitcoin futures. On June 2nd, the Commodity Futures Trading Commission (“CFTC” or “Commission”) filed a civil complaint against the cryptocurrency exchange Gemini “for making false or misleading statements of material facts or omitting to state material facts to the CFTC in connection with the self-certification of a bitcoin futures product.” The complaint alleges that in the months leading up to the self-certification of the CBOE Futures Exchange (“CFE”) cash-settled Bitcoin futures contract in December 2017, Gemini engaged in a systematic effort to deceive the CFTC about the trading volume on the Gemini exchange and in the Gemini Bitcoin Auction. The trading volume on Gemini had direct bearing on whether CFE’s Bitcoin futures contract could be manipulated, because the contract settled based upon the price of Bitcoin from the Gemini Bitcoin Auction. Therefore, the CFE contract came to market under false pretenses and in violation of CFTC Core Principle 3: “[t]he board of trade shall list on the contract market only contracts that are not readily susceptible to manipulation.”
The Gemini complaint reveals the weaknesses and limitations of the self-certification process and the Commission’s overall approach to virtual currency. Self-certification is a congressionally authorized process that allows designated contract markets (“DCMs”) to list new derivative products one day after submitting in writing to the CFTC that the product complies with the Commodity Exchange Act (“CEA”) and CFTC regulations. Self-certification became the exclusive method by which new commodity derivatives products were listed shortly after it was introduced in 2000, and the process received little scrutiny until CFE and the Chicago Mercantile Exchange Inc. (“CME”) self-certified new contracts for cash-settled Bitcoin futures products in the midst of a historic run-up in Bitcoin’s price in December 2017. In January 2018, in response to criticism – including from me in a series of blog posts (here and here) which I later expanded upon in an academic article – that the Commission should have stayed the self-certification of these contracts, the Commission released a “CFTC Backgrounder on Oversight of and Approach to Virtual Currency Futures Markets,” which defends the Commission’s actions by noting that “there are limited grounds for the CFTC to “stay” self-certification such as filing a false statement in the certification” and that “in the case of the CME and CFE self-certifications, no such grounds were evident.” The “Backgrounder” also notes that the Commission engaged in a “heightened review” with CME and CFE in the months leading up to the self-certification of their Bitcoin futures contracts:
“At the heart of the CFTC’s heightened review is extensive visibility and monitoring of markets for virtual currency derivatives and underlying settlement reference rates. Virtual currency self-certification under heightened review means that the CFTC not only has clear legal authority, but now also will have the means to police certain underlying spot markets for fraud and manipulation.”
Despite directly engaging with Gemini prior to December 2017, heightened review failed to identify serious problems in the Gemini Bitcoin Auction that was used to price the CFE contract. This is particularly troubling when you consider that the problem of Gemini’s low trading volume was known within the virtual currency industry and by the Securities and Exchange Commission (“SEC”) well before December 2017. The Commission’s failure to identify the problem eroded market integrity by permitting the trading of a futures contract that was susceptible to manipulation. The oversight also risks eroding the Commission’s credibility unless additional steps are taken to ensure the integrity of other virtual currency derivatives and a wholesale review of the policies and procedures governing self-certification is conducted so that similar mistakes may be avoided in the future.
This article highlights the inherent weaknesses in using self-certification to list novel commodity derivatives, weaknesses laid bare in the Gemini complaint. It concludes with several recommendations for reforming the Commission’s approach to self-certification and virtual currency more generally. Until these recommendations are implemented, the Commission should consider pausing all ongoing reviews of virtual currency-related proposals, including FTX’s request to amend their derivatives clearing organization order to permit it to clear non-intermediated, virtual currency derivatives for retail traders on margin.
Readily Susceptible to Manipulation
To demonstrate their contracts could not be manipulated, and thus were compliant with Core Principle 3, CME and CFE needed a robust reference rate that was resistant to manipulation (in cash-settlement, if you can manipulate the reference price, you can manipulate the futures contract). Because Bitcoin trades at different prices on different exchanges, all with varying amounts of liquidity, CME and CFE took great pains to enlist a Bitcoin reference price that was resistant to manipulation. CME helped develop the Bitcoin Reference Rate (“BRR”) which aggregates Bitcoin trades across six different constituent exchanges during a one-hour window and then partitions this one hour window “into 12, five-minute intervals, where the BRR is calculated as the equally-weighted average of the volume-weighted medians of all 12 partitions.”
The CFE contract utilized the Gemini Bitcoin Auction (CFE stopped listing new cash-settled bitcoin futures contract in March 2019 due to lack of demand). The auction price was determined by “finding the price at which the greatest aggregate buy demand and sell demand from all eligible orders can be fulfilled; all continuous trading orders and auction-only orders are considered. The auction price then applies to all fills, allocated based on price-time priority.” In their self-certification submission, CFE emphasized specific features of the Gemini auction that CFE believed made its contract resistant to manipulation. Most notably, CFE pointed to Gemini’s pre-funding requirement, meaning that all orders must be fully pre-funded with assets on deposit at the exchange. In their complaint last month, the Commission notes that “Gemini represented that the ‘prefunding’ aspect of the Gemini Exchange made the Gemini Exchange and the Gemini Bitcoin Auction, and thus the Bitcoin Futures Contract, less susceptible to manipulation because it increased traders’ cost of capital and made improper trading conduct more expensive to malicious actors.”
Beyond questioning the basic premise that a derivatives contract, even if carefully constructed, can somehow be resistant to manipulation when the underlying asset is readily manipulated, I previously pointed out specific problems with both reference rates that should have given the CFTC pause. For the BRR, I called out the fact that Bitfinex was a constituent exchange until April 2017, when it was removed, along with OkCoin, for “transfer restrictions.” Bitfinex has a troubled history that includes multiple hacks resulting in the loss of customer funds, legal and regulatory violations, and using the stablecoin Tether – which was established by the owners of Bitfinex – to prop up the price of Bitcoin.
On December 13, 2017 – just three days after CFE’s contract started trading – I noted in a blog post that “Gemini is a very small exchange compared to its rivals, ranking twenty-fourth globally by 24-hour trading volumes and accounting for barely more than 1% of trading in the entire Bitcoin market.” I elaborated on Gemini’s problems in my article, noting that on numerous occasions leading up to CFE’s self-certification, the Gemini auction failed to clear a single Bitcoin. Had auction failure occurred on a final settlement date for a Bitcoin futures contract, the contract’s settlement value could not be readily determined. With such low trading volumes, I was concerned that the CFE Bitcoin futures contract could be manipulated by manipulating the Gemini auction.
I was not the only one with this concern. In 2016, the SEC first considered a proposal from Bats BZX Exchange to list a Bitcoin exchange traded product (ETP) to be known as the Winklevoss Bitcoin Shares (“Shares”) issued by the Winklevoss Bitcoin Trust (“Trust”). The Shares would track the spot price of Bitcoin at 4pm Eastern time on the Gemini Bitcoin Auction and the Trust’s “administrator will use the Gemini Exchange spot price as measured at 4:00 p.m. Eastern time to calculate the Trust’s net asset value (“NAV”).” The SEC sought public comment on several aspects of the proposal, including “commenters’ views regarding the susceptibility of the price of the Shares to manipulation, considering that the NAV would be based on the spot price of a single bitcoin exchange.” The SEC also cited a previous comment submitted by Jorge Stolfi that noted “relatively low liquidity and trading volume in bitcoins” on the Gemini Exchange raises the risk that the ETP’s price “will be manipulated, by relatively small trades that manipulate the bitcoin price at that exchange.”
In a letter to the SEC regarding the proposal, Tim Swanson, a veteran of the virtual currency industry, noted that Gemini’s auction volume was “underwhelming” and at the time, was averaging “lower volume than most other exchanges do in a given day.” Swanson goes on to raise a number of particularly prescient questions in light of the CFTC’s Gemini complaint: “Who are the participants in the auction? Do these participants have any conflicts of interest? Are they affiliated with other exchanges or with mining farms or pools?”
CFTC Sues Gemini
Given the widely known issues with Gemini’s volume, it is not surprising that the Commission filed a complaint alleging that Gemini and its employees engaged in a systemic effort to deceive the CFTC by making “false or misleading statements of material facts, or omit[ting] to state material facts, to Commission staff” with respect to “the operations of the Gemini Exchange and the Gemini Bitcoin Auction,” all of which had bearing on the Commission’s analysis of “whether the proposed Bitcoin Futures Contract would be readily susceptible to manipulation.” What is surprising is how long – over five years after the self-certification – it took for the CFTC to take action.[1]
The alleged conduct was designed to “increase trading volume and liquidity on the Gemini Exchange, including the Gemini Bitcoin Auction” in order to satisfy CFTC Core Principle 3. As previously noted, a key feature of Gemini’s sales pitch was that its pre-funding requirement would make the auction “less susceptible to manipulation,” but without notifying the Commission, Gemini took several measures to reduce or bypass the pre-funding requirement for select customers. One such measure involved making low interest, unsecured loans of “digital assets controlled by Gemini Principal-1 and Gemini Principal-2 from an entity they controlled” – I assume the two principals are Gemini founders and co-owners Cameron and Tyler Winklevoss – to certain market maker customers for the express purpose of increasing “trading on the Gemini Exchange and/or the Gemini Bitcoin Auction.” These loans allowed market makers to “use Gemini Principal-1 and Gemini Principal-2’s digital assets, rather than their own, to trade on the Gemini Exchange.”
Gemini also provided “advances” or “credits” of fiat currency or digital assets to certain customers by directly crediting the customer’s account for the sole purpose of participating in the Gemini Bitcoin Auction. In some instances, the advanced funds were debited from the customer’s account immediately after the auction. According to the Commission, such advances “could reduce traders’ cost of capital – and the cost of manipulative conduct – and thus potentially undermine a purported rationale as to why the Bitcoin Futures Contract was not readily susceptible to manipulation.”
Gemini also mislead the Commission when it said that self-trading, or self-crossing, was prohibited on its exchange. In fact, before May 2017, Gemini lacked the “technological means to prevent self-trading from occurring in Gemini Bitcoin Auctions” and that self-trading “in the Gemini Bitcoin Auction during this period could account for a significant portion of the Gemini Bitcoin Auction’s total trading volume on a given day.” In one of the more shocking items from the complaint, the Commission notes that “for one auction in December 2016, approximately 70% of the total auction trading volume resulted from a single auction participant trading with itself.”
Finally, Gemini misled the Commission around the prevalence of fee rebates and fee “overrides,” the presence of which “could reduce traders’ cost of capital – and of manipulative conduct – and thus potentially undermine a purported rationale as to why the Bitcoin Futures Contract was not readily susceptible to manipulation.” In fact, Gemini entered into custom fee arrangement with select market participants “that were not available to all Gemini market participants and that were not disclosed to the public on Gemini’s website” for the express purpose of incentivizing participation in the Bitcoin auction. Some customers abused this rebate system to generate “millions of dollars” “over a period of weeks essentially by trading large volumes among themselves.”
The above misconduct all occurred during the period in which the CFTC was actively engaged with CFE and CME and other relevant parties, including Gemini, to ensure that cash-settled Bitcoin futures contracts would be compliant with the Commodity Exchange Act and CFTC regulations. Without these measures, Gemini could not have demonstrated that they had the necessary trading volume and liquidity to prevent their Bitcoin auction from being manipulated. That this conduct went undetected for so long indicates that self-certification is not fit for purpose when it comes to evaluating the risks associated with novel commodity derivatives products.
CFTC Leans In to Bitcoin Futures and Self-Certification
The self-certification of Bitcoin futures is a pivotal moment in the history of the CFTC. What was previously a little-known and poorly-funded regulator was thrust into the limelight, perceived by many as a champion of innovation and retail investors everywhere. The decision not to stay the self-certification of Bitcoin futures earned then-CFTC chairman, Chris Giancarlo, the moniker “Crypto Dad,” which he heartedly embraced, as evidenced by the title of his new book by the same name.
Internal Commission deliberations and interagency conversations leading up to the launch of Bitcoin futures constitutes a whole chapter in Giancarlo’s book; another chapter is dedicated to the aftermath and criticism he and the Commission received. Giancarlo notes that the Commission viewed the self-certification of Bitcoin futures as an opportunity to engage with CME and CFE on contract design and data sharing. He notes that the Commission wrested “valuable concessions” from the exchanges, such as trading data that would enable the Commission to “better protect consumers and Bitcoin market participants and to better detect fraud and manipulation” (p. 136). Unfortunately, the Commission was unable to detect the fraud that Gemini was perpetrating on them leading up to the self-certification.
Giancarlo argues that the critics were making much ado about nothing, and that he was ultimately proven right by the contract’s performance, concluding: “Blocking self-certification would have also been a mistake. It would have meant virtually no federal regulatory oversight of Bitcoin markets for fraud and manipulation” (p. 157). However, last month’s complaint against Gemini indicates that it is premature to claim vindication.
Once self-certification was used to list cash-settled bitcoin futures, it was only a matter of time before it was used to list additional crypto derivatives with new terms and conditions. In recent testimony before a subcommittee of the House Agriculture Committee, CFTC Director of Market Oversight Vince McGonagle noted that five of the sixteen designated contract markets overseen by the CFTC “list for trading futures and options contracts on bitcoin, ether, or both” and that these markets offer “over a dozen different futures and options contracts on digital assets.” All these contracts were listed via self-certification, but McGonagle did not comment on the efficacy of self-certification or the Commission’s “heightened review” process for digital asset products despite acknowledging the Commission’s recent complaint “involving allegations for making false or misleading statements of material facts or omitting to state material facts to the CFTC in connection with the self-certification of a bitcoin futures product.” It appears as though institutional inertia has set in at the CFTC, and that the framework used to assess Bitcoin futures in 2017 continues to guide the Commission’s decision making around virtual currency products. Fortunately, change is possible.
Recommendations for Moving Forward
The allegations in the Gemini complaint reveal the challenges in assessing the risks associated with new derivatives products ex ante, especially derivatives on novel assets like Bitcoin. While the Commission should be applauded for seeking robust relief from Gemini – including disgorgement, civil monetary penalties, and injunctions – it should also acknowledge that investor protection and market integrity were severally compromised by letting CFE’s Bitcoin futures contract come to market. Four of the five current CFTC commissioners have been on the job for less than four months, and they should view the Gemini complaint as an opportunity to take a fresh look at the Commission’s past and current approach to virtual currency and related products. This includes reviewing: all previous self-certifications of virtual currency derivatives, the current staff advisory for listing virtual currency derivatives, and policies and procedures governing self-certification. Until these steps are taken, the Commission should consider pausing all virtual currency proposals currently before the Commission.
Review all Digital Asset Derivatives
The Commission’s Market Risk Advisory Committee (MRAC) should hold one or more open meetings to review the performance of every digital asset derivative that came to market since 2017. This review should include an assessment of how the claims made in each product’s original certification letter compare to how the product has traded in the marketplace. For each product, the Commission should ask: What are the trading volumes and how have volumes changed over time? Who is doing the trading and why? What are the volumes at the exchanges that supply the pricing information for each product? Is there any evidence of manipulation in the derivatives contract or the underlying? Have there been any enforcement actions taken against parties involved in the product’s trading or listing by the Commission or any other federal or state regulatory agency? What are the DCM’s market surveillance capabilities and what is the quality of the data being shared with the CFTC?
This review would allow the Commission to proactively identify any unforeseen problems, ideally before investors are harmed. If the review turns up any concerning information, the Commission may want to consider initiating proceedings to delist the product in question.
Update CFTC Staff Advisory No. 18-14: Advisory with respect to Virtual Currency Derivative Product Listings
Shortly after the December 2017 launch of Bitcoin futures, Commission staff issued an advisory to clarify their “priorities and expectations when reviewing new virtual currency derivatives to be listed on a designated contract market or to be cleared by a derivatives clearing organization.” The advisory contains five main elements: 1) enhanced market surveillance; (2) coordination with CFTC surveillance group; (3) large trader reporting; (4) outreach to stakeholders; and (5) DCO risk management.
For element 1, enhanced market surveillance, staff members note that ‘[w]ithout adequate visibility into the underlying spot markets, an exchange has diminished ability to effectively identify and address risks in the trading of listed virtual currency derivatives.” Therefore, Commission staff will review each DCM and swaps execution facility’s (SEF) surveillance program into the underlying spot markets. Clearly, in the case of CFE’s Bitcoin futures contract, such surveillance capacities were insufficient to identify the underlying problems on the Gemini exchange and Gemini Bitcoin Auction (unless CFE was aware of these problems and said nothing). Staff may want to consider providing more specific and concrete examples of the type and quality of surveillance sharing DCMs and SEFs are expected to have when they list virtual currency derivatives. Similarly, for element 2, coordination with CFTC surveillance group, Commission staff note they expect surveillance information to be supplied upon request, including data around the settlement process for each contract. Here again, Commission staff may want to consider a more explicit and formal process for providing surveillance data, ideally in real time. Staff should also review whether current large trader reporting thresholds are sufficient, given the trading history of virtual currency derivatives and low trading volumes on certain virtual currency exchanges
Review Policies and Procedures around Self-Certification
On January 31, 2018, the CFTC’s Market Risk Advisory Committee held an open meeting to discuss the statutory and regulatory process for the listing of new and novel products on CFTC-regulated designated contract markets (DCMs) and swap execution facilities (SEFs) through self-certification. At the time, the MRAC was sponsored by Democratic commissioner Rostin Behnam, while the majority of his fellow Commissioners were Republicans. During his opening remarks, then CFTC Chairman Chris Giancarlo noted that “Congress deliberately framed the self-certification process so that development of derivatives products would not be hampered by cautious regulators wary of the political risks of approving new products.” Giancarlo expressed his openness to amending existing processes around self-certification while also making clear his admiration for self-certification: “the CFTC’s current product self-certification framework is consistent with public policy that encourages market-driven innovation that has made America’s listed futures markets the envy of the world.”
Democrats now make up a majority on the Commission, and Chairman Behnam should once again call on the MRAC to review the Commission’s approach to self-certification. The allegations in the Gemini complaint, along with the recent use of self-certification to list multiple futures contracts on voluntary carbon offsets, which have their own integrity issues, is sufficient justification for another review of self-certification. Specifically, the Commission should assess the feasibility of seeking public input when self-certification is being used to list novel products. Chairman Behnam signaled his openness to this possibility at the 2018 MRAC meeting: “While the self-certification process does not expressly provide for public input, that does not mean that public input in the process of launching new and novel products is impossible or undesirable.”
CFTC Regulation 40.6 governs the self-certification process and provides a mechanism to stay a new rule or rule amendment that “presents novel or complex issues that require additional time to analyze.” Once a stay is in place, the Commission has 90 days to conduct a full review, during which time it must provide a 30-day comment period. Therefore, the Commission should assess the current criteria for determining the presence of “novel or complex issues” and consider releasing formal guidance for when public comment will be sought on new self-certifications.
Pause All New Digital Asset Proposals Until the Above Recommendations are Implemented
The Commission’s decision not to stay the self-certification of Bitcoin futures has left an impression that the CFTC is a crypto-friendly regulator. This perception is why many within the virtual currency industry want the CFTC to be given regulatory authority over virtual currency spot markets and has led to the Commission receiving additional novel proposals related to virtual currency. One such proposal currently before the Commission would allow the cryptocurrency exchange FTX to amend its order of registration as a Derivatives Clearing Organization (DCO) to permit it to clear non-intermediated virtual currency derivatives on margin. This past May, the Commission hosted an all-day public roundtable to consider the proposal. Representatives from all corners of the derivatives market participated, and many expressed concern that FTX’s proposed automated liquidation model could spark contagion by liquidating many traders’ positions in rapid succession. In light of the findings from the Gemini complaint, the Commission should be sensitive to the unintended consequences of novel virtual currency products and business models, consequences which are more acute when considering the unregulated nature of virtual currency spot markets. Until the Commission is able to complete a thorough review of all current virtual currency derivatives and the procedures governing self-certification and heightened review, it should refrain from approving new virtual currency proposals.
Conclusion
The recent collapse in virtual currency prices and the failure of several high-profile virtual currency firms has left many wondering why the crypto industry is not subject to the same kinds of consumer and investor protections that are present in traditional finance. It has also given fresh urgency to competing proposals to comprehensively regulate the virtual currency industry. The most glaring weakness that must be addressed is the lack of virtual currency spot market regulation, and a recent bill introduced by Senators Kirsten Gillibrand (D-NY) and Cynthia Lummis (R-WY) would give this authority to the CFTC. But unless the CFTC is willing to conduct an honest assessment of all past virtual currency-related decisions and learn from its mistakes, members of Congress should be hesitant to give the Commission such great authority. Now provides an ideal opportunity for a revamped Commission to take a fresh look at the virtual currency market and be honest about what it sees.
Lee Reiners is the executive director of the Global Financial Markets Center at Duke Law
The views expressed in this post are those of the author and do not represent the views of the Global Financial Markets Center or Duke Law.
[1] It is not clear how the Commission learned about the alleged conduct in the complaint, but a potential source may be one or two former Gemini employees directly involved in misleading the Commission, including one “that was closely involved in the engagement with Commission staff concerning the Bitcoin Futures Contract.” The complaint notes that “Gemini did not inform Commission staff that it had chosen to suspend an employee who had been speaking for Gemini at the meetings or that Gemini Principal-1 and Gemini Principal-2 had formed the belief that this employee was not trustworthy.”
