What You Should Know About the CFTC, Part 1: The Regulatory Basics

In Part 1 of this three-part overview of the Commodity Futures Trading Commission (CFTC), we take a look at the basics of CFTC regulation, highlighting what you need to know about the agency and its jurisdiction.

The CFTC Regulates Derivatives

The Commodity Exchange Act (CEA), which has expanded over time, established the CFTC to regulate commodity derivatives; it does not regulate commodities. The definition of a commodity is extremely broad and includes certain enumerated agricultural products and “all other goods and articles … and all services, rights and interests ... in which contracts for future delivery are presently or in the future dealt in.” The phrase “contracts for future delivery are presently or in the future dealt in” at a minimum refers to derivative contracts currently traded on CFTC designated contract markets. The CFTC also has argued it includes commodity derivatives traded on foreign markets (even if not traded in the U.S.) and derivatives contracts in similar commodities because they arguably demonstrate the potential for similar contracts “[to be] dealt in” the U.S. in the future.

The definition of a commodity interest, however, is narrower and comprises any financial instrument that derives its price from the value of an underlying commodity. Examples of derivatives include futures contracts, options and swaps, whether traded on a contract market or over the counter. First, futures contracts — referenced in the CEA as a “contract of sale for future delivery” — are standardized, legally binding contracts to purchase or sell a commodity at a specified time in the future where the price is predetermined at the initiation of the contract. Futures contracts are used to assume or shift price risk, and the contracts typically are satisfied by offset between the contract price and market price. Second, options on futures provide buyers the right, but not the obligation, to buy or sell a futures contract at a specific price. Third, swaps are defined as (i) options based not on futures but instead on the value of one or more financial or economic interests or property, (ii) contracts where parties agree to exchange at least two different financial or economic interests or property, (iii) contracts where the purchase, sale, payment or delivery is dependent on the occurrence of an event or contingency “associated with a potential financial economic, or commercial consequence”; or (iv) contracts commonly known as swaps, including interest rate, commodity, currency, equity, credit default and cross-currency swaps, as well as non-deliverable forwards, foreign currency or other options and event contracts. With limited exceptions, derivative contracts with U.S. persons must be traded on CFTC-registered exchanges.

The CFTC does not regulate spot commodity transactions — i.e., contracts for physical delivery of commodities typically within two days (or similarly short time period accepted as cash market convention). However, margined, leveraged or financed spot transactions are treated “as if” they are futures contracts by the CFTC, and regulated as such, unless the spot commodity is “actually” delivered to the buyer within 28 days. The Commission also has antifraud authority over spot markets, which it interprets broadly to cover spot commodities that could be the subject of a futures contract, not just those currently traded on exchanges (more about this later). Although a reading of the statute suggests its fraud authority is limited to spot contracts that are actually referenced in existing futures contracts, the CFTC has consistently argued its jurisdiction is much broader.

The nature of the commodity may determine the nature and scope of CFTC regulation. For example, the Dodd-Frank Wall Street Reform and Consumer Protection Act specifically reserves regulation of securities to the SEC, although certain security futures and swaps are jointly regulated by both agencies. Other commodity interests may have somewhat varied regulatory treatment depending on the nature of the commodity. As a result, the CFTC must make a legal judgment as to the nature of the commodity (i.e., security, agricultural, exempt or excluded) and the scope of the agency’s jurisdiction before taking regulatory or enforcement action.

Bottomline: While the CFTC’s regulatory authority is limited to derivatives, it has broadly interpreted its authority to investigate and punish wrongdoing in spot markets connected to the regulated derivatives markets.

The Long Arm of CFTC Jurisdiction

The CEA does not authorize extraterritorial jurisdiction and limits the CFTC authority to domestic activities, with few exceptions — though those exceptions can be broad, depending on the circumstances. Specifically, the CFTC has authority to regulate transactions involving U.S. persons, transactions executed on domestic markets, and domestic purchases or sales in interstate commerce.

U.S. Persons: The definition of U.S. person generally includes any person residing in the United States, but it can be more complicated because person includes “associations, partnerships, corporations, and trusts.” The swap cross-border rules focus on the principal place of business of the entity, which is defined as the location where the officers, partners or managers primarily direct, control or coordinate the activities of the organization and may include under certain circumstances foreign entities guaranteed or directly controlled by U.S. entities. A recent enforcement matter presents an interesting wrinkle. A federal district court held that a decentralized autonomous organization (DAO), the Ooki DAO, was a “person” under the CEA, because it operated as an unincorporated association under state law. A DAO is an organization run by smart contracts on a blockchain, rather than by centralized leadership. Although the Ooki DAO operated outside the United States, had no central leadership or organization, and had no apparent central location, the court found that token holders, by exercising their rights as holders of governance tokens to vote and authorize certain DAO actions, acted in concert as members of an association when they voted. Because the token holders largely resided in the United States, the court found that the association (token holders who voted their tokens) was a U.S. person under applicable state law.

Domestic Transactions: A transaction is domestic if the transfer of title or irrevocable liability (e.g., liability to pay) occurs within the United States, typically characterized as the last significant act necessary to execution. Courts also have focused on U.S. acts necessary to negotiating and executing the transaction. For example, courts have found that CFTC jurisdiction extends to a foreign transaction executed on a foreign exchange among foreign counterparties where an act necessary to execution of the derivative (e.g., clearing) occurred in the United States.

Swaps Extraterritorial Jurisdiction: Dodd-Frank further authorized extraterritorial jurisdiction for swap contracts that have a “direct and significant” connection with activities in, or an effect on, U.S. commerce or violate CFTC rules aimed at preventing the evasion of certain CEA provisions. Dodd-Frank did not define “direct and significant.” The CFTC subsequently issued guidance interpreting “direct” to require a “reasonably proximate causal nexus” and “not to require foreseeability, substantiality, or immediacy.” In a recent case, a federal district court found the U.S. nexus was neither sufficiently direct nor significant where a swap contract negotiated in Japan for the purposes of hedging a Japanese transaction among Japanese counterparties was priced based on prevailing prices in the New York interest rate swap market. Regardless of the ultimate conclusion regarding extraterritorial jurisdiction, the CFTC has broadly interpreted its authority to investigate matters relating to swaps where U.S. contacts exist.

The CFTC also has exercised jurisdiction over foreign corruption where the residual effects of foreign contracts, which were obtained by bribing foreign government officials, adversely impacted U.S. spot commodity markets referenced in U.S. derivatives, especially where there is a demonstrable price effect on those markets. In addition, the CFTC has made clear that it will pursue fraud committed abroad if U.S. residents are involved. For example, the CFTC has exercised jurisdiction over swap contracts entered among foreigners and executed on a Filipino digital exchange where key aspects of the pricing and hedging were performed in the United States.

Bottom-line: The CFTC has consistently asserted its authority to investigate and pursue foreign conduct where there is an arguably sufficient U.S. nexus.

CFTC Regulation Relies on Intermediation

The CEA established the framework for clearing and intermediation through registered entities, namely Futures Commission Merchants (FCMs) and designated clearing organizations (DCOs), and regulated markets — collectively, designated contract markets (DCMs). The framework is at the heart of the Commission’s customer protection program and has held up incredibly well under periods of stress, most recently during the Covid-19 crisis. As former Commissioner Goldsmith-Romero pointed out, the “existing regulatory framework ... has a proven record of reducing financial stability risk.” This market structure generates a fair amount of friction, which to some extent is the point: central clearing by registered entities, segregated custodial accounts, checks and balances imposed through multiple compliance layers, and supervision not only by the CFTC but also by self-regulatory entities, like DCMs and the National Futures Association (NFA) — all of which are empowered to ensure customer protections, guardrails and safeguards. In June 2023, the CFTC authorized Cboe Clear Digital, LLC (Cboe) to expand its clearing of futures contracts on crypto assets to include margined digital products, where trades will be executed and cleared through an approved set of member FCMs and the CBOE clearinghouse will act as the central counterparty. In August 2023, the NFA also approved Coinbase’s FCM for operation alongside its DCM. These are recent examples of traditional intermediation architecture applied in the context of emerging technologies and products.

The focus on intermediation, however, has led to concerns about concentrated risk, cross-border coordination issues and perceived inability to adapt to new technologies. Those concerns are amplified by the dwindling number of FCMs (61 by last count, with most of the business concentrated in the 10 largest). Non-intermediation has been offered as a possible solution. Proposals for non-intermediation are not new — non-intermediated clearinghouses approved by the CFTC have operated for years. At least four currently operate on a fully collateralized basis, and a fifth offers margined products (but only to high net-worth individuals or entities). FTX’s application for direct-to-customer disintermediation requested authorization to clear retail margin contracts without intermediaries and authority to self-liquidate when customers fail to meet margin requirements — essentially combining the marketing and leverages of an FCM with exchange-style execution. Although the FTX application was overtaken by subsequent events (and later withdrawn), many see benefits to expanded disintermediation and reduced friction in certain (but not all) situations, although questions about implementation remain.

The CFTC Division of Clearing and Risk hosted a wide-ranging and highly informative roundtable discussion on clearing, which included discussion about disintermediation. The big issues with disintermediation involve the handling of margin accounts and retail participation — in what markets, with what products and under what circumstances margin products may be offered to retail customers. Other issues concern what entities should be involved in that process — for example, does a vertically integrated structure incorporating multiple related entities in the process lead to conflicts among affiliated entities, especially if one of the entities is a digital custodian? The approval of CME’s registration as an FCM, in addition to its registration as a DCM where it acts as an SRO, is an example of the vertical integration that has raised concerns for some.

It will be interesting to see how the Commission staff sorts through these issues, but if recent roundtable discussions are any indication of the future, it appears the Commission is moving toward a more flexible approach that includes disintermediation as a viable option in certain situations with certain products provided sufficient guardrails are in place. This changing, potentially hybrid landscape presents opportunities for market participants, but those opportunities will need to be balanced against customer protection and risk mitigation concerns.

Bottomline: Regardless of structure, participants in the U.S. derivatives markets should expect to operate in a manner consistent with the CFTC’s core principles and business conduct standards; otherwise, they likely will prompt regulatory and enforcement scrutiny.

Private Funds and OTC Derivatives (an Imperfect Fit)

Over-the-counter (OTC) derivatives are financial contracts traded directly between two parties, instead of through an exchange or clearinghouse. From macro hedging to foreign-currency feeder hedging to synthetic leverage to equity disposition strategies, over-the-counter derivatives have become increasingly commonplace in the private fund industry. Constantly evolving and complex structure charts and use cases pressure the fit between existing regulations and guidance and real-world application. This poses a functional challenge both for regulators (how do regulators avoid being over-broad and/or under-inclusive?) and for sponsors (how do sponsors prudently implement OTC derivatives without undue and/or insensible compliance burdens, such as variation margin, that do not fit budgeting and investor-driven constraints). Given the somewhat unique division of labor with respect to OTC derivative regulation in the United States, knowing what law applies poses further challenges. Many distinctions, while sensible in the context of the history of U.S. derivatives, securities and banking regulation are hardly intuitive. For example, differences in cross-border treatment of margin rules between prudential regulators, the CFTC and the SEC, or product-specific distinctions (e.g., a delta-one TRS on a single loan versus a delta-one TRS on two loans) can be difficult for nonpractitioners to predict and plan for. The result is, in some instances, jurisdiction-shopping in efficiency-seeking and substitution of near-equivalent products (such as repo in lieu of TRS) to sidestep the confusion altogether.

Bottomline: Matching private fund objectives with an evolving OTC derivatives market requires careful planning and an in-depth understanding of the market and regulatory environment.