Why I’m All-In on TradFi’s Regulated Approach to Digital Assets
I’ve always considered myself keyed into the next big thing. Early in my career, I discovered the power of technology as a disruptor as the futures market transitioned from open outcry to all electronic trading and processing. Since then, I’ve been chasing what’s next in finance. And today, despite recent controversy, I’m still all-in on digital assets. Change isn’t easy, but with the right people in the room – like capital markets risk, technology and market structure experts – we can grow this market and still protect investors.
There is incredible potential with digital assets, as well as significant risk – as with any asset class and financial market. That’s why the rules, regulations and ethics we hold ourselves accountable to as regulated financial exchange operators are critical. They include full transparency, rigorous regulatory oversight, relentless operational resilience and a multitude of controls, including stringent restrictions concerning conflicts of interest.
I know, crypto is supposed to be exciting and edgy but it’s time to let go of the past and untether digital assets from any illicit finance label. Let’s combine the ingenuity of crypto with the principles of traditional markets. Trust me, it’s going to be exciting.
So, where do we start? With the basics. Let’s breakdown the role of a U.S. regulated crypto exchange, clearinghouse and custodian.
Cboe Digital: The U.S. Regulated Platform
Cboe Digital is a unified platform for spot and regulated futures on cryptocurrencies. Cboe Digital is comprised of an exchange and clearinghouse. Cboe Digital Exchange operates the technology that matches buyers and sellers, both in spot and futures. Structured and built like exchanges for other traditional financial instruments, we operate a central limit order book to promote transparency and price discovery. The same structure powers some of the most robust and liquid markets in the world today, namely the U.S. equities and futures market.
Did I mention that Cboe® also operates one of the largest global networks of equities exchanges, including four U.S. equity exchanges? That experience and expertise is powering our approach with a transparent and trustworthy digital asset exchange.
Cboe Clear Digital operates our clearinghouse – more on that later.
In the U.S., whether you want to trade spot or derivatives on digital assets, there are regulations in place that platforms, or exchanges like Cboe Digital, must adhere to. Our spot market activity is regulated as “money service business” (MSB) under Financial Crimes Enforcement Network (FinCEN) and licensed in accordance with state money transmitter licensing requirements. State money transmitter licenses provide basic protections to customers insofar as the transmission and holding of their fiat and digital assets are concerned. To date, Cboe Digital can operate in 51 U.S. states and jurisdictions as we are currently working to offer services in Virginia and USVI.
The Commodity Futures Trading Commission (CFTC) regulates our futures market – where we are trading in physically delivered and cash-settled bitcoin and ether contracts. To comply with federal regulations, Cboe Digital holds both Designated Contract Market (DCM) and Derivatives Clearing Organization (DCO) licenses.
What does that mean? Cboe Digital must comply with the same federal regulations and oversight from the CFTC that exchanges operating in commodity markets have complied with for over 50 years. That’s 50-plus years of protection and oversight and 50-plus years of expertise in protecting customers that not all other jurisdictions and exchanges can provide.
In the U.S., the Securities and Exchange Commission (SEC) regulates securities markets. As the regulatory environment in the U.S. continues to mature, it’s conceivable to envision a market structure where participants, including robust exchanges where the same price discovery and customer protections are in place as other markets regulated by the SEC, operate and list digital asset securities for trading.
But can’t you already trade hundreds of tokens across many platforms today? Sure, participants have been able to access digital tokens of all kinds via many different avenues. But what about ETFs holding those tokens? Or asset managers that have specific mandates and investments they can make? If a pension fund can’t, or won’t, invest some allocation of their funds into digital assets, what can we do? Would transparent SEC oversight over participants, including exchanges, clearing houses and custodians, open the door for these firms to participate? I think so. But we are not there – yet.
Going the Extra Mile
It is important to note that not all exchanges in the digital asset space operate in a regulated and traditional manner. In fact, many operate in a decentralized manner without regulation.
Also, not all regulatory jurisdictions are created equal. Regulation and oversight isn’t automatic. It takes expertise, systems and funding. We should stop focusing on the bare minimum of “being regulated” and start self-regulating to the standards of our most liquid and robust markets.
In addition to following state-level requirements, we apply CFTC core principles from the futures market, bringing time-tested standards and methods to digital asset spot trading. While the CFTC does not have oversight of the spot market, and state requirements are at a minimum, Cboe Digital chooses to apply these core principles to protect our investors and the integrity of our markets. This is on top of Money Service Business (MSB), Money Transmitter Licenses (MTL) and Bit License requirements. This level of protection is unique among digital asset operators. We do this not because we must, but because it is the right thing to do.
Digital Clearing: Separated and Centralized
Clearing isn’t usually the hot topic in financial markets. It’s that behind-the-scenes part of the trade lifecycle that does a few really important things. Maybe I didn’t say that clear enough. Clearing is important. What’s more important is how something is cleared.
Clearing, like operating an exchange, is also regulated in the U.S. Broadly speaking, clearing in equity, commodity and derivative markets in the U.S. is regulated by the SEC and CFTC. In those markets, the exchange and clearinghouse are separate entities. Furthermore, the clearing houses are centralized. The benefits of this structure are that clearinghouses provide transparency, reduce counterparty risk and adhere to strict guidelines around recordkeeping and financial reporting, among other things.
What about digital assets?
Regulatory oversight of clearing digital assets falls to state agencies for spot and the CFTC for derivatives. Cboe Clear Digital, otherwise known as the clearinghouse, is the entity that clears digital asset spot and futures traded on our regulated exchange. As the clearinghouse, it complies with the CFTC’s DCO core principles under the Commodity Exchange Act, including establishing standards and procedures to protect funds of members and their customers.
To protect member funds and assets, the clearinghouse is obligated to segregate member and customer assets from its own assets by holding them in appropriately titled designated accounts. This is required by CFTC regulations for futures trading and state requirements related to spot trading.
Our exchange and clearinghouse are separated as Cboe Digital Exchange and Cboe Clear Digital, respectively. Participants enter orders and trade on the exchange and the exchange sends those trades to the clearinghouse to clear and settle. We’ve structured it this way purposefully to intentionally look like the structure in other U.S. financial markets.
Custody: This Is not new
While digital assets are a nascent asset class, the concept of custody or the role of a custodian is not. Custodians are present in many of the asset classes the world trades today. In the U.S., who plays the role of custodian depends on the asset and its regulator. For equities, clearing and custody are separated from the exchange. In derivatives, the clearinghouse is the custodian. For spot digital assets, it may or may not be part of the platform used to trade. For derivatives on digital assets, like other derivatives, it is the clearinghouse.
Safekeeping customer assets is the primary function of a custodian, and in the U.S., custodians are subject to significant regulatory compliance obligations related to their operations covering record-keeping, information security, separation of duties, segregation of customer assets, physical security, risk, controls, accounting and external audits. Custodians implement rigorous policies and procedures and adhere to high operational standards consistent with their safe-keeping responsibilities.
Cboe Clear Digital operates as the custodian for our participants in both spot and derivatives. However, for spot assets, we store physical digital assets with independent third parties.
Wouldn’t a window into how a digital asset exchange operates and manages its systems be helpful when selecting where to custody your funds? There are also independent audits that do exactly this. For example, Cboe Digital recently completed an independent Service Organization Controls (SOC) audit of our clearing services platform, by a large national public accounting firm, and received a SOC 1 Type II certification. The SOC 1 Type II examination reviewed Cboe Clear Digital's design, implementation and operating effectiveness of its financial transaction operations and reporting controls. Cboe Digital also completed a SOC 2 Type II certification, which reviewed Cboe Clear Digital's security, system changes and upgrades, systems availability, protection of customer funds and information and auditing procedures, as well as the internal standards by which Cboe Digital staff hold themselves accountable.
It’s important to note that some platforms will tout that they work with providers that have SOC 1 and/or SOC 2 certifications. That is an important distinction, working with vs. having.
Working with regulatory agencies is crucial in navigating this new asset class. Cboe Digital was built by capital markets experts and we’re part of Cboe’s global trading network. The wisdom and knowledge of established market operators, who have proven their ability to withstand extreme turbulence and uncertainty time and time again, are critical to maximizing the technology and opportunities afforded by this nascent asset class.
It’s true that regulation is not always expedient or convenient, but history has proven it plays an important role in establishing and sustaining the integrity of markets. Cboe Digital is built from a strong foundational understanding of the rules. By applying this framework, we look forward to the continued adoption of clear, precise and solutions-oriented regulation in the digital asset marketplace.
Digital assets are a new frontier, but investor protection is not. Investors need to have the assurance that where they trade is properly regulated, has their best interest in mind, ensures their funds are safe and that there is significant market oversight through proper governance.
As the saying goes, what’s old is new again. So, what do I view as the next big thing in crypto? Traditional finance.
There are important risks associated with transacting in any of the Cboe Company products or any digital assets discussed here. Before engaging in any transactions in those products or digital assets, it is important for market participants to carefully review the disclosures and disclaimers contained at: https://www.cboe.com/us_disclaimers/. These products and digital assets are complex and are suitable only for sophisticated market participants. These products involve the risk of loss, which can be substantial and, depending on the type of product, can exceed the amount of money deposited in establishing the position. Market participants should put at risk only funds that they can afford to lose without affecting their lifestyle. The information provided is for general education and information purposes only. No statement provided should be construed as a recommendation to buy or sell a security, future, option on a future, security future, digital asset, financial instrument, investment fund, or other investment product (collectively, a “financial product”), or to provide investment advice. Past performance of an index or financial product is not indicative of future results. © 2023 Cboe Exchange, Inc. All Rights Reserved.