The CFTC and DeFi

Continuing from our last article outlining the regulatory environment for crypto in the United States, in this article, we look at one of the key US regulators relevant to the crypto industry: The Commodity Futures Trading Commission (CFTC). We recommend reading our first article outlining the US regulatory environment before this one. The CFTC is primarily responsible for regulating derivatives and commodities markets and plays a pivotal role in overseeing various aspects of DeFi.

The CFTC’s Mandate

The CFTC is tasked with ensuring the integrity, transparency, and efficiency of the derivatives and commodities markets in the United States. Historically, this mandate primarily covered traditional financial instruments like futures and options contracts tied to commodities such as oil and agricultural products. The CFTC also oversees leveraged/margin trading and even direct “spot” trading of commodities (not securities spot trading, though, which is within the SEC’s regulatory purview). However, the CFTC’s jurisdiction happens to also encompass a broader range of financial instruments, including some instruments prevalent in DeFi.

The CFTC assumes the crucial role of regulating derivatives primarily to safeguard US consumers and users of financial products. Derivatives are financial instruments that are separate from, but linked to the price of an underlying asset. For example, oil is an asset — a commodity that has a market price. You then have “derivatives” linked to oil which are separate assets that trade separately — such as oil futures and options contracts. The same applies to crypto assets.

Derivatives encompass a wide range of financial contracts, including futures, options, and swaps, and can be complex and carry significant risks that retail clients may not fully comprehend. By overseeing these markets, the CFTC aims to ensure transparency, fair pricing, and integrity, thereby protecting individual investors and market participants from fraudulent practices, market manipulation, and highly risky products. To fulfill this mission effectively, companies offering derivatives-related products and services in the United States or to US users, including in the decentralized finance (DeFi) realm, are often required to register with the CFTC. This registration process enables the CFTC to monitor and supervise these entities, ensuring they adhere to established rules and standards, and providing consumers with greater confidence in the integrity and security of derivative markets.

In other words, as discussed in our previous articles, CFTC registration by companies offering services and products that fall within the CFTC’s regulatory purview, enables the CFTC to regulate the intermediaries in financial markets and use that ability to protect the retail investing public. However, it may be difficult or almost impossible for crypto and DeFi projects to meet the CFTC’s requirements and successfully register, for a range of reasons.

In brief — the CFTC’s role is to oversee derivative and commodity markets and market operators in the United States. Although the relevant laws were not written with crypto in mind, many crypto and DeFi activities are likely to fall within the CFTC’s regulatory purview and therefore DeFi projects must pay attention to CFTC regulations and comply with them in order to do business in the United States.

Obvious Derivatives in DeFi: Futures and Options

Futures and options contracts are among the most apparent derivatives that fall within the CFTC’s purview, even in the DeFi context:

1. Crypto Futures: DeF (and CEX)i platforms that offer cryptocurrency futures contracts are subject to CFTC regulation. These contracts allow traders to speculate on the future price of digital assets without owning them.
2. Crypto Options: Similarly, DeFi projects that facilitate cryptocurrency options trading must adhere to CFTC guidelines. (Crypto options give traders the right, but not the obligation, to buy or sell digital assets at a predetermined price).

The CFTC ensures that these markets are transparent, fair, and free from fraudulent activities. Compliance with position limits, reporting requirements, and anti-manipulation rules is essential for DeFi platforms offering such derivatives.

Not-So-Obvious Derivatives in DeFi: Leveraged Tokens and Perpetual Contracts

DeFi’s innovation extends beyond traditional derivatives to include complex and novel instruments, some of which may not be immediately recognizable as derivatives. Examples include (but are not limited to):

1. Leveraged Tokens: Leveraged tokens are tokens that aim to provide traders with amplified exposure to an underlying asset, often with leverage as high as 3x or 10x. These tokens can be highly risky and are likely subject to CFTC scrutiny even if the underlying token does not fall with the CFTC’s regulatory purview.
2. Perpetual Contracts: Perpetual contracts are derivative products that mimic the behavior of futures contracts but do not have a predefined expiry date. Traders can use perpetual contracts to speculate on the price of various assets. Perpetual contracts are a new kind of derivative that was pioneered by the crypto industry (and BitMex in particular) and are typically not found in traditional finance, but will nevertheless likely fall under the CFTC’s regulatory purview.

There may be other products in DeFi that fall within the CFTC’s jurisdiction, especially the CFTC’s broad conception of its powers and authority and therefore, DeFi projects must carefully consider the potential regulatory consequences of any product they create.

CFTC Activity and Enforcement in the DeFi space

Although not as well known (or as feared) as the SEC in the crypto world, the CFTC can be extremely aggressive in pursuing enforcement, litigation and penalties against crypto and DeFi projects that it feels are breaching the regulations that it enforces.

In particular, in 2022, the CFTC successfully sued the Ooki DAO (formerly known as bZx) which operated a DeFi lending platform and a linked margin trading platform. The CFTC reached a settlement with the founders, and separately sued the DAO, alleging that it was operating a leveraged trading platform in breach of US laws (and that all DAO voters were liable for the DAO’s actions). The CFTC secured a default judgment against the DAO, and the DAO geo-blocked the United States so that its product is no longer accessible to US users.

More recently, the CFTC went after several other DeFi protocols and reached civil settlements with Opyn, 0x and Deridex under which they were required to pay hundreds of thousands of dollars. In some of these, the key allegations was that the platforms facilitated trading of leveraged tokens as described above, and therefore fell under the CFTC’s jurisdiction, and consequently, the CFTC claimed they were in breach of US regulations.

Conclusion

The CFTC is zealous about exercising its regulatory authority to oversee commodities and derivatives markets in the United States. As many DeFi projects have discovered, the CFTC will not hesitate to enforce the laws and this may result in projects having to pay significant penalties and/or go out of business (depending on circumstances). As a result, many projects have chosen to geo-block US users (and take other measures to deny access to their platform to US users) in order to significantly reduce the risk of the CFTC and other US regulators pursuing them for breach of US regulations — most famously, DyDx operates a large and active derivatives trading platform but blocks US users not just from trading but also from its airdrop in 2022.

September 2023

— The Compliant Defi Team
www.compliantDefi.org