The Roles and Responsibilities of Exchanges, Custodians and Clearinghouses in Crypto
We are avid listeners of Castle Island Venture’s On the Brink podcast and welcomed the recent discussion on the July 13th episode with Caitlin Long. We agreed with most of the conversation; that cryptocurrencies are still a young asset class and that bringing experts in market structure, risk, and technology from the established capital markets to crypto is important. We also see similarities in the gold market compared to cryptocurrencies and have written about it in an earlier post. We also agree that crypto is not going to be solely for institutional traders or exclusively for individuals.
However, we wanted the opportunity to discuss two important points from the episode: with Long when she referred to regulation as a problem (around the 10 minute mark) and with Carter when he said that the crypto exchange regulatory space is vague or confusing (around the 42 minute mark).
We believe, similar to U.S. Commodity Futures Trading Commissioner Dawn Stump, that regulation is the key to clarity. Below we breakdown the role of a U.S. regulated crypto exchange, clearinghouse and custodian, entities whose responsibilities Carter and Long bring into question, as well as highlight the licenses we abide by to protect our Members from having the negative experiences Long refers to in the podcast.
Eris Exchange: A DCM License
ErisX is a unified platform for spot and regulated futures on cryptocurrencies. Our futures market for physically delivered bitcoin and Ether contracts is regulated under the jurisdiction of the Commodity Futures Trading Commission (CFTC). Specifically, on the Federal level, we hold, respectively, Designated Contract Market (DCM), and Derivatives Clearing Organization (DCO) licenses.
Eris Exchange is the entity which holds the DCM license. Exchanges provide fair and orderly trading as well as the efficient dissemination of price information for all their traded instruments. Members make use of exchanges primarily for price discovery and liquidity, and benefit from the protections of surveillance and compliance procedures.
Depending on the instruments traded, exchanges could fall under the jurisdiction of the CFTC or the Securities and Exchange Commission. Since Eris Exchange lists derivatives products based on cryptocurrencies deemed commodities, we are regulated by the CFTC.
It is important to note that not all exchanges in the digital asset space operate in a regulated and traditional manner. In fact many of the exchanges that Carter and Long discuss on the podcast operate in a decentralized manner, unregulated (or potentially in violation of existing regulations). We compare some of the benefits of a centralized versus a decentralized model in this blog post.
Eris Clearing: A DCO License
Eris Clearing is the entity that holds the DCO license and clears cryptocurrency futures contracts traded on our regulated derivatives exchange. Specifically, Eris Clearing is a custodian for futures customer trades. Eris Clearing complies with core principles under the Commodity Exchange Act including, among other things, establishing standards and procedures to protect members and participant funds. As part of its regulatory obligations Eris Clearing must protect Member funds and assets, and eliminate counterparty risk.
To protect member funds and assets, Eris Clearing is obligated to completely segregate customer assets from its own assets by holding them at a bank in a designated account, separate from the funds of ErisX, and for the benefit of our Members. This is required by CFTC regulations for futures trading and state requirements related to Money Service Business (MSB) licenses.
On this point Long and Carter acknowledged the importance of counterparties you can trust as well as the practice of segregating funds. Long says that “custodian requirements exist on Wall Street…for very good reasons and…this is not likely going to change.”
Safekeeping customer assets is the primary function of a custodian and licensed custodians are subject to significant regulatory compliance obligations related to their operations covering e.g. record keeping, information security, separation of duties, segregation of customer assets, physical security, risk, controls, accounting and external audits. They implement rigorous policies and procedures and adhere to high operational standards consistent with their safe-keeping responsibilities.
In addition to safeguarding customers’ assets, custodians may provide a range of additional valuable services including e.g. account administration, post-trade processing and settlement transactions (including DvP), collection of dividends and interest (on assets that bear them), collateral management, tax support, and foreign exchange. For customers that trade a broad range of assets, with a multitude of counterparties, on a variety of exchanges and markets (including OTC), globally, these operations can become quite complicated and intense. Custodians also present the opportunity for significant efficiencies and cost savings for customers if managed effectively.
Spot Market Regulation
Our spot market activity is licensed in accordance with state money transmitter licensing requirements. To date, ErisX can operate in 48 states and jurisdictions, including New York. ErisX is proud to have secured the New York Virtual Currency License. We are currently working to complete the map and offer our services in Delaware, Hawaii, Nevada, Virginia as well as the U.S. Virgin Islands.
State money transmitter licenses provide basic protections to customers insofar as the transmission and holding of their fiat and digital currency are concerned. To date, custody of customers’ crypto assets under the money transmitter framework is not addressed with one exception: New York State. The often criticized New York Virtual Currency License, or Bit License, provides for specific requirements in the custody and protection of customer crypto assets held by a virtual currency market operator.
In addition to following state-level requirements, we apply CFTC core principles from the futures market, bringing time-tested standards and methods to cryptocurrency spot trading. The CFTC does not have oversight of the spot market. However we chose to apply the core principles to ensure we have taken every step to protect our investors as well as the integrity of our markets. This is on top of Money Service Business (MSB), Money Transmitter Licenses (MTL) and Bitlicense requirements. We are aware of no other market operator that has gone this far.
The CFTC sent out a disclaimer urging anyone trading digital assets to make sure they are working with a regulated entity. We believe that working with regulatory authorities such as the CFTC and the New York Department of Financial Services is helpful in navigating this new asset class. From our launch announcement back in October 2018, we have called attention to our heritage in the capital markets, highlighted the status of our MSB licenses, discussed the core principles we abide by and outlined our approach to provide a regulated marketplace for spot and futures on cryptocurrencies.
In the spirit of transparency, we publish our rulebook and other policies that guide our markets. We look forward to watching this asset class develop and the ways it will break our current financial system, as Long refers in the podcast. However, we also believe that regulation will help us get there.
In closing, while we acknowledge that regulation is not always expedient, or convenient, we believe that history has proven time and again that it plays an important role in establishing and sustaining the integrity of markets. Because our team has spent their careers operating in regulated markets we are building off of a strong foundational understanding of the rules. We have deliberately sought to apply existing rules where applicable, and best practices where they make sense. By applying this framework we believe that regulation can be clear, and part of the solution, rather than vague and problematic as Long and Carter refer to on On the Brink.