Comment Text:
I write to provide further comments to the CFTC concerning LedgerX’s application to register as a Swaps Execution Facility and Derivatives Clearing Organization. I take this opportunity to also respond to Kari Larsen’s, LedgerX’s General Counsel and Chief Regulatory Officer, January 30, 2015 letter submission to the CFTC wherein she attempted to address certain of the public comments that others and I had previously submitted to the CFTC concerning LedgerX’s application.
As an initial matter, Ms. Larsen states that “now more than ever, the digital currency market needs a bitcoin derivatives contract to help mitigate risk of volatility, add liquidity to the market and increase transparency.” However, there already exists a CFTC regulated bitcoin derivatives contract that is traded on a SEF where participants post margin in USD. That SEF and its bitcoin derivatives contract are not encumbered by the severe limitations of LedgerX’s proposed trading platform and flawed options contracts. There is no urgency therefore to approve LedgerX’s applications, and I submit that until and unless LedgerX eliminates its intended use of bitcoin as collateral and permits its options to be settled in USD with the use of margin, the CFTC must deny LedgerX’s applications to register as a SEF and DCO.
1. A DCO cannot hold bitcoin as collateral
Ms. Larsen claims “market participants will not be subject to the risk of a default by another market participant or broker as they would be in a traditionally margined clearinghouse.” This is an unsubstantiated statement that fails to consider the existing risks associated with holding bitcoin as collateral. Transactions at traditional clearinghouses are completed in USD, and participants in the USD marketplace have experience with and can gauge counterparty risk. Nothing of the sort currently exists with bitcoin. As I explained in my prior submission, lost bitcoin cannot be recovered. The consequences therefore of sending bitcoin to the wrong recipient, or if bitcoin are stolen or otherwise lost, would be fatal (and as I explain below, a multi-signature protocol, which thus far has been the extent of LedgerX’s disclosure around its security measures, does not solve this dilemma).
Ms. Larsen further claims that LedgerX “has instituted extensive security measures to protect Participants and their funds from theft, fraud or hacking attempts.” LedgerX, however, has failed to demonstrate what these purported “security measures” are, how they will protect participants and why LedgerX believes it will be insulated from cyber attacks to its network. As recent events have proven, no class of financial institutions is invincible when it comes to computer hacking. LedgerX’s intent to operate a DCO that relies upon bitcoin asset security should be of utmost importance to the CFTC as it considers LedgerX’s application.
In the same vein, LedgerX’s intended use of a multi-signature protocol creates a number of compliance and regulatory issues that LedgerX will be unable to resolve. When the source of bitcoin originates from a multi-signature address with potentially multiple parties holding keys, title to the underlying is impossible to determine. This complication means that on top of possible loss of bitcoin due to theft or negligence, LedgerX will be faced with yet another challenge when multiple parties lay claim to the same bitcoin.
The CFTC should likewise be concerned with bitcoin transaction timing. In its current state, the bitcoin network does not guarantee or commit to a set protocol for transaction times. In fact, transaction confirmation times are unpredictable and can vary from seconds to more than an hour (see the time between blocks 152217 and 152218). Thus, a user of LedgerX’s platform may be subject to extensive and completely unpredictable waiting periods before receiving bitcoin at the expiration of a contract. Over the course of one hour, the price of bitcoin can move by 25% or more. Although bitcoin solves the so-called “double spending problem”, the network has no central administrator to prevent or address unauthorized transactions. The lack of a central administrator and associated support infrastructure makes it impossible to guarantee performance in the event of system errors or failure. The loss of bitcoin assets could imperil market participants on LedgerX’s platform, and a failure of timely transactions would prevent the DCO from being able to clear transactions. In fact, in March of 2013 the bitcoin network experienced a failure event preventing the confirmation of transactions for six hours. Core principal 4 requires the “ability to complete settlements on a timely basis under varying circumstances.” The bitcoin network introduces uncertainty in transaction confirmations such that LedgerX never can adequately comply with the CFTC’s core principal 4.
LedgerX’s intention to use a multi-signature to store bitcoin assets does not solve the security and transaction issues described above. A multi-signature wallet is a corporate governance tool (and, at best, an imperfect tool, as key-holding parties can act in cahoots with one another). Multi-signature does not in and of itself prevent the theft or loss of bitcoin if private keys are compromised. To be clear, it is not possible to be certain that private keys remain uncompromised. Private keys generated from an offline computer are still subject to risk (see https://www2.informatik.hu-berlin.de/~verbuech/klepto-ecdsa/klepto-ecdsa.pdf).
There simply is no way for LedgerX’s DCO to reliably hold bitcoin such that the above described risks are eliminated.
2. Inadequate financial resources
Ms. Larsen notes in her submission that “before a participant will be permitted to enter most types of orders on the Platform, the Participant will be required to transfer funds to LedgerX’s settlement bank account or transfer collateral ….” Ms. Larsen, however, fails to explain what she means by “most types of orders,” leaving the investing public and the CFTC to guess which types of orders are excluded.
Based on its application and Ms. Larsen’s submission, LedgerX does not intend to maintain a guaranty fund for its DCO. To the extent the CFTC permits a DCO to operate without a guarantee fund, LedgerX’s will be, as far as I’m aware, the only such DCO sanctioned by the CFTC. A DCO without a guarantee fund would eliminate any mutualization of risk, and, as a practical matter, lose its ability to function as a central counterparty. A DCO that is not a CCP cannot perform the functions of a genuine DCO.
LedgerX’s proposed formation is also inconsistent with the principals for market intermediaries as set forth by the International Organization of Securities Commissions, which require: (i) minimum entry standards for market intermediaries, (ii) initial and ongoing capital and other prudential requirements for market intermediaries that reflect the risks that the intermediaries undertake, (iii) standards for internal organization and operational conduct that aim to protect the interests of clients, ensure proper management of risk, and under which management of the intermediary accepts primary responsibility for these matters, and (iv) procedures for dealing with the failure of a market intermediary in order to minimize damage and loss to investors and to contain systemic risk.
LedgerX has limited resources and will be unable to substitute its credit for that of the participants on its platform. This of course would be of less concern if LedgerX’s DCO was adequately capitalized, which it is not and apparently has no intention of becoming. Because LedgerX is not sufficiently capitalized it will be unable to substitute its credit for the credit of participants on its platform, which is key to the financial welfare and success of a properly functioning DCO. Indeed, such a construct would relegate LedgerX’s DCO to nothing more than an unlicensed bitcoin exchange.
3. LedgerX’s options contracts will be susceptible to price manipulation
LedgerX does not intend to use an index to price its options, instead relinquishing pricing responsibilities to participants and liquidity providers on its platform. As Ms. Larsen notes, “LedgerX settlement prices are not based on an index, forward price or other benchmark.” This is surprising given that the CFTC has already approved and regulates a bitcoin price index.
LedgerX must consider the fact that there does not currently exist a regulated cash market for bitcoin in the US, which by definition means that there is no meaningful way to fairly price bitcoin options. In reality, bitcoin is susceptible to price manipulation and LedgerX will be unable to adequately conduct surveillance on the underlying given that the greatest volume of bitcoin is traded in Asia and Europe. The market for bitcoin is relatively small and remains illiquid, and LedgerX has failed to propose an enforcement infrastructure that would prevent price manipulation of the underlying.
To reduce the risk of price manipulation, LedgerX should either rely on the CFTC regulated bitcoin price index or construct and propose its own index to the CFTC. Leaving pricing in the hands of participants and liquidity providers makes little sense under these circumstances, and it makes it highly likely that LedgerX’s options contracts will not be priced with any degree of certainty, resulting in inevitable price distortions and the likelihood of price manipulation.
Lastly, I note that Ms. Larsen has failed to provide any explanation regarding Jim Newsome’s, and his firm Delta Strategy Group’s, involvement in LedgerX’s application process. Delta Strategy Group is the second-most frequent visitor with the commission, behind only Goldman Sachs. (See http://www.bloomberg.com/infographics/2013-09-04/banks-push-back-against-swap-rules.html and, http://deltastrategygroup.com/.)
As an equity holder in LedgerX, it is abundantly clear that Mr. Newsome has a personal stake in the outcome of LedgerX’s application. The adequacy of LedgerX’s application therefore has taken a back seat to Mr. Newsome’s personal motivations in seeing LedgerX succeed.
Bitcoin at its core is a technology, and the CFTC should craft regulations for bitcoin-based derivatives and exchanges based upon the specifics of bitcoin technology. Well over 300 academic papers have been written about bitcoin, but neither the CFTC nor any other US regulator has crafted regulations based on the academic work (see https://docs.google.com/spreadsheets/d/1VaWhbAj7hWNdiE73P-W-wrl5a0WNgzjofmZXe0Rh5sg/edit#gid=0). Commissioner Mark Wetjen has made it clear that the CFTC wants to regulate bitcoin (http://www.wsj.com/articles/mark-wetjen-bringing-commodities-regulation-to-bitcoin-1415060058), and mentioned LedgerX as the only pending bitcoin-related application (http://youtu.be/JdG1OhD2wVI). The CFTC should therefore regulate bitcoin by demonstrating the requirements for adequacy, which will no doubt be far above what LedgerX is offering in its application. The CFTC should not jump the gun by approving the first application, especially one as deficient as LedgerX’s, to come across its desk.
