In-house market makers — entities that share ownership with an exchange they trade on — can exist, but only if they act as “bona fide” market makers and do not take directional positions on one side or another, the Commodity Futures Trading Commission (CFTC) proposed Thursday. However, there appears to be ambiguity at this stage in how elements of that proposed rule would be enforced.
The potential rule came in a consultation on proposed rulemaking issued by the CFTC Thursday. The CFTC will seek comments for 60 days before making a decision on whether it will go into force.
ConflictsAndAffiliationsNPRM073026“The Commission has continued to observe growth in the number of affiliations between CFTC-regulated entities — including derivatives clearing organizations, designated contract markets, swap execution facilities, futures commission merchants, and other market participants — such as market makers,” the announcement of the consultation said. “In light of these developments, the Commission proposes new rules and amendments to its existing regulations to address issues that may arise in connection with such firms, including with respect to perceived and potential conflicts of interest.”
The CFTC said that there were some concerns about the presence of market makers owned by the same business as an exchange. The Commission said the phenomenon was most common in prediction markets, due to the large number of markets they offer, and said it was aware of “approximately eight” such entities.
In-house market makers
Most prediction markets have an in-house market maker, which makes trade offers that other users can “take.” Market makers can improve liquidity in a market, ensuring that traders can buy or sell outcomes at a similar price. However, many market makers seek out positions on one side of a market and often make significant profits this way.
While many market makers are third parties who may receive incentives to make trade offers but do not share ownership with an exchange, some market makers are owned outright by the company that owns the exchange, like Kalshi’s market maker Kalshi Trading. Others are not completely owned by the same company but still share ownership. For example, Susquehanna International Group is a market maker on Rothera and owns a 45% stake in the exchange via a joint venture.
The proposal said that exchanges often had disclosures explaining the existence of an in-house market maker and rules in place to prevent them from profiting off confidential market information.
“The Commission recognizes the value of these measures and preliminarily believes that they have contributed to the integrity of these markets and to the confidence of market participants in their fairness,” the CFTC wrote. “At the same time, the Commission preliminarily believes that the existing framework of voluntary practices, however constructive, is uneven.
“A codified framework would afford registered entities and market participants predictable expectations; help ensure that comparable conflicts are subject to comparable safeguards regardless of the venue on which they arise; and render those safeguards durable and subject to Commission oversight.”
The CFTC said that besides risks of unfair advantages, there is also a potential conflict with exchanges’ roles as self-regulatory organizations, which are meant to police activity on their own platforms.
“Where the firm under surveillance is the exchange’s own affiliate and a potential profit center, the exchange is asked to investigate and, if warranted, discipline the source of its own revenue,” it said.
‘Bona fide’ market making only
The CFTC said that despite concerns, it would not propose a ban on in-house market makers. It said that the entities clearly serve a purpose, especially for bootstrapping liquidity on new markets.
“A new exchange faces a coordination problem — unaffiliated market makers are reluctant to commit capital and bear the fixed costs of participation until a market demonstrates sufficient volume to make participation worthwhile, yet volume is difficult to attract without quoted liquidity — and an affiliate principal trading firm aligned with the venue’s success may supply that initial liquidity when independent firms will not,” it said. “The Commission preliminarily understands this dynamic to be especially pronounced in prediction markets, which characteristically list a large and continually refreshed population of individual small, short-lived, and idiosyncratic contracts.”
However, the document added that the CFTC aims to make sure that they engage in “bona fide market making” instead of taking specific positions.
“The Commission does not, however, preliminarily propose to bar affiliate principal trading altogether,” it said. “Instead, the Commission proposes to distinguish bona fide market making from directional proprietary trading. Such a bona fide market maker would be a firm that is contractually obligated to maintain continuous two-sided quotations, that is filled only after unaffiliated members at every price level (even where such affiliate placed its bids or offers prior to such unaffiliated members), and that may not establish directional positions other than in connection with its obligation to maintain two-sided quotations.”
The rule that orders from the in-house market maker must be fulfilled after orders from other participants, the CFTC said, should ensure that in-house market makers can trade on markets where liquidity is needed, but would be less likely to have orders filled on more popular markets where providing more liquidity is not necessary. It said that one exchange already did this, but did not name the exchange.
It added that the requirement to not establish positions except in its connection to maintain two-sided quoting should be a limit on the market maker’s ability to “convert operational and information advantages into proprietary profit, and on the exchange’s stake in the affiliate’s directional gains.”
The rules around not establishing positions appear to be left intentionally open, referring to market makers not making trades “inconsistent with [the] purpose” of a liquidity provider.
It said it considered requirements with specific thresholds for net positions on certain contracts that wouldn’t be exceeded, but determined that even a bona fide market maker only trying to boost liquidity may end up with a position strongly in one direction or another at times.
“The Commission requests comment on whether the rule should include such a limitation or any alternatives that could help to ensure that affiliate market makers only engage in bona fide market making activities,” it said.
The CFTC proposals add that exchanges must disclose the presence of affiliated market makers in a clear way.
“The disclosure would have to be presented in a clear and conspicuous manner, in plain language reasonably understandable to a non-specialist, and in full rather than through a reference or link to another disclosure,” it said. “The disclosure also would have to disclose the conditions and limitations imposed on the affiliate market maker, including the order subordination condition.”
CFTC chair says rules strike balance
CFTC Chair Michael Selig said the new rules would help improve market integrity without being overly burdensome.
“By setting forth principles-based regulations for vertically integrated market structures, the CFTC is taking a significant step in our continued efforts to support responsible innovation in U.S. derivatives markets,” Selig said via press release. “This proposal would institute purpose-fit rules of the road that bolster market integrity without stifling novel market structures or imposing excessive compliance costs on registrants.”
The proposals also looked at other elements of integrated relationships, such as a company owning both a DCM, or exchange, and an FCM, a type of broker. CME is the majority owner of FanDuel Predicts, Kalshi owns an FCM named Kinetic that it uses for its perpetuals product, and DraftKings owns an FCM and exchange.
