January 13, 2022
“I want to thank the Chamber of Digital Commerce for inviting me to speak today. Before beginning, I want to provide the standard disclaimer that the views I express today are my own and not necessarily those of the Commission I am proud to serve upon.
Do any of you have a theme song? I have several that describe various milestones in my life, and as I reflect on my time at the CFTC, I’m leaning towards I Can Do Hard Things by Jennifer Nettles.[1] As the song goes, “Sometimes I don’t like it, but that don’t mean I don’t love it.” I do love my job—not in spite of, but because of, the challenging matters that we tackle (often in the face of difficult circumstances well beyond our comfort zones).
That’s where I would like to start—getting out of our comfort zones and doing hard things. This is front of mind for me in light of the incredible innovations we are seeing these days in terms of the structure, products, and services being offered in financial markets. Many—but by no means all—of these innovations arise from developments in financial technology such as the growth of digital assets and decentralized finance (or DeFi).
As financial markets evolve and adapt to new demands, market regulators must not stifle beneficial innovations by clinging rigidly to regulatory approaches of the past that may no longer be fit for purpose. But by the same token, infrastructure providers who offer the market access to new, innovative services must not dismiss the fact that they may be required to seek and comply with regulatory oversight in order to assure market integrity and customer protection. It’s time to thoughtfully consider the hard things we all must do to get comfortable with current realities.
So there, I have acknowledged the obvious, but why is this so hard? Achieving the benefits of innovation in the context of market regulation is tougher than it sounds because we are not starting with a clean slate. Take, for example, the U.S. derivatives markets regulated by the Commodity Futures Trading Commission. These markets have, for some time, been characterized by futures and swaps contracts with varying degrees of execution and clearing occurring on centralized venues through intermediaries responsible for brokering and guaranteeing such transactions predominantly for institutional clients. Recently, though, the pace of technological development and increasing retail interest in these markets is driving new business models that rely less on the traditional centralization of institutional participation via intermediaries, and rather propose to fulfil these functions in a more decentralized way.
These new market innovations are increasingly presenting novel issues that require comprehensive thinking by those of us at the CFTC who regulate the derivatives markets. I believe that our current approach of relying primarily on enforcement actions to impose penalties on those with novel products and markets for their failure to register with the agency is simply an insufficient response. I agree that many of the entities in question should be registered with the CFTC for oversight purposes, as we are tasked by Congress to regulate the infrastructure that permits access to swaps and futures—and many of these entities are, in fact, performing that function. However, we must acknowledge that the infrastructure we oversee is rapidly changing—and our current regulatory regime was not designed to fit the types of services that are evolving to meet the market’s demands.
So, what’s a regulator to do—continue to take enforcement actions against companies that develop products and business models that are outside-the-box, all the while knowing that our existing rules governing the registration and regulation of the traditional market infrastructure are ill-suited to the very thing that has driven their development (i.e. an expansion in the types of participants seeking access to these products and markets, and their preference for less intermediation)? Certainly, that is the easiest answer: “It’s not our job to tell you how to meet our rules, just figure it out.” Wait, what? How do we expect these companies to conform to a system that does not recognize their value add, the demands of their customers, or even perhaps the future of these markets? What is the goal—to shut down these services, or to encourage those who deliver these services to do so under proper oversight?
I certainly hope it’s the latter. After all, it is innovation that provides solutions to meet new market demands. Congress has established a principles-based regime with flexibility to permit adaptation to innovation in the derivatives markets. And welcoming innovation in those markets historically has been at the heart of what we do at the CFTC.
I believe it is thus incumbent upon the CFTC to bridge the gap between its enforcement and oversight functions by setting more clearly defined regulatory expectations for new, innovative applications in the derivatives market infrastructure. That is a much taller task as compared to simply enforcing rules on the books beyond their original context. It’s a tough job—but it is our job—and I am confident in our ability to do hard things. We cannot be mere bystanders to the fundamental market changes taking place before our eyes, nor should we abdicate the responsibility Congress has given us to “promote responsible innovation and fair competition.”[2]
Adaptation by market regulators, however, should not be viewed by participants as a means to escape regulation. Quite the contrary, our adaptation to innovation is necessitated by the responsible oversight we owe the marketplace. As these matters continue to land on the CFTC’s enforcement docket, it is urgent that we provide direction to those who seek to comply with the law. And then, armed with more clearly defined expectations, the CFTC can better identify those truly bad actors who seek evasion of the rules—and who deserve the full force of robust enforcement action.
In an attempt to start a helpful conversation, I have below identified a non-exhaustive list of areas in which our current rulebook governing infrastructure may require adapting to account for various new innovations taking shape in response to current market demands:
Trading Platforms (Designated Contract Markets and Swap Execution Facilities): In its recent enforcement action against Polymarket,[3] the CFTC found that an online trading platform offering event-based binary options failed to register as a designated contract market (DCM) or swap execution facility (SEF). To operate its markets, Polymarket deploys smart contracts, which are hosted on a blockchain. This was a matter of first impression for the CFTC with respect to a blockchain-based trading platform. Yet, despite this fundamental difference from the traditional DCM/SEF infrastructure for which the CFTC’s rules were written, the CFTC has not given any public consideration to how such a platform seeking to register as a DCM or SEF would be expected to operate under its existing rules.
The term “DeFi” is often used to describe some of the protocols relevant in this framework, and some argue DeFi can exist without regulatory oversight—a topic I will leave for another day. But in a broader sense, I believe that DeFi is spurring innovative functionalities by market infrastructure providers that may improve efficiencies for those seeking the benefit of centralized liquidity (a feature of more traditional and regulated derivatives markets). The really hard thing that requires our attention is this: How do we achieve our regulatory objectives in a manner that still enables infrastructure providers, and their customers, to benefit from these innovations?
Clearinghouses (Derivatives Clearing Organizations): Beyond trading, difficult questions persist relative to central clearing, which is a key tenet of addressing counterparty credit risks in derivatives markets. Our clearing rules are designed around a structure where intermediaries stand between clients and clearinghouses as guarantors, and where clients (often institutional) use leverage to increase their exposure. But we are lately seeing many new retail-focused derivatives clearing organizations (DCOs) that do not use an intermediary model.
To date, we have accommodated this model by imposing conditions such as requiring products to be fully collateralized. But as we begin to see requests from DCOs to offer leveraged clearing to retail market participants, we would be well-served to clearly define regulatory expectations before enforcing the application of ill-suited rules. And we must do so in a transparent way in order to fairly encourage competition. We are well aware that there is a need for such engagement to maintain the safety and soundness of DCOs while at the same time encouraging retail access to the clearing infrastructure. It’s a difficult task, but we can do hard things.
Brokers and Counterparties (Futures Commission Merchants): In its recent enforcement action against Kraken,[4] the CFTC found that an online exchange enabling customers to engage in “retail commodity transactions” in digital assets such as Bitcoin operated as an unregistered futures commission merchant (FCM) with respect to those transactions. This finding begs the question: If Kraken had sought to register as an FCM, how would it have been expected to operate? The CFTC has never comprehensively addressed how retail commodity transactions are to be regulated, and many of the CFTC’s rules for traditional FCMs do not fit Kraken’s role as an exchange.[5] As a result, we are now obligated, in my view, to explain the regulatory parameters such transactions and such non-traditional FCMs are expected to meet—yet, another hard thing the CFTC must tackle.
In conclusion, the key takeaway is that we are at a crossroads that requires everyone to roll up their sleeves and do hard things. Derivatives infrastructure providers must recognize that while their business models may be novel, they do not operate outside of the regulatory oversight required by U.S. law under the Commodity Exchange Act. And for its part, the CFTC must urgently consider fine-tuning its rulebook (often a hard and tedious task), because responding to technological developments and ongoing market dynamics primarily through enforcement is neither good for the marketplace nor sustainable for the agency. We all benefit from clearly defined regulatory expectations that promote compliance and strong enforcement focused on those who blatantly disregard such expectations to the detriment of your markets.” — Dawn Stump
[1] Jennifer Nettles, “I Can Do Hard Things,” I Can Do Hard Things EP (Big Machine Records, LLC 2019).
[2] Section 3(b) of the Commodity Exchange Act, 7 U.S.C. § 5(b) (emphasis added).
[3] In re Blockratize, Inc. d/b/a Polymarket, CFTC Docket No. 22-09 (January 3, 2022).
[4] In re Payward Ventures, Inc. (d/b/a Kraken), CFTC Docket No. 21-20 (September 28, 2021).
[5] See Concurring Statement of Commissioner Dawn D. Stump Regarding Enforcement Action Against Payward Ventures, Inc. (d/b/a Kraken) (September 28, 2021), available at https://www.cftc.gov/PressRoom/SpeechesTestimony/stumpstatement092821b. See also Concurring Statement by Commissioner Dawn D. Stump Regarding Tether and Bitfinex Settlement (October 15, 2021), available at https://www.cftc.gov/PressRoom/SpeechesTestimony/stumpstatement101521.
Alton Drew 