06.09.2021

Unlicensed DeFi Derivative Markets Are Not Legal

Keynote Address of Commissioner Dan M. Berkovitz Before FIA and SIFMA-AMG, Asset Management Derivatives Forum 2021

Climate Change and Decentralized Finance: New Challenges for the CFTC

June 08, 2021

Good morning, and thank you for the opportunity to address this joint forum of FIA and SIFMA AMG.[1]  Today I will provide an update on several regulatory issues of interest to this group, as well as my views on the role of the CFTC in addressing climate change, and my concerns regarding the rise of decentralized financial markets.

Last year, the CFTC completed the rulemakings mandated by the Dodd-Frank Act.  The CFTC’s Dodd-Frank rulemakings began over a decade ago—as Billy Joel said, “when I wore a younger man’s clothes.”  The completion of these rulemakings reflected the leadership of four CFTC Chairs, ten Commissioners, hundreds of CFTC staff, and thousands of pages of comments from market participants and members of the public.  As a result of these rulemakings and their implementation by the financial industry, our financial system is stronger and more resilient than ever before.  Customers and other market participants are better protected.

As evidence of this strength, the derivative markets generally performed well during the Covid pandemic, enabling firms to hedge their risks and discover prices despite extraordinary stresses to the economy and financial markets.  It was not that long ago that the failure of a single firm, such as Long-Term Capital Management or Lehman Brothers, threatened the entire financial system.  During the pandemic, entire sectors of the economy ground to a halt and volatility rose to historic levels, yet the derivative markets continued to perform largely as designed and without disruption.

We must not become complacent, however.  We cannot rest on our recent accomplishments.  History never repeats itself, and as you all know well and inform your customers, the past is not a guarantee of what may happen in the future.  The CFTC must continue to monitor our markets for emerging risks, and we must continue to aggressively enforce the requirements of the Commodity Exchange Act (CEA) and our regulations.

We also must continue to evaluate the effectiveness of our existing regulations, to ensure they are working as intended and are adequate to address new risks.  The CFTC has made significant investments in systems to receive and analyze industry data, and we should continue to build these capabilities.  We must always draft our regulations, and evaluate their effectiveness, using the best available data.

Within this context, I’d like to turn to several of the specific regulatory issues that FIA and SIFMA AMG have urged the CFTC to address.  These include the thresholds for the real-time reporting of block trades, central counterparty transparency and governance, and the adequacy of current initial margin requirements.

Block trade reporting thresholds.  Last fall, the CFTC issued a final rule to improve the real-time reporting of block trades.[2]  As part of this rulemaking the Commission increased the block size threshold that determines which swaps are subject to the real-time reporting timeframes.  The higher the threshold, the more swaps are subject to these real-time reporting timeframes.  The Commission determined that larger block sizes appropriately balanced the statutory objectives of enhancing price discovery, not disclosing the business transactions and market positions of any person, preserving market liquidity, and providing appropriate time delays for block transactions.

Market participants, including the “buy side,” have expressed concern that the timeframes for reporting the new larger blocks may negatively impact liquidity for some of these swaps and increase costs without commensurate benefits.[3]  As I indicated at the time the Commission approved these new thresholds, I support evaluation and refinement of the block trade reporting rules, as appropriate, based upon market data and analyses.[4]  I invite market participants to provide the Commission with any updated analyses or data regarding the effect of the larger block sizes on market liquidity, so that we may ensure that the block sizes are appropriately calibrated to promote price discovery and do not harm market liquidity.  Compliance with the new rule is not required until May 25, 2022.  We can use this time to consider new information and market data and make any adjustments that may be appropriate.

Central counterparty governance.  The mandatory clearing of standardized derivatives is one of the pillars of the Dodd-Frank reforms.  The Dodd-Frank reforms and other measures adopted by the derivative clearing organizations (DCOs) have strengthened their resilience in the years since the 2008 financial crisis, and the clearing system performed well during the stresses of the past year.  However, the increased reliance on clearing has focused attention on the performance of central counterparties (CCPs) during periods of financial stress.  Clearing members and their customers have urged a number of measures to further improve the governance, transparency, and resilience of CCPs in periods of extreme stress.[5]

In a financial crisis, confidence in the financial system is critical to maintaining the stability of the system.  Market participants must have confidence in the integrity of the CCPs and their governance.  Transparency into the CCP’s rules and processes, particularly in times of stress, is vital to this confidence.  The CFTC should continue to work with clearing members, counterparties, and DCOs to ensure there is an appropriate level of transparency into DCO rules, processes, and procedures; that DCOs have appropriate governance structures to manage these risks; and that there are appropriate procedures for equitably allocating losses during extreme events.

Procyclicality of initial margin requirements.  CCPs generally performed as designed during the extreme market volatility precipitated by the Covid pandemic.  However, FIA and others have expressed concern that the increase in margin requirements at derivative clearinghouses during the initial phase of the pandemic indicated that the current clearinghouse margin models may be overly procyclical by increasing the demands for highly liquid assets in times of financial stress, and that such procyclicality could pose significant systemic risks.[6]  CCPs, on the other hand, have disputed this assertion of procyclicality.[7]

Last week the CFTC staff issued a preliminary report entitled “Interim Staff Report on Cleared Derivatives Markets: March – April 2020.”[8]  The CFTC staff stated that its initial analysis of changes in aggregate initial margin flows did not provide “conclusive evidence that these models and associated practices were excessively procyclical,” but also that it will “continue to study the performance of CCP margin models to address these questions.”[9]

The adequacy of initial margin levels is not an issue for the CFTC alone. The CFTC’s initial margin requirements were developed to be consistent with those of other domestic regulators and international standards.  The CFTC should continue to review the FIA and ISDA analyses in light of its ongoing staff analysis, together with the reviews conducted by other national and international organizations, and analyses conducted by the CCPs and other market participants.  It should engage with stakeholders and consult with other regulators to determine whether regulatory action is appropriate to address procyclicality concerns.

I would now like to address several emerging challenges facing the CFTC and indeed, the entire global financial system.

Climate Change

The dangers to our financial markets from climate change are clear and present.  Last fall, the Climate Subcommittee (Subcommittee) of the CFTC’s Market Risk Advisory Committee (MRAC) released a landmark study warning that climate change poses a major risk to the U.S. financial system.[10]  More recently, Secretary of the Treasury Janet Yellen stated that climate change poses an “existential threat” to financial markets.[11]

Derivatives markets can play an important role in facilitating the transition to a low-carbon economy, but the CFTC will need to be vigilant to ensure that climate change does not threaten the stability of these markets.  The Subcommittee’s specific recommendations to the CFTC are a good starting point to address the climate-related risks affecting derivatives markets and the financial system more broadly.[12]  This work will require collaboration with other domestic and international regulators, as well as consultation with affected stakeholders.

In my view, there are three principal ways in which the CFTC, as a financial market regulator, should support the transition to a carbon-neutral economy.  First, the Commission is charged with protecting the integrity of the markets it regulates, and this includes markets for carbon derivatives, among other climate-related derivatives.  To do this effectively, the CFTC must be aware of how the various primary, secondary, and derivative carbon markets are interacting and how companies use these markets to meet their compliance obligations, manage risks, and discover prices.  Second, the CFTC should work with exchanges and market participants on the development and approval of new products that are intended to help companies hedge their climate-related risks.  And third, the CFTC should ensure appropriate management and disclosure of climate-related risks.[13]

Last week, the CFTC Energy and Environmental Markets Advisory Committee (EEMAC), which I sponsor, met to explore the role of carbon markets in the transition to a low-carbon economy.  The discussion of existing carbon markets and the future expansion of those markets indicates that carbon trading may provide a significant new asset class for climate-related risk management and investment purposes.

The success of a market-based mechanism for carbon reduction will depend upon timely, transparent, and accurate information about prices in the primary, secondary, and derivative carbon markets.  The CFTC should work with other regulators and stakeholders to ensure the effectiveness, and protect the integrity of, these inter-related markets.  This effort should include collaboration on the development of standards for products traded across these markets.  I encourage interested persons to view a recording of the EEMAC carbon markets meeting and the accompanying presentations available on the CFTC website and engage with the Commission on these issues.[14]

Decentralized Finance

Decentralized finance—or “DeFi”—is a rapidly-expanding technology related to cryptocurrency and the blockchain.  As of January 2021, approximately $20.5 billion in cryptocurrency was invested in DeFi, compared to approximately $1 billion at the beginning of 2020.[15]  According to the Financial Times, in 2021, private investors have already backed 72 DeFi companies.[16]  As the saying goes, “A billion here, a billion there, pretty soon, you’re talking real money.”  Given the explosive growth of this sector, federal regulators should become familiar with this new technology and its potential uses and be prepared to protect the public against misuse.

Wikipedia describes DeFi as follows:

[DeFi] is a blockchain-based form of finance that does not rely on central financial intermediaries such as brokerages, exchanges, or banks to offer traditional financial instruments, and instead utilizes smart contracts on blockchains, the most common being Ethereum.  DeFi platforms allow people to lend or borrow funds from others, speculate on price movements on a range of assets using derivatives, trade cryptocurrencies, insure against risks, and earn interest on savings-like accounts.[17]

If you type “DeFi” into Google search, a top link is to a Coindesk article, “What is DeFi?”  The subtitle states, “DeFi is short for ‘decentralized finance,’ an umbrella term for a variety of financial applications in cryptocurrency or blockchain geared toward disrupting financial intermediaries.”[18]

A threshold question is whether the public will benefit from disrupting the current financial system that relies extensively on financial intermediaries.  Supporters of DeFi argue that cutting out intermediaries offers consumers more control over their investments.[19]  But intermediaries such as banks, exchanges, futures commission merchants, payment clearing facilities, and asset managers—such as many of you at this conference—have developed over the past two or three hundred years of modern banking and finance to reliably provide critical financial services to support the financial markets and the investing public.  Intermediaries provide information, analyses, and advice to the public seeking access to financial markets.  Intermediaries often have fiduciary or other legal duties to act in the best interests of their customers.  They provide liquidity to the markets and support the stability of the financial system in times of stress.  They provide custody of assets and safeguards for investments.  They are responsible for preventing money-laundering through financial markets.  Regulated and licensed intermediaries must meet established standards of conduct and can be held legally responsible for failing to meet those standards of conduct.  Intermediaries can be held accountable when things go wrong.

Today, the United States has the most effective and efficient capital formation and risk management markets in the world.  When people the world over want to invest their money or manage their risks in safe ways, they come to the U.S. financial system.  One of the key reasons our financial system is so strong is the legal protections that investors enjoy when they invest their money in U.S. markets, most often through intermediaries.  We have a system in which intermediaries are legally accountable for protecting customer funds.  In many instances, such as in the clearing system, if a counterparty fails to perform, an intermediary will make the customer whole.

In a pure “peer-to-peer” DeFi system, none of these benefits or protections exist.  There is no intermediary to monitor markets for fraud and manipulation, prevent money laundering, safeguard deposited funds, ensure counterparty performance, or make customers whole when processes fail.  A system without intermediaries is a Hobbesian marketplace with each person looking out for themselves.  Caveat emptor—“let the buyer beware.”

Not only do I think that unlicensed DeFi markets for derivative instruments are a bad idea, I also do not see how they are legal under the CEA.  The CEA requires futures contracts to be traded on a designated contract market (DCM) licensed and regulated by the CFTC.[20]  The CEA also provides that it is unlawful for any person other than an eligible contract participant to enter into a swap unless the swap is entered into on, or subject to, the rules of a DCM.[21]  The CEA requires any facility that provides for the trading or processing of swaps to be registered as a DCM or a swap execution facility (SEF).[22]  DeFi markets, platforms, or websites are not registered as DCMs or SEFs.  The CEA does not contain any exception from registration for digital currencies, blockchains, or “smart contracts.”

Apart from the legality issue, in my view it is untenable to allow an unregulated, unlicensed derivatives market to compete, side-by-side, with a fully regulated and licensed derivatives market.  In addition to the absence of market safeguards and customer protections in the unregulated market, it is unfair to impose the obligations, restrictions, and costs of regulation upon some market participants while permitting their unregulated competitors to operate wholly free of such obligations, restrictions, and costs.  Experience with the development of the “shadow banking” system shows that competition between regulated and unregulated entities in the same market can result in the regulated entities assuming either more risks in order to generate the higher yields necessary to compete with the unregulated competition, or seeking less regulation for themselves to level the playing field.[23]  Either of these reactions can introduce significant risks into the financial system.  For all these reasons, we should not permit DeFi to become an unregulated shadow financial market in direct competition with regulated markets.  The CFTC, together with other regulators, need to focus more attention to this growing area of concern and address regulatory violations appropriately.

Thank you again for this opportunity to discuss these issues of mutual importance.

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