Keynote Address of Commissioner Kristin N. Johnson at the World Federation of Exchanges Annual Meeting
Creating Rules of the Road for (Dis)Intermediated and (De)Centralized Markets
September 21, 2023
Good morning, thank you very much Nandini Sukumar for the kind invitation to join you today at the World Federation of Exchanges Annual Meeting. As is customary, I note that my contributions today are my own and do not reflect the views of my colleagues or the capable, indefatigable efforts of the Commission Directors or staff.
Following the global financial crisis, a period characterized by the onset of the COVID-19 pandemic and geopolitical conflict in Europe, specifically Russia’s invasion of Ukraine, marked an almost unprecedented disruption to markets. In the face of these challenges, our markets demonstrated remarkable resilience.
Post-financial crisis reforms proved effective. Clearing members of central counterparties (CCPs) met rising margin requirements and the markets navigated acute liquidity stresses. As Sir Jon Cunliffe, Deputy Governor of the Bank of England for Financial Stability, remarked, "the financial system entered the Covid crisis in a much stronger position with regard to collateral and counterparty credit risk, with, for example, at least $1trn trillion in additional collateral against over the counter (OTC) derivative exposures." Yet, much remains to be done. While we continue to buttress the resilience of our markets through rule-making regarding traditional financial market structures and products, new entrants, enshrined in emerging technology, create new opportunities and present new challenges.
(Dis)Intermediation and (De)Centralization
Alongside these challenges, markets have evolved and expanded with the explosive growth of novel direct-to-customer services.
While we have yet to settle on a widely-adopted legal definition for either term, disintermediation and decentralization are related, but distinct twin-peak phenomena that merit careful reflection and discussion. Each represents a novel market structure that enables direct services to customers. The rapid deployment and adoption of these two market structures in traditional financial markets as well as emerging cryptocurrency and crypto-derivatives markets should be top of mind for global regulators, investors, customers, market participants, and other stakeholders.
Evidence of the Need for Intervention
A little less than a year ago, a story surfaced in the media describing a solvency crisis at FTX, a cryptocurrency exchange, and referenced the activity of an affiliated hedge fund and trading firm, Alameda Research, which held a significant portion of its assets in FTX's native token. While we continue to investigate the details regarding the crisis, the public record supporting FTX’s bankruptcy proceedings indisputably reveals a staggering shortfall of almost $9 billion, a sum largely comprised of customer funds.
In response, I made internal and public calls for action and asked my fellow CFTC Commissioners and the Commission staff to begin to draft rules to fill the gaps in our regulations. We need rules to strengthen customer protection and market integrity. Specifically, I have advocated for, and will continue to advocate for, rules protecting customer funds (including requirements to segregate customer funds) and that address a series of natural tensions that arise from certain types of market structures.
In addition, I am calling for regulations consistent with our core principles, effective corporate governance and risk management, cyber-risk systems safeguards, liquidity reserve requirements, external audits, and conflicts of interest policies, among others, for all of our registered entities.
This final regulatory requirement – the adoption and implementation of sound conflicts of interest policies – has become all the more critical as registered entities launch multiple services within corporate entities that are owned and controlled by a shared parent company.
Same Activity. Same Risks. Same Rules.
It is imperative that we ensure parallel guardrails apply across our markets. Same activity, same risks, same rules.
Market Regulation and Intermediation
For more than two centuries, U.S. state and federal market regulations have largely been characterized by a focus on intermediation.
In May of 1792, twenty-four brokers gathered in lower Manhattan and signed the Buttonwood Agreement. The agreement initiated the development of an auction house where admitted members executed securities trades on behalf of clients and subject to a gentleman’s agreement that included rules of conduct. This members-only club was, in fact, a predecessor to the New York Stock Exchange. At the time of inception, the exchange traded Revolutionary War bonds. Similar auction houses emerged facilitating the trading of commodities, including tobacco, cotton, corn, wheat, and other agricultural products.
Regulation and Intermediaries
Historically, intermediaries have been at the center of our financial markets. Exactly, one hundred and one years ago today, Congress enacted the Grain Futures Act, the predecessor to the Commodity Exchange Act. The Grain Futures Act created the Grain Futures Administration. The statute was later revised, renamed and superseded by the Commodity Exchange Act and the Commodity Futures Trading Commission. In parallel, in 1933 Congress enacted the Securities Act and a year later the Securities Exchange Act of 1934 that established the Securities and Exchange Commission.
To accomplish the goals of greater customer protection and market integrity, our statutes and regulations, in many instances, introduce regulatory requirements at the point of intermediation. Meaning, the presence of one or more entities that facilitate financial markets transactions on behalf of customers triggers a regulatory requirement. This is especially true and there is heightened concern when the customers are less sophisticated, vulnerable market participants. Because early markets developed with intermediaries as a central structure in the execution, clearing, and settlement of transactions, our regulation often attaches at the point of intermediation and requires supervision of intermediaries.
With respect to the derivatives markets, futures commission merchants (FCMs) provide important advisory, trading, and clearing services to customers, enabling customers to access the derivatives markets for risk-mitigation and speculative purposes, charging fees, reaping meaningful compensation, and holding customer assets. These intermediaries interface with clients directly.
FCMs solicit and accept orders for derivatives transactions on behalf of customers and receive customer funds to margin, guarantee, or secure derivatives transactions. FCMs are subject to significant regulatory requirements, including customer protection safeguards, safety and soundness capital requirements, risk management, conflicts of interest requirements, and anti-money laundering and know-your-customer programs.
FCMs are critical to an exchange’s price discovery, price accuracy, and price transparency functions. As a result of effective regulation and responsible innovation, our markets are the deepest and most liquid derivatives market in the world. As members of CCPs, FCMs provide financial resources that are vital to the resilience of CCPs by contributing to the default resources, participating in the default management process, or serving as liquidity backstops to the CCPs. The competition of a rich and robust intermediary market should inure to the benefit of customers.
Benefits and Risks of Disintermediating
In the context of some use cases, we can imagine that responsible adoption of disintermediation and decentralization many have practical, commercial, and even regulatory benefits.
Some of the benefits often touted by promoters of blockchain technology include greater efficiencies including faster, cheaper, and frictionless financial markets transactions, greater access to financial services, and broader inclusion in financial markets. There are arguments that decentralization, in particular, has the great potential to increase regulatory transparency, enhance record-keeping and reduce concentration risk.
While, for some use cases, the benefits of these technologies may be immediately achievable, there are many use cases that have not yet realized the promises of distributed digital ledger technology. In almost all instances, these new technologies pose new and notable risks.
Responsibility and Accountability
Under the current regulatory regime, market structures that eliminate intermediaries and enable direct trading or clearing model without establishing parallel regulatory obligations may undermine long-established customer protections.
Almost three years ago, the New York Stock Exchange adopted a new listing rule permitting direct listings. In response, Commissioners Allison Herren Lee and Caroline Crenshaw issued a statement articulating the risks that arise from minimizing the role of firm-commitment underwriters.
For more than a hundred years, regulations imposed on firm-commitment underwriters heightened disclosure obligations for companies accessing public markets by improving the quality of registration statements, introducing important gate-keeping functions, establishing reputational risks for underwriters, and creating a path for investors to impose legal liability on underwriters under Sections 11 and 12(a)(2) of the Securities Act. As the Commissioners explained, “chipping away” at existing market structures may have significant consequences for customer protections.
In our derivatives markets, parallel questions regarding responsibility and accountability arise as a result of the elimination of intermediaries. FCMs, for example, have statutory and regulatory obligations to verify the identity of customers. Compliance with these anti-money laundering and know your customer requirements protect the integrity of our markets by reinforcing Bank Secrecy Act obligations and creating the data repository necessary for surveillance to prevent our markets from becoming a playground for illicit transactions. FCMs separate customer funds and safeguard customer assets in custody against unnecessary losses or misuse.
Indisputably, our regulatory efforts to date do not incorporate robust protections for customers in direct services models. As a result of this regulatory gap, we will need to investigate and fully appreciate the consequences for unsophisticated or vulnerable customers engaging in direct services arrangements. Even if decentralized platforms claim not to directly offer custody services, other challenges (particularly vulnerabilities to cyberattacks and other threats arising from customer transfers associated with reliance on cross-chain bridges) may merit careful consideration and regulatory intervention.
We also find market integrity concerns. We may need to recalibrate default loss management. FCMs have offered a vital contribution to resilience and recovery programs; in their absence, alternatives will require careful consideration. In addition, the elimination of traditional intermediaries will likely impact market liquidity as well as competition.
Finally, it is worth noting that transitions to alternative market structures have also created opportunity areas for fraudsters. As the use and popularity of digital assets and decentralized protocols have proliferated, we have witnessed an uptick in fraudulent schemes aimed at sophisticated and unsophisticated customers.
Notwithstanding the volume and diversity of these schemes, the CFTC has acted to ensure compliance with applicable statutory and regulatory requirements across our markets for anyone engaged in regulated activity. We are sending a clear message that regulated activities are subject to oversight. Full stop.
The CFTC has brought over one hundred enforcement cases related to digital assets. More than eighty of these cases alleged or found fraud or manipulation. Many of the remaining cases involve cutting edge fact patterns. The CFTC has time and again been able to use its existing statutory and regulatory framework to reduce fraud. As one might expect, this fiscal year has been our busiest yet. So far, the CFTC has announced 34 actions in the 2023 fiscal year, and the agency has imposed more than $4.4 billion in civil monetary penalties, disgorgement, and restitution claims in digital asset cases.
I am calling on my fellow Commissioners and Chair of the CFTC to begin working on several rulemakings to immediately address any gaps that may arise as a result of novel market structures that eliminate intermediaries or integrate under the same corporate ownership affiliated entities acting as intermediaries.
I am the lead architect of a rulemaking that seeks to establish protections for DCO member property in the context of novel market structures. This rule will ensure that, in the event a DCO experiences a liquidity crisis or fails, customer property is protected. In addition, this rule-making creates a pathway for introducing anti-money laundering and know your customer due diligence obligations for novel market structures.
When we reflect on the history of our markets, it is clear that in many respects, thoughtful and innovative ideas created pathways to the future. As we build a sustainable future in traditional financial markets as well as markets introducing novel financial products, it will be imperative to maintain the customer protection and market integrity principles that have long guided our regulation. If we care careful in safeguarding these values, our markets will continue to thrive.
 Sir Jon Cunliffe, Deputy Governor, Financial Stability, Bank of England, Keynote Address at the FIA & SIFMA Asset Management Derivatives Forum 2022, Learning From the Dash for Cash – Findings and Next Steps for Margining Practices (Feb. 9, 2022), https://www.bankofengland.co.uk/speech/2022/february/jon-cunliffe-keynote-address-fia-sifma-asset-management-derivatives-forum.
 See Vicky Ge Huang et al., FTX Tapped Into Customer Accounts to Fund Risky Bets, Setting Up Its Downfall, WALL ST. J. (Nov. 11, 2022), https://www.wsj.com/articles/ftx-tapped-into-customer-accounts-to-fund-risky-bets-setting-up-its-downfall-11668093732.
 In re FTX Trading Ltd., Case No. 22-11068 (JTD) (Bankr. D. Del. Jan 12, 2023), [ECF No. 487].
 See Kristin N. Johnson, Commissioner, CFTC, Federal Reserve of Chicago Financial Markets Group Fall Conference, Investing in Investor Protection (Nov. 16, 2022); see also Nahiomy Alvarez, Nomaan Chandiwalla, Alessandro Cocco, 2022 Financial Markets Group Fall Conference–Recap, https://www.chicagofed.org/publications/blogs/ chicago-fed-insights/2023/2022-fmg-fall-conference-recap (Feb. 6, 2023).
 Allison Herren Lee and Caroline A. Crenshaw, Commissioners, SEC, Statement on Primary Direct Listings, (Dec. 23, 2020), https://www.sec.gov/news/public-statement/lee-crenshaw-listings-2020-12-23.
 CFTC, Keynote Address at PLI White Collar Crime 2023, Enforcement by Enforcement: The CFTC’s Actions in the Derivatives Markets for Digital Assets (Sept. 11, 2023), PLI White Collar Crime 2023 Keynote Speech of Enforcement Director Ian McGinley: “Enforcement by Enforcement: The CFTC’s Actions in the Derivatives Markets for Digital Assets” | CFTC.