Introduction

Good morning.  I want to thank Tom Wipf, the ARRC, and the New York Fed for holding this series of symposia and for inviting me to share my thoughts and moderate an important discussion on our progress in the transition from LIBOR to SOFR specific to the derivatives markets.  Before I begin, please allow me to remind you that the views I express today are my own and do not represent the views of the Commodity Futures Trading Commission (CFTC or the Commission) or my fellow Commissioners.in

In early 2020, just before the global pandemic seized us, and when taking the train between D.C. and New York in a day was routine, I spoke at the ISDA/SIFMA AMG Benchmark Strategies Forum.[1]  My message for that day regarding LIBOR transition was about progress.  Quoting the ultimate Renaissance man Richard Buckminster Fuller, I stressed that a successful transition would only be achieved if we moved away from LIBOR altogether and adopted a new model that makes it obsolete.

At that point, we were just shy of two years away from the December 31, 2021 LIBOR “end-game,” and I was several years into my persistent engagement and dogged messaging in support of a successful transition through, among other things, sponsorship of the CFTC’s Market Risk Advisory Committee (MRAC) and establishment of its Interest Rate Benchmark Reform Subcommittee (the Benchmark Subcommittee).  The goal of the Benchmark Subcommittee, which is chaired by Tom (Wipf), has always been to complement the work of the ARRC by raising awareness and shedding light on potential challenges, identifying risks for financial markets and individual consumers, and providing solutions within the derivatives space as we barreled towards the endgame.

The previous ARRC SOFR symposium focused on loans and related markets. Andrew Bailey, Governor of the Bank of England, delivered salient remarks reminding us of the progress we have made and the challenges ahead as we make our final descent.[2]  I would like to take some time today to echo his remarks with a focus on our progress in the U.S. and some next steps, including today’s announcement by the Benchmark Subcommittee.

Habits

Before that, however, I want to take a moment to again emphasize that we need to end our caustic relationship with LIBOR.  While we talk about making a smooth transition to alternative risk-free-rates such as SOFR, what we really need to do to is cut the cord, make LIBOR obsolete, adopt a habit of “SOFR First.”

It has been over a decade since the first allegations of benchmark manipulation surfaced, and nine years since the CFTC began levying sanctions for LIBOR-related misconduct, which resulted in the collection of more than $3.3 billion.  In July 2017, when Governor Bailey, then the Chief Executive of the UK Financial Conduct Authority (FCA)—which regulates LIBOR—acknowledged that despite significant improvements to LIBOR, the goal of anchoring LIBOR submissions and rates to the greatest extent possible to actual transactions could not be achieved.[3]  The underlying market that LIBOR seeks to measure, the market for unsecured wholesale term lending to banks, was no longer active enough to anchor a benchmark.

By the numbers, around that time, the U.S. Federal Reserve estimated that the more than $200 trillion in outstanding volumes of USD LIBOR contracts were benchmarked to a rate generated by $1 billion per day.  For the three-month LIBOR, the standard reference rate in the derivatives markets, was less than US $1 billion of borrowing among the largest banks.  On many days, that number dropped below $100 million.[4]  As I looked forward in 2018 to what is now our present situation, I remarked that as a market regulator, it would be indefensible to allow hundreds of trillions of dollars of transactions to reference such a “zombie” LIBOR after several years of lead time.[5]

Last month, at the previous ARRC Symposium, Governor Bailey reminded us that this dire situation has not changed in the last four years.[6] 

The skewed proportionality that underlies LIBOR continues to raise serious concerns about market integrity, conduct risks, and greater financial stability risks.  Regulatory authorities have relied on broad market participation in the global cooperative and consultative efforts undertaken by ISDA (International Swaps and Derivatives Association) and committees like the ARRC, and have stood by ready to facilitate transition efforts by helping to avoid market dislocations.  However, we have often had to recognize that our policies, mandates, and missions do not always support requiring compulsory industry standard setting or change through regulation.  As has often been the hallmark of our derivatives markets, the CFTC’s role as the regulator is to support the industry-led process and apply and enforce existing standards under the Commodity Exchange Act and regulations.  As products and markets develop and evolve, along with the assets, benchmarks, and data points on which they are priced, regulators and lawmakers must ensure that the existing framework is adaptable or make necessary changes to support progress and ensure it remains transparent, equitable, and representative of what it is endeavors to achieve.

Domestic and global regulators are coordinating in their efforts and guidance, publishing timelines and transition plans, encouraging customer and client education, and most critically, standing firm that the most effective way to break from LIBOR is to cease entering new LIBOR contracts.

First, a Word on SOFR

Thanks to the ARRC, we have a new rate available to serve as a robust and reliable risk-free rate (RFR): the Secured Overnight Financing Rate or SOFR.  SOFR is a fully transactions-based rate with the widest coverage of any U.S. Treasury repurchase rate available.[7]  SOFR futures began trading on the Chicago Mercantile Exchange (CME) in May of 2018, with both one- and three-month contracts offered.  It offered clearing of over-the-counter (OTC) SOFR swaps that following October.[8]  LCH began clearing SOFR-based OTC overnight index and basis swaps that July, both well ahead of the ARRC’s phased transition plans.[9]  The Intercontinental Exchange, Inc. (ICE) launched trading in one- and three-month cash-settled SOFR futures in October 2018.[10]

Trading in the SOFR derivatives market has gradually expanded, with over $6 trillion in open interest in SOFR-based futures and swaps as of March.[11]  According to the ARRC’s most recent progress report, trading activity picked up noticeably in October 2020 when LCH and CME – the two major USD interest rate central counterparties or CCPs—successfully transitioned from the Effective Federal Funds Rate (EFFR) to SOFR for discounting and the calculation of Price Alignment Interest (PAI) on all outstanding cleared USD-denominated products.[12]  Of note, this transition was aided by the Benchmark Subcommittee’s sponsorship of a June 2020 virtual table-top exercise as a prelude to the PAI/discounting switch.[13]  The CCP discounting shift in October 2020 marked a fundamentally important event in the transition to robust alternative reference rates and the insights drawn from the tabletop exercise informed critical and fast approaching decision points.

Despite the overall rising growth in SOFR-based derivatives, it remains a small fraction of the total volume of cash and derivative products traded on LIBOR.

We all know that SOFR is different from LIBOR. The compounded SOFR used for SOFR derivatives is set in arrears at the end of the interest period while LIBOR is set in advance at the start of an interest period. Unlike LIBOR, SOFR (as it is fully collateralized) does not have a credit spread.  But given the market structure changes that fundamentally have brought LIBOR to its end, it would be irresponsible to wait for a new rate that replicates that blueprint for LIBOR.  We must move on with a rate that is based on sustained and robust transactions. Of note, SOFR is currently based on a daily average transaction volume of $900 billion.[14]

To avoid the conduct and stability risks that emerged when LIBOR became disconnected from actual activity, we must rely on a benchmark that is both representative of transactions and proportional to the depth and breadth of products that rely upon it.  SOFR demonstrates that fitness for the derivatives markets.

About that Progress

At this point, it is important to note that thanks to the incredibly hard work by ISDA and market participants, we now have robust fallback language for both cleared and uncleared interest rate derivatives contracts.  ISDA successfully launched the 2020 IBOR Fallbacks Protocol[15] to introduce robust fallback language for interest rate swaps.  The Protocol became effective on January 25, 2021.  The relevant CCPs simultaneously adopted the fallback language in their respective rule books for cleared swaps.[16]

Based on CFTC staff analysis of information from ISDA and data from swap data repositories, legal entities that account for close to 95% of gross notional outstanding – cleared + uncleared - in interest rate swaps (IRS) have adhered to the Protocol.  According to the ARRC, as of March 12^th, there were 13,540 adhering parties to the IBOR Fallbacks Protocol.[17]  There is a long tail of end-users with a small footprint in the swaps markets.  Our expectation is that many of them will either close their swap positions or negotiate appropriate fallback language bilaterally with their counterparties.  But not having a plan just because the firm has 1-2 open swaps is not an option.  To the extent there are large, active firms who have not yet adhered to the Protocol, relevant regulators and counterparties will be apt to take notice.  We’ll hear in a bit from ISDA’s CEO Scott O’Malia and others about adherence to the protocol.

Authorities had been highlighting the lack of robust fallback language in swaps contracts as a financial stability risk factor, for good reason.  Robust contractual language must be in place because we have known for over a decade that cessation of the reference rate was on the horizon.

2021: Time for Clean Break

ICE Benchmark Administrator, the administrator of LIBOR, working closely with its regulator, the UK FCA, announced in late 2020, that it would consult on its intention to cease the publication of the one week and two-month USD LIBOR settings immediately following the LIBOR publication on December 31, 2021, and the remaining USD LIBOR settings immediately following the LIBOR publication on June 30, 2023.[18]  Around the same time, recognizing the consumer protection, litigation, and reputational risks, the U.S. Federal Reserve, the Office of the Comptroller of the Currency, and the Federal Deposit Insurance Corporation issued an Interagency Statement on LIBOR Transition encouraging banks to cease entering into new contracts that reference USD LIBOR post December 2021.[19]  Mike Gibson, Director of the Division and Supervision and Regulation at the Federal Reserve Board will speak in a bit about the direction given to banks, and most important, the very narrow set of carve-outs for continued use of USD LIBOR post December 31, 2021.

On March 5, 2021, the FCA confirmed that all LIBOR settings will either cease to be provided by any administrator or no longer be representative: immediately after December 31, 2021, in the case of all sterling, euro, Swiss franc and Japanese yen settings, and the 1-week and 2-month US dollar settings; and immediately after June 30, 2023, in the case of the remaining US dollar settings. [20]

From previous studies by CFTC staff, we observe that there is a CFTC registered swap dealer, mostly all banks, on one side of nearly all interest rate swaps.  Which means, in just over six months, as a customer, you will not be able to call your dealer, or request an electronic quote from your dealer, for a LIBOR swap, unless it is to hedge a transaction that was entered into before the end of 2021.  So how do we go from the low single-digit market share of SOFR, to what some expect, low single-digit market share of LIBOR?

SOFR First

This takes us to the announcement made earlier today by the MRAC’s Benchmark Subcommittee.[21]   Today’s announcement follows several years of collaboration between the CFTC, the Benchmark Subcommittee, and the ARRC.  CFTC staff has been working closely with the ARRC to provide regulatory relief to facilitate transition from the various IBORs to SOFR and other relevant alternative reference rates.  For example, in response to ARRC requests, in December 2019, three divisions of the CFTC issued staff no-action letters providing relief to market participants relating to the transition of swaps referencing IBORs.[22]  These letters and the staff no-action relief therein were updated in August 2020 to provide relief for additional types of swap amendments and refine relief previously provided based on feedback from market participants.[23]

The Benchmark Subcommittee has focused on finding ways to collaborate with market development initiatives of the ARRC, with a view to supplement and support these efforts.  The first major effort was around “plain English” disclosures that market participants could use, as they deem appropriate, with all clients and counterparties with whom they continued to transact derivatives referencing LIBOR and other IBORs.[24]  The disclosures informed clients and counterparties about the implications of using such products.  The second significant effort was the tabletop exercise with respect to the SOFR discounting switch by the CCPs I mentioned earlier.  The third, announced today, is to adopt a plan to shift [interdealer] USD derivatives trading in IRS, from LIBOR to SOFR, known as the “SOFR First” initiative.

To be clear, this is not Commission action and should be viewed as a best practice.  The SOFR First [Transition] Initiative (the Initiative) represents a prioritization of interdealer trading in SOFR over LIBOR.  Specifically, as part of the Initiative, the Benchmark Subcommittee recommends that interdealer brokers change USD linear swap trading conventions to SOFR on July 26, 2021.  After July 26, 2021, the interdealer market should replace trading of LIBOR linear swaps with trading of SOFR linear swaps.  LIBOR would be expected to be accessible as a basis to SOFR after this date.  However, screens for LIBOR linear swaps should remain visible for informational purposes only after this date.  In other words, the recommendation is that dealer to dealer trading in LIBOR linear swaps should cease at the end of July. All trading, outrights and basis swaps, would be around SOFR.  After October 22, 2021, the recommendation is that screens operated by platforms specializing in inter-dealer trading for LIBOR linear swaps should be turned off altogether.

Many of you have likely heard of the Sonia First effort in the UK, and we will be hearing from Edwin-Schooling Latter, Director of Markets and Wholesale Policy at the FCA, and others about it.  There is strong collaboration among authorities and as we learn from others’ experiences, the expectation is that in coming months, the Subcommittee will consider initiatives related to non-linear derivatives, exchange traded derivatives, and cross-currency swaps.

Given the most recent Financial Stability Board and International Organization of Securities Commissions (IOSCO) statements on LIBOR transition[25] which are consistent with and supportive of the interagency guidance from U.S. banking regulators that banks cease new LIBOR activities that I mentioned earlier,[26] the Benchmark Subcommittee believes it is prudent to change quoting conventions in the USD interest rate swaps market from USD LIBOR to SOFR in the near term.  This change in trading conventions is an important step to increase overall SOFR swap volumes and contribute to a smooth transition of liquidity towards SOFR.

Given the close economic and symbiotic relationship between futures and swaps markets, we should expect trading in SOFR futures to track the growth in SOFR swaps.  Tom (Wipf), will speak about why the group chose July and not a later date.  Simply put, given the sheer size of the USD IRS market, waiting till after summer, until Fall, will give us very little time to manage the transition.  There is broad consensus among all market participants, and not just the dealer banks, of the urgency to shift out of LIBOR.  Even today’s announcement is timed to ensure that market participants, the trading platforms, other service providers, have sufficient time to prepare for the July 26^th event.

Conclusion

I know that was quite a download to kick off this panel, so I will wrap it up quickly so we can dig more deeply into our progress to date and look further down the slope to our endgame.

I want to thank everyone at the ARRC, on the panel today, and out there watching for the collaboration, coordination, and communication that have already brought us this far in terms of progress.

[1] Rostin Behnam, Commissioner, CFTC, Remarks of Commissioner Rostin Behnam at the ISDA/SIFMA AMG Benchmark Strategies Forum 2020, New York, New York (Feb. 12, 2020), https://www.cftc.gov/PressRoom/SpeechesTestimony/opabehnam14.

[2] Andrew Bailey, Governor, Bank of England, Descending Safely: Life after LIBOR, Speech given at the Alternative Reference Rates Committee SOFR Symposium: The Final Year (May 11, 2021), https://www.bankofengland.co.uk/speech/2021/may/andrew-bailey-a-moderated-discussion-with-john-williams-president-of-ny-fed.

[3] Andrew Bailey, Chief Executive, Financial Conduct Authority, Speech at Bloomberg London: The Future of LIBOR (July 27, 2017), https://www.fca.org.uk/news/speeches/the-future-of-libor.

[4] Jerome H. Powell, Governor, Federal Reserve, Introductory Remarks at the Roundtable of the Alternative Reference Rates Committee, The Federal Reserve Bank of New York, New York (Nov. 2, 2017), https://www.federalreserve.gov/newsevents/speech/powell20171102a.htm.

[5] Rostin Behnam, Commissioner, CFTC, Our Collective Strength, Remarks of CFTC Commissioner Rostin Behnam at the 2018 ISDA Annual Japan Conference, Shangri-La Hotel, Tokyo (Oct. 25, 2018), https://www.cftc.gov/PressRoom/SpeechesTestimony/opabehnam11.

[6] Bailey, supra note 2.

[7] SOFR has been published daily by the Federal Reserve Bank of New York since April 3, 2018.  See, e.g. Federal Reserve Bank of New York, Reference Rates (2018), https://www.newyorkfed.org/medialibrary/media/research/advisory_panel/far/lieber_far_april2018.pdf?la=en.

[8] Press Release, CME Group, CME Group Announces First OTC SOFR Swaps Cleared (Oct. 9, 2018), https://www.cmegroup.com/media-room/press-releases/2018/10/09/cme_group_announcesfirstotcsofrswapscleared.html.

[9]Press Release, LCH, LCH Clears First SOFR Swaps (July 18, 2018), https://www.lch.com/resources/news/lch-clears-first-sofr-swaps.

[10] Press Release, ICE, Intercontinental Exchange Announces October 1 Launch of ICE one and Three Month SOFR Futures (Aug. 1, 2018), https://www.businesswire.com/news/home/20180801005430/en/Intercontinental-Exchange-Announces-October-1-Launch-of-ICE-One-and-Three-Month-SOFR-Futures.

[11] ARRC, Progress Report: The Transition from U.S. Dollar LIBOR at 6 (Mar. 2021), https://www.newyorkfed.org/medialibrary/Microsites/arrc/files/2021/USD-LIBOR-transition-progress-report-mar-21.pdf.

[12] Id.

[13] See Press Release Number 8171-20, CFTC, CFTC Market Risk Advisory Committee’s Interest Rate Benchmark Reform Subcommittee Holds Table Top Discussion and Revises Membership (June 2, 2020), https://www.cftc.gov/PressRoom/PressReleases/8171-20.

[14]Federal Reserve Bank of New York, Secured Overnight Financing Rate Data,  https://www.newyorkfed.org/markets/reference-rates/sofr (last visited June 3, 2021).

[15] The ISDA 2020 IBOR Fallbacks Protocol is available at http://assets.isda.org/media/3062e7b4/08268161-pdf/.

[16]See Letter from Christopher Bowen, Managing Director & Chief Regulatory Counsel, CME Group to Christopher Kirkpatrick, Office of the Secretariat, CFTC, Re: Regulation 40.5(a) Submission of Rules for Commission Review and Approval—Modifications to Interest Rate Swap Products to Implement ISDA IBOR Fallback Provisions, CME Submission No. 20-517 (Dec. 8, 2020), available at https://www.cftc.gov/sites/default/files/filings/orgrules/20/12/rule120920cmedco001.pdf.  See also Letter from Julian Oliver, Chief Compliance Officer, LCH Limited to Christopher Kirkpatrick, Office of the Secretariat, CFTC LCH Limited Self Certification: SwapClear Pre-cessation Triggers (Dec. 1, 2020), available at
https://www.lch.com/system/files/media_root/LCHLTD%20Self-Cert_pre%20cessation%20triggers%20final%20v1.pdf.

[17] ARRC, supra note 11 at 9.

[18] See ICE Benchmark Administration, ICE LIBOR Consultation on Potential Cessation (Dec. 2020), https://www.theice.com/publicdocs/ICE_LIBOR_Consultation_on_Potential_Cessation.pdf.

[19] Board of Governors of the Federal Reserve System, SR 20-27: Interagency Statement on LIBOR Transition (Nov. 30, 2020), https://www.federalreserve.gov/supervisionreg/srletters/SR2027.htm.  See also Board of Governors of the Federal Reserve System, SR 21-7: Assessing Supervised Institutions’ Plans to Transition Away from the Use of the LIBOR (Mar. 9, 2021), https://www.federalreserve.gov/supervisionreg/srletters/SR2107.htm.

[20] Press Release, Financial Conduct Authority, Announcements on the End of LIBOR (Mar. 5, 2021), https://www.fca.org.uk/news/press-releases/announcements-end-libor.

[21] Press Release Number, CFTC, CFTC’s Interest Rate Benchmark Reform Subcommittee Recommends Dates for Transitioning Interdealer Swap Market Trading Conventions to SOFR (June 8, 2021), https://www.cftc.gov/PressRoom/PressReleases/8394-21.

[22] More specifically, the Division of Swap Dealer and Intermediary Oversight issued CFTC Letter 19-26 providing relief to swap dealers from registration de minimis requirements, uncleared swap margin rules, business conduct requirements confirmation, documentation, and reconciliation requirements, and certain other eligibility requirements.  The Division of Market Oversight issued CFTC Letter 19-27 providing time-limited no-action relief from the trade execution requirement, while the Division of Clearing and Risk issued CFTC Letter 19-28 providing time limited relief from the swap clearing requirement and related exceptions and exemptions.  See Press Release Number 8096-19, CFTC, CFTC Provides Relief to Market Participants Transitioning Away from LIBOR (Dec. 18, 2019), https://www.cftc.gov/PressRoom/PressReleases/8096-19.

[23] See Press Release Number 82280-20, CFTC, CFTC Provides Additional Relief to Market Participants Transitioning from LIBOR (Aug. 31, 2020), https://www.cftc.gov/PressRoom/PressReleases/8228-20.

[24] See Interest Rate Benchmark Reform Subcommittee of the Market Risk Advisory Committee, Plain English Disclosures for New Derivatives Referencing LIBOR and other IBORs (Sept. 9, 2019), available at https://www.cftc.gov/PressRoom/Events/opaeventmrac090919.

[25]Press Release, Financial Stability Board, FSB issues statements to support a smooth transition away from LIBOR by end 2021 (June 2, 2021), https://www.fsb.org/2021/06/fsb-issues-statements-to-support-a-smooth-transition-away-from-libor-by-end-2021/; International Organization of Securities Commissions, Statement on Benchmarks Transition (June 2, 2021), https://www.iosco.org/library/pubdocs/pdf/IOSCOPD676.pdf.

[26] See supra note 19.

I want to thank Commissioner Berkovitz for his leadership, and extend a special thanks to Abigail Knauff who serves as the EEMAC’s Secretary, and to Dena Wiggins who serves as the EEMAC’s chairwoman.  I also want to thank and acknowledge the EEMAC members and invited speakers, including our very own CFTC staff, who will participate on the panels today.  And of course, a special thanks to the all the CFTC staff who help us bring these meetings together.

As you can imagine, I am pleased and excited that today’s meeting will examine how derivatives markets can facilitate the transition to a low-carbon economy and will include an update on recent events in the energy markets.  With panels dedicated to domestic and international cap-and-trade carbon markets, exchange-listed carbon derivatives, and an exploration of the underlying markets, I believe the EEMAC is taking a critical step at a time when anticipation and opportunity are building exponentially.

The financial markets, particularly the derivatives markets overseen by the CFTC, are used for hedging a myriad of risks in the traditional commodity as well as interest rate, foreign exchange, credit, and equity markets.  They also serve as powerful information resources for hedgers and investors alike when it comes to price discovery, market transparency--and, perhaps most importantly for our purposes today-- facilitating the allocation of capital towards sustainable investments and to financial, agricultural, and industrial sectors as they manage the impact of physical risks and transition towards a lower carbon economy.

In as much as Commissioner Berkovitz and I have prioritized addressing the impact of climate change on the derivatives and larger financial markets, I would be remiss if I did not take this opportunity to note that this is not the first time the EEMAC examined the promise and transition to a low-carbon economy.  And I do this not to suggest that there is anything repetitive about the today’s agenda; rather I would like to take the opportunity to honor our past CFTC Commissioner Bart Chilton.

We lost Bart a little over two years ago, just as leaders across domestic and international regulators and financial institutions were building the momentum needed for the industry, public, and policymakers to recognize that the impact of climate change can no longer be compartmentalized as an environmental issue.  Today’s EEMAC could not come at a more appropriate time.  We are at an inflection point in the climate discussion, and I am confident that today’s meeting will further advance our understanding of the critical action needed to address climate risk.

Commissioner Chilton, Chaired the first meeting of the expanded EEMAC in May of 2009, which featured panelists from our own Division of Market Oversight providing “An Overview of Environmental Markets: CFTC & A Carbon-Constrained World.”[1] 

Even before that, in 2008, Commissioner Chilton used his signature flair to deliver statements and speeches lauding efforts by legislators, markets, and market participants to address the increasingly critical need to incorporate climate related market risk into our financial markets and to protect our environment.  He intrigued us with titles such as “The Start of Something Green,”[2]  “It’s Not Easy Being Green … Markets, in the US,”[3]  “Banquet of Consequences,”[4]  “‘Green CAT’ Markets; You Gotta Show Some Guts,”[5] and one that inspires me, “The Most Important Thing.”[6] 

In June of 2008, Bart asked his New York City audience, “What is the most important thing you have never done?”  To avoid a cliffhanger, and ever the statesman, Bart moved beyond his own life and thought about the U.S. and the world and concluded that, as a nation, we had failed to address climate change.

There is now a common understanding that climate change not only presents systemic risk, sub-systemic shocks, and wide-ranging ripple effects to the U.S. financial system and larger economy. It presents opportunities as we work to ensure decisive and cohesive leadership over the markets and institutions charged with monitoring and managing risk, capital, and asset allocation, especially as the physical risks of the sudden and extreme weather events associated with climate change have an increasingly profound impact on our most vulnerable communities.  

Bart would be so pleased that we have convened today, almost 13 years later to take the steps needed to replace the “never” with “ever.” 

For my part, in support of the Commission and industry efforts, I have spent the last several years as sponsor of the CFTC’s Market Risk Advisory Committee or “MRAC” within which is housed the Climate Related Financial Market Risk Subcommittee.  Last September, the Subcommittee released the report Managing Climate Risk in the U.S. Financial System,[7] the first of-its-kind effort from a U.S. government entity.  I followed its release with testimonybefore the House Select Committee on the Climate Crisis[8] and presentations in other venues focused on climate-related market risk and incorporating sustainability resilience into our financial systems. 

More recently, in March, I announced the establishment of the Climate Risk Unit or “CRU” within the CFTC.[9] The CRU will be comprised entirely of staff across our offices and divisions, and will focus on the role of the derivatives markets--and the CFTC as a market regulator--in understanding, pricing, and addressing climate-related risk.  To the extent that new products and market developments must accurately, uniformly, transparently, and fairly factor climate-related risks into pricing and related market functions, the Commission needs to engage early in order to ensure coordination within the larger financial regulatory space--domestically and abroad--and to provide other support. 

The CFTC’s unique mission focused on risk mitigation and price discovery puts us on the front lines as we will increasingly need to use our wide-ranging and flexible authorities to prepare for and address the impact of climate change, and more specifically, the transition to a low carbon economy. 

In thinking about the future of the CRU as a resource for the Commission, and the current administration’s “all of government” approach, the goal is really to dedicate the resources we have—and that includes our advisory committees—towards raising risk management awareness and visibility within our markets and the broader economy so that we can identify where the holes are; where we need to be most vigilant in both our support and leadership as regulators. 

At the heart of the EEMAC, the MRAC, the Climate Report, the CRU, all the remarks you will hear today, and the legacy of CFTC Commissioner Bart Chilton is the concept of partnerships.  In speaking about climate change and financial markets and market structures, and what role policy makers should and could play.  

As the remit of our new administration supports a firm commitment to full participation in the global effort, I am fully prepared for the CFTC to be an active player, partner, and leader.  To that end, I want to end these remarks by again, thanking Commissioner Berkovitz, Abigail Knauff, Dena Wiggins, and the esteemed members and guests of the EEMAC. I look forward today’s discussion.

Good morning, and welcome to the Energy and Environmental Markets Advisory Committee (EEMAC).  I am pleased that we are able to conduct this meeting by video today, and look forward to when the Committee can meet in person again.

This meeting of the EEMAC will explore the potential role of carbon markets in the transition to a low-carbon economy.  Reducing global carbon emissions to net-zero by 2050 is a significant global undertaking.  To accomplish this goal, the International Energy Agency is calling for a “transformation of how we produce, transport and consume energy.”[1]  This transformation will affect all sectors of the economy and retail customers in their daily lives.  Although decisive action is necessary to protect our environment and society, the path to net-zero emissions will have significant costs for market participants.  Whether incentives, mandates, voluntary reductions, or other approaches are adopted to cut carbon emissions, financial markets can serve to more efficiently allocate the costs and risks of the transition to a low-carbon economy.  At today’s meeting we will examine the ways in which energy companies, financial firms, and other market participants are using carbon markets to meet their emissions compliance obligations and hedge risks associated with climate change and green lending, and how these markets may continue to evolve to meet current challenges.

The term “carbon markets” refers broadly to primary markets, secondary markets, and derivatives markets for carbon emission allowances and offsets.  Primary markets are the mechanism by which allowances and offsets are initially distributed, either through direct allocation by governmental authorities, by auction, or through voluntary measures.  Entities may purchase or sell these allowances or offsets in the secondary market for a variety of reasons, including to meet emissions standards, speculate on price movements, or provide liquidity.  Entities that purchase allowances and offsets to meet compliance obligations can use the derivatives markets to hedge their exposure to potential changes in the cost of these underlying assets and discover prices over longer time horizons.  Speculators, market makers, and intermediaries may also participate in the derivatives market, as they do for other types of commodities.  In a well-functioning market system, prices in the primary, secondary, and derivative markets are related economically.

While they can be an important tool to achieve climate goals, financial markets may also be negatively affected by climate change.  Last fall, the Climate Subcommittee (Subcommittee) of the CFTC’s Market Risk Advisory Committee (MRAC) released a landmark report describing how climate change poses a major risk to the U.S. financial system and to its ability to sustain the American economy.[2]  The report details how climate change could create price shocks in a variety of asset classes, potentially disrupting the functioning of the financial markets and the underlying economy.  The Subcommittee recommended a variety of actions for financial market participants and regulators to recognize and address these risks.  With respect to the CFTC in particular, the Subcommittee recommended that the agency conduct research to understand how climate-related risks could impact markets and their participants under CFTC oversight, including central counterparties, futures commission merchants, traders, and funds.  The Subcommittee urged the CFTC to coordinate with other regulators to develop a “robust ecosystem of climate-related risk management products.”  It further recommended that the CFTC “consider expanding the CFTC’s risk management rules and related quarterly risk exposure reports to cover material climate-related risks.”[3]  I commend the Subcommittee for its work in producing this report and Acting Chair Behnam for his leadership of the MRAC and on the issue of climate change at the CFTC.

I see three principal ways in which the CFTC, as a financial market regulator, can support the transition to a carbon-neutral economy.  First, the Commission is charged with ensuring the integrity of the markets it regulates, and this includes carbon derivatives markets.  This requires an understanding of how the various carbon markets interact and how companies use them to meet compliance obligations, manage risks, and discover prices.  Second, the CFTC should work with exchanges and market participants on the development of new products that will help companies meet these needs.  And third, as the Climate Subcommittee recommended, the CFTC should ensure appropriate management and disclosure of climate-related risks.

Market-based mechanisms—such as cap-and-trade programs—are intended to achieve climate goals at a lower cost and to direct investment to cost-effective projects and technologies for reducing emissions.  Increased investment in sustainable technologies can lead to more efficient greenhouse gas reductions, but this requires transparent and timely information not only for current prices associated with such reductions, but also for future prices.[4]  The relationship between the primary and secondary markets and the derivative markets for carbon can drive more informed decision-making and more effective allocation of resources.  The price of carbon allowances also can affect the prices of other commodities, such as fossil fuels.  Given these linkages, and the potential for carbon markets to meaningfully contribute to the reduction of carbon emissions, the CFTC should work with other regulators and stakeholders to optimize the effectiveness and integrity of these interrelated markets.

To that end, our first panel will examine the cap-and-trade programs in the United States, European Union, and United Kingdom, as well as lessons learned from these programs and ways in which they may evolve in the future.  We are fortunate to be joined today by Benjamin Grumbles, the Secretary of the Maryland Department of the Environment, who is here today on behalf of the Regional Greenhouse Gas Initiative; Rajinder Sahota, Deputy Executive Officer of Climate Change and Research for the California Air Resources Board; Hans Bergman, the Head of Unit for ETS Policy Development and Auctioning within the European Commission’s Directorate General for Climate; and Gordon Bennett, Managing Director of Utility Markets for Intercontinental Exchange, which hosts allowance auctions for the UK emissions trading system.

Another way in which the CFTC can support the move to a low-carbon economy is through its mandate of promoting “responsible innovation” in markets and among market participants.[5]  In order to meet the goal of net-zero emissions by 2050, investment in renewable energy infrastructure projects must ramp up rapidly.  Investors will need to manage the risks of these investments with appropriate hedging tools, including both exchange-traded and over-the-counter derivatives.  Derivatives also allow commercial entities and investors to manage exposure to changes in the price of their assets due to climate change and transition risks caused by the shift to a net-zero economy.  In addition, entities with emissions compliance obligations participate in the physical markets to ensure they have appropriate allowances or offsets to meet those obligations.  As energy standards evolve, futures contracts will need to evolve to respond to changes in the physical markets.  The Commission should work with exchanges and market participants as they develop climate-related products and services to meet these needs, as well as collaborate with our domestic and international counterparts to develop consistent standards for environmental products.

Our second panel today will explore the current state of exchange-listed carbon derivative products.  We will hear from Gordon Bennett of ICE; Christian Schneider, Managing Director of Strategy for Nodal Exchange; and Derek Sammann, Senior Managing Director and Global Head of Commodities at CME Group about the carbon products offered on their exchanges.

Our third panel will feature a diverse group of stakeholders who will provide their perspectives on how the derivatives markets operate as risk management and price discovery tools, and how they expect these markets to change over time.  We welcome Evan Ard, Executive Managing Director of Evolution Markets, who will discuss the OTC carbon markets; Suzi Kerr, Chief Economist of the Environmental Defense Fund, who will discuss the economics of carbon pricing and considerations for developing equitable carbon pricing policies; Erik Heinle, Assistant People’s Counsel for the Office of the People’s Counsel for the District of Columbia, who will share a ratepayer perspective; Annette Nazareth, Senior Counsel at Davis Polk, who will discuss the work of the Taskforce on Scaling Voluntary Carbon Markets and its recently issued Public Consultation Report; Dena Wiggins, President and CEO of the Natural Gas Supply Association (NGSA), who will talk about why NGSA views carbon pricing as the most effective long-term solution to climate change; and Matt Picardi, Vice President of Regulatory Affairs for Shell Energy North America on behalf of the Commercial Energy Working Group, who will discuss carbon market design.

A third area in which the CFTC should play a role in the transition to a low-carbon economy is with respect to the management and disclosure of climate-related risks.  For example, the CFTC currently requires commodity pools and advisors to address pool performance and the risks of speculating in derivatives.  The CFTC also requires certain registrants, such as swap dealers, to periodically report material risks, such as credit, market, and operational risks.

The Commission should examine how climate-related risks are currently considered and reported by registrants, and determine whether additional considerations of climate-related risks or disclosures are appropriate.  While this aspect of risk management is not specific to the carbon markets discussion today, it is an issue that requires further exploration and one that the EEMAC could consider in a future meeting.

On our final panel of the day, we will hear a presentation from CFTC staff—Rahul Varma of the Market Intelligence Branch in the Division of Market Oversight, and Bill Heitner of the Risk Surveillance Branch in the Division of Clearing and Risk.  They will discuss the impact on the derivatives market of the winter storm in Texas in February 2021 that caused widespread power outages and hardship for Texas consumers.  I appreciate Rahul and Bill’s excellent work in preparing this presentation and the dedication of the CFTC staff in closely monitoring this and other market events.

I would like to conclude by thanking Acting Chair Behnam, Commissioner Quintenz, and Commissioner Stump for their participation in today’s meeting.  I would also like to thank the EEMAC members and our guest panelists for their contributions to this meeting, Dena Wiggins for her dedicated service as the EEMAC Chair, Lucy Hynes in my office for her work in supporting this Committee, and mostly, Abigail Knauff for her service as Secretary of the EEMAC and for always making these meetings so informative and seamless.

I am very much looking forward to today’s meeting and to hearing from our very distinguished panelists.  With that, I’ll turn it back to Abigail.

Remarks as Prepared for Delivery at the World Federation of Exchanges’ (WFE) Clearing and Derivatives Conference 2021

During the past decade, the focus in the derivatives clearing space has been implementation of new clearing mandates for over-the-counter (OTC) products—a response to the last crisis.  But no one could have predicted what was to come, and as a crisis of a different sort emerged and the pandemic surged in 2020, the global derivatives markets experienced a real-time stress test, surviving heightened volatility, increased volumes, and interest from a wider variety of market participants.

In the early days of 2020, you might recall that we were all reflecting on the 10 years since passage of the Dodd-Frank Act,[1] which established the OTC clearing mandate in the United States.  But, as the new COVID-19 crisis emerged, we were quickly reminded that there is never time to rest on our laurels.  Rather, we once again had to learn the lesson that we are building and simultaneously operating an infrastructure project in a constantly shifting environment.  The construction on this project will never end, and requires continuous adaptation.  Why does it always take a crisis to bring this point back into focus?

I’m not suggesting that we can plan for every crisis.  Quite the contrary.  I’m suggesting it is time to acknowledge that we cannot.  Once we accept our inability to predict the next crisis, we should use the lessons learned from past experience to look for opportunities to reinforce the system.

Equally important, we must have frequent and honest dialogue with the public (as well as policymakers) about the utility of the clearing system—and also its limitations.  In 2008 and 2009, I had a front row seat to the debate around various solutions considered in response to the financial crisis.  At the time, I was working on the legislative team tasked with devising things such as the new clearing mandate for OTC derivatives.  After the G-20 leaders determined that central clearing was a solution to issues that arose during the precursor to the financial crisis, many people I encountered were confused when told that central clearing does not eliminate risk—but rather, in some cases, is a preferred method of managing risk in a world of interconnected counterparties.  These nuanced distinctions need to be reinforced because too often our clearing system faces blame in the midst of challenging times due to misconceptions about its function and a misunderstanding of its bounds.

So, let’s start recovering from the current crisis by getting back to the basics:  Let’s be clear about clearing.

And we start by acknowledging that everyone here today is in the business of managing uncertainty.  At the Commodity Futures Trading Commission (CFTC or Commission), we regulate markets designed to help those facing uncertainty from inherent business risks.  Those of you in the audience represent central counterparties tasked with mitigating uncertainty of counterparty performance in those markets.

When asked as children what profession we might choose once grown up, none of us likely said “I want to be in the uncertainty management business.”  I rather had planned to be a teacher, but here we are in the uncertainty management business during a time of great global uncertainty.  Getting back to the basics, I think there are two foundational elements that will move us forward during this time of uncertainty—collaboration and education (ok, maybe I can still live out my dream of being a teacher).

But first, I need to note that the views I express today are my own and not necessarily those of the Commission I am proud to serve upon, nor my fellow Commissioners.

Education, Education, Education

Managing Uncertainty – The Ultimate “Derivative” of COVID-19
Let me start with why it’s incumbent upon all of us to educate the public about the utility of derivatives.  Confronting the challenges of the pandemic reminds us of derivatives’ primary function, which in a word (or two) is “risk management” —the response to uncertainty.  We must ensure the public understands that the critical function of our markets is managing uncertainty in providing the goods and services we all rely upon.

The recent pandemic has highlighted the ever-present uncertainty in our lives with regard to things we often take for granted, and it extends well beyond the obvious public health concern.  For example, how will my mom’s teacher pension plan be impacted just as she nears retirement?  What about the availability of goods we routinely seek—remember how hard it was to find rice and paper goods last spring, at least in the US?  All of these concerns have reinforced the need for derivatives as a tool relied upon by food and energy suppliers, manufacturers, mortgage providers, and retirement plan managers to manage uncertainty so they can effectively deliver the goods and services we have come to expect.

Our obligation is to spread the word: Derivatives are risk management tools that are especially critical in times of uncertainty.

Note to Social Media “Influencers”: #Derivatives #Food #Retirement #Mortgages
I know this sounds rudimentary to those of us operating in this space every day, but the evidence of misconception and misunderstanding is widespread.  We need look no further than recent trading activity and market volatility triggered by posts on online message boards and social media platforms.  Do the authors and readers of this misinformation realize they are unknowingly jeopardizing the utility of these markets to the detriment of those who have committed their hard-earned income to college savings and pension plans?  Probably not.

So, here is our opportunity to step up and educate the public about our markets.  I am pleased that the CFTC has recently initiated a new advisory encouraging the public to research and understand the commodity futures markets, physical markets, and securities markets before trading based on information on social media.

Coming Soon to a Clearinghouse Near You: Retail Interest
Education is a shared responsibility between the regulator and you, the infrastructure providers.  And it is no small task because the range of sophistication possessed by those trading products cleared at our regulated Central Counterparties (CCPs) is vast.

For example, it is evident that retail interest in the derivatives markets has increased significantly.  The CFTC’s Global Markets Advisory Committee (GMAC), which I sponsor, held a meeting just last month highlighting some of the recent trends relative to retail interest in the derivatives markets.[2]  During that meeting, the CFTC’s Market Intelligence Branch (MIB) discussed the increased numbers of retail participants in certain derivatives markets, as well as how the markets we regulate at the CFTC are being impacted by retail interest in certain exchange-traded funds (ETFs).

Signs of this changing landscape of market participants are apparent.  First, we have seen increasing listings by CFTC-registered exchanges of “micro” and “micro e-mini” futures and options contracts that allow participants to gain exposure to the futures markets at a much lower cost and capital requirements compared to standard futures contracts.  Indeed, it has been reported that the CME expects to launch a new micro bitcoin futures contract in early May.[3]  Second, last year, the CFTC granted designations to four new futures exchanges whose business models focus on retail traders.  Some do not yet have contracts listed for trading, but one that does has seen modest—but steady—participation.

This appears to be a global trend.  At our recent GMAC meeting, we also heard from a representative of the Ontario Securities Commission (OSC), who noted that they have seen both:  1) a significant rise in the past decade in the number of online trading platforms offering derivatives products to retail customers; and 2) significant acceleration in the number of retail participants opening trading accounts over the past year.[4]

If increased retail participation in the derivatives markets is a trend that is here to stay, how does that change the way we, the regulators, and you, the infrastructure providers, fulfill our obligations?  This evolution in the makeup of derivatives market participants requires us all to think about whether our regulations and practices are fit-for-purpose in this new landscape.

From a regulatory perspective, I believe the CFTC’s principles-based regulatory framework provides flexibility to respond to changing market dynamics.  Yet, we must constantly evaluate what, if any, adaptations need to be made to account for the expanding variety of participants trading and seeking access to clearing services.

From an industry perspective, given increased retail demand, how will CCPs and their clearing members need to adapt?  How do the risk profiles of the various clients need to be accounted for, and how does that impact initial margin expectations?  This goes to my point that we are simultaneously operating and building the infrastructure of our constantly changing markets and clearing system.

Innovation – We are Constantly Updating the Textbook
(this course is not for the risk averse)
In a world where human nature prefers certainty, human regulators can sometimes fall into the trap of viewing new products and market innovation with skepticism.  But here again, we are reminded that our job is facilitating uncertainty management for those facing inherent business risks—and with new uncertainties emerging every day, we need innovative solutions.  This requires constant education such that the potential merits of new products can be weighed against the unknowns in an informed manner.  Regulators must be open-minded and willing to take some risks of our own lest we inadvertently limit valuable solutions.  Again, education is key, and sometimes we should be the students rather than the teachers.

In the past few years, regulators have spent much time learning of many new proposed solutions.  For example, there is obviously increasing interest in listing and clearing derivatives on digital assets.  We also are seeing exchanges that intend to list event contracts for hedging risks from the anticipated outcomes of future events.  And last year, the industry added $21 billion to “ESG”[5] mutual funds and ETFs, an indication of increased investor demand which inevitably leads to interest in the development of related derivatives products that will be regulated by the CFTC.

It is not particularly remarkable to consider that as risks evolve, derivatives contracts will develop in response—this progression is a rather common evolution.  In fact, the CFTC already regulates almost 150 climate-related derivatives products developed in response to identified vulnerabilities faced by various end users.  The remarkable takeaway here is the tremendous ingenuity that goes into building these innovative products.

Innovation is the lifeblood of the derivatives industry, and welcoming innovation in financial markets is at the heart of what we do at the CFTC.  It is not an accident that the CFTC is structured to be nimble in order to enable innovation—that was an intentional decision by our Congress, and one that I am proud to promote.  Our self-certification process for new products was deliberately designed to give the initiative and option to exchanges to certify a new derivatives product, and list the product for trading the following day,[6] in order to avoid impeding innovative development in the context of ever-evolving financial markets.

Collaboration, Collaboration, Collaboration

Family Counseling for CCPs and Their Clearing Members
This gets me to the importance of collaboration.  It is incumbent upon each CCP to design a plan for the impact of any new product on the risk profile and management of the clearing infrastructure.  And yes, you will need to explain this to your regulator in Washington, London, Paris, Singapore, or Tokyo.  But equally important to the dialogue with your regulators is the need for an early communication plan with your members.

As I mentioned previously, we are all in the uncertainty management business, and your business model is a partnership with your members.  Perhaps we avoid some unnecessary impediments to offering clients the new products they seek if there is better communication among all those tasked with risk managing the clearing of such products.  I realize this is a tall order because development and regulatory approval processes present constantly shifting dynamics.  But I offer the observation that perhaps more well-informed stakeholders can minimize opposing interpretations being delivered to regulators—which only serves to frustrate and belabor the approval process, thereby delaying solutions.

This is the part of the program where you likely expect me to talk about other matters that seem to divide CCPs and their members (margin models and governance come to mind).  Well, to be honest, I would like to be on the receiving end, rather than the delivery, of that speech.  That is, rather than competing white papers, I hope you all might lead discussions with your members to design solutions.  Please don’t take that as an indication that I am naïve to the difficulty of such a task, or that I believe all is well and good and regulators have no role to play.  Rather, I implore you all to find some common ground and bring solutions to the table to help us do our job in the spirit of collaboration, which I have already indicated is critical to our path forward.

Private sector solutions focused on making the clearing system safer will yield far better results than a government-dictated, one-size-fits-all-approach.  In contrast, failing to find common ground among yourselves likely results in governments responding in the face of pressure, often without industry collaboration.

Derivatives League Unite – The Global Alliance
Collaboration is not only an expectation for the clearing market infrastructure, but also for the international regulatory community.  We all know these markets are global, but too often we are stuck in a jurisdictional mindset.  We must do better when responding to current and future challenges than we did in the past decade implementing reforms after the financial crisis.  And one of the lessons learned during this past decade is that we must trust our regulatory colleagues around the globe.

No two regulatory bodies should be expected to put forward identical rules—comparability must be the standard.  Without deference to comparable regulatory regimes, we subject the very infrastructure we depend upon to deliver the reforms, such as CCPs, to a confusing web of compliance issues, or worse, a market that is fragmented and less systemically sound.

As the G-20 leaders grappled with the financial crisis in 2009, regulated CCP infrastructure was hailed as a means to alleviate problems presented by a previously undesirable web of interconnected counterparties to bilateral OTC transactions.  CCPs were not a contributing factor to the crisis, but rather a potential solution.

If we as regulators expect CCPs to offer a global solution, and we implement comparable requirements for these CCPs, then our regulatory similarities should provide the basis to support regulatory deference between jurisdictions.  Moving in the opposite direction undermines the coordination and consistency envisioned by the G-20,[7] as well as all of the work regulators have committed to date.  More concerning is that duplicative oversight complicates, rather than improves, the intended risk management benefits of increased clearing of OTC transactions.

A Case Study – Exempt DCOs
I acknowledge that the US has not always been as deferential as I believe we should, and there is tremendous confusion regarding recent attempts to establish a registration exemption process for non-US CCPs to offer clearing to US clients.  As you know, the US implemented its OTC clearing mandate and the requisite infrastructure requirements ahead of other jurisdictions.  And it is my view that as other jurisdictions adopted their own measures to achieve these common goals, the CFTC should have long ago revisited our policies with respect to allowing US persons access to non-US OTC markets.  After all, we have been doing so for over 30 years with regard to listed futures.  We don’t need to reinvent the entire deference process for OTC products.

Unfortunately, after a decade of little progress, I believe that in 2019, we rushed to propose an incomplete path for non-US CCPs (which we refer to as derivatives clearing organizations or DCOs) to obtain an exemption from DCO registration to clear OTC transactions for US clients based on comparable regulation in the CCP’s home country (the Exempt DCO Proposal).[8]  Most notably, the 2019 Exempt DCO Proposal would have disallowed any US OTC client from accessing a CCP that is exempt from registration with the CFTC through its futures commission merchant (FCM).  This makes no sense, as US clients are today permitted to engage in similar arrangements for their futures clearing needs abroad.

And worse, it would set a potentially irreversible precedent.  Even if the CFTC subsequently recognized the merits of extending to OTC products an FCM system that is already familiar to US persons engaged in foreign futures, the CCPs would likely have already made a commercial decision to abandon any potential future engagement from FCMs.  Rather than find ways to enable a CFTC-registered FCM to facilitate clearing for US clients, these CCPs would likely have focused instead on building their US-facing offering to avail themselves of the only path permitted under the Exempt DCO Proposal for obtaining a registration exemption—one that, oddly, would disallow the use of an FCM, thus effectively killing any hope US clients have of applying to the OTC markets the efficiency of a clearing system that has worked for many years in listed futures.  Although some individual jurisdictions might benefit if the CFTC were to advance the 2019 Exempt DCO Proposal, we cannot ignore the fact that its lack of optionality would likely be irreversible, and thereby limit choices for US clients—even if the CFTC sought to correct the policy later.

Despite my pleas to re-propose the pathway for non-US CCPs to obtain a DCO registration exemption to clear OTC transactions for US clients based on comparable home-country regulation, with enhancements sought by US clients, no such effort was made last year.  From my perspective, leaving this undone could result in long-lasting limitations on the options US clients want and deserve.

Location-Based Policies Run Counter to Our Shared Goals
I would now like to make a brief comment about location-based policies, and to acknowledge that balancing the global nature of CCPs and the financial stability within each individual jurisdiction is a challenge.  However, I take seriously our responsibility at the CFTC to help market participants and infrastructure providers achieve the commitment our governments made at the G-20 Summit in 2009 to increase utilization of central clearing.[9]  This responsibility requires global access to global markets.  As such, we must permit CCPs around the globe to compete, and we must seek to minimize location-based limitations among jurisdictions implementing comparable principles for their CCPs because such access limitations run counter to our goal of increasing central clearing around the world.

Additionally, I believe such polices run afoul of their very justification.  That is, they can actually contribute to, rather than mitigate, financial instability within a jurisdiction by ignoring the global nature of these markets, leaving those within their confines without access to clearing and thereby without access to markets for which there is a clearing mandate.  If we are truly committed to the outcome we all agreed to a decade ago, such location-based policies have no place in the discussion.  It is counterproductive to mandate clearing and then disallow those who need access to derivatives from utilizing the clearing infrastructure best suited to their needs—clearing infrastructure that may very well be outside their home country.

Bottom Line
The bottom line: In order to create a stronger, more resilient clearing system, we must work together and collaborate across our borders in our global markets.  This responsibility lies first and foremost among regulators.  Let’s not allow past mistakes or constantly shifting geopolitical dynamics to jeopardize our progress.

Class Dismissed, Assignments Due

If I was in fact living out my childhood dream of being a teacher, I would award you all an A+ for your attention today.  I look forward to each of us working on the assignments of enhanced educational efforts and better collaboration.  Thank you for allowing me the opportunity to share with you my thoughts on how we can continue to promote central clearing while strengthening our clearing system to build a resilient infrastructure for our global markets into the future.

Introduction

Thank you to Professor Korok Ray and Texas A&M University for the kind invitation to participate in this conference.  I am happy to be here with you today, even if only virtually.  I would much prefer to be back in my home state of Texas to join you in person, but I am nonetheless grateful for the technology that allows me to participate remotely.

Over the course of the conference you have heard others explain various developments in the evolution of bitcoin.  Rather than repeat what you have already heard about the tremendous growth and noteworthy interest in bitcoin, my remarks instead will focus on the regulation of bitcoin.  There are many federal and state regulators that also have an interest in bitcoin, as well as the entities that trade and custody bitcoin—among the most prominent at the federal level are the Securities and Exchange Commission (SEC), the Office of the Comptroller of the Currency (OCC), the Financial Crimes Enforcement Network (FinCEN), and the Commodity Futures Trading Commission (CFTC or Commission), where I have been privileged to serve as a Commissioner since 2018.  Today, my focus is going to be on what we have been doing at the CFTC with respect to bitcoin and digital assets more generally.

Before going any further, I would like to note that the views I express today are my own and not necessarily those of the Commission I am proud to serve upon, nor my fellow Commissioners.

The CFTC’s Regulatory Framework

The CFTC is perhaps less well known than other financial services regulatory agencies.  As our name indicates, we regulate futures contracts—grain futures, energy futures, interest rate futures, etc.  And since 2010, after passage of the Dodd-Frank Act,[1] the CFTC has also regulated other derivatives products known as swaps.  Today, we oversee a $400 trillion derivatives marketplace. 

These derivatives products are used for risk management and/or risk transfer, as well as price discovery for commodities that are an integral part of our daily lives.  The CFTC works to ensure that derivatives markets continue serving these risk management and price discovery functions for those who provide us with various goods and services, including farmers feeding the world, pension managers overseeing teacher retirement funds, airlines with fluctuating fuel demands such as that experienced during the Covid-19 pandemic, and mortgage providers offering long-term interest rates for home buyers.[2]

The CFTC’s Jurisdiction Over Bitcoin

            CFTC Regulatory Authority

The CFTC’s regulatory authority under our authorizing statute, the Commodity Exchange Act (CEA), extends to futures contracts in any commodity, and also includes swaps,[3] as well as certain leveraged retail foreign exchange contracts.[4]  The definition of the term “commodity” in the CEA is very broad—generally defined as goods “in which contracts for future delivery are presently or in the future dealt in.”[5]  The CFTC has determined that bitcoin fits the legal definition of a “commodity” under the CEA.  But treating bitcoin as a commodity is no more surprising or unusual than, say, treating corn, oil, or copper as a commodity, given the breadth of the CEA’s definition of the term “commodity.

Even though the CFTC has exclusive jurisdiction to regulate futures on commodities, other regulatory bodies may be on the frontline of regulating the underlying commodity itself.  For example, the CFTC regulates futures and swaps on interest rates, but the Federal Reserve Board of Governors manages the level of short-term interest rates through its monetary policy.  The CFTC regulates natural gas futures and swaps, but the Federal Energy Regulatory Commission regulates the interstate transmission and sale of the underlying natural gas for resale in interstate commerce.  Where the underlying is a security, the CFTC regulates certain futures and swaps pursuant to the framework in the CEA and the federal securities laws for allocating jurisdiction between the CFTC and SEC, but in all cases the SEC regulates the underlying securities.

Because this point seems to be confused from time to time, I want to be very clear that the CFTC regulates derivatives associated with the underlying commodities, but not the underlying commodities themselves.  In other words, we regulate futures on bitcoin because bitcoin is a commodity—but we do not regulate bitcoin itself, much like we regulate cattle futures because cattle are commodities, but we do not regulate the sale of cattle at auction barns throughout the country.

CFTC Enforcement Authority

As for enforcement activities related to bitcoin (and other digital assets), the CFTC has taken actions against unregistered derivatives exchanges,[6] and registered derivatives exchanges that have violated requirements imposed on them by the CEA and CFTC regulations.[7]  These are the same types of actions the CFTC would take against exchanges offering derivatives involving any other commodity.

You may have seen that just recently, the CFTC brought and settled an enforcement action against a digital asset exchange operator, Coinbase Inc. (Coinbase), for false, misleading, or inaccurate reporting, as well as wash trading by a former employee on Coinbase’s GDAX platform.[8]  This was a different type of enforcement action because Coinbase is a cash market that has never offered any derivatives products, and thus, as discussed above, falls outside the scope of the CFTC’s regulatory authority under the CEA.[9]

It is worth noting at this point that there is a critical distinction between the CFTC’s enforcement authority and the authority we have to conduct day-to-day regulatory oversight.  The CFTC’s regulatory authority, as discussed above, is limited to derivatives products such as futures and swaps—as compared to the expanse of our enforcement authority, which is broader.

This is where things get confusing.  The CEA does not provide the CFTC with jurisdiction to regulate exchanges or other markets involving cash commodity transactions—be they for corn, oil, or digital assets.  While the CFTC does not regulate the underlying cash markets, we do have authority to investigate and prosecute civil enforcement actions in cases of fraud or manipulation in these cash commodity markets—including the bitcoin cash market.[10]

Although it may seem odd that an agency not tasked with regulating the underlying cash commodity can bring an enforcement action concerning the underlying cash commodity, I believe there is a very logical explanation as to what Congress intended here, and I’d like to offer what I view as the rationale.  Futures contracts regulated by the CFTC serve a price discovery function.  Well-functioning futures (and other derivatives products) rely upon a sound underlying cash market and may reference cash market indexes in their pricing.  Therefore, cash market transactions can potentially be part of a scheme to manipulate prices of derivatives products that are regulated by the CFTC.  This can occur where, for example, a trader manipulates the cash market for natural gas in order to affect the price of natural gas futures in which the trader has a substantial position.

Congress has recognized these relationships between prices of cash transactions and derivatives products, and thus the CEA provides the CFTC with limited enforcement authority with respect to cash transactions.  And this is no different for the cash and derivatives markets for digital assets than for any other commodity.[11]

The Need for Clarity

Even with good reason for the broader enforcement authority over bitcoin itself, though, I often worry that the CFTC’s exercise of that authority may leave the public with the impression that we are the frontline regulator of cash digital asset markets.  This is simply not the case, nor in my opinion is this what the CFTC is best tasked to do.  This concerns me for two reasons.

First, I believe it may give the public a false sense of security that when they engage in transactions on cash digital asset trading platforms, they enjoy the protection of CFTC regulatory oversight of digital assets.[12]  The basis for my concern was illustrated by some of the press coverage of the CFTC’s recent enforcement action against the cash exchange Coinbase, such as an article suggesting that the penalty the CFTC imposed on Coinbase “provid[es] further confirmation that the space is regulated.”[13]  This is not the case, and it is incumbent upon the CFTC to make this clear each time we discuss or take action involving digital assets.  Only then can these new and innovative products be properly understood and responsibly developed.

Second, I believe it may confuse the public as to what our agency does, and potentially lead to a slippery slope of ever-expanding and ill-defined priorities for the CFTC.  I will give an example.  During my time working in and around the CFTC, some have suggested that we should regulate things such as benchmarks on cash aluminum, or the cash market for Renewable Identification Numbers (RINs) on every gallon of ethanol produced.  This is not what the CFTC is designed to oversee, and regulatory grab is not the objective.  We need to stick to what we do best—regulating derivatives products, and involve ourselves in cash commodity markets only to the extent enforcement action is necessary to guard against fraudulent or manipulative conduct that may impact the proper functioning of markets we regulate.

That is, the public should be aware that where cash commodity markets are concerned, limited enforcement authority (anti-fraud/manipulation, as opposed to day-to-day regulatory oversight) is bestowed upon the CFTC as a tool to assist in its primary function of regulating derivatives products, such as futures.  However, we are not in the business of regulating bitcoin transactions or the individuals or entities that buy, sell, transfer, or store bitcoin.

Innovation & Digital Assets

Having attempted to clarify any confusion relative to the CFTC’s unique role in regulating digital assets, I now want to turn to what truly sets the CFTC apart:  Welcoming innovation in financial markets is at the heart of what we do, and I am pleased that we have been at the forefront of innovation with respect to digital assets.  It is not an accident that the CFTC is structured to be nimble in order to enable innovation.  That was an intentional decision by Congress, and one that I am proud to promote.  After all, most all of the contracts listed on the derivatives exchanges we regulate were designed as an innovative solution to an existing problem—even dating back to the 1800s, when grain farmers needed to get grain to processors and processors needed a reliable supply of grain and would arrange for a price in advance, but a lack of delivery or payment often frustrated the process.  So, the futures market evolved as an innovative solution.

Now 200 years later, innovation continues to provide solutions and drive demand in our markets.  In 2017, the CFTC allowed bitcoin futures contracts to be listed on two futures exchanges.[14]  Just as has occurred with other commodities, as bitcoin has received more exposure and developed in its utility, the inherent price volatility demands risk management tools and a mechanism for price discovery.  Those are the two fundamental purposes of derivatives markets generally—risk management and price discovery.[15]  Only when an exchange identifies these needs as sufficient to potentially sustain listing the derivatives contract will it seek to do so.

As far as the process for listing futures on digital assets, any new product on a CFTC-regulated exchange can take one of two paths.  Exchanges may self-certify compliance with the CEA and CFTC regulations and list the product for trading the following day.[16]  Alternatively, exchanges can request that the CFTC approve a new product prior to listing, and the CFTC must then approve the product unless the terms and conditions of the product violate the CEA or CFTC regulations.[17]

The self-certification process was utilized by the Chicago Mercantile Exchange and CBOE Futures Exchange in 2017, and later by other futures exchanges, to list bitcoin futures.[18]  This process was deliberately designed by Congress and prior Commissions to give the initiative and option to exchanges to certify new derivatives products without the lengthy CFTC approval process that was required in the Commission’s early years.

But self-certification should not be mistaken for hands-off regulatory applications.  The CFTC product review teams spend a lot of time with registrants working through those questions we (and the listing exchanges) are obligated to consider.  And in fact, we have heightened review methods for digital assets.[19]  I have found myself, on several occasions, grappling with the application of our process so that it does not exceed the permissible bounds of our assessment—limitations that, as noted above, are designed to avoid impeding innovation and market development.  A fact I often need to remind myself.

Some have called into question the self-certification process—and I am always interested in suggestions about how we can make the process more workable.  I also would note the responsibility that rests with the exchanges to help assure that the certification process works effectively.  But I would caution against dismissing or judging the self-certification process without an eye towards why it exists in the first place, and whether it is preferred to other models in the context of ever-evolving and innovating financial markets.

International Developments

I would like to note that while I may be partial to the CFTC’s system of regulation, we do not do so in a bubble.  The bitcoin market is a truly global market.  The CFTC is a leader in international standard-setting bodies, such as the International Organization of Securities Commissions (IOSCO).  While we do not sit on the Financial Stability Board (FSB), our Chairman plays a leadership role in ensuring coordination between IOSCO and the FSB.

As important as the opportunity for setting standards, these fora provide for an equally important dialogue among regulators to better understand each jurisdiction’s approach and receptiveness to innovation.  It is important to resist generalizing other regulators’ positions because the devil is always in the details and sometimes mis-reported.  For example, the U.K. Financial Conduct Authority (FCA) is taking a look at the utility of bitcoin among retail investors but seems committed to advancing a framework for institutional investors.[20]

I expect that the U.S. market regulators will continue to be among those that lead on regulatory standards that can responsibly encourage innovation, and to do so we must be active participants around the globe.  It is a task that requires many in the federal Government beyond the CFTC—sometimes we lead (say, in the case of our work with IOSCO) and sometimes we support others, such as a few years ago when the G-7 met in France to discuss privacy, money laundering, and consumer protection in the context of digital assets.

The phenomenal growth of digital assets and the proliferation of exchanges for cash digital asset transactions, like many other past market innovations, present unique challenges for various regulators around the globe.  It is incumbent upon the entire community of regulators, including the CFTC, to clearly convey the scope—and the limitations—of our role in ensuring that such new innovations can be brought to the public with integrity.

XRP Litigation

There is one final development I want to mention before ending my remarks—litigation involving XRP.  As you may know, the SEC recently charged Ripple and two executives with engaging in an illegal securities offering in connection with the digital asset XRP.[21]  In its complaint, the SEC alleges that since 2013, the defendants sold more than 14.6 billion XRP tokens worth $1.38 billion in an unregistered offering.

The question of whether XRP is a security will be crucial.  XRP is similar to bitcoin and other digital assets but also different in key respects, which prompted the SEC’s investigation.  Bitcoin was an open software project launched by a pseudonymous creator calling himself Satoshi Nakamoto.  XRP was created, sold initially, and backed by the company known as Ripple.

I am watching the outcome of this case closely because it will help to establish the scope of the SEC’s authority in the digital assets space.[22]  In this regard, I would like to draw your attention to the important work that has been done by SEC Commissioner Hester Peirce.  In a number of speeches that I would encourage you to read, she has addressed the application of the “Howey test” to digital assets.[23]  This test refers to the Supreme Court case, SEC v. Howey,[24] which provides the framework for determining whether certain assets are securities.  I am encouraged by her attempt to create a safe harbor that recognizes both “the need to achieve the investor protection objectives of the securities laws, as well as the need to provide the regulatory flexibility that allows innovation to flourish.”[25]  I look forward to working with Commissioner Peirce, incoming SEC Chairman Gary Gensler, and the other Commissioners at the SEC and CFTC in applying the agencies’ authorities to develop sound public policy with respect to digital assets.

Conclusion

The regulatory application to digital assets, much like the assets themselves, is evolving every day.  It is exciting, yet also frustrating to those who seek more certainty.  But the incredible transformation in this space requires adaptation and creative thinking, and let’s be honest, neither are among a regulator’s natural tendencies.  This situation reminds me a bit of the many days I spent as a child watching the Texas sky, where clouds move fast such that if you are willing to think creatively you can make out amazing shapes, constantly shifting to tell a great story.  On many a long road trip (is there any such thing as a short road trip in Texas?), my brother and I often formed very different stories from the same cloud formations.  Sometimes the clouds in Texas quickly develop into devastating storms—and over the years, we have attempted to study, predict, and build safeguards around such events.

That is where the regulatory state of digital assets currently sits:  We must enable innovators to think creatively such that the story can evolve, we must acknowledge there will be differences of opinion as to the utility and potential of various products, and we must expect some storms to arise.  These are the considerations that should guide us as regulators in exercising the authorities to fulfill our mission such that the market can develop and meet its full potential.