Farewell Address Of CFTC Commissioner Kristin N. Johnson

Thank you to Aaron Klein, Miriam K. Carliner Chair—Economic Studies, Senior Fellow—Center on Regulation and Markets and Brookings Institute for kindly inviting me to join you this afternoon. Thank you for your thoughtful introduction.

A Critical, High-Stakes Moment 

There is no better place to close out my tenure as a Commissioner at the Commodity Futures Trading Commission (CFTC or Commission) than with a conversation on the future of financial regulation.[1] It is a privilege to join you at Brookings. You have demonstrated an unparalleled commitment to convening stakeholders and the public to explore significant questions such as—what does the future of financial markets look like?

As someone who spent part of my career as a lawyer in private practice, in-house at a large financial institution, as an academic, and now a regulator—I know exactly how important great conversations are for developing transformative policy insights. 

We gather at a critical moment in the history of our nation and a unique time in the evolution of financial markets and the role of financial markets regulation. 

It has never been more important for the public to be engaged and have a voice in the role of financial market regulation. The decisions that Congress and regulators will make during the next few years will shape our national economy, the global economy, and the role of the United States in the global economy for generations to come. 

The stakes are high. And, if I only have one piece of wisdom to share, it would be the following—Get it right. Measure twice, cut once.

Deciding the course for financial markets and financial markets regulation simply requires remembering why we regulate and the catastrophic consequences that may follow if we fail to regulate well.

Throughout my tenure as a Commissioner at the CFTC, I have prioritized two pillars that anchor the foundation of financial markets regulation—consumer protection and market stability.

Consumer Protection and Growth—Twin Pillars, Anchoring Values  

Some may try to challenge the notion that these values work together and argue that sustainable growth and consumer protection are in tension, at odds, or mutually exclusive. I reject the notion that these anchoring values are in conflict and instead argue that each is a necessary component of a healthy financial system.

Recall, in 2008, on a September day, similar to the cool, crisp weather we are enjoying today, lawyers for Lehman Brothers entered a federal court building, and one of the most storied financial institutions in our nation’s history filed for bankruptcy protection. The filing served as a catalyst, precipitating the events of a global financial crisis.

According to the Federal Reserve Bank of New York, around the same time “[i]n September 2008, the Federal Reserve extended credit to American International Group, Inc. (AIG) to preserve the stability of an already fragile U.S. economy and to protect the U.S. taxpayer from the potentially devastating consequences of the company's disorderly failure. From that initial intervention, the New York Fed and the U.S. Department of the Treasury worked with AIG to stabilize the company so that it no longer posed a systemic risk and to ensure repayment of taxpayer assistance.”[2]

A little over a decade later, on a similar day in the fall of 2022, after cascading losses and multiple collapsed crypto firms, lawyers for FTX marched into a federal court building seeking bankruptcy protection.

What should we take away from these crises?

Lessons Learned from Crises 

If we fail to rightly prioritize consumer protection or market stability on the road to capturing the benefits of innovation or growth, the results can be devastating.

When I share the story of Lehman or AIG or the more contemporary story of FTX, I emphasize that certain guardrails or safety measures may well have helped prevent the 2008 financial crisis and certainly could go a long way to ensuring that developing digital asset markets function in a manner that is consistent with consumer protection and market stability and integrity.

To achieve sustainable growth and get it right, we must measure twice, cut once.

The Costs of Risk Management and Corporate Governance Failures

Crises have the potential to create catastrophic costs for customers, creditors, investors, markets, and the domestic and global economies. The factors that lead to corporate governance and risk management failures are often clearly identifiable, easily predicted, and often preventable. Firms that experience significant corporate governance and risk management failures often seek bankruptcy protection, only to later re-emerge from bankruptcy to solicit and expose new customers to devastating losses because the firms continue relying on the same deeply deficient (and possibly non-existent) governance, compliance, and risk management programs. Unfortunately, unless these firms learn from this experience and adopt a culture of compliance that effectively alters behavior and closes gaps in risk management and corporate governance, they will find themselves repeating the same cycle.

We’ve Seen This Movie (or Bankruptcy) Before

For almost a decade, but with increasing frequency in recent years, international media headlines repeatedly (sometimes weekly, and sometimes almost daily) present a new cautionary tale. The cautionary tales are woven together by a set of common threads.

An almost 30-year-old CEO launches an international crypto-exchange. Within a few years, the founder and the exchange achieve crypto-celebrity status. At its peak, the exchange captures significant market share—processing a sizable percentage of global coin or token transactions. The firm, organized in a jurisdiction outside of the United States, lacks many aspects of traditional corporate governance including oversight by a qualified, informed, engaged and independent board of directors.

All too often, the corporate governance and, compliance systems—including anti-money laundering and know your customer programs, and conflicts of interest policies that prohibit or limit certain transactions (particularly self-serving loans)—may be weak or may not exist at all.

Like lightning striking, in an instant, the exchange suspends trading, shutters the windows for withdrawals, silences traffic on its website, and files for bankruptcy protection—leaving customers infuriated, investors stunned, and creditors scrambling in a footrace to the courthouse.

Interconnectedness among crypto-firms amplified by fragile or non-existent risk management, corporate governance failures, and conflicts of interests at individual firms fuels the likelihood of crises.

In the late spring of 2022, a “run” on the fourth largest stablecoin and tenth largest cryptocurrency, TerraUSD (“UST”), led to a precipitous decline in the value of UST and, in tandem, a sell-off of LUNA, its companion token. A broad market sell-off and cascading losses followed. With the onset of a “crypto winter,” a number of highly-influential and central crypto-firms lunged toward bankruptcy. With significant exposure to the TerraLUNA ecosystem, Three Arrows Capital (“3AC”), a Singapore-based crypto-hedge fund, defaulted on a loan to crypto-lender Voyager Digital. On July 1, 2022, less than one week after the default, 3AC filed for bankruptcy protection. Almost on cue, within a week, Voyager halted trades, deposits, and withdrawals and filed for bankruptcy protection. Eight days later, another crypto-lender, Celsius Network, also filed for bankruptcy.

In November 2022, FTX and BlockFi joined the list of crypto-firms seeking bankruptcy protection; and the list continued to grow.

A week after FTX filed for bankruptcy, I delivered a keynote address at the annual meeting of the Federal Reserve Bank of Chicago Financial Markets Group. I emphasized the need for proactive adoption of internal governance and risk management measures that introduce important know-your-customer and customer identification program obligations, financial resource requirements, limitations on the use and treatment of customer funds, internal controls and conflicts of interest policies designed to address transactions with affiliates. I admonished firms that have failed to implement recovery and resilience programs. Businesses operating in our markets must have a day-one plan for how to address a capital shortfall.

Later that same week, at Stanford Law School’s Crypto-Policy Conference, I explained the need for the Commission to have a seat at the table as the court and creditors considered an appropriate buyer in the sale of non-debtor LedgerX. While there has been a general acknowledgement of the need for any buyer to be “familiar with” the Commodity Exchange Act (CEA) and CFTC regulations and a historic acquiescence to Commission inquiries, regulations only provide that the CFTC receive notice of the transfer of equity ownership. Particularly in times of crises, such a low threshold may not be sufficient to ensure that the Commission receives meaningful access and material information regarding all relevant aspects of the transaction in real time.

Customer Protections Look Similar in Most Markets 

Don’t lie. Don’t cheat. Don’t steal.

Customer protection is a foundational and core principle of our market regulatory framework. Several specific provisions of the CEA direct the CFTC to adopt regulation to this effect.

Customer funds consist of margin collateral posted by customers of futures commission merchants (FCMs) to cover exposure under their futures contracts. Section 4d(a)(2) of the CEA requires each FCM to segregate from its own assets all money, securities, and other property deposited by futures customers to margin, secure, or guarantee futures contracts and options on futures contracts traded on designated contract markets.

In addition, Section 4d(a)(2) of the CEA requires an FCM or the custodian of customer funds to treat and deal with customer funds as belonging to the customer, and prohibits an FCM from using the funds deposited by a futures customer to margin or extend credit to any person other than the futures customer that deposited the funds. After the collapse of MF Global and Peregrine Financial Group, the Commission thoughtfully and meticulously supplemented the protections embedded in Commission regulations 1.20 through 1.30, and 1.32 to enhance customer protections and transparency at the FCM level.

Two Hard Truths

First, governance and risk management failures can and often do lead to crises, including liquidity crises. Second, apart from undermining the reputational integrity of the industry and fueling calls for harsh regulatory and legislative action, these failures all too often impose tremendous costs that fall disproportionately on customers.

In my final months at the Commission, we also witnessed a surge in new applicants and registered market participants in prediction markets. These prediction market contracts enable retail investors to take a position on everything from U.S. elections to whether Michigan would take New Mexico in the season opener in Ann Arbor last weekend (as an alumnae of the law school, I will admit that I am glad to see that Michigan did secure that win). 

I am disappointed that during my time at the Commission we were not able to successfully advance a final rule that addressed the introduction of political event contracts. Activity in markets in most recent months underscores my concerns and the concerns of others about prediction markets.

As of today, we have too few guardrails and too little visibility into the prediction market landscape. Because the target audience for these contracts is retail customers and some market participants seem to be marching down a path to offer leveraged, margined prediction market contacts to retail investors, there is an urgent need for the Commission to express in a clear voice our expectations related to these contracts.

A bi-partisan group of members of Congress indicated that they agreed with that the CFTC should not be required to police election contacts and expressed concerns about betting on the outcome of democratic elections. There are also a number of legal questions surrounding these contracts that the Commission should use the rulemaking process with embedded notice and comment period obligations to create effective regulation to address.

Finally, the “rent or buy” my license in derivatives markets is booming as prediction markets promise to eclipse crypto markets in volumes of retail customers’ cash captured. The Commission has recently witnessed a number of newly created and legacy firms seeking licenses to offer event contracts. In a number of instances, these businesses approach the Commission seeking licenses to offer traditional products, only to quickly shift once a license is in hand and seek to self-certify prediction market contracts. In other contexts, firms that have received a license quickly auction their newly minted license to others.

Never Let a Good Crisis Go to Waste

I referenced the financial crisis of 2008 earlier. As I return to academia, I appreciate that some of my students were not yet born when Enron collapsed and others may have been in elementary school during the 2008 global financial crisis. One of my goals as a teacher is to ensure that our students are well-versed in the history of financial markets regulation and that they understand my commitment to never let a good crisis go to waste.

Innovation, Cutting-Edge Technologies Impacting Market Stability and Market Integrity

To that end, during my time at the Commission, I have worked diligently to ensure that we advance our understanding of the innovation and cutting-edge technologies that have the potential to disrupt markets and create systemic risk concerns. While I will focus on cyber threats here, I have regularly advocated for financial market regulators to think critically about operational resilience and third-party risk management as well as concentration risks among third parties.

As I explained earlier, innovation and market stability should work together—enabling one to foster the other. I can identify at least a dozen of valuable use cases for artificial intelligence in financial markets—surveillance and compliance use cases immediately spring to mind.

However, as we integrate AI into financial markets, we must be aware of bad actors’ ability to use AI to perpetuate fraud. We must also be aware of risks that arise as hackers integrate or embed AI into necessary technology, facilitating cyber threats.

I have advocated for the CFTC and other U.S. federal regulators to collaborate in convening conversations regarding the integration of AI in financial markets. I worked with the Commission staff to develop the Commission’s request for comment on AI. I also supported Treasury in developing a request for information on the integration of AI in financial markets.

I have also advocated for some specific policy interventions that I believe may separate the wheat from the chaff.

First, for U.S. financial market regulators, coordination and cooperation are imperative. We must harmonize expectations. Second, we should enhance information sharing. Third, we need to strengthen crisis recovery and response. Finally, we must tackle concentration risk and supply chain vulnerabilities.

Even for these complex issues, the adage offered at the outset of my remarks still replies. Get it right—Measure twice. 

Conclusion

In closing allow me to acknowledge the Commission’s most significant asset, its secret weapon—a Navy-seal styled (in some cases, literally) team of the most capable and talented lawyers, economists and professionals that I have had the privilege of working with—the CFTC staff. In a moment in time when it is easy to forget, it was the Commission staff that worked around the clock during the financial crisis to help get our markets back on track and to build the blueprint for a regulatory framework that has stood the test of a pandemic and significant geopolitical conflicts. Facing these issues alongside persistent inflation, our markets have demonstrated resilience. I credit markets’ resilience, at least in part, to the regulatory reform that followed the financial crisis in 2008 and the individuals who built those reforms by hand.

I also deeply grateful to President Biden and the many Senators that supported me during my confirmation process for my current role as a Commissioner at the CFTC as well as my nomination to join the U.S. Department of Treasury.

I am also thankful to everyone in my village. When I think of your support and sacrifices, I am overwhelmed with gratitude. I am hopeful that I made you proud and served you well.