Opening Statement Of CFTC Commissioner Kristin N. Johnson Before The Market Risk Advisory Committee Meeting

Introduction

Good morning and welcome to the first Market Risk Advisory Committee (MRAC) meeting of 2022.  It is an honor to sponsor this Committee.  The work of the MRAC and the other Commodity Futures Trading Commission (CFTC or Commission) Advisory Committees is critical to the development of the CFTC’s regulations and policies, industry best practice standards, and registrants’ independently developed internal compliance systems and controls.  This work influences approaches adopted by fellow U.S. regulatory agencies as well as standards embraced by regulators around the world.

 

The MRAC has long served as an effective venue for exchanging important and diverse views, engaging the thought-leadership of experts, and relying on discussion and debate to determine recommendations that advance public interest as outlined in the CFTC’s core principles—promoting financial stability, preserving market integrity, and enhancing customer protections.

Today is the first meeting of the reconstituted MRAC under my Sponsorship.  I am fortunate to have received the mantle of service as Sponsor of the MRAC from former Commissioner Sharon Bowen and Chairman Rostin Behnam who benefitted from the efforts of the then DFOs Petal Walker and Alicia Lewis, respectively.

Since its inception, MRAC has served as a critical forum, evaluating emerging developments and technologies, evolving market structure questions and concerns, and endemic systemic risk concerns at the earliest (embryonic or fledgling), maturing, and senior stages of development.  In formal meetings and less formal discussions, MRAC Committee members’ have previously considered the merits of self-certification in the context of the launch of two Bitcoin futures contracts, climate-related market risk, interest rate benchmark reforms, the market impact of the COVID-19 global pandemic, DCO governance, cybersecurity threats, systems safeguards, resiliency, and recovery.

In shaping our agenda today, members of the MRAC, renewed subcommittees, and newly-formed subcommittees should anticipate contributing to the creation of solutions to complex questions, issues, and concerns that will define the future of our markets and shape the economy of our nation and many nations around the world.

As I explained recently in framing the agenda for this meeting,

“Today, our markets stand at a crossroads, having witnessed a prolonged season of sustained growth and development, marked by the creation of many important, innovative technologies, that now may be followed by a more difficult season, characterized by the reverberations of a global pandemic; inflationary pressure; disturbing and disruptive geopolitical events; and increasingly frequent and intense, severe weather events, among other challenges.  In order to navigate such turbulence, it is imperative to effectively calibrate regulation, policy, and legislation governing existing and emerging market participants, products, and platforms to preserve the integrity of our markets and protect the welfare of customers and institutions.

“The CFTC’s MRAC serves as an invaluable resource to assist the CFTC in identifying and exploring timely issues in the derivatives and underlying commodity markets.  Consistent with this history and mandate, the MRAC will continue pathbreaking efforts to examine climate-related market risk as well as the development of sustainable resources, migration to new global interest rate benchmarks, and questions regarding central counterparty risk and governance. In addition, the MRAC will explore the future of market structure in finance, the impact of emerging technologies and alternative approaches to clearing and settlement, including but not limited to cloud migration, digital asset development and secondary market trading, and transformative climate-related initiatives that impact market structure.”

I will formally introduce you to the new Chair of the MRAC Committee, Alicia Crighton shortly and she will lead the dialogue this morning. Alicia, thank you for taking on this responsibility, the Committee is indeed fortunate to have you.  Before I turn the program over to Alicia, it may be useful to describe our agenda for today.

The Agenda

The Future of Finance

Our first panel today explores the future of finance. Over the past decade markets have witnessed remarkable, transformative growth and innovation.  Earlier this year, the Commission hosted a roundtable examining the impact of non-intermediation—a market structure that removes intermediaries that have historically facilitated activities such as the clearing and settlement of market transactions.  A recent proposal seeking to permit retail market participants to participate in leveraged transactions adopts a form of this model. Parallel to proposed changes in market structure, exponential growth in the market of digital assets, specifically cryptocurrencies, creates a related set of questions for our discussion today.  Industry participants interested in this market structure or newly emerging class of assets as well as traditional market participants desire a clear indication of the Commission’s next steps.  I am hopeful that this Committee and our subcommittees will directly participate in crafting balanced, effective reports, hearings, or proposals so that the Commission may advance regulatory clarity regarding these market structure and risk management challenges.

The Committee’s work will be supported by ongoing efforts in the Market Participant Division, Division of Market Oversight, the Division of Clearing and Risk, and the Division of Enforcement.  The Commission has already effectively employed its existing regulatory authority to police novel digital asset markets to prevent fraud and manipulation.

Since 2014, the CFTC has diligently exercised its enforcement authority and initiated over fifty enforcement actions pursuing violations under the Commodity Exchange Act (CEA)[1] and CFTC regulations[2] in which the underlying assets were digital asset commodities.[3]  All too often, these schemes have targeted vulnerable or marginalized retail investors.  This year alone, we have charged several individuals and entities with perpetrating more sophisticated fraud schemes, including Ponzi schemes, and the first digital asset “pump-and-dump” case brought by the CFTC.[4]  Just last week the CFTC filed both a settlement and an injunctive complaint in federal court relating to a novel decentralized blockchain-based software protocol that was designed to circumvent regulatory enforcement.[5]

A recent action illustrates the novel legal questions that emerging technologies pose. bZeroX, LLC and its founders created smart contracts on the Ethereum blockchain and enabled customers to engage in leveraged retail commodity transactions in digital asset commodities.  Under the CEA, these sorts of transactions must be conducted on a designated contract market (DCM) and offered by a futures commission merchant (FCM). bZeroX, however, had not registered with the CFTC at all. Moreover, in August 2021 bZeroX transferred control of its software protocols to a decentralized autonomous organization, or DAO, subsequently renamed as the Ooki DAO.  The founders later explicitly claimed that this transition to an unincorporated association would render the operations enforcement-proof.[6]  The CFTC in its complaint argues that this gambit failed and may create liability for certain members of the DAO.

Emerging technologies often don’t fit neatly into either the Commission’s traditional areas of responsibility or that of other regulators like the Securities and Exchange Commission (SEC). The lack of clarity on the regulatory framework has not gone unnoticed.

Both the White House and Congress very much intend to address these concerns.  On September 16, 2022, the White House released the first-ever Comprehensive Framework for Responsible Development of Digital Assets.[7]  At the core of the Framework lie six key priorities: consumer and investor protection; promoting financial stability; countering illicit finance; U.S. leadership in the global financial system and economic competitiveness; financial inclusion; and responsible innovation.

To further these priorities, the Framework outlines a variety of concrete steps government agencies (and their partners) will take to balance two overarching policy aims: fostering and driving domestic innovation, research, and competitiveness in global markets, and mitigating consumer- and investor-related downside risk, especially through strong, fair enforcement of existing statutes and rules, and the development of new, more focused regulations.  This, in addition to the creation of a Treasury-led interagency working group on a potential U.S. central bank digital currency, form the core of the Framework’s approach.

To better protect consumers, investors, and businesses, the Framework focuses on baseline enforcement by the SEC, CFTC, CFPB, and FTC of existing consumer- and investor-protection statutes.  Investigating unlawful practices and bringing enforcement actions, where appropriate, remains at the forefront of the Administration’s approach.  This, coupled with a directive to issue new guidance, rules, and potential legislation, can provide real clarity and regulatory certainty to market participants.

To foster financial stability, the Framework provides for broad collaboration and information sharing between the Department of Treasury and financial institutions to help bolster financial institutions’ ability to identify and mitigate significant risks, including cyber-related risks and risks associated with digital assets, so as to bolster and ensure the stability of our financial markets.

Both the Senate Banking and the Senate Agriculture Committees are reviewing bipartisan bills that would expand the jurisdiction of the CFTC to include oversight of digital commodities.  The Digital Commodities Consumer Protection Act of 2022 (DCCPA),[8]  introduced by Senators Stabenow and Boozman, has received significant attention as it adopts a narrow framework for addressing imminent questions regarding jurisdiction over digital asset spot market transactions.  The proposed bill seeks to expand the definition of “commodity” in the CEA to include “digital commodities.”  The bill includes registration mandates, requiring any entity acting as a digital commodity platform to register with the Commission in one or more of the applicable categories (i.e., digital commodity broker, digital commodity custodian, digital commodity dealer, and digital commodity trading facility).  The DCCPA also includes an obligation for Digital Commodity Platforms to comply with all applicable core principles, which are designed to protect customers and the integrity of the digital commodity marketplace.

Additionally, the DCCPA would require participants in the digital commodities markets to join the National Futures Association, the self-regulatory organization for the derivatives markets.  By requiring registration, the DCCPA would then allow customers to use the CFTC’s Reparations Program to resolve disputes with registered entities and professionals, providing a strong tool for customer protection.  Our reparations program provides a cost-effective way for customers to address their grievances with a registrant without having to hire a lawyer and engage in costly litigation or arbitration.

Section 7 of the DCCPA may be transformative, because it requires the CFTC to conduct a study on the impact of digital assets on diverse communities and use the gathered data to facilitate the development of effective, thoughtful customer protections and tailored regulations to foster access and inclusion.  During a roundtable that I recently hosted at the CFTC, I invited experts and thought leaders to explore both concerns regarding retail investment in digital assets and the promise of building generational wealth for communities that are unbanked or underbanked and have experienced exclusion in traditional financial markets.[9]

As I have previously explained, it will be necessary to adopt a whole-of-government or comprehensive regulatory regime to ensure effective customer protections in digital asset markets.  These protections would include segregation of customer funds, compliance with know your customer and anti-money laundering regulations, risk disclosures and bankruptcy protections, as well as policies to manage conflicts of interest, require robust cybersecurity, and regular reporting of data.  Retail customers investing in novel products deserve the same protections as those investing traditional products.

As Congress works to draft legislation, we are prepared to support its efforts and to collaborate with our colleagues at other financial market regulators.  In the context of crafting regulations for swaps and security-based swaps, we have demonstrated that we can work hand in hand with regulators such as our sister agency the SEC to define the landscape of regulatory oversight.

The CFTC is well-situated to do its part developing and enforcing responsive regulation related to digital assets that are commodities.  As demonstrated during the demanding period following the adoption of the Dodd-Frank Act, the CFTC has deep expertise and the talent to get the job done. Based on the size of the market for digital commodities, however, additional funding would be necessary to support any expanded authority.

Climate-Related Market Risk

The second segment of this morning’s presentation examines issues explored by the Climate-Related Market Risk subcommittee.  According to data gathered by the National Oceanic and Atmospheric Administration’s (NOAA’s) National Centers for Environmental Information, since 1980, the United States has sustained more than three hundred weather and climate disasters, including droughts, floods, severe storms, cyclones, wildfires, and winter storm events that, in the aggregate, led to costs or damage exceeding more than $1 billion.[10]

Earlier this month we have seen Hurricane Fiona knocking out power in Puerto Rico and inflicting significant damage and loss of life, on the fifth anniversary of the terrible devastation inflicted by Hurricane Maria.[11]  Extreme weather causes not only physical damage to our infrastructure and property, but also disrupts the normal functioning of the economy, distorts prices, diverts resources, and changes risk calculations for capital investment.  All of these factors impact our markets in multiple ways.  Notwithstanding our long history of navigating these severe weather-related events, the increasing frequency, severity, and intensity, as well as the rising costs of these events, raise important policy questions and remarkable commercial concerns.

As a financial regulator with oversight over the derivatives markets, with their importance for risk-management, the CFTC is deeply thoughtful about the growing and systemic threat climate-related risk poses to our financial systems.  This Committee took a huge leap forward in this space before I arrived at the Commission in September 2020, when it published a wide-ranging report on climate risk in the U.S. financial system.  The report built on the good work of numerous international regulators and associations, including the International Organization of Securities Commissions (IOSCO), the Network of Central Banks and Supervisors for Greening the Financial System (NGFS), and the Financial Stability Board (FSB).  The report’s recommendations for U.S. financial regulatory agencies, ranging from requiring financial firms to integrate climate risk into their supervisory frameworks to supporting regulatory sandboxes to facilitate the development of innovative climate risk reduction tools, have deservedly found their way into the international climate risk dialogue.

In June of this year I supported the publication by the CFTC of a Request for Information (RFI) on Climate-Related Financial Risk in order to solicit comment from the public, including participants in our markets.[12]  The RFI seeks comments on how climate-related financial risk may affect “registered entities, registrants, or other market participants, and the soundness of the derivatives markets,” including an assessment of “how registrants and registered entities may need to adapt their risk management frameworks—including, but not limited to, margin models, scenario analysis, stress-testing, collateral haircuts, portfolio management strategies, counterparty and third-party service provider risk assessments, and enterprise risk management programs—as well as how market participants may need to adapt their dealing, trading, and advisory businesses in the derivatives markets.”  These inquiries are well within the ambit of the CFTC’s statutory authority and continue a long-established tradition of engaging in thoughtful dialogue with our market participants and diverse stakeholders in order to understand their concerns related to emerging and evolving risk management oversight.  Responses to the RFI are due shortly, on October 7, and will help to inform the work of the CFTC, as well as this Committee, on these issues.

In addition to the RFI, the CFTC held a public convening concerning the voluntary carbon markets in conjunction with the issuance of the RFI.  The voluntary carbon markets are a key tool in reducing carbon emissions and raising investment capital to promote innovation for carbon reduction.  Among many complimentary and comprehensive efforts, careful evaluation of carbon markets may reveal a useful path for mitigating climate-related financial risk.  Moreover, growing use of carbon offset derivatives listed on CFTC-regulated exchanges brings this subject squarely within the regulatory interest of the CFTC, and it is therefore incumbent upon us to ensure that the underlying markets are of high integrity and that the carbon offsets traded there in fact achieve the indicated carbon reductions.[13]

There are currently a number of initiatives, such as the Integrity Council for the Voluntary Carbon Market and the Voluntary Carbon Markets Integrity Initiative, that seek to ensure that voluntary carbon markets are transparent and efficient, dealing in high quality carbon credits, with integrity on both the buy- and sell-side, and integrity in the way that climate impact is measured and reported. ISDA has also undertaken a project to standardize documentation for trading voluntary carbon credits to facilitate secondary markets.

At the intersection of the issues of climate-related market risk and digital assets, there are threads that bind together two of the issues that we will discussed today—energy use for the trading and generation of digital assets.  From 2018 to 2022, annualized electricity used in connection with digital assets grew rapidly, with estimates of electricity usage doubling to quadrupling—recently amounting to the equivalent to 0.4% to 0.9% of annual global electricity usage.[14]  Because the profitability of mining these digital assets is directly tied to the cost of energy, miners move to areas with lower energy costs, straining local grids and affecting energy markets.[15]

Earlier this month, the Ethereum blockchain converted from a proof-of-work consensus mechanism, which requires energy-intensive computer calculations for validation of each block added to the blockchain, to a proof-of-stake consensus mechanism, a much less energy-intensive approach that substitutes an algorithmic transaction verification system based on miners depositing digital assets as collateral for the right to validate transactions on the network.  It is estimated that this so-called "Ethereum Merge" will significantly decrease the overall energy consumption associated with the Ethereum blockchain.  Whether other blockchains will follow suit is an open question, but one that urgently needs answering given the growing impact of digital assets on energy consumption.

The International Emissions Trading Association Council Task Group on Integrity in Digital Climate Markets is exploring the potential use of digital credits or tokens as a way to facilitate trading of carbon credits and utilize blockchain technology to create public registries that avoid double selling, duplicate claims, and non-authorized tokens.  Finally, given the continued focus on national climate commitments and targets, there is a risk that some countries may take steps to exert increased control over carbon abatement projects within their borders, impacting existing and planned voluntary projects and potentially disrupting markets.

Biofuels and Climate

The MRAC must operate in support of the CFTC and in tandem with national and international complimentary work streams. In February 2022, U.S. Department of Agriculture Secretary Vilsack introduced the Partnership for Climate-Smart Commodities to support the production of climate-smart commodities—these are agricultural commodities that are produced using recognized climate-friendly practices. Climate-smart commodities will include biofuels that convert biomass into transportation fuel.

The incentives created through programs like the Partnership will profoundly impact how traditional agricultural commodities are produced, refined, and marketed.  The investments needed to support retrofitting into a green economy cannot happen without derivatives, which means that they cannot happen without sound and clear guidance from the CFTC. More than ever, the commodities markets—both financial and physical—are correlated.

Interest Rate Benchmark Reform

The MRAC has served as a central hub in the CFTC’s work in facilitating the transition from LIBOR and other interbank offered rates—which were susceptible to manipulation—to alternative reference rates.[16]  The third segment of this agenda today focuses on transition efforts. On July 13, 2021, the MRAC voted to approve a recommendation from its Interest Rate Benchmark Reform Subcommittee to recommend that interdealer brokers prioritize trading in swaps referencing the Secured Overnight Financing Rate (SOFR) rather than USD LIBOR for particular market segments and products, in light of the decision to phase out use of LIBOR generally, an approach referred to as SOFR First.  Over the intervening months, additional portions of the market have transitioned from LIBOR to SOFR.[17]  Most recently, I supported the issuance of a final rule modifying the swap clearing requirement in support of the transition from LIBOR and other interbank offered rates to alternative reference rates, which has its last effective date on June 30, 2023, for the transition away from USD LIBOR in the fixed-to-floating swap, basis swap, and FRA classes.[18]

CCP Risk and Governance

The Dodd-Frank Act introduced groundbreaking reforms that directed significant volumes of OTC transactions to DCOs hand-in-hand with reforms that required DCOs to adopt comprehensive risk mitigation practices and governance procedures.  DCO Core Principle O expressly directs each DCO to establish governance arrangements that “permit the consideration of the view of owners and participants.”

The Commission recently issued a proposal to build on a DCO governance framework that is compliant with the PFMIs and addresses the critically important and unfinished debate about how DCO governance should operate within the broader Dodd-Frank Act regulatory framework.  The proposed rulemaking will require DCOs to stand-up risk management committees and directs the DCOs’ boards of directors to consult with and consider feedback from the committees on all matters that could materially affect a DCO’s risk profile.

In the coming months, we will navigate refined interpretations of standards that may introduce enhanced governance requirements, including when decisions of DCOs should be interpreted as having a material impact on a DCO’s risk profile.  Ideally, market participants and DCOs will build consensus around interpreting these standards.

Market Structure

The final panel this morning examines emerging issues in market structure.  In February and March of 2020, our markets faced concerning shocks from the appearance of a global pandemic.  Rising, and in some instances, unpredictable calls for collateral left many who rely on our markets scrambling to meet margin requirements.  Markets witnessed unprecedented volatility coupled with extreme trading volumes and, at times tight liquidity, placing extraordinary pressure on market infrastructures.  Two years later, geopolitical events, namely the invasion of Ukraine encouraged persistent volatility, particularly in the interest rate markets and the markets for energy and agricultural commodities.  Inflationary pressures and broken supply chains have introduced tremendous challenges for core CFTC constituencies and stakeholders.  Coupled with these concerns, the frequency and severity of unprecedented weather events has significantly influenced market conditions

Under the CEA, the CFTC’s jurisdiction is broad and directly intertwined with the macro-economic and environmental conditions that I have just described, because of their profound impact on the markets for financial derivatives, energy derivatives, derivative instruments related to agricultural (wheat, corn, soybeans, cotton, pork, cattle) and precious metal (gold, silver, iron, copper) commodities, and equity futures and swaps.  Yet, in the coming years, the CFTC’s jurisdiction may expand further to new frontiers including the rise of Web3, migration to cloud services, and the evolution of digital assets including cryptocurrencies as well as other financial products created through the use of decentralized distributed digital ledger technology, commonly described as blockchain technology.

The MRAC is an opportunity for us to hear from the best and brightest minds in our industry and engage in dialogue about what you are seeing in your businesses, and where you are going, and what risks you face.  Technology is evolving faster than the law, and we want to be responsible and responsive to market participants and the public so that our decisions are always well researched, well-considered, and in the best interests of growing our markets and protecting our market participants.  But we can’t do it alone. Increasing our engagement with the industry is critical to our success as a regulator in overseeing our markets.

As an example, digital assets and blockchain technology offer many potential benefits, including increased efficiency, lower transaction costs, and improved access.  These innovations are not without their risks, however.  The disintermediation of traditional market participants and the decentralization of financial transactions challenges us as regulators to consider how these emerging concepts will impact markets designed for traditional derivatives.  The MRAC can play a role in helping us create better policies around data security and cyber security, governance, customer protection, and other unanticipated risks.

Closing

Before we move into the substance of today’s meeting, I want to thank Chairman Behnam and Commissioners Goldsmith Romero, Mersinger, and Pham and all of our Members and panelists for joining in person or virtually today here at the CFTC’s Washington, D.C. offices.  We are fortunate to have a distinguished group of expert presenters, industry representatives voicing diverse perspectives, public interest advocates, and academics.

I am grateful to Bruce Fekrat, the Committee's Designated Federal Officer (DFO).  Bruce started working in my office in June, and MRAC has been a priority for him since the day that he arrived.  Just six short weeks ago, Marilee Dahlman agreed to serve as the Alternate Designated Federal Officer for the Committee (ADFO).  Bruce and Marilee have demonstrated exceptional professionalism and their tremendous work ethic and commitment will be on display throughout the day.  Finally, allow me to thank Lillian Cardona for her service as ADFO for the Interest Rate Benchmark Reform Subcommittee.  This meeting would not have been possible without their hard work and significant effort.

With that, I will turn it over to my fellow commissioners who are joining us virtually today for their remarks.  I look forward to a robust and informative discussion.