Keynote Speech of Commissioner Kristin N. Johnson at the Salzburg Global Finance Forum

Thank you to former FDIC Chairman Jelena McWilliams, the esteemed board of directors of the Salzburg Global Seminar, and the forum organizers for the invitation to join you for the 2023 Salzburg Global Finance Forum.  It is great to have an opportunity to launch the discussion this morning on exciting innovation and emerging novel technologies such as the integration of supervised and unsupervised machine learning or neural networks—artificial intelligence or AI—and financial products such as the introduction of digital assets (cryptocurrencies or stablecoins).  What wonderful views everyone enjoys from the conference site nestled alongside Schloss Leopoldskron, a eighteenth century palace defined by singular architecture reflective of a golden age in Europe, but fostering a contemporary dialogue and debate inspiring a new millennium of global leadership in art, political science, and finance.

It is an honor and a privilege to have an opportunity to address this body.  And, I must share that my family regards this as the most prestigious speaking invitation that I have received—perhaps influenced by the fact that the conference convenes at the site of a favorite film and musical—The Sound of Music.

Before I begin, I also want to thank my former Commodity Futures Trading Commission colleague Daniel Gorfine—the CFTC’s first Chief Innovation Officer and Director of LabCFTC—for his generous introduction.  I should also offer an anticipated disclaimer, the views that I will share today are my own.

I am, however, hopeful that many of you share my aspirations for harnessing the benefits of innovation while contemporaneously establishing effective guardrails that address potential regulatory gaps.[1]  I strongly believe that we benefit from responsible innovation developed by accountable leadership.

I believe that we can future proof financial markets by balancing responsible innovation with accountability.  And, we have long developed and frequently refined a robust regulatory framework that has demonstrated remarkable resilience even in the context of the defining challenges of most recent years—a period marked by the twin economic shocks of a global health pandemic and disturbing geopolitical events, namely Russia’s invasion of Ukraine.

Events over the last several years reveal notable fragilities within asset classes among critical financial market intermediaries and more generally across the financial market ecosystem.  On the heels of the global health crisis, monetary and fiscal policies endeavor to effectively address a confluence of challenging conditions driving macroeconomic indicators, including international supply-chain disruptions,[2] persistent and extreme volatility[3] and inflationary pressures.[4]  Coupled with these shocks, inflationary pressure and persistent and sustained volatility have also created pressure.  In every sense of the term, market conditions stress tested the pro-cyclicality reforms codified under EMIR and the Dodd-Frank Act.  Responding to these events, CCPs increased initial margin requirements, particularly for equity products, as an integral part of their market risk mitigating solutions.

Same Activity, Same Risk, Same Regulation

The crypto-winter experienced over the last year also demonstrates that we must ensure that nascent financial products and platforms (including exchanges or clearinghouses that engage in digital asset transactions), rapid changes in the market structure including concentration or adoption of vertical integration strategies, as well as technologies that accelerate the pace of pre- and post-trade operational infrastructure including transaction clearing and settlement and system safeguards including cyber resilience preparedness are subject to longstanding regulatory principles that ensure customer protection, market integrity, and market stability.[5]

Our markets are indisputably more diverse and technologically enhanced than ever before in human history.[6]  We are more interconnected as a result of technology.  Our markets are truly global markets. As we approach adopting a regulatory framework for emerging technologies—much like our modern conversation about crypto or AI in the ornate halls of this salon—there may be benefits to acknowledging the lessons that we have learned and the potential application of the same lessons to contemporary issues.[7]

Before turning to the potential for regulatory oversight of crypto derivatives markets, it may be useful to acknowledge three specific lessons that we have learned that directly influence market integrity, market stability, and our ability to manage and mitigate system risks that have the potential to impact broader segments of financial markets.  Ahead of turning to these lessons, it is worth noting that certain types of businesses in our markets must accept heightened levels of responsibility and therefore, at the most senior levels and throughout the enterprise, they must ensure accountability.  These institutions are repositories of trust and confidence in our society.  They act as custodians of the assets and wealth of both hard-working citizens and the largest financial services firms in the global economy.

What’s special about banking?

Four decades ago, on January 1, 1982, in opening an annual report for the Federal Reserve Bank of Minneapolis, then President Gerald Corrigan, penned an essay—“Why Are Banks Special?” that has proved an important reflection on the role and function of banks as institutions within our society.[8]

Banks and bank regulators have long recognized “the importance of banks acting in ways that preserve public confidence in banks’ capacity to meet their deposit obligations, thereby minimizing the likelihood of large, sudden drains of bank deposits.”[9]  The relationship between banks and bank regulators is, in part, defined by bank regulators’ obligations to ensure that banks’ demonstrate responsibility and accountability in their role as custodians of the property of others—a tremendous role of trust and confidence.  In addition, regulators are ever mindful of a regulatory framework that provides banks’ access to deposit insurance and the Federal Reserve as the lender of last resort.

As Corrigan explained, “deposit insurance and access to the lender of last resort constitute a public safety net under the deposit taking function of banks.  The presence of this public safety net reflects a long-standing consensus that banking functions are essential to a healthy economy.  However, the presence of the public safety net—uniquely available to a particular class of institutions—also implies that those institutions have unique public responsibilities and may therefore be subject to implicit codes of conduct or explicit regulations that do not fall on other institutions.”[10]

Without question, “[e]xperience suggests rather strongly that public confidence in a bank—with or without deposit insurance and the Fed’s discount window—is ultimately related to public perceptions about the financial condition of banks and specifically about the quality of banking assets, liquidity, capital, and the capacity to absorb short-run shocks.  Sudden drains on bank deposits occur when depositors conclude that loan losses or other circumstances might jeopardize a bank’s ability to meet its deposit obligations.”[11]

Earlier this year, Vice Chair for Supervision of the Board of Governors of the Federal Reserve System Michael Barr acknowledged this tension and noted that “the benefits of innovation can only be realized if appropriate guardrails are in place.”  Later this spring, in testimony before the U.S. Senate Banking Committee, the Vice Chair echoed may of the concerns long expressed by banking and market regulators regarding the need for effective oversight, especially in any context that involves the custody of customer funds or deposits.

Today, the lessons surrounding banks and banking may easily become foundational learning for regulators or supervisors of many sectors of financial markets.

Lessons From Recent Banking Sector Disruptions: Signature Bank, Silicon Valley Bank, and Credit Suisse

Recent disruption in banking markets—the failure of Signature Bank (SB), Silicon Valley Bank (SVB), and Credit Suisse (a storied European institution with almost two centuries of operating history)—underscores the critical relationships among banking institutions and depositors as well as the role of responsibility and accountability in serving as a custodian of customer deposits.  The accelerated and unprecedented pace of customer deposit withdrawals during the “runs” on SB and SVB also demonstrate that we are no longer in the era of George Bailey’s fabled speech in It’s a Wonderful Life.  Changes in technology and market structure as well as the introduction of new highly correlated and deeply interconnected financial products and platforms have altered the financial markets ecosystem.

At the center of our banking regulation is a principle that transcends our regulatory silos and should influence regulation of any entity engaged in serving as the custodian of the assets of another.  The observation is timeless and in just a few minutes, I’ll explain how his observation requires us to carefully consider regulation that preserves customer assets or deposits held in custody and addresses conflicts of interest, particularly the potentially pernicious conflicts that may arise from unsupervised vertical integration— an issue to consider as we evaluate the evolving structure and modernization of financial markets.

The Rise of NBFIs

During a recent panel at the ISDA Annual meeting, I joined UK and European market and prudential regulators to discuss the growing importance of non-bank financial institutions (NBFIs) in the global financial system.  NBFIs have become increasingly interconnected and have significant linkages with traditional banking institutions.  The exposure of banks to NBFIs, both directly through credit lines and loans and indirectly through common asset holdings, can lead to losses and distress if NBFI counterparties fail to honor their liabilities.

The rise of NBFIs highlights two significant issue.  First, we must increase our vigilance regarding oversight of known systemically important financial institutions as well as appreciate new sources of risk.  These new sources of risks may arise beyond the traditional financial market sector and may arise as a result of the participation of NBFIs with the traditional banking sector.

Identifying New Risks – Moving Beyond the Last Crisis

In my service as sponsor of the CFTC’s Market Risk Advisory Committee, I am advocating for a comprehensive evaluation of these issues as related to our markets. Specifically, we must be mindful of the significance of collateralization and margin requirements in managing counterparty risks in the financial system.  As Sarah Breeden of the Bank of England mentioned during our panel and in a prior public speech, the widespread collateralization of derivatives, although a crucial reform after the Global Financial Crisis, has increased the sensitivity of liquid-asset demand to market volatility.  If market participants are unprepared for collateral demands, their actions to raise cash can further squeeze liquidity in stressed markets and amplify shocks.  Sarah emphasized the challenges in assessing the risks of leveraged institutions, particularly those with hidden or complex exposures, and underscored the need for adequate risk assessment and margin requirements to safeguard the resilience of systemically important firms and the real economy.

It is important to reflect on the lessons learned from over two centuries of U.S. banking and markets regulations, including the lessons learned from the recent financial crisis as well as the rapidly changing structure of financial market.  As a commodity derivatives market regulator, I focus on our market structure daily, and this discussion prompts me to raise a few points about gaps in our regulation governing custody, specifically separation of customer property and conflicts of interest as markets for novel asset classes adopt vertically integrated market structures.

Beginning hundreds of years ago, markets began to organize as private clubs, and later as market utilities facilitating a forum for the exchange of goods and services.  Today, most large market structures include privately owned businesses (some of which have registered and listed securities on capital markets exchanges).  A critical group of institutions providing these services in commodity derivatives markets is derivatives clearing organizations (DCOs).

Is Our Market Structure Regulation Ready for Digital Assets?

A derivatives clearing organization (DCO) is an entity that enables each party to an agreement, contract, or transaction to substitute, through novation or otherwise, the credit of the DCO for the credit of the parties; arranges or provides, on a multilateral basis, for the settlement or netting of obligations; or otherwise provides clearing services or arrangements that mutualize or transfer credit risk among participants.[12]  A DCO that seeks to provide clearing services with respect to futures contracts, options on futures contracts, or swaps must register with the CFTC before it can begin providing such services.[13]  In order to maintain its registration, a DCO must comply with the core principles derived from Section 5b(c)(2) of the Commodity Exchange Act (CEA) and subsections A, B, and C of part 39 of the Federal Register.[14]

 

Section 5b(c)(2) of the CEA sets forth core principles with which a DCO must comply in order to be registered and to maintain registration as a DCO (DCO Core Principles).  In 2011, the Commission adopted regulations in subparts A and B of part 39 to implement the DCO Core Principles.  In 2013, the Commission adopted regulations in subpart C of part 39 to establish additional standards for compliance with the DCO Core Principles for those DCOs that have been designated as systemically important (SIDCOs) by the Financial Stability Oversight Council in accordance with Title VIII of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act).  The subpart C regulations are consistent with the Principles for Financial Market Infrastructures (PFMIs), published by the Committee on Payments and Market Infrastructures (CPMI) and the Technical Committee of the International Organization of Securities Commissions (IOSCO).  Other DCOs may elect to opt-in to the subpart C requirements (subpart C DCOs) in order to achieve status as a qualifying central counterparty (QCCP).[15]

For regulators at the CFTC, many of the most important banks in the global financial system participate in our markets acting as futures commission merchants (FCMs) or the equivalent of broker-dealers, designated contract markets and swap execution facilities.  Similar to DCOs, FCMs, which play an essential role in futures markets, are also subject to extensive regulations and requirements.  FCMs are entities that facilitate purchase and sale orders for futures contracts, options on futures contracts, or retail off-exchange foreign exchange (forex) contracts or swaps, in exchange for commission or other assets from customers.[16]  These entities are required to register with the National Futures Association (NFA) and obtain and maintain accreditation by the CFTC in order to operate.  In order to operate as intended, FCMs hold and transfer customer assets and funds, including resulting margins, when facilitating transactions.  An FCM’s access to customer funds creates the need for robust regulation so as to ensure customers ultimately receive the funds or assets that result from the trade.  FCMs are subject to the regulations found in Section 1.20 of the CEA, the NFA’s Rulebook, and the CFTC’s Regulations.

Both DCOs and FCMs are required to, among others, ensure their processes include safeguards and structures that guarantee consumer funds and assets are secure and separate from business funds and assets.  It is strictly prohibited that either organization permit the comingling of consumer funds with business funds.

As the NFA has stated, the “segregation of customer funds forms the foundation of the futures industry’s customer protection regime.”[17]  The segregation of consumer funds contributes to the previously referenced public perception and confidence that influences the general success or failure of financial systems, specifically banks.  Requiring DCOs and FCMs to segregate customer funds allows customers the confidence that their funds are secure and available to them at any time, which affords these financial systems opportunities for growth and success.

During my term of service, I have continuously advocated for the Commission to begin to examine the need for parallel customer protection rules for certain DCOs that may not rely on intermediation and therefore, may not be subject to the FCM regulations outlined above.  This need for parallel protection becomes even more acute as more market participants adopt this non-intermediated market structure.  Coupled with these market dynamics are growing concerns that retail market participants may engage in leveraged transactions in asset classes on these platforms without the benefit of longstanding custody and separation of customer property regulations.

Adding to concerns regarding the need for clear custody regulations, it is imperative that firms adopting this market structure are subject to regulations that mitigate conflicts of interest.

Conflicts of Interest

I have previously discussed the degree of responsibility that the Dodd-Frank Act of 2010 entrusts upon DCOs regarding the integrity of the derivatives markets, specifically through risk mitigation practices.[18]  Requirements to disclose conflicts of interest via annual reporting for DCOs and in certain market communications for FCMs are integral to customer protection and market integrity.

The CEA states that DCOs are required to establish and enforce rules to minimize conflicts of interest in their decision-making processes and to establish a process for resolving conflicts of interest encountered in their decision-making processes.[19]  In addition to these practices, DCOs are required, among other things, to establish fitness standards for specified executive roles and ensure their governing body includes a market participant[20]  in order to allow for reputable and well-rounded governance.  These governance and disclosure requirements assure market participants and, more broadly, general consumers that these organizations are held to certain standards, which encourages confidence in the market as a whole.

Likewise, the CEA requires FCMs to implement conflict of interest systems and procedures that establish safeguards to ensure researchers or analysts cannot be influenced or pressured by persons involved in actual trading.[21]  Coupled with this requirement, the NFA requires that the mandatory ethics training programs implemented by FCMs include a comprehensive discussion about conflicts of interest, including how to avoid, disclose, and handle any such conflicts.[22]  The NFA also requires that FCM members who have a relationship with a security futures product or its issuer must disclose that conflict of interest within any promotional material that provides a recommendation about that product or its issuer.[23]  The intent behind these requirements is identical to those in place for DCOs, namely to embolden present and potential participants’ confidence in the market.

These entities maintain such extensive permissions in their respective operations, because of that, it is vital that they are subject to distinct requirements and regulations.  Conflict of interest requirements are just one example of the comprehensive rules in place for these entities, but they can contribute in a significant way.  These measures facilitate not only confidence and engagement among participants, but also mandate superior business practices for operational bodies like DCOs and FCMs.  A multifaceted outcome of this kind provides exceptional support to this market’s pursuit of stability and expansion.

In the absence of conflicts of interest protections, customers may be exceptionally vulnerable.  The potential for firms to adopt vertical integration approaches and fail to address these conflicts may exacerbate customer protection and market integrity concerns.

Vertical Integration in the Digital Asset Ecosystem

A number of market participants in the crypto asset ecosystem increasingly favor operational approaches that offer a diversified range of financial services to customers.[24]  Levering the customer relationships in a particular business line, firms create business models that combine various functionalities such as custody, transfer, pre- and post-trade activities, clearing and settlement within a single operational approach.

As the recent bankruptcies associated with the crypto winter demonstrate, without sufficient risk management, corporate governance, and conflicts of interest guardrails, vertical integration may present endemic conflicts of interest and risks.[25]  These episode highlight the need for careful consideration and regulatory oversight.

A recent Financial Stability Oversight Council (FSOC) report highlights the risks associated with such integration, exposing retail customers to potential losses that might be prevented simply by introducing long established regulatory reforms.[26]  In the contexts of firms adopting vertical integration, it is imperative to ensure that known risks and anticipated threats such as cyber risks are not amplified, triggering excessive customer losses.

FSOC recently called upon regulatory agencies to thoroughly analyze the impact of vertical integration and determine whether it is a model that should be supported by existing laws.[27]

In addition, the International Organization of Securities Commissions (IOSCO) has published formal guidance with recommendations regarding conflicts of interest and vertical integration in the crypto market.[28]  The IOSCO principles emphasize the importance of accurate and transparent disclosure by crypto-asset service providers (CASP) about their roles and capacities to their clients, prospective clients, the general public, and regulators across jurisdictions.  The goal is to ensure that clients are fully informed about the services provided by CASPs and any changes in their roles or capacities.

The staff of the CFTC recently announced its intentions to study the impact of vertical integration in our markets and I look forward to the thoughtful commentary that the Commission will receive and to participate in the develop of regulation that addresses issues outlined here and others that merit careful study and consideration.

Conclusion

In a recent public speech, I shared that my relationship with the CFTC dates back to the hours after the onset of the financial crisis in 2008.  I had the distinct privilege of being invited as an external expert to comment on how we might approach mandatory clearing for certain over the counter derivatives.  For a decade following the financial crisis, I spent countless hours supporting CFTC and SEC efforts to craft regulation that integrated bespoke bilateral OTC derivatives contracts into a market that introduced well-established safeguards.  When I think of the concerns in crypto markets, I feel compelled to repeat that call to action captured in my nearly 20 years of published writing, consumer advocacy, and market integrity driven-commentary.

I am internally and publicly advocating for the CFTC to introduce and actively enforce regulations consistent with our Core Principles in certain retail markets that may be vulnerable to crises.  This approach will ensure parallel customer protections, enhance market integrity and market stability, and mitigate crises in crypto-commodity derivatives markets and possibly other markets as well.

I am also urging Congress to include in any new legislation statutory authority for the CFTC to conduct effective due diligence on any firm—not already subject to the CFTC’s oversight—that seeks to purchase ten percent or more of the equity interest in a CFTC-registered exchange or clearinghouse.  I am also encouraging my fellow Commissioners to consider, with the utmost urgency, initiating a notice and comment process to identify a path that ensures that the Commission has greater visibility into the financial health, corporate governance, and risk management processes of any business seeking to acquire a significant equity ownership stake in CFTC-registered entities.  While our existing approach, deeply influenced by custom and tradition, serves as an effective soft power in the context of several recent acquisitions of CFTC-registered entities, I am concerned that “moral suasion” may not be sufficient for the hard cases.

Events in the banking sector, the failure of Silicon Valley Bank and Signature Bank and the hurried intervention to shore up the nearly two centuries old storied firm Credit Suisse revealed the need for us to continue to be vigilant in developing, refining, and enforcing effective liquidity preparedness measures and collateral management and oversight supervision.

The Salzburg Global Finance Form creates an exceptional opportunity for global thought leaders in finance to join in a robust exchange of views regarding the current state of financial markets as well as concerns on the horizon.  I look forward to our conversations and your valuable insights on these and so many other issues.