SPEECHES & TESTIMONY

Remarks of Daniel Gorfine, Director of LabCFTC at ISDA

LabCFTC: Developments and Discoveries

June 11, 2019

 

Good morning and thank you for the opportunity to speak with you at the ISDA Annual Legal Forum.  I am Chief Innovation Officer and Director of LabCFTC at the U.S. Commodity Futures Trading Commission (CFTC).  My remarks presented here reflect my own views and do not necessarily reflect the opinions or views of the Chairman, Commissioners, or the Commission. 

 

I want to pause and note at the outset how interesting it is that ISDA has made the forward-looking decision to include the previous panel and now my talk in order to emphasize the impact of technology on our markets.  As my talk today will explore, there are two key ways that I believe technology will continue to transform our markets: the first is through the ongoing enhancement of our computing and market infrastructure and the second is through a process by which the world of computers and digital connectivity are going to link-up with and increasingly automate activity in the physical world. 

 

In order to unpack all of this though, I am going to spend the first portion of my remarks talking a bit about how FinTech has impacted our markets and perhaps more importantly the challenges it presents to regulators and regulatory frameworks.    

 

The second portion of my talk will go into more detail on how the CFTC through LabCFTC is evolving to keep pace with our changing markets and related new regulatory demands. 

 

And then I will conclude with a few of my so-called LabCFTC “discoveries” derived from our work over the past few years and engagement with hundreds of innovators across the country and, indeed, the world.

 

From Farms to FinTech

 

Stepping back, the mission of the CFTC is to foster open, transparent, competitive, and financially sound markets.[1]  As you all know, the agency oversees markets vital to supporting the transfer of risk between market participants and by extension to the stability and reliability of real-world economic activity, ranging from the production and provision of gasoline for our cars, to the availability of credit for our purchases, and the offering of produce in our grocery stores.[2]

 

So how do we now find ourselves here making the jump from traditional commodities and risk transfer to FinTech topics like DLT and bitcoin?

 

The answer is that our financial markets are fast-evolving due to technology-driven innovation and this has changed the way market participants interact and engage in economic activity. No longer do market participants rely on face to face interactions and telephones.  Instead, markets have become increasingly digital, and interconnected.  This new world in turn creates new market and regulatory opportunities, challenges, and risks.    

 

Some question, however, whether all of this talk about FinTech is just good marketing and they might point to historical innovation in finance ranging from the ATM machine to electronic trading in order to suggest that there is nothing new here.  These are fair points, though I would argue that there are at least three identifiable threads or characteristics regarding current innovation that do make “this time different” – at least from a regulatory perspective.[3] 

 

The first centers on speed, both in terms of innovation and subsequent adoption.  The speed phenomenon is the result of the profound impact that increased computing power and lower computing costs have had in the development of new business models and products.  And when it comes to the ability to scale, the internet and mobile technologies have rapidly sped the adoption of these new models and products.  This means that markets and regulators are faced with a constant barrage of innovations and not much time to grasp their implications before inter-connected computers and devices permit their ready adoption.

 

The second characteristic is that innovation largely seeks to either disintermediate traditional gatekeepers or change the way they operate.  Current financial regulatory frameworks are centered on the intermediaries or gatekeepers that manage the access to our markets or financial services activity.  To the extent that innovators are seeking to disintermediate or substantially transform traditional models in order to increase efficiencies, regulators will need to proactively identify how rules and regulations conform or will need to change.  We will also have to consider whether new types of intermediaries are arising in the marketplace but in different form.

 

The third characteristic is that new technologies and the Internet have reduced barriers to entering new businesses and driven convergence across historically distinct sectors of the economy.  More specifically, traditional financial institutions, telecom providers, technology companies, and startups are increasingly competing for the same set of users or customers with the same general set of financial services or activities.  This dynamic can drive rapid innovation and competition, which can benefit consumer and end-users, but put strain on regulatory frameworks that typically focus on the actor to be regulated rather than the activity.

 

Importantly, a critical consequence of the increasing complexity of technology-driven business models is that it requires significantly more focus on technological literacy at all levels of leadership, including within business and government.  It is simply not enough to all agree to high level platitudes that items like cybersecurity are of great importance – instead it is imperative that we have deep understanding of the details of security protection in order to avoid bad outcomes. 

 

Indeed, I would suggest that a key emerging risk in our markets is a potential lack of required literacy in the face of increasingly technology-driven business models and processes.

 

LabCFTC: The Need for an Innovation Stakeholder

 

Given these market dynamics, and related emerging regulatory challenges, we believe thoughtful 21st century regulatory approaches are needed.  This is why in 2017, CFTC Chairman Chris Giancarlo announced with bipartisan Commission support the launch of LabCFTC.[4]  

 

LabCFTC is the CFTC’s effort to help create a replicable model for regulatory engagement and modernization.  The mission of LabCFTC is to facilitate market-enhancing innovation, inform policy, and ensure that the Agency has the technological and regulatory tools and understanding to keep pace with changes to our markets. 

 

The building blocks of the effort are engagement, testing and experimentation, education, and collaboration.  Through this approach, we can gain a better understanding of emerging risks, technologies, and trends, modernize our regulatory tools and operations, engage with innovators early in the development of new business models, and support better informed policymaking.

 

The effort seeks to involve both internal and external stakeholders through three primary work streams. 

 

First, ‘Guide Point’ provides a dedicated point of contact for FinTech innovators to engage with the CFTC, learn about the CFTC’s regulatory framework, and obtain feedback. Such feedback and discourse may provide innovators with valuable information that can help them save time and resources, or allow for the identification of potential friction or uncertainty in existing rules. 

 

Through this effort, we have met with over 250 entities across the country, published two primers on virtual currencies and smart contracts, and last year held the first CFTC FinTech Forward conference at our Washington, DC headquarters.

 

Second, ‘CFTC 2.0’ fosters the testing, understanding, and potential adoption of new technologies that can improve markets or make the Commission a more effective and efficient regulator.  Last year we crowdsourced ideas for future innovation competitions,[5] which may involve, for example, novel ways to visualize CFTC published data, develop market surveillance tools, or make our rules more readily machine-readable.  And we are now further exploring ways for the Agency to test new technologies through pilots and proofs of concept.  Our belief is that better understanding of core technologies can drive both better informed policymaking as well as better informed internal technology strategies. 

 

Finally, ‘DigitalReg’ is designed to support the Commission’s effort to build a 21st century regulator and regulatory approach. Internally, DigitalReg serves as a CFTC-wide resource to help inform the Commission and staff on Fintech-related developments.  Externally, DigitalReg acts as a hub to help the Commission collaborate with other U.S. and international regulatory authorities in order to share best practices around FinTech engagement.  We were accordingly pleased last year to enter into a CFTC-first FinTech cooperation arrangement with the UK’s Financial Conduct Authority (FCA),[6] and subsequently enter similar arrangements with the Monetary Authority of Singapore (MAS) and Australian Securities and Investments Commission (ASIC).[7] 

 

Going forward, we are keen to continue ongoing constructive engagement with our domestic and international regulatory peers.

 

The Lab Goes Crypto

 

When it comes to substantive areas that LabCFTC has been engaged in helping to inform the Commission the topic of digital or crypto assets has certainly been at the top.  As many of you know, in 2015 the Commission determined that certain virtual currencies, such as Bitcoin, met the definition of “commodity” under the Commodity Exchange Act (CEA).  This means that the CFTC’s jurisdiction is implicated from an oversight perspective if a commodity-based future or swaps product is offered to the market and from an enforcement perspective if there is fraud or manipulation involving such products or their underlying commodity markets.

 

Heading into the Fall of 2017, we thought it would be wise to do a LabCFTC deep-dive into the topic of virtual currencies.  And it’s a good thing we did!  LabCFTC published its first FinTech primer in October 2017.[8]  The goal of the primer was to help educate the public about potential use-cases of the technology, CFTC jurisdictional considerations, and relevant risks, including around investment speculation, cybersecurity, and platform operations.

 

Just a few months later in December 2017 a few of our regulated exchanges self-certified and launched bitcoin futures products.  LabCFTC was well-positioned to provide support to the Commission and operating divisions based on our prior engagement and study of DLT and virtual currencies.

 

At the outset a major focus was on better understanding the mechanics of virtual currencies like Bitcoin, including their consensus and validation mechanisms, as well as their risks and vulnerabilities.[9]  We further explored potential use-cases and how the underlying blockchain technology and DLT-inspired systems could drive efficiencies in a range of market, economic, and regulatory activities.  There was also a period during the ICO boom where we heard visions for a wide range of hypothetical tokens, but much of that has tapered off in the face of certain market realities and regulatory action.

Today the conversation has increasingly shifted to the topics of stable coins, whether backed by fiat currencies or physical assets like gold, and to other virtual currencies like Ether where there may be some market interest in derivatives products.

 

With respect to the former, we frequently remind folks that given the potential to tokenize a broad range of economic assets, it is important to note that a token may be a derivative or commodity, depending on its terms and how it is structured.  A token that calls for future delivery of a gold bar, for example, may be a regulated futures contract.

 

With respect to Ether, earlier this year we received public comment in response to a Request for Input we issued on crypto-asset mechanics and markets.[10]  In the Request, we asked for feedback on a range of questions related to the underlying technology, opportunities, risks, mechanics, use cases, and markets.  The purpose of our request was to benefit the work of LabCFTC and help inform the Commission’s understanding of this and related crypto assets. 

 

Some of the issues I have gleaned from the comments and our broader engagement include distinctions between Bitcoin’s design as a payment network as compared to Ethereum’s focus on facilitating the development and deployment of smart contracts, a potential Ether shift from proof of work to a proof of stake consensus mechanism, and different sizes in the reported market caps of these virtual currencies.

 

One thing, however, is clear from our work in this space: the launch of Bitcoin nearly 10 years ago has many re-thinking the nature of money, how people transact, and how we can more efficiently engage in regulatory, economic, and market activity.[11]  As with other areas of innovation, I suspect we are still in the early stages of where this all may lead and it is difficult to predict the threads or themes that will prevail.        

 

Making Sense of the Buzz

 

I want to conclude my remarks on a related point and with some high-level thoughts on the FinTech buzz words of today – words like blockchain, crypto, smart contracts, big data, cloud, machine learning, and AI.  We are all constantly inundated with all things FinTech, and certainly through our engagement efforts we frequently hear these buzz words.  But, again, is this all just clever marketing and cloaking old concepts in shiny new terminology?  

While some certainly take liberties with these terms, I would suggest that when woven together all of these concepts stand for a fairly straightforward and very real proposition: that we are about to witness the upgrading of our technology infrastructure, or effectively our back-office systems, to accommodate the next generation of computing and networks.  Let’s unpack this a bit.

To begin with, we are all aware that we are increasingly living in a world awash with data.  And now with the Internet of Things and smart sensors the availability of data will only increase.  The trouble, however, is that much of this data is messy or unstructured, which makes it difficult to process, analyze, and use.  Compounding these problems, we may not have the most efficient or rationalized data management systems that contemplate future movement and use of data.

Indeed, today, most back office computing systems – whether at a bank, a utility, or a manufacturer – rely on largely bespoke databases that have been bubbled-gummed and scotch-taped over to work for their current business purpose.  These systems, however, do not agree on standardized data fields or formats, and nor do they communicate well with each other.  So, as noted above, we end up with siloed and messy data, which does not lend itself to the potential of next generation data analytics and machine learning platforms.

With this context, let’s now turn back to making sense of FinTech buzz words.  With respect to blockchain and DLT, at the most basic level, what Satoshi Nakomoto and bitcoin have done is make thinking about back-office ledger and database systems the in-thing to do.  The incredibly helpful byproduct of this development is that people are being forced to think about data standardization and platform interoperability.  If many adopters agree to particular data formats and standards, and use a common DLT-based or inspired system, then the data that is produced and stored will be clean, accessible, and consumable. 

This is where cloud comes into play – it allows for the elastic supply of storage in order to corral all of the data that flows into data management systems.  This data may be, for example, financial, agricultural, market, traffic, weather, or a range of other categories. 

Now let’s consider machine learning and AI tools.  Cloud architecture frequently enables application of substantial computing power to work with data.  This means analytics tools and algorithms can be applied to and process our now clean and standardized data sets to yield high value-add predictions and insights.  The availability of organized and standardized data can greatly enhance the productivity of today’s generation of machine learning tools.

And to round out my discussion of FinTech buzz words, the processing of data also leads to consideration of the topic of smart contracts.  Put simply, I would suggest that the concept of smart contracts – or self-executing code – is really synonymous with automation.  Computer systems are capable of consuming data and automating processes through smart contracts that previously required intermediation – usually of the human kind.       

Stepping back this overall shift to more evolved computer infrastructure should help drive more efficient economic activity whether in the realm of trading, compliance, or complex decision-making.  For example, one could imagine a future state where real-time weather data flows through thousands of interconnected systems, including smart insurance contracts, commodity pricing models, a power grid looking to calibrate anticipated energy demand, and even a digital speed limit on a highway that increases or decreases based on weather and road conditions.

All of this said, however, it is important to note that there will likely be major technological and market barriers to overcome before we see this potential future state.  For starters, recent reports note delays and disillusionment with many current DLT-inspired pilot projects,[12] and much work remains before the realities of machine learning and AI match the promise. 

There will also be many questions to answer: with respect to DLT, for example, how do we solve for the collective action problem in that real benefit is likely only when many market participants adopt a common system and standards?  How do we avoid inadvertently stifling innovation by prematurely dictating those standards?  And, how do we justify the upfront investment cost to upgrade to new systems, especially when the current bespoke systems seem to work well enough?  I expect these are all questions many of you are actively considering. 

Conclusion

Ultimately, my remarks today were intended to be thought-provoking and help stimulate further discussion throughout the remainder of the day.  I hope I have done that.  I do believe that when it comes to FinTech today this time is different, at least with respect to how regulators need to modernize approaches to keep up with a digital world.  A major aspect of that modernization is the need to listen, discuss, debate, and learn from those engaged in new ideas and projects.  And that means many of you in this room.  I do hope that you will engage with us and continue this important conversation.  Thank you. 

 

[1] See CFTC Mission Statement, Commodity Futures Trading Commission http://www.cftc.gov/About/MissionResponsibilities/index.htm (last visited July 16, 2018). 

[2] Many of my introductory remarks here derive from my prior publication: See Daniel Gorfine,  FinTech Innovation: Building a 21st Century Regulator, Georgetown University Law Center Institute for International Economic Law (IIEL), Issue Brief 11/2017 (November 2017), https://www.law.georgetown.edu/iiel/wp-content/uploads/sites/8/2018/01/LabCFTC-Chris-Brummer-Dan-Gorfine-IIEL-Issue-Brief-November-2017-Accessible.pdf; see generally Bruce Tuckman, Derivatives: Understanding Their Usefulness and Their Role in the Financial Crisis, J. of Applied Corp. Fin. Vol 28, No. 1 (Winter 2016).

[3] Much of the following section is derived from “Cryptocurrencies - Oversight of New Assets in the Digital Age: Testimony of Daniel S. Gorfine before the U.S. House Committee on Agriculture” (July 2018), at: https://www.cftc.gov/PressRoom/SpeechesTestimony/opagorfine1;  see also Remarks of Chairman J. Christopher Giancarlo at the 4th Annual DC Blockchain Summit, “The Digital Trinity: Technology, Markets, and Policy,” (Mar. 6, 2019) Commodity Futures Trading Commission, https://www.cftc.gov/PressRoom/SpeechesTestimony/opagiancarlo66.  

[4] Address of J. Christopher Giancarlo to the New York FinTech Innovation Lab, “LabCFTC: Engaging Innovators in Digital Financial Markets,” (May 17, 2017) Commodity Futures Trading Commission,  http://www.cftc.gov/PressRoom/SpeechesTestimony/opagiancarlo-23. 

[5] CFTC Asks Innovators for Competition Ideas to Advance FinTech Solutions, (Apr. 24, 2018) Commodity Futures Trading Commission, https://cftc.gov/PressRoom/PressReleases/7717-18.

[6] US CFTC and UK FCA Sign Arrangement to Collaborate on FinTech Innovation, Commodity Futures Trading Commission, (Feb. 19, 2018)  https://www.cftc.gov/PressRoom/PressReleases/pr7698-18.

[7] US Commodity Futures Trading Commission and Monetary Authority of Singapore Sign Arrangement to Cooperate on FinTech Innovation, Commodity Futures Trading Commission, (Sept. 13, 2018) https://www.cftc.gov/PressRoom/PressReleases/7784-18.  

[8] CFTC’s LabCFTC Releases Primer on Virtual Currencies, Commodity Futures Trading Commission (Oct. 17, 2017), https://www.cftc.gov/PressRoom/PressReleases/7631-17.

[9] See id.

[10] CFTC Seeks Public Comments on Crypto-Asset Mechanics and Markets, Commodity Futures Trading Commission  (Dec. 11, 2018), https://www.cftc.gov/PressRoom/PressReleases/7855-18.

[11] For some of my additional thoughts on the nature cryptocurrencies and how to value them, see Daniel Gorfine, Valuing Cryptocurrencies As . . . Currencies?, Medium (Mar. 26, 2019), https://medium.com/@CFTC_/valuing-cryptocurrencies-as-currencies-c37fa965923e.

[12] Michael del Castillo, Reality Check: ASX Delays DLT Launch Amid User Concerns, Forbes (Sept. 4, 2018).  https://www.forbes.com/sites/michaeldelcastillo/2018/09/04/reality-check-asx-delays-dlt-launch-amid-user-concerns/#6adea5412371