Editor’s Note: We need to develop new policy approaches to keep pace with fast-moving blockchain technology. So what should a 21st century regulator look like? Chairman of the U.S. Commodity Futures Trading Commission (CFTC), Christopher Giancarlo (more about him below) shared the following remarks on how the CFTC has been evolving and crafting a modern regulatory approach at the inaugural a16z Crypto Regulatory Summit — which brought together leading crypto experts and builders, other technologists, academics, industry executives, and government officials along with forward-thinking regulators to foster collaboration and the exchange of ideas. What are the “formula” or four key elements/ mindsets involved, how might they inform regulators, and what should entrepreneurs do as a result?
I’d like to talk to you about the tension between the current FinTech revolution and our existing financial regulatory structure.
As you know, the digitization of information that took place in the last decades of the 20th century occurred in a regulatory “light” zone of the US Constitution’s protection of speech. Conversely, the current, early 21st century digitization of finance is taking place in a regulatory “heavy” zone of the long-established authority of U.S. state and federal governments to protect consumers of financial services.
As a result, the practices that guided the digitization of information (and that you are all familiar with, such as “don’t ask permission, ask forgiveness”) will not work, as we have seen with initial coin offerings.
Yet, regulation and regulators need to adapt and not be an impenetrable barrier to the current wave of fintech innovation.
Today, I want to explain the four-part model for regulatory adaptation to fintech innovation that we have successfully deployed at the U.S. Commodity Futures Trading Commission.
But first, some personal background. I spent a decade and a half practicing law in New York and in London in the 80s and 90s. And in 2001, I teamed up with a group of entrepreneurs, and we built the world’s first hybrid electronic trading platform for over-the-counter derivatives. We raised three rounds of private equity. We built trading platforms in 18 financial centers around the world. And in 2005, we took our company public and had one of the most successful IPOs and follow-on offerings of that period of time. And we were doing fintech before anybody had even an idea what fintech was, very successfully, I might add.
In 2008, we had emerged into the world’s largest trading platform for a type of a derivative traded over the counter called, “credit default swaps”. You may have heard of them – played a role in the financial crisis. And I want to tell you a story about that, that tells you about a little bit of the junction of markets, regulation and technology.
In September of 2008, on a Wednesday afternoon, three days before Lehman Brothers failed, I got a call from a senior official of the New York Federal Reserve. And he said to me, “We’ve met before, right?” And I said, “Yeah.” And he said, “Remind me what you guys do again.” And I said, “We’re the world’s largest platform for trading credit default swaps.” And he said, “Right, that’s what I thought you did.” And he said, “Now, what are you seeing in the markets?” And I said, “It’s pandemonium. It’s absolute crisis conditions in the markets.” And he said, “Well, what does that mean? Does it mean things aren’t trading?” And I said, “No. What it means is, the price of getting protection against the default of one major Wall Street bank against another major Wall Street bank is going through the roof. Credit default swaps are priced as a spread to the expected survivability of Treasury securities. And the spreads we’re now running in hundreds of basis points above.”
Which meant that the marketplace perceived that the likelihood of failure, of not just Lehman Brothers, but JP Morgan, and Goldman Sachs, and Morgan Stanley, was also very great. So we knew, the marketplace knew of the crisis. But the major regulator, the New York Federal Reserve, was calling around to platforms like us, asking, “What do you guys do, again? And what is the market telling us about what’s happening?”
I explained to him what’s happening and he said to me: “That is really interesting. I’d really like to understand that a lot better. Do you have time to come around the Federal Reserve and talk to us about this?” And I said, “Oh, gosh, it is such a crazy day.” I said, “But maybe by 8:00 or 9:00 tonight, I’ll get off the floor and come over and visit with you.” He says, “Oh, no, no, I’m way too busy.” He says, “I don’t have time. Look in your calendar. Maybe sometime in October, we can get together.” And I said, “Boy, in October, I may have plenty of time to sit down with you and talk about this because it may all be over.”
Two realizations in that experience. One is, that there needed to be a regulatory intervention in this unregulated over-the-counter market. It just was not acceptable that in a crisis, regulators had to make phone calls around to understand what was going on in the market. But two, there needed to be a data and technology intervention in this market. It was perceived at the time, in September of 2008, the amount of credit default swaps protection written against Lehman Brothers was $400 billion, or thereabouts. But they didn’t know for sure. And if you multiply that across every Wall Street bank, you will get an idea of what would happen if any bank failed, with that much exposure.
What we now know, that if you took all of that exposure on Lehman Brothers, that $400 billion and netted it down, longs against shorts, collateralization, the total exposure would have been less than $9 billion, if Lehman Brothers failed. If we knew in 2008, that the failure of Lehman Brothers was a $9 billion exposure, the regulatory response could have been entirely different.
Now, that would have been a decision for the officials then. But certainly, $9 billion is a number the federal government could have guaranteed, and we could have a very different financial situation. The lack of visibility into counterparty credit exposure was at the root of the crisis. Why is that relevant? Because if all of that exposure had been on a blockchain, we would have known in real time, immediately, that it wasn’t $400 billion, that it was $9 billion. So, a tremendous amount of technology and market intelligence needs to come into the regulatory scheme. And it turns the conversation on its head. Just listening to Mark, interestingly, he was talking about why does the United States need to make sure innovation happens here? I take that even further and say, we, regulators, need fintech innovation to happen here and be available to us to change the dynamic.
I became an advocate for the core reforms that made its way into Title VII of Dodd Frank, which are the reforms of the swaps market. And in 2013, I was honored by President Obama to serve on the U.S. Commodity Futures Trading Commission. In 2017, President Trump named me as Chairman of the agency. And what I’ve observed over the last five years, is this phase of innovation that we’re in, this phase of fintech innovation is unlike ones that came before, because when the innovation came into the information space [in the late 20th century], it came into a regulatory light-touch environment because of our First Amendment, because information, and opinion, and speech is largely unregulated. But this level of innovation is entirely different. This round of innovation is coming smack dab into a brick wall of a heavily regulated space — financial services.
As my colleague, Dan Gorfine says, “Whenever you’re talking about people’s money, you’re talking about regulation.” Every Congressman and Congresswoman and every Senator has a concern about the sanctity of the money and savings of their constituents. And this is a new phase of “innovation meets regulation” — and a very different one than before.
Let me tell you a number of reasons why:
- Number one, the exponential rate of change, the exponential rate of innovation, the exponential rate of adoption, is totally alien to a political and regulatory system that was built and purposely designed to be impervious to change. Our founders didn’t trust political power and they built a system that is very difficult to change. Our system is intended to change very, very slowly.
- Secondly, our system of regulation is one that is favorable to intermediation. If you think about the way regulators approach an ecosystem to regulate it, they look at the ecosystem and they say, “Okay, who are the intermediaries? Let’s register them. Let’s authorize them. Let’s confirm them. And let’s give them authority in the space.” Whether they be banks, exchanges, clearing houses. They’re all authorized, they have responsibilities. Regulators seek to intermediate spaces, whereas innovators seek to disintermediate and decentralize systems. So, this is another large conflict.
- Another difference is, these new fintech protocols are brand new, whereas regulatory protocols go back to the 1930s. The securities laws were written in the 1930s, our Commodity Exchange Act was written in the 1930s. So, you have a lot of inherent conflict between innovation and financial regulation.
So, what have we tried to do with the CFTC to change some of that dynamic? We try to do four things at the CFTC and we like to think that they’re perhaps a model for what other regulators in Washington and abroad can be doing.
First, we’ve sought to adopt an exponential growth mindset. That is a mindset throughout our agency, expecting that the rate of innovation and the rate of market adoption of new technologies will be in line with Moore’s Law, that is grown exponentially faster all the time. And we’ve tried to adopt that same mindset in how we go about things. Now, part of that is in the CFTC’s DNA as an agency because we’re a principles-based, not a rules-based regulator. But we’ve tried to take that even further. So I’m very proud to say that several of my CFTC staff colleagues are with us today and one of my fellow Commissioners, Rostin Behnam.
We’re here. Why? Because if you’re going to have an exponential setup mindset, you’ve got to be learning. You’ve got to be with innovators. You’ve got to be understanding what’s going on. As an agency, we try to flood the zone of learning, of understanding. We can only regulate effectively, if we understand and anticipate the potential disruption to our regulatory framework.
Next, we’ve built an internal stakeholder at the CFTC to represent innovation within our agency, and it’s called Lab CFTC. Daniel Gorfine is head of Lab CFTC. It’s not a sandbox, as Mr. Osborne described, it’s a laboratory, because we’re a principles-based regulator, because we have certain tools like “no action relief.” We don’t believe we need a sandbox and say, “That company, no, not you, that company over there, you can go into our sandbox and innovate.” We don’t pick winners and losers. That’s not our approach. Our approach is, how do we look at our rule set on a principles basis and apply it across the board, to perhaps all innovation, without having to pick winners and losers? And I don’t mean to take anything away from the British approach. I think it’s been very formative, but we have a different approach.
Lab CFTC has done over 250 separate interactions with innovators, not just in Washington. In fact, we launched Lab CFTC on the floor of the New York Stock Exchange, not in Washington, D.C. It was a bipartisan effort. It was formed by myself and a former Democrat Commissioner, with full support across the aisle. So, there’s nothing partisan about it. It is entered into collaboration agreements with the UK FCA, with the Singapore MAS, with the Australian regulator. And it really has become a model, I think, for this type of approach that other U.S. regulators are taking. And also, it’s our internal disruptor. We need to be set back on our heels internally from time to time, to open ourselves to new innovation, and that’s the job of Lab CFTC.
Okay, so an exponential growth mindset, an internal stakeholder. Third, we have a quantitative growth mindset. We want to be a quantitative regulator, which I have described at length elsewhere.
And fourth, and I’ll end with this is (because I am out of time), we’re very focused on looking at markets to guide us as to where do we go forward. We’re a believer in markets. We believe that as regulators, we don’t want to make moral judgments on the value of innovation. We want to use market forces to do that. And when we were approached with Bitcoin futures two years ago, we received some resistance, both in Washington and around the globe, that we were going to allow this new innovation. But we really believed that the presence of Bitcoin futures would do its part to bring the value of Bitcoin into a real market basis.
And what I’ll end with is, we had watched Bitcoin break away from its fundamentals, in terms of its cost to production, and a bubble emerged. And it was the launch of Bitcoin futures on December 17th of 2017, that did more than anything else to bring Bitcoin back into its fundamentals. And we think that’s healthy in the long run. The worst thing you want is regulation written in a crisis or upon the popping of a bubble.
So, I’m out of time. It’s been a pleasure to be here with you today. Thank you.
J. Christopher “Chris” Giancarlo was unanimously confirmed as Chairman of the U.S. Commodity Futures Trading Commission by the U.S. Senate on August 3, 2017. Prior to becoming Chairman, Mr. Giancarlo had served as a CFTC Commissioner since his swearing in on June 16, 2014, after a unanimous consent by the U.S. Senate on June 3, 2014. He was nominated by President Obama on August 1, 2013. Before entering public service, Mr. Giancarlo served as the Executive Vice President of GFI Group Inc., a financial services firm. Prior to joining GFI, Mr. Giancarlo was Executive Vice President and U.S. Legal Counsel of Fenics Software and was a corporate partner in the New York law firm of Brown Raysman Millstein Felder & Steiner. Mr. Giancarlo attended Skidmore College in Saratoga Springs, New York where he graduated Phi Beta Kappa with Government Department Honors. Mr. Giancarlo received his law degree from the Vanderbilt University School of Law.