2022 Financial Markets Group Fall Conference–Recap
On November 16, 2022, the Financial Markets Group (FMG) of the Federal Reserve Bank of Chicago hosted its ninth annual Fall Conference. The conference featured a keynote address from Commissioner Kristin N. Johnson and a fireside chat with Commissioner Christy Goldsmith Romero, both of the U.S. Commodity Futures Trading Commission (CFTC). Lamont Black, a professor of finance at DePaul University and former Federal Reserve Board economist, discussed “Decentralization as a Paradigm Shift for Financial Markets,” and Klaus Löber from the European Securities and Markets Authority (ESMA) offered “Reflections on Regulatory Policy.”
This year the three conference panels focused on innovation: 1) in trade execution—crypto trading; 2) in post-trade clearing and settlement and market structure; and 3) in CCP governance. The conference opened and concluded with remarks from Alessandro Cocco, vice president and head of FMG.
Panelists and attendees at the conference included representatives from central counterparties (CCPs), exchanges, investment firms, regulatory authorities, technology firms, clearing members, and proprietary trading firms. This event was held for invited guests who are thought leaders among policymakers, market participants, and academics, with no press in attendance, and under the Chatham House Rule to encourage an open and candid discussion. Of note, the conference took place a week after the collapse of the cryptocurrency exchange FTX, providing a timely opportunity for discussion of the potential spillover risks into traditional finance, existing opportunities and risks in digital assets, and key regulatory tools in place or under consideration to address systemic risks and strengthen consumer protections going forward.
Commissioner Johnson emphasized the remarkable speed and breadth of fintech innovation and discussed how innovation is reshaping traditional finance (TradFi) and market structure in important ways. She stated that the integration of decentralized finance (DeFi), in some contexts, can lead to disruption of markets, particularly if market participants fail to effectively employ the longstanding body of best practices and regulation. She cited the following examples of best practices: setting aside adequate reserves to address liquidity issues or solvency crises, effective internal controls, risk management oversight, appropriate governance of conflict of interests, and use of circuit breakers.
Commissioner Johnson explained that market regulators can and should act now using their existing regulatory authority to ensure adequate customer protections in every market within the ambit of the CFTC’s jurisdiction. The CFTC’s mission, she noted, is to promote the application of the core principles at the center of the CFTC’s statutory and regulatory mandate—transparency and disclosure—without regard to technology or asset class. The spectacular and mounting risk management and governance crises that crypto markets experienced during the third and fourth quarters of 2022 demonstrate the necessity of introducing these values through regulatory interventions as swiftly as may be practicable
Following the failure of MF Global and the discovery that the firm had misappropriated $1.6 billion in customer funds in 2011, Commissioner Johnson said, the CFTC supplemented and tightened regulation that mandates the segregation of customer assets and guardrails around the investment and treatment of customer funds. She argued there is a gap within the existing regulatory structure that leaves customers, particularly crypto-market customers, vulnerable, and it should be addressed. Not all crypto-market participants embrace governance and risk management principles. In fact, operating behind a veil of opacity, some abuse the corporate form, obscuring related party transactions, lending arrangements, reinvestment of customer funds, and the role of affiliates operating as intermediaries, she said.
Commissioner Johnson indicated that she asked the CFTC to investigate these deeply concerning issues. She is encouraging the commission to address the disparate customer protections in intermediated and non-intermediated market structure. Specifically, she noted that lack of statutory protections and regulations that require segregation of customer funds and the treatment of funds in intermediated markets in certain disintermediated markets. Noting the string of bankruptcies at cryptocurrency firms over the course of the summer and fall of 2022, Commissioner Johnson proposed the CFTC consider releasing a request for information or advanced notice of proposed rule-making or hosting a hearing or series of roundtables to gather the information necessary to close this regulatory gap and immediately establish needed customer segregation and treatment of fund protections for customers of crypto firms or other firms in non-intermediated markets operating in a manner similar to FCMs, broker-dealers, CCPs or in other custodial roles.
In addition, Commissioner Johnson stated that she had recently asked Chair Benham if she could serve as an ambassador to marginalized communities, because she wanted to work on implementing investor protections in the context of new technologies, so that citizens from many communities, including marginalized communities, can access new markets and new opportunities while benefiting from appropriate investor protections. She concluded by underscoring that we should not let a good crisis go to waste and emphasizing that it is imperative to introduce effective customer protections in the crypto ecosystem.
The fireside chat with Commissioner Goldsmith Romero focused on the systemic stability implications of crypto trading, including her prior warnings about the risks in crypto, whether the crypto market will reach a size that will impact systemic stability, and how to achieve greater consumer protection in crypto markets. Commissioner Goldsmith Romero stated that she was seeing growing interest from TradFi players in crypto and that their interest had changed significantly from the prior six months. She noted that despite being designed to break from the TradFi system with all of its vulnerabilities, crypto presents many similar financial stability risks as the traditional financial system, and she saw many parallel themes between crypto and the 2008 financial crisis: Crypto has innovative, complex, and opaque products that are not regulated, it has a lot of hidden exposure and risk, it is a highly interconnected market that can produce contagion risk, and there are concerns about the quality of underlying assets that can produce run risk. She also talked about novel risks to crypto, including fraud scams, cybertheft, conflicts of interest, and the lack of segregating customer assets from company assets.
Speaking on whether crypto will impact systemic stability, Commissioner Goldsmith Romero said that crypto remains relatively small and contained from a level of systemic risk that would come with greater scale or interconnections with TradFi. However, because it is unregulated, regulators cannot see all the connections and intermarket risk occurring between crypto and traditional finance. She said financial stability risk will increase and could rise to systemic risk if in the future there are greater interconnections. She added that she is observing a lot of interest by traditional finance players in stablecoins and is concerned about pension funds and retirement funds investing in crypto. She highlighted that credibility for stablecoins would be bolstered if these coins had independent third-party audits and comprehensive disclosures, which is what she has proposed. She said she takes a “same risk, same regulatory outcome” approach, and is not in favor of bespoke treatment that could increase financial stability risks. She said crypto companies set up in an unregulated environment need to change to look more like a regulated entity. Crypto companies coming within U.S. markets should expect the full application of the CFTC’s existing regulatory framework, which has stood the test of time and has reduced financial stability risks.
Turning to consumer protection in crypto markets, Commissioner Goldsmith Romero emphasized that for consumer protection, the most important thing is that crypto companies must segregate customer assets from company assets and provide customers with bankruptcy protections. She added that conflicts of interest in crypto firms must be resolved. She said that crypto companies or their affiliates are serving multiple roles, such as the lender, broker, exchange, custodian, and CCP. She said there is contagion risk, so when these firms collapse, they pull down their affiliates with them. She also proposed a breakdown of the CFTC’s definition of retail customers, which constitutes a broad range. She proposed breaking the definition of retail into two categories of household retail customers and high-net-worth/professionals and then tailoring the customer protection regime to each category. Customer protections for household retail could include plain English disclosures, limits on leverage, and suitability determinations. She expressed concern about the loss of suitability determinations in a disintermediated model.
The chat ended with a discussion on representation in the financial sector, where Commissioner Goldsmith Romero discussed her career journey as an LGBTQ woman. She remarked that despite coming out at work in 2009 during her time at the Treasury Department and feeling that a burden had lifted off her shoulder, the thought that crossed her mind was that she was being successful despite her identity. She added that today, her identity is a celebrated part of her success, but it took years for the federal government to get to this point. When asked for suggestions on how others can be allies to the LGBTQ community, Commissioner Goldsmith Romero advised that people should not be worried about being perfect in saying the right thing, they should treat people like people, and that people should actively work against stigmas.
The first presentation focused on the differences between centralized finance (CeFi) and decentralized finance. Centralization was described as a hub and spoke model, whereas decentralization was described as a network without a hub. Lamont Black argued that while decentralization was the issue during the 2008 financial crises, the centralized world created post financial crisis has had its own set of risks and inefficiencies. He discussed decentralization on the blockchain as a way forward for financial markets, which would result in code replacing some financial intermediaries and enabling more transparency and efficiency in financial markets.
The second presentation focused on the rapid change in existing market infrastructure and its regulatory implications. Klaus Löber highlighted the emergence of new players, such as unregulated actors, fintech firms, and big tech firms, with different motivations and focus. He also noted two high-level trends in the emergence of new products and services, including decentralization and the bundling of financial services. With such rapid change, he said, regulatory policy needs to evolve. Specifically, Löber stressed the need for the regulatory and oversight frameworks to adapt to the evolving landscape, for public authorities to obtain relevant knowledge to fully understand and assess new technologies, and for more cooperation and coordination of central banks and regulatory authorities.
Panel 1: Innovation in trade execution: Crypto trading
The first panel discussion among five panelists discussed the recent collapse of the crypto platform FTX, 24/7 trading in crypto markets, and investor protection issues.
The conversation began with reflections on the collapse of FTX. A panelist stated that as an active fund manager, they are witnessing client redemptions from funds citing losses in FTX and other crypto firms. The same panelist noted that other active managers were not affected by FTX’s collapse. Another panelist stated that the FTX collapse followed a formula that is ubiquitous among firms that fail across crypto and traditional finance: a tightly controlled organization that is opaque, mishandles liquidity and risk management, and has little oversight by the firm’s board of directors. The same panelist noted that blockchain technology, with its decentralization, transparency, visibility, and democratic governance, provides a new opportunity to solve old problems. This panelist also added that blockchain technology must improve its user interface and deal with anti-money laundering (AML) and know your customer (KYC) issues before becoming a useful solution.
Turning to crypto markets more broadly, a panelist noted that crypto markets operate 24/7, and current traditional finance operations are not designed to support any market 24/7. This panelist added that to support crypto markets, either operations in traditional finance need to be fixed or market participants need to re-think the ecosystem of accessing the market. Another panelist echoed this sentiment by relaying that their firm is looking to move to 24/7 trading in their designated contract market (DCM) to have a critical match with the underlying 24/7 spot exchange. However, they face difficulties with this transition due to a lack of service providers and partners that can meet operational demands, such as 24/7 banking and clearing. A different panelist added that innovation must occur on the settlement side in traditional finance to allow banks and investment managers to settle faster. This panelist said that the counterparties they work with are operating on traditional settlement timelines and do not possess the technical capability to settle faster despite their desire to do so.
Later, the conversation shifted to investor protection issues in crypto markets. One panelist listed exchange controls, segregation of customer assets, and transparency as necessary investor protections, while another panelist added the need for disclosures tailored to retail customers that accurately describe the risks in crypto markets. A different panelist echoed the importance of disclosures but added that disclosures are not enough, as some crypto protocols are difficult to understand even for the most savvy customers. This panelist also stated that “code is law” is not a sufficient argument for investor protection and overlays are needed on top via laws and regulations. One panelist stated that a lack of adequate disclosures and investor education is a big issue especially regarding stablecoins. This panelist provided the Terra/Luna debacle as an example where, according to this panelist, the algorithmic stablecoin protocol worked as designed, but investors failed to understand the difference between an algorithmic stablecoin and a fiat-backed stablecoin.
Panel 2: Innovation in post-trade clearing and settlement and market structure implications
This discussion began with comments by panelists on the bankruptcy filing by FTX Trading Ltd. and related entities. Panelists agreed, based on publicly available information, that the FTX bankruptcy appears to have been the result of fraud. Panelists also shared their perspectives on striking the right balance between innovation and the need for effective regulation of nascent models of clearing and settlement.
Panelists also discussed the adoption of new technologies and the implications of those changes, as well as changing business practices, regulation, and other factors in reshaping traditional post-trade market infrastructure and in emerging DeFi markets. In particular, panelists noted the difficulty of transferring assets—even those that are already in digital form—a problem that was attributed to market structure frictions, undeveloped or incompatible technology platforms, and legal and regulatory issues.
This was followed by a discussion of the ability of crypto markets to transfer digital assets immediately anywhere in the world and achieve “atomic settlement” (meaning that in the exchange of one asset versus another, the transfer of the first asset occurs instantly and simultaneously with the transfer of the other asset) using smart contracts and other novel technologies. One panelist expanded the focus to the application of these technologies in TradFi, noting they could significantly shorten settlement timing and enable alternative margining frameworks.
Panelists also discussed whether market participants are trying to use new technologies to solve a problem of behavior, noting that market participants are often resistant to adopting new operational and risk management processes. They also shared their perspectives on the cost of implementing new technologies and the problem of finding a common timeframe for transition.
The discussion focused, in part, on the problem of moving from the existing reliance on various “batch” (aggregated/periodic) operations to a “real-time” or near real-time environment for data and risk management operations. Panelists noted that it would take some time to replace legacy systems with distributed ledger technology (DLTs) and other new technologies. There was some disagreement among panelists regarding the capacity of DLT and other new technologies to support traditional market activity. Panelists agreed that it is important to ensure that any new technology is resilient and secure.
Panel 3: Innovation in CCP governance
The conference concluded with a panel conversation focused on progress in central clearing counterparty (CCP) governance. The topic was last discussed at our Fall Conference in 2019, and since then CFTC and SEC have issued proposed rules on CCP governance.
CCPs reduce counterparty risk by becoming the buyer to every seller and the seller to every buyer and applying prudent risk management principles to the transactions they clear. The key question discussed by this panel was who drives risk management at the CCP, and in whose interest the stakeholders are acting: the interest of the stability of the financial markets, of the CCP, of the clearing members, or of the end users? A panelist stated that there has been demonstratable progress on CCP governance, starting with the recommendations of the CFTC Market Risk Advisory Committee’s subcommittee on CCP Risk and Governance in February 2021. This panelist added that other areas of governance still need to be addressed, including determining whether public quantitative disclosures (PQDs) achieve their intended purpose and making progress on concerns around margin procyclicality. Another panelist noted that CCP governance has seen good progress in terms of disclosures. This panelist added that end users would like to see all principles for financial market infrastructure (PFMI) disclosures and PQDs in machine-readable format to easily scrape for data that can be entered into models to conduct internal risk analysis.
On the topic of the newly proposed CCP governance regulations by the CFTC and SEC, a panelist highlighted that, under the current CFTC proposal, two primary categories of risk bodies would be required. The first would be a risk management committee, and the second would be risk working groups. The panelist added that the purpose of risk working groups is to provide CCPs with a broader range of expertise and to provide market participants with more opportunities to express their views on risk matters affecting the CCP. Regarding the SEC proposal, this panelist underscored the significant subject matter and time frame overlap between the two regulatory proposals while calling attention to some differences between the two. Later in the panel, a different panelist stated that the SEC proposal contains specific language that would make the risk committee a subcommittee of the CCP board, which has a fiduciary duty toward the CCP. As a result, risk committee members in the SEC proposal would be subject to a fiduciary duty and care obligation.
To conclude, the panel discussed challenges in staffing risk committees, such as CCP clearing members and end users having a limited number of trading experts that can serve on risk committees, and how more frequent rotations could be a solution. One panelist emphasized the major investment of time that is required to be a useful member of a risk committee and warned of the potential loss of expertise if committee members’ terms are too short. Another panelist responded that there is a difficult balance to strike due to the desire for continuity on risk committees by having members who have gone through past proposed changes to the CCP’s risk management policies, yet some level of rotation should be included. Another panelist echoed the desire for having continuity and expertise on risk committees, while acknowledging the necessity of fresh ideas and perspectives. Thus, this panelist charted a middle ground by stating a rotational process for risk committees is required, but not all committee participants should roll off simultaneously.
The conference was then adjourned to the fall of 2023. Key takeaways from the conference are:
- The importance of tried and tested customer protection tools, such as segregation of house and client collateral, adequate disclosures, transparency, financial resources, and risk management standards.
- The tradeoffs of decentralization on the blockchain as a potential way forward for financial markets to enable more transparency and efficiency.
- The challenges and opportunities posed by new ways to connect customers directly to CCPs.
- The risk management implications of transitioning from “batch” (aggregated/periodic) operations to a “real-time” or near real-time environment for data and risk management operations.
- The challenges and opportunities of ensuring that CCP risk management reflects the input of CCPs, as well as clearing members and customers, so that CCPs can perform their function of increasing the stability of the financial markets.