The Commodity Futures Trading Commission (“CFTC”) held a public meeting of the Technology Advisory Committee (“TAC”) on March 27, 2019. The TAC is sponsored by CFTC Commissioner Brian Quintenz and Daniel Gorfine, Director of LabCFTC, is the Designated Federal Officer. The TAC, comprised of industry business, technology, and legal minds, meets periodically to discuss pressing technology-related issues affecting the commodity and derivative markets and regulation.
This meeting of the TAC consisted of four panels focusing on the following core areas: Automated Trading, Cryptocurrency, Cybersecurity, and Blockchain Technology.
Automated Trading has been a topic of concern for the CFTC for several years given a number of mini-crashes arguably caused by automated trading. As a result, the CFTC has proposed a concept release on Risk Controls and System Safeguards for Automated Trading Environments in 2013, then Regulation Automated Trading (“Reg AT”) in 2015, along with a supplemental proposal in 2016, only be tabled with the change of administration. Since then, many in the industry have anticipated a new approach to regulation of automated trading and the CFTC has continued its analytical work on automated trading.
Presenters of this panel noted the percentage of automated orders increased in the futures markets over the last several years. Additionally such orders were almost exclusively limit orders and were much smaller compared to non-automated orders. Presenters also pointed to a maintenance in perceived stability in pricing within the automated trading market, accentuating the point that automated trading provides liquidity to the marketplace and does not lead to market volatility.
The CFTC’s view of cryptocurrency has become clearer over the past several years, thanks in part to several key enforcement actions against market participants and particularly the court decisions in 2018. In short, the CFTC has successfully confirmed its general jurisdiction over fraud and manipulation in the spot cryptocurrency markets, along with its exclusive jurisdiction over the crypto-futures and swaps market. As of 2019, it has been established that all cryptocurrencies are commodities and therefore subject to CFTC’s jurisdiction. Accordingly, the CFTC has set out to keep its finger on the pulse of cryptocurrency technology and market developments.
This panel provided an overview of the differing consensus mechanisms underpinning various cryptocurrencies, including proof-of-work (“PoW”) and proof-of-stake (“PoS”). By first teaching the TAC about the purpose of blockchain technology, how cryptocurrency “mining” works, the hardware that supports such activity, the potential for market manipulation (such as “51% attacks”) and the software updates that sometimes create offshoots of existing cryptocurrencies (also known as “forks”), the panelists were then able to explain how current developments in the cryptocurrency market could affect institutional investors. Specifically, the panelists asserted three implications for institutional investors. First, the PoS vs. PoW question is generally not relevant for traders and funds. Institutional investors should have documented procedures for how risk around which consensus mechanism wins out will be mitigated. Second, 51% attacks are not a major risk for well-capitalized cryptocurrencies. Such attacks are a major risk for poorly capitalized cryptocurrencies that share a common mining algorithm with larger cryptocurrencies. Therefore, institutional investors should be wary of such poorly capitalized cryptocurrencies. Third, institutional investors should have well documented procedures for how they will determine how to approach a fork in a cryptocurrency in which they are invested. Institutional investors will need to determine of the forked cryptocurrencies they will honor and what to do with any windfalls from the other forked cryptocurrency.
The panel also discussed the recently published ABA Derivatives and Futures Law Committee White Paper (Digital and Digitized Assets: Federal and State Jurisdictional Issues – March 2019). According to the panelists, a main issue in the marketplace is the regulatory uncertainty surrounding when a coin may be an “investment contract” and therefore a “security” (over which the Securities Exchange Commission or “SEC” has authority) or “commodity” (over which the CFTC has authority), or when a coin converts from an investment contract to a commodity. This, the panel opined, leads to issues in capital raising, evidenced by a chilling effect due to this lack of clarity. The lack of regulatory clarity also leads to jurisdictional issues regarding regulatory authority over fraud and manipulation enforcement.
According to the panel, there are tools available to the SEC and CFTC to work together without legislation. Those tools include the Dodd-Frank Act Section 718 provisions establishing a framework for the two agencies to resolve and provide clarity around novel derivative products, each agency’s exemptive authority, established formal ongoing inter-agency process for resolving jurisdictional issues, and publication of guidance that the public may rely upon. SEC-CFTC coordination would also be useful in considering issues of common interest relating to uses of blockchain technology in the financial markets, such as custody of digital assets.
The panel on Cybersecurity discussed the dire need for training and employment in the area of financial institution cybersecurity. According to a poll conducted by panel members, Chief Information Security Officers were spending as much as 40% of their time conducting compliance related activity as part of their overall daily portfolio. The panel estimated that the industry is facing a shortage of 3,000,000 cyber security professionals. In an effort to facilitate sound cybersecurity governance in the financial industry, one set of panelists engaged in an effort to achieve sector-wide scaling of cybersecurity programs by impact, creating certain risk profiles for varying types of market entities.
The panel also discussed best practices for financial entities moving their data into the cloud. Specifically, cloud technology adoption should be executed using a thoughtful and deliberate approach. The panel noted that a fast, go-to-market approach is not best practice when moving into shared-responsibilities environment, especially with regulated apps and data. Strong foundations for a new cloud-based system include data protection and encryption, service and application segmentation, intrusion detection and prevention capabilities, security information and event management, and vulnerability management, with strong governance over controls, data, and vendor management.
The final panel discussed the current state of blockchain technology implementation in the institutional financial sector, where it is possibly heading, and some recent innovation by the International Swaps and Derivatives Association (“ISDA”) to facilitate blockchain-enabled derivatives transactions.
The panel noted that the industry has moved beyond the world of proof-of-concepts and experimentation, as blockchain technology is now being used in real-world transactions and money movement. In trying to determine where the technology will be deployed next, one panelist instructed the TAC to look at the areas where processes are most antiquated, some examples of which are trade finance and insurance. According to the panelist, entities in these spaces still “play by rules” of time-consuming processes involve multiple parties in multiple locations. The panel noted its efforts to help large financial institutions deploy blockchain in-house. In looking ahead, the panel pinned 2019 as the year the industry will begin to see deployment of blockchain technology to the marketplace. Further, in 2020-2021, the industry will see deployment at scale. Importantly, other types of important and influential technologies such big data, machine learning, and artificial intelligence will begin to converge with blockchain, creating beneficial and innovative synthesis both in-house and in the marketplace.
The panel discussed a proposal by ISDA to update the Common Domain Model (“CDM”). CDM is a machine-readable and machine-executable data model for derivatives products, processes and calculations. The objective of ISDA CDM is to standardize how derivatives are traded and managed through their lifecycle, which should reduce costs associated with current manual processes, especially in the areas of:
- trade affirmation and trade management;
- collateral management;
- regulatory reporting;
- exercises and settlements;
- portfolio compression; and
- novation and transfers.
ISDA CDM is provided in several languages to aid deployment on many new and existing technology platforms, which the panel noted will help implement all of the blockchain lifecycle innovations to execute derivatives. According to the panel, CDM is now open source and made available to anyone who wishes to download it. The panel hopes that the CDM will enhance interoperability and straight through processing, deliver better regulatory oversight, and creates an environment for innovation in financial markets.
On the Lookout
The CFTC should be commended for its efforts to run and maintain the TAC. The TAC provides a thoughtful and effective means of tracking technological innovation in the marketplace. It also provides a forum for business, technology, and legal minds to meet, learn, and discuss ways in which the CFTC could provide effective regulatory oversight and supervision while ensuring innovation is not unnecessarily stifled.
The developments discussed during this TAC meeting provide valuable insight into both the technological innovations afoot and the CFTC’s willingness to be a participant and facilitate such innovation.