How the CFTC can take a pro-innovation posture while maintaining orderly markets
A CFTC Commissioner responds to Coin Center’s thinking on publishing code and regulation
This past fall, I made a speech in Dubai to highlight what I believe will be a fundamental challenge for financial regulators in the coming years: how do regulators apply or modernize regulatory frameworks in the face of emerging technologies, especially where the functions performed by registered market intermediaries and exchanges may be increasingly performed by computer code or protocols.
My speech was designed to ask questions, offer preliminary thoughts, and start a larger conversation about these complex policy issues. Regulators and innovators will have to grapple with these challenges together. I very much appreciate Coin Center’s thoughtful analysis of my supportive approach to innovation generally, as well as my speech specifically, and I am grateful for the opportunity to build upon that conversation here.
At the outset, I would like to say that the views I express on this topic are my own and do not represent the views of the Commodity Futures Trading Commission (CFTC), where I am fortunate enough to serve as a Commissioner. The CFTC is responsible for regulating the derivatives markets in the United States, including derivatives on commodity crypto-assets.
A Pro-Innovation Posture
The CFTC has developed a robust, pro-innovation, do-no-harm posture that engages with innovators to understand how evolving technologies fit within our current regulatory structure. In instances where an innovation may achieve the desired outcome of a regulation, but not fit within the letter of the rule, the CFTC is open to considering whether rule revisions or regulatory relief may be appropriate. Through engagement with innovators, entrepreneurs and disruptors, the CFTC can best determine whether exemptions from the immediate application and full weight of regulatory responsibilities would better allow, or at least not preclude, a limited demonstration of an innovation’s potential. I strongly believe that the government should not create existential regulatory economies of scale or costs of regulatory compliance so large as to insulate existing market participants. Rather, we should promote free and full competition from new entrants that maximizes the marketplace’s efficient allocation of capital. Therefore, I am supportive of the CFTC’s willingness to simplify, and in many cases rationalize, its rules, or provide limited exemptions from them, to promote or at least not inhibit the innovation potential of a truly competitive market.
The Promise of Smart Contract Protocols and Disintermediated Markets
The CFTC has a responsibility to ensure that broad-based activity which falls within the definitions and requirements of its existing rules is approached consistently, regardless of the underlying technology, form, platform, or code. Given that mandate, it is important to consider how, or if, our existing supervisory framework is implicated by certain innovations, including the blockchain, related smart contracts, and trading software more generally.
But first, some background into smart contracts and their tremendous potential. Certain blockchain networks, like Ethereum, allow smart contracts to be integrated into the chain. A smart contract is a computer code containing all terms of the contract and is self-enforcing – meaning the software can execute the terms of the contract without additional input from the parties.1 Once the smart contract is formed on the blockchain network, it operates without further intervention. Some software developers have written code that allows users to create various types of smart contracts that can then be deployed on the blockchain. Once users download these applications, they can find others using that same protocol willing to transact.
Smart contracts are easily customizable and can be used in a wide variety of exciting applications or to disrupt currently inefficient processes. For example, smart contracts can be used to facilitate the sharing economy by enabling users to rent houses, cars, and other property. They can be used to streamline business operations by, for example, tracking product movement along the supply chain. They can also be used to streamline certain corporate actions, for example, by automating the payment of dividends to shareholders. Many of the potential applications of smart contracts do not fall within the CFTC’s jurisdiction and have the potential to create substantial efficiencies and savings for businesses and users.
However, certain smart contacts more closely resemble traditional financial products or services within the CFTC’s jurisdiction, and it is upon this narrower ambit of activity that I would like to focus. One area I would like to explore today is how the CFTC can ensure it is holding the appropriate parties responsible for software code or computer programs used to violate CFTC regulations – for example, trading programs designed and executed to manipulate the price of a particular futures contract. In all cases, the CFTC should work to ensure its regulations are applied fairly to similar activity across existing and new marketplaces while working to establish clear lines of accountability that do not depress innovation.
Smart Contracts and Software Programs Facilitating Unlawful Activity
Advancements in technology, from trading software to information dissemination to market connectivity, have revolutionized the electronic trading environment on registered exchanges, and promise to continue to do so. Similarly, there is a broad spectrum of activity by developers, programmers, miners, and users on the blockchain that are revolutionizing efficiencies and markets. In both the existing markets and the newer blockchain ecosystem, some of these technological innovations, protocols, or computer code may be used to facilitate unlawful activity, leaving regulators with the duty to hold the appropriate people accountable for that unlawful conduct. While much of the assignment of liability depends on the facts and circumstances, I would like to further explain some of my own thoughts.
Looking at the spectrum of activity, on one side there is the publication of code alone. Absent proof that developers intended that the code facilitate conduct that is illegal, the CFTC should not bring a case against them. On the opposite side of the spectrum, there are instances where developers knowingly design code that can be used for unlawful purposes, and intend that the code be used for such purposes. For example, take the case of a software developer who, at a broker’s request, personally develops custom trading software that the developer knows can be used to “front run” or “trade ahead” of the broker’s clients, and intends for the code to be used by the broker for that purpose. In that situation, the CFTC could pursue a case against the developer under an aiding and abetting theory.
I expect most activity will likely fall somewhere in the middle of the spectrum. Focusing the conversation on this gray area will yield the greatest benefit for both innovators and regulators.
The key determination in every matter concerns the developers’ intent. Questions that should be considered include whether the developers: 1) made modifications to the code that enhanced the unlawful activity; 2) promoted the unlawful activity through a website or marketing materials; or 3) had a financial stake in the unlawful activity. Another factor to consider is whether the code is narrowly designed to enable an unlawful purpose rather than broadly designed for legal activities. The more a code is narrowly tailored to achieve a particular end, the more it appears as if it was intentionally designed to achieve that end. Take for example, a computer code that is specifically programmed only to trade heavily on one side of the market during a future’s contract settlement period to purposefully distort the final settlement price either higher or lower, otherwise known as “banging the close.” If developers were aware that traders would use the program in this manner, the developers’ conduct begins to look a lot like classic aiding and abetting.
Let me be clear. I do not view any of these factors as being independent, dispositive tests for liability. Nor do I view the list above to be exhaustive. But, when taken as a whole, these factors will help provide regulators with insight into an individual’s responsibility for a software code’s unlawful use. I am hopeful that this more holistic and detailed explanation of potential liability eases the minds of the vast majority of developers designing code for broad purposes intended to be put to legal uses.
Due to the nascency of this space, more work remains to be done to establish regulatory clarity. To-date, the agency and I have benefited immensely from the current engagement with market participants and innovators, from LabCFTC’s numerous interactions with the technologists and disruptors to the CFTC’s Technology Advisory Committee (which I am proud to sponsor) and its public meetings where novel issues involving blockchain and distributed tokenization are presented for debate.2 We also have a number of tools available – no-action relief, exemptions, and ultimately, rule amendments – that can be used to give embryonic innovations a chance to flourish while the agency modifies an existing, or builds a new, regulatory framework. But I also expect, like many areas at the confluence of technological advancements and complex policy issues, legal standards and norms in this space will be developed incrementally based upon a facts and circumstances analysis that evolves with the innovation and disruption.
In Dubai, I expressed my strong interest in hearing feedback from innovators, technologists, disruptors, and others within the blockchain community. I reiterate that interest today and look forward to being part of that ongoing conversation, while always remaining open to learning and hearing other points of view. My hope is that, through good faith engagement, both regulators and innovators can educate one another, with the end result being a regulatory regime that supports innovation, protects customers, and promotes the integrity of our financial system.
1. Nick Szabo first defined the term “smart contract” in 1994. He described a smart contract as, “[A] computerized transaction protocol that executes the terms of a contract. The general objectives ...are to satisfy common contractual conditions (such as payment terms, liens, confidentiality, and even enforcement), minimize exceptions both malicious and accidental, and minimize the need for trusted intermediaries. Related economic goals include lowering fraud loss, arbitration and enforcement costs, and other transaction costs.” Ryan Surujnath, Off The Chain! A Guide to Blockchain Derivatives Markets and the Implications on Systemic Risk, 22 Fordham J. Corp. & Fin. L. 257, 270 (2017).↩
2. Since its inception, LabCFTC has held over 300 meetings with innovators, technology providers, and others involved in fintech ventures. To view TAC meetings from February and October 2018, see: https://www.cftc.gov/exit/index.htm?https://youtu.be/qinevlp2g2Y and https://www.wirestream.tv/customer/cftc/2018/10-05/↩