At a recent OnTheBlock event in New York, Daniel Gorfine, chief innovation officer and director of LabCFTC, talked to Galen Stops, editor of Profit & Loss, about the challenges facing regulators overseeing crypto markets, why the rules in this space are often more clearly delineated than many will admit, and the key technology trends he sees shaping financial markets in the future.
Galen Stops: As a regulator, how does the CFTC approach the crypto space? Because it seems to me like there’s a fairly fine line to walk between allowing and encouraging innovation and new markets on the one hand, but ensuring that there are protections against potential bad actors on the other…
Daniel Gorfine: We’ve tried to take a balanced, multifaceted approach to all new technologies, because there’s a recognition that some of these technologies are going to have potential market benefits. So we’re trying to create an environment where we’re fostering and facilitating these positive elements while also ensuring market integrity and looking at emerging risks.
One thing that has been a focus for us in this regard over the past 18 months is just basic technological literacy. The reality is, whether it’s in government, in businesses or investors at the highest levels of leadership, I do challenge and question how much people really understand the multiple layers of the onion of some of these new technologies, and that can pose a real risk – if you don’t understand the technology that’s driving business models and operations, how are you sure that you have the right defenses and redundancies in place?
In the context of crypto, and the blockchain space more broadly, we see a spectrum of activity. At one end are private permissioned ledgers – you could perhaps just call them at their most basic level interoperable databases – and at the other end of the spectrum are the open, public blockchains that frequently have a cryptoasset associated that’s used to incentivise participation in the ledger system. And in between the two ends of this spectrum, there is a whole range of activity.
Now at CFTC we’re interested in the full range of this spectrum, and this is what I mean when I talk about a multifaceted approach. We spend a lot of time engaging with innovators and working to understand these technologies so that we can better inform policy and at the same time our enforcement division has been quite active in this space policing for fraud and bad actors. Additionally, our office of customer education and outreach has been active in helping to educate the public on potential risks involved in crypto markets.
What I’m pointing out here is that there’s no simple silver bullet with regards to how you approach this space. You don’t want to throw the baby out with the bathwater and assume that all new technology and innovation is scary and therefore dangerous. You want to create an environment where you allow space for things to develop, but at the same time you keep a watchful eye, you target bad actors and you make sure that you’re maintaining market integrity.
GS: You’ve just outlined a big spectrum of new technology that the CFTC needs to stay on top of and at the same time the technology is developing so rapidly and in directions that are hard, if not impossible, to predict. So which is the bigger challenge for you: having the bandwidth to monitor what’s going on or being nimble enough to keep up with it?
DF: That’s a great question and my answer is actually somewhat evolving on this. With efforts like LabCFTC, we’re seeing an attempt by financial regulators to create a new model for engaging with technology and innovation, and that model is going to evolve over time. Right now, the role of LabCFTC is to stay as much as possible on the front-edge of new technologies.
In the fall of last year, LabCFTC made a conscious decision to start focusing on virtual currencies and we published a primer on this subject a few months before the launch of bitcoin futures. At the time, I would say that there was a pretty weak public understanding about virtual currencies, whereas today I would say that the conversation has increased in sophistication and most people involved in these markets have a decent sense of the crypto space.
So we’re not going to spend our limited bandwidth – and it is limited, we currently only have six people on the LabCFTC team – focused on well understood topics, instead we’re trying to think about what’s coming next. That’s why we recently put out a second primer on smart contracts, because we think the market is going to start hearing and seeing a lot more about smart contracts in the near future.
GS: In the virtual currency primer that you produced, you highlighted some of the risks associated with these assets. In particular you noted that there were operational, cybersecurity, speculation and fraud and manipulation risks. Which of those categories is the CFTC as an agency most concerned about?
DF: Well this comes back to that multifaceted approach I talked about. I could literally go through all those risks and talk about how the various operation divisions, given their responsibilities, think about them.
So, for example, when you look at bitcoin futures that are cash settled products, our division of clearing and risk has thought about what this means from a margining perspective, because this is a volatile asset. When we think about fraud and manipulation, that’s obviously an area where our enforcement division is vigilant. Then in terms of general volatility or speculative risk, that’s something that gets flagged for investors in the retail space through our office of customer education and outreach.
GS: Also in the primer it says that there’s no inconsistency between the SEC analysis and the CFTC determining certain virtual currencies to be a commodity. Do you think it’s a challenge for market participants though to have various regulators looking at these cryptoassets and seemingly applying different approaches or definitions to them?
DF: First of all, I will say that we actually have very good communication and collaboration with the SEC. We’re in constant communication with the SEC and the reality is – and maybe some people will throw tomatoes at me for saying this – but for a significant number of different types of tokens and projects there’s probably more clarity in the marketplace than many let on.
I think the SEC has been pretty explicit that you’ve got capital raising tools that are unregistered securities offerings if they’re not properly done through an exemption or registered with the SEC and most people today can wrap their heads around what a pure capital raising effort looks like.
One thing that we also remind people about is that you can tokenise essentially any type of asset or instrument, but just because you’re tokenising it doesn’t change the legal characteristics of it. We’ve had people come through LabCFTC posing all these incredible hypotheticals about creating a token that’s going to be somewhat anchored to this and is going to be redeemable for that, and you know what? The devil’s in the detail and once you start fleshing it out, it’s usually pretty clear how the product would be characterised based on its structure.
I also sometimes think: be careful what you wish for. Because if a regulator comes out early and provides bright lines and rules and says, “this is how we’re going to think about this product and here’s a box that everything needs to fit in”, the reaction would be that they’re boxing in innovation and determined themselves the way that the market is going to develop. And that’s not necessarily the best outcome.
P&L: Looking ahead more broadly, where do you see some of the technology trends in the market today leading?
DF: One of my big takeaways from the last 18 months is that we’re moving to the next overall generation of computer infrastructure and architecture. What I mean by that is, you can take all of the buzzwords of the day: ‘DLT’ and ‘cloud’ and ‘machine learning’, but can you then actually tie these all together? DLT stands for the proposition of having interoperable databases with standardised data formats and fields, and I know that’s not rocket science, but the reality is that bitcoin has made that exact topic, interoperable databases, a sexy topic that everyone’s thinking about.
And you know what? Systems that can communicate with each other are very valuable. Most banks and financial institutions have these bespoke, customised databases for particular applications that don’t even talk to each other within the same entity. If you start creating broader systems that can speak to each other, you increase efficiencies and then you actually create usable data.
And this is where cloud comes into play. Cloud is a great and elastic repository to store that usable, clean data. Then you start thinking: well, what can you do with that data? Here, data analytics and machine learning tools can consume the data and actually make sense of it to help produce predictions and glean insights. That’s really powerful. Smart contracts are about automation, so if you’ve got standardised data, you can start to automate certain processes across economic actors.
The Internet connected computers and allows you to do a lot, but if everyone’s using these different systems that don’t speak to one another, then it doesn’t maximise the potential benefits of this interconnected system. So I think that’s where we’re going, towards a more interconnected technology infrastructure and architecture.