Unchained Podcast

by Laura Shin

Can a DeFi Smart Contract Be Regulated? Two CFTC Commissioners Discuss

CFTC Commissioners Dan Berkovitz and Brian Quintenz discuss the difficulties of regulating crypto derivatives and DeFi. Show highlights:

  • their backgrounds
  • what the CFTC’s duties are regarding crypto
  • how the CFTC’s jurisdiction has evolved over the years
  • why Commissioner Quintenz believes SEC Commissioner Hester Peirce’s safe harbor proposal is “brilliant”
  • what relationship the CFTC and SEC have when making decisions on crypto assets
  • why the commissioners believe CFTC’s complaints regarding BitMEX are “well-founded”
  • why formal regulation for crypto derivatives is unlikely to be produced by the CFTC
  • why leveraged derivatives products are a “concern” to the CFTC
  • what makes regulating DeFi platforms so difficult
  • when it comes to DeFi, who is a natural entity for the CFTC to regulate, if any
  • whether the CFTC would ever go after DeFi “market participants,” who the CFTC also regulates
  • why smart contracts involving futures could be illegal 
  • how the possibility that smart contracts could be illegal squares with the view that software development is a form of free speech 
  • whether the CFTC could prosecute developers who write smart contracts
  • whether the CFTC needs to re-write its laws in light of DeFi innovation
  • why Commissioner Berkovitz thinks the DeFi “winners” will be protocols that focus on meeting regulatory requirements
  • why the CFTC approved Bitcoin futures in 2017 while the SEC has not yet approved a Bitcoin ETF
  • how a Bitcoin ETF could solve Bitcoin’s accounting issue, which currently gives companies no upside for adding BTC to its balance sheet

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Episode Links

People

Dan Berkovitz, CFTC Commissioner (Sep 2018+)

Brian Quintenz, CFTC Commissioner (Aug 2017+)

Related Links

Bitcoin futures approval from CFTC in 2017: https://www.businessinsider.com/bitcoin-price-futures-trading-exchanges-cftc-2017-12

 

Episode Transcript:

 

Laura Shin:

Hi, everyone. Welcome to Unchained, your no hype resource for all things crypto. I’m your host, Laura Shin, a journalist with over two decades of experience. I started covering crypto over six years ago and, as a senior editor at Forbes, was the first mainstream media reporter to cover cryptocurrency full-time. This is the August 3rd, 2021 episode of Unchained. 

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Laura Shin:

Today’s guests are CFTC Commissioners and Berkovitz and Brian Quintenz. Welcome Commissioners Berkovitz and Quintenz. Thanks, Laura. Let’s start with each of you giving your background, including your experience with and knowledge of crypto. Commissioner Berkovitz, why don’t we start with you.

Dan Berkovitz:

Thank you, Laura. My involvement in commodity markets and commodities started when I was counsel to the Senate permanent subcommittee on investigations. This was in the 2000 sand at that time, there was a lot of volatility and things going on in the energy markets and energy commodity markets: oil, natural gas. There was a lot of price volatility and oil prices ended up peaking at $147 a barrel in 2008. After I worked for the Senate, I had the privilege of being General Counsel of the CFTC during the Dodd-Frank years when the Dodd-Frank act was passed by the Congress regulating the swaps markets. And the next several years, the CFTC passed many regulations implementing that law. 

I was in private practice for a number of years. In 2018 I had the privilege of being appointed by the President to one of the seats on the CFTC. I was appointed by President Trump is one of the Democratic commissioners on the CFTC. 

Cryptocurrency has been an increasing field since the early 2010s, is when I think I became first aware of it. But in the last few years, there’s been a huge explosion of interest and breadth in these markets. I’m eager to talk about those today. 

Laura Shin:

And Commissioner Quintenz?

Brian Quintenz:

Thanks, Laura. It’s always great to be with you always and always great to be with my fellow commissioners and esteemed colleague, Dan Berkovitz. I don’t have nearly the distinguished background that Dan does. I mean that very seriously. He’s a brilliant lawyer and a, and a wonderful addition to the Commission since I’ve been there. I’m not an attorney. That’s more rare than I would like it, but certainly more rare than has been the case that you might expect for markets regulator over the last number of years.

 I started off my career on Capitol Hill and worked for a member of Congress from Columbus, Ohio, where I’m from originally for about six and a half years. I then decided to career switch and got an MBA and decided to go into the markets where I joined an investment firm that was focused on the banking sector during the financial crisis.

So it was kind of trial by fire right off the bat. I learned how to, to the best that I could, and I think to the best that anyone can, evaluate some of the largest and most complex financial institutions in the world. While that was going on, I did see the evolution of cryptocurrencies. I saw them come into the marketplace in the early 2010s. I think it’s an important point to note that they did come into the marketplace on the heels of the financial crisis — given the centralization of the the stresses in the marketplace that led to that crisis. Following my time at the investment firm, I formed my own investment management company, where I was involved in trading commodity derivatives on behalf of clients.

I was interviewed and asked to join the commission in 2015. I was nominated by both President Obama and by President Trump and ultimately joined the commission in August of 2017. 

The second part, it was about cryptocurrencies. I think from the commission’s perspective, when I was preparing for this role in 2015, 2016, obviously I had a familiarity with Bitcoin and some of the developments in crypto, but it wasn’t really front and center. I think Dodd-Frank was front and center, in terms of how the CFTC was implementing rules to address the last crisis. But very quickly after I joined the commission, we were presented with two exchanges that wanted to list Bitcoin futures contracts. And I think that put the agency headfirst and front and center in the cryptocurrency environment.

Laura Shin:

To your point earlier about how Bitcoin was born during the financial crisis, famously the Genesis block of the Bitcoin blockchain does reference a headline from the Times of London about a third bank bailout. So clearly, that was on Satoshi’s mind. So for the rest of the conversation, let’s just make sure that all the listeners have the lay of the land here. Can one of you describe what it is that the CFTC duties are when it comes to crypto or what its purview is? Maybe we’ll start with you commissioner Quintenz.

Brian Quintenz:

So the CFTC has a very broad authority over derivatives products. Derivatives on commodities, on broad based securities. The evolution of the markets that we regulate really formed in the 1800s within was formed without regulation. And it was centered around hedging activity and risk transfer activity. The core of those markets were the agricultural markets. They were corn, wheat, and soybeans. As risk management tools like futures contracts evolved to allow the participants in those markets, the growers, the producers, the processors, to trade off their risks so that they wouldn’t go under if they had a bad crop, or if the prices inflated way too much for them to afford and not risk manage their business. Eventually, the federal government decided to get more involved in regulating how those contracts were listed: who could participate in how they could participate.

And ultimately, in the 1970s, the CFTC was created to supervise derivatives markets activity. As our authorities relate more directly to crypto-assets themselves, we do have very broad based anti-fraud and anti-manipulation authority over commodity transactions. Generally, I think we usually try to exercise that authority in very limited circumstances where we see overt fraud or where we see a significant amount of manipulation that is very directly tied to the futures contracts and the derivatives markets that we regulate upon which risk manager is really a lie.

Laura Shin:

And Commisioner Berkovitz?

Dan Berkovitz:

Thank you, Laura. I would agree with everything that Commissioner Quintenz said. The Commissioner provided an excellent summary of the evolution of the commodity markets and the reason for their existence. I just want to put up a finer point on several of the things that Commissioner Quintenz mentioned.

First, as the markets evolved from agricultural commodities, which they were from the late 19th century until basically around the 1970s, but in the 1970s with the oil embargo and coming off the gold standard, there developed financial commodities. So a commodity doesn’t have to be a tangible commodity, such as gold or oil or wheat or corn. A commodity under the 1974 law, which created the CFTC, can be an intangible. It can be an interest rate. It can be a stock index, or it can be a cryptocurrency. A commodity under the Commodity Exchange Act is basically anything you can have a futures contract on currently or potentially in the future.

So we we’ve had several test cases recently about cryptocurrency. There’s futures contracts on Bitcoin. So cryptocurrency, therefore, it is a commodity. Now excluded from our jurisdiction as commodity is security. So the SEC has jurisdiction over securities, and we have jurisdiction over commodities, but commodity is a very broad category. It can be tangible or intangible. The instruments involving commodities that we specifically regulate are futures, contracts for future delivery, their swaps, and their options on commodity. So all of those instruments have to be traded on regulated exchanges. A futures contract has to be on what we call a designated contract market, but that’s basically a futures exchange. Swaps have to be traded either on a swap execution facility or a designated contract market, if they reach a sufficient amount of liquidity in the market. If you’re a retail person, you have to trade a swap on a futures exchange. That’s the only place a retail person could be able to trade a swap. 

And as Commissioner Quintenz mentioned, in addition to our regulatory authority, we regulate these facilities for the trading futures. And we regulate the trading of swaps. We regulate swaps or intermediaries such as big banks or swap dealers. We also have anti-fraud and anti-manipulation authority. We can prosecute persons who commit fraud or manipulation in the spot or cash market on any exchange. Even if we don’t regulate a spot exchange, we can prosecute persons who, who manipulate those markets. So we have both regulatory jurisdiction over derivative execution facilities — how they’re executed, but we also have this anti-fraud and anti-manipulation authority over the commodity of transactions themselves.

Laura Shin:

And so I’m glad that you brought up the SEC, because I believe that in the crypto space, that SEC right now, and for awhile actually, has been kind of the big regulator that everybody talks about. And as you mentioned, kind of what tends to not fall in the SEC’s bucket will fall into the CFTC’s. And there was a period when, and this is just one example, where, for instance, people were concerned that ether could be a security because of how it was sold in a crowd sale. But eventually, the SEC said it was not. Later at the CFTC also said that it was a commodity. And I think people are curious how that decision making happened at that time. Is that something that the two agencies discussed actively together to make the determination together? And it just in general, how do the CFTC and the SEC work when it comes to matters involving crypto?

Brian Quintenz:

I’ll take a first stab at that. Yes, there is a lot of interaction between the agencies when it comes to the legal status of any specific product. I think we see that on the enforcement side. If we see fraud around a particular crypto asset, the agencies have to make a determination about which agency has authority. And then they look at the specifics of that asset to make that determination so that the right appropriate agency takes the lead. I do think I wasn’t involved in any discussions between the agencies around the status of bitcoin or ether and whether or not they were securities. But the Chair of the CFTC at the time did come out and say it was a commodity. I think that implied that ether was not as security and that it was within the CFTC jurisdiction, should futures contracts or derivatives contracts be listed upon it. But I do think that there should be more transparency around those kinds of decisions. There should be more official analysis that’s provided to the public. I think that the the limbo that a lot of the community finds themselves in is not productive to innovation. And I think that there is a very clear path forward towards providing that clarity. I would hope that our counterparts at the SEC seriously consider that.

Laura Shin:

And when you say that, what would be that clear path forward?

Brian Quintenz:

Well, I think Hester Peirce’s Safe Harbor Proposal is a brilliant proposal. I think there is a there is an opinion within the CFTC that that products can evolve from an initial securities offering into a commodity. They can become commoditized through widespread acceptance and utility that moves something beyond the ownership and control of a common enterprise. And I think that a Safe Harbor-like proposal can take advantage of that of that legal theory and not unduly limit the ability of entrepreneurs and innovators to take advantage of the blockchain space and the development and the crypto assets. I think the challenge is that if you rigidly applied securities laws to crypto-assets that started off as securities, you may prevent them from evolving into commodities. So some level of a Safe Harbor, I think makes a lot of sense. And besides Commissioner Peirce, I’ve yet to hear a lot of a lot of additional support from the SEC on that kind of concept, I think it’s an important one.

Laura Shin:

And Commissioner Berkovitz, what do you think of the Safe Harbor proposal?

Dan Berkovitz:

We actually have an excellent working relationship with the SEC and that’s improved over the years and a large amount of improvements are due to Commissioner Quintenz, who has been a point person for us in our relations with SEC and helping along with the Chairman of the CFTC and the Chairman of the SEC working together. And so our relations are very good.

But fundamentally, each agency in the end, we will consult and we will discuss these issues, but fundamentally, each agency is charged by Congress with protecting the markets under its jurisdiction. So in terms of what is a security or what is a commodity, our lawyers will discuss with their lawyers, and we have discussions. But by the end of the day, it’s up to each agency to decide what’s what’s in its jurisdiction and enforce the laws that it’s it’s charged with enforcing.

So the SEC will determine what’s a security at the end of the day. And if it’s a security, it’s in their jurisdiction. I totally agree that with what Commissioner Quintenz said about how an instrument can change its nature, depending on the use as as evolve. So in terms of really whether the SEC should grant a Safe Harbor or something in terms of securities law, I would defer to the SEC on that because they’re really primarily charged with enforcing the securities laws.

Once it comes over on the commodity side, we have our legal requirements. And if people believe that there’s a way that the current regulations may or may not be suited to their particular structure, people come in as they typically do and say, well, here’s why the CFTC regulations in our specific case should not apply.

And we’ll listen to their arguments and make a determination of potentially what we can do various things. We can grant in some instances what we call no-action relief on a trial basis. If you can’t comply this way, you can comply that way. And we’ll have a number of conditions and say, okay, if you can’t meet the regulatory requirement or it’s inappropriate for you to meet it by doing X, Y, Z, we’ll allow you to A, B, C, provided you do D, E, and F also, and give us assurance that the intent of the regulation is being met. We issue, let’s say, a hundred something, no action letters a year with various entities coming in, or potentially people can petition for a change in rulemaking, which admittedly is harder. We do have some flexibility, and we exercise that flexibility numerous times each year.

Our regulatory structure is not so rigid that we demand everybody do everything in a cookie cutter approach. At this point, maybe it’s perhaps worthwhile to mention, overarching our philosophy, our regulatory philosophy, is what we call principles base. The statute says, here are the principles, and here are the standards that we expect the CFTC to hold the market participants to. And it’s called principles-based regulation. The statute, for example, a futures exchange. There’s about 20 of what we call core principles for futures exchange. It has to be able to ensure that there’s no manipulation. You have to post the prices. You have to ensure the financial integrity of transactions. You have to be able to operate your facility and have redundancy. So if there’s a storm and there’s an outage or a disruption, you can continue operations. You have to be secure against cyber threats. These general are general objectives, and we fill in a lot of the details on that and say, here’s, here’s how to do it. 

But fundamentally there’s those 20 principles you have to meet, and we give the exchanges considerable leeway in how they meet it. Now, there are some times we do get very specific it’s we say, thou must do X in certain circumstances, but it’s really a principles-based approach. If entities in the marketplace seeking additional flexibility as to different ways to meet the regulations, our system and our regulatory structure can accommodate that.

Laura Shin:

So earlier you talked about how the focus at the CFTC has been on fraud and other kinds of obvious bad behavior. There was a civil case that the CFTC brought against BitMEX and its owners. At the same time, the Department of Justice also brought a criminal case against them for violating and conspiring to violate the bank secrecy act by willfully, failing, to establish, implement, and maintain an adequate anti money laundering program. And each count carries a maximum penalty of five years in prison. There are some legal observers who say that these charges are unprecedented since there are no allegations of specific criminal activities, such as fraud or credit card theft or terrorist financing. And they compare this to some cases where banks admitted, such as HSPC admitted to actual money laundering. And the Justice Department did not indict the bank courts officials. So I think some crypto observers do believe that this case shows a double standard. What is your take on that?

Dan Berkovitz:

The BitMEX case is being prosecuted by several agencies. The CFTC, we have a complaint regarding violations of the Commodity Exchange Act, as well as the bank secrecy act — civil violation. So we prosecute the civil violations. And with respect to BitMEX, the complaint lays out a number of issues: selling swaps without registering as a swap execution facility, providing leverage for transactions without registering as a futures commission merchant, trading futures contracts without registering as a designated contract market or a futures exchange, and civil violations of the bank secrecy act. And so we laid out the facts in the complaint and obviously standby the complaint that we issued as as a well-founded complaint. In terms of the criminal prosecution, that’s up to that really the DOJ and whether it meets the standards for criminal prosecution.I believe the DOJ has an extreme amount of integrity in their prosecutions and that it meets the appropriate standards for bringing a criminal prosecution. I believe all the actions that the federal government in this matter have brought here are well-founded.

Brian Quintenz:

I can’t talk about the BitMEX case specifically. I think it’s important to contrast what a centralized entity that is seeking to list products that are directly in the commission’s jurisdiction and doing that in a way that contravenes or completely ignores our rules for entities engaged in that kind of behavior, with what we’re seeing in the DeFi space, where protocols through decentralization are offering innovation and opportunities outside of an intermediated functional marketplace. 

That is a new paradigm of a market that our law and our rules were not designed to comprehend. I view them as somewhat different, and maybe we’ll explore some of this. But I think in cases like the one you mentioned, there is a centralized entity that flaunted our rules, benefited themselves in doing so. I think it’s reasonable to expect that in accessing us customers, I think the agency has a lot jurisdiction to bring the case there.

Laura Shin:

And so we will get an a DeFi, as there’s so much to discuss there. But before we move on to that, I do want to ask a little bit more about derivatives, because that is what was offered on BitMEX and it’s just one of the most popular areas of crypto. And also it’s a very popular financial instrument in the traditional financial world. And in the US, derivatives are regulated by the CFTC, but there’s no formal regulatory framework for crypto derivatives exchanges. So when could we expect such rules and regulations from the CFTC and what would that framework look like?

Brian Quintenz:

I guess when you say there’s no formal regime or regulation for crypto derivatives exchanges, I don’t think our rules necessarily look at the products, as opposed to whether or not they are derivatives. Just like there’s no agriculture derivative specific exchange set of rules or energy derivatives specific set of rules, there are derivative exchange sets of rules that centralized entities looking to offer contracts, derivatives contracts for trading are captured by.

Dan Berkovitz:

We do have licensed facilities trading crypto products. We have futures contracts on Bitcoin trading on a number of licensed exchanges. And we have event contracts trading on exchanges. So we do have crypto products trading on licensed facilities.

Laura Shin:

Okay. So maybe it’s just certain types of crypto derivatives that are popular not in the US are maybe not ones that would be allowed in the current framework.

Dan Berkovitz:

If you want to list the type of contract or derivative, if you want to list a particular derivative and you have a license to trade derivatives, you submit what we call a product certification saying we want to trade this product and there are standards for products traded on our facilities that the exchange will submit a product certification to the CFTC. And they’ll either what we call self-certify and say, if this meets all your regulatory requirements, or they’ll say, you know, this is a new, different type of product. We’d like you to actually approve this product before we list it. So they can either self-certify or ask us to approve the product. So if you’re a licensed futures exchange or swap execution facility, and you want to trade a novel type of crypto product, that nobody else is trading, you can you apply for a product certification. Now, if you’re not approved as a licensed exchange, and you want to trade that product in the US, you have to get approval to be a licensed exchange. So the first step is becoming an approved exchange, but once you’re an approved exchange and you want to do a new product, it’s a product approval process.

Brian Quintenz:

I was just going to try to add to that and maybe take a step back, which is that I think a lot of the conversation around crypto derivatives overseas really involves leverage, and leverage considerations, and how much leverage different exchanges exchanges can offer, and different clients can get. And I think we saw recently an exchange talk about that and decide to start to self limit the amount of leverage it was going to provide.

As we look back in the US at the evolution of the derivatives markets, there was a reason why given the technology available at the time we had intermediaries develop, which was because it made no sense from a risk management perspective to pre-purchase, or completely pre-sell a commodity, because then it’s just a pre-sale. That’s not a risk management feature. A risk management feature would, you know, allow for some limited amount of risk to be taken with the cash flows on top of that.

A derivatives contract could have a 10% amount of margin that you’d have to put up as collateral, that shows you’re going to make good on the payments of that contract. Because of the involvement of leverage in risk management and in futures contracts, we have clearinghouses that developed to trade to take both sides of a trade, so that if one party defaulted, the clearinghouse could stand in the middle and make sure the other party was made good, so that their risk management process wasn’t impeded. And then as futures contracts proliferated and expanded to more potential clients. We have intermediaries that come in to service those clients and provide an extra layer of protection for the clearinghouses, so that there’s extra margin put into what we call FCMS, but think of them as kind of commodity derivative brokers, and then the FCMS put an extra capital to the clearinghouses so that if there’s a waterfall effect, hopefully there’s a set of resources there to ensure that contracts can continue to be made whole from the defaulting party.

Brian Quintenz:

Because of that, the agency doesn’t necessarily approve margin models but has a set of standards by which it looks at margin models for exchanges that need to meet a certain set of mathematical criteria to try to prevent defaults from occurring. I think some of those rules would probably preclude the extreme amount of leverage that we see overseas, that when offered to us clients would conflict with our regulations.

Dan Berkovitz:

If I could just add another point on this. Historically, we have seen with retail currency transactions, the reason we’re so concerned about it, or one of the reasons we’re so concerned about these leveraged transactions, is with respect to foreign currency. Leveraged foreign currency transactions. Now not preceding cryptocurrency, is one of the highest, most fraud prone areas in our jurisdiction. A lot of fraud has occurred in the retail foreign currency space. And because of that, Congress specifically gave the CFTC jurisdiction over these leveraged retail foreign currency transactions, and then added to that in the Dodd-Frank act this same jurisdiction over retail commodity transactions. It’s selling these products to retail consumers with high amounts of leverage. You put a thousand dollars down, you can get a hundred thousand dollars worth of exposure at 100:1 leverage or something like that. This was an area where a lot of retail people were not sophisticated, and they’ve promised a great opportunity to get rich very quickly. So historically, there’s obviously many, many upstanding actors in the space, but historically it’s been an area of rife with fraud. So as we see it move into the cryptocurrency space, that’s of concern to us.

Laura Shin:

Just to be clear for listeners, the two exchanges that did limit their leverage recently were FTX and Binance. Both said that very, very, very few customers ever used more than 20X leverage. So the max now is 20X on both exchanges. 

So in a moment, we’re going to talk about DeFi and how that relates to the CFTC purview, but first, a quick word from the sponsors who make this show possible. 

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Back to my conversation with CFTC commissioners Dan Berkovitz and Brian Quintenz. So the CFTC regulations are almost based on a policy of mandatory intermediation in a way. And what that means is that for certain transactions falling into certain categories, they’re required to take place only on a CFTC regulated exchange, which basically forces this intermediation, which has obviously antithetical to DeFi.

Laura Shin:

So DeFi transactions can kind of get similar results to some commodities transactions. For instance, you can create a collateralized debt position on MakerDAO, and use that to mint DAI, which is a stablecoin pegged to the US dollar, which you can then use to buy more ether, which is basically providing yourself more leverage. But this happens through these peer to peer protocols. There’s no kind of like traditional counterparty as you would traditionally define it. And so some of these CFTC regulations, in a way, they’re made for a different world than DeFi. And I wanted to get your thoughts on how the CFTC would regulate this type of activity, if at all.

Dan Berkovitz:

So our regulations, I think it’s fair to say, and it’s accurate to say, that our regulations really are based on an intermediation model. They don’t necessarily mandate it in every instance, but when all these regulations were being written and they were based on exchange-traded models or broker intermediated models. Many of the regulations are centered around and assume the presence of intermediaries. Ultimately, in many of these DeFi applications, they’re very innovative. They approach the market in a different way. So maybe don’t need intermediaries for everything that they’re doing. And there’s additional friction and cost, and we could be more efficient and speedier, without the intermediaries, and they accomplish that in a number of respects. The difficulty and the challenge is when you take out an intermediary from some of the functions in a regulatory system that presupposes their existence, how do those two systems mesh?

That’s a question that really DeFi poses to the regulators and to the marketplace. That doesn’t mean that you could totally do without all the intermediation or the functions that the intermediaries do in terms of what they do. For example, the intermediaries, the exchanges, not only match up parties, which is a DeFi protocol you can do without the exchange, but they also have a surveillance obligation and an affirmative obligation to make sure that the markets are free from fraud or manipulation. They also are basically a clearinghouse. In a futures model, a clearinghouse stands behind the trade. So if one party somehow defaults, then the clearinghouse will make it up. Now you could say in the DeFi protocol, well, there’s an automatic liquidity provider that will liquidate the contracts before you get to default.

And that may be, and if you don’t need a clearinghouse, then that’s an interesting development that we certainly could look at. So there are some functions I think you could do a better without an intermediary, but some, an intermediary may be necessary. And the question is, can you do it totally without intermediaries? Many of the ensuring the integrity of the code, explaining to the retail persons how this system works. Not everybody can go on and and all of a sudden analyze the code and figure out if the code is appropriate. And we have, presumably if there’s retail people on there, they’ll need somebody to say, yeah, this is a good code. Yes, you can trust the system. So I think we do have a challenge with DeFi in terms of how to fit this new technology within the regulatory structure. But as currently exists, the regulatory structure does impose obligations, not just on the intermediaries, but on the market participants — certain obligations on the market participants themselves. So taking out the intermediaries doesn’t necessarily take out all the regulations that might apply to a trade in a derivative. So the persons operating platforms have to consider, or even the terminology operating platforms. Persons developing platforms or developing technologies may want to consider we’ll need to consider all of that.

Laura Shin:

And at the moment, with the way that many of these DeFi projects are set up, who do you think is a natural entity for you to regulate — for the CFTC in general to regulate?

Dan Berkovitz:

Well, that’s a great question. And so one has to look at a number of factors to see whether there is actual sufficient addition of control or intermediation. Who’s financing it? Who’s making the decisions? Is somebody benefiting by it? Financially, is there really an organization behind this? How decentralized or centralized is it? It can be very factual specific, and it’s an evolving area. We’re looking carefully at a number of these things. It’s different facilities and different protocols seem to have different degrees of centralization or decentralization. And I think some of these present very interesting questions for us.

Laura Shin:

And earlier, when you said that you also regulate the market participants, does that mean that the CFTC would consider enforcement actions against market participants?

Dan Berkovitz:

Traditionally, and this is one benefit of intermediation, traditionally and you’ve seen this in our enforcement actions to date in the space, where we have gone after we have filed complaints and then taking enforcement actions against if somebody is operating an exchange and it’s not registered or basically as a broker, as a futures commission merchant, without being registered, our enforcement actions have been directed against those persons, not against the transactions that have taken place on an unregistered facility. A futures transaction that does not take place on a futures exchange is unlawful under the Commodity Exchange Act, but we haven’t gone after the end-users. We haven’t gone after the market participants traditionally. So our focus traditionally has been on the entities who should have been intermediaries in those circumstances.

But if, for example, let’s take the oil market. If one were to trade on a DeFi platform an oil contract and you might have a market participant who decides I’d rather trade on an unregulated platform than on a regulated platform. You know that would present a more difficult question for us, whether if somebody consciously decides to trade in an unregulated environment to avoid our regulations, then a retail person who may be trading on something that somebody offered them and they shouldn’t have offered them without being unregistered. So that’s traditionally how we approached enforcement, but we’ll approach each case under the facts and circumstances. Fundamentally, whether or not we take an enforcement action, the contract still is not a lawful contract under the Commodity Exchange Act. So there’s a question about the basic enforceability of a contract, let alone, whether we take enforcement action against the parties who entered into it.

Laura Shin:

So you’re saying like a contract, just a smart contract could be illegal just on its own?

Dan Berkovitz:

Correct. The Commodity Exchange Act says that that for a futures contract to be legal, it has to be traded through a regulated exchange. This question, this question about the legality of essentially futures contracts that are not traded on exchange was a great source of debate. And basically, it led to the commodity futures modernization act, which is going back history a little ways, but history is instructive. When the swaps market developed in the 1980s, the question became well, what’s the difference between a swap contract and a futures contract? And I don’t want to go too far down the rabbit hole here, but I do want to point out the history on this and the argument that swaps contracts were no different and we’re really futures contracts really troubled the troubled the industry in the 1990s. 

And it really was one of the motivating factors behind the commodity futures modernization act of 2000, which provided legal certainty that swaps did not have to be traded on futures exchanges. So we had a statute passed by Congress that told the CFTC and the SEC you can’t regulate swats. They’re legal. They’re not illegal futures contracts, basically. And then that caused a whole bunch of problems in the 2000s with the leading to the financial crisis. And so the swaps markets were regulated. They’re not futures contracts. Swaps are not futures, but the legal uncertainty over a contract, that’s essentially a futures contract, that’s not traded on a futures exchange, was very, very significant. Financial institutions were very, very concerned about, well, what do I have then if I have a futures contract, that’s not traded on a futures exchange. So at best, at best, there’s legal uncertainty. But I also think there’s a strong argument that Commodity Exchange Act says it shall be unlawful to enter into a contract unless it’s on a futures contract, unless it’s on a registered futures exchange.

Laura Shin:

Then how does this square? And maybe this is just an opinion, but I think there’s a view that software development is like an expression of free speech. And so is that something that you would say can be regulated by the CFTC, simply creating a smart contract?

Dan Berkovitz:

Well, it’s not the creation. The development of the software is one issue. But somebody who enters into a a transaction purporting to be a future transaction, what is that? Is that a contract? If you want to call it a smart contract, the question is, if it’s purporting to be a futures contract, is it an enforceable contract? What rights do you have if you enter into that to get the money your promised? It might be just a bunch of code that says, here’s how this code is going to execute. But if it doesn’t execute as it promised, if there’s some electrical problem or it’s misrepresented, or it has some trick in it, or if somehow you don’t get the money that you think you’re going to get, what can you do? In the regulated world, you have a very, very high degree of certainty because there are multiple intermediaries in the regulatory system.

And there’s a legal system backing you up that you are going to get your money provided you’re entitled to it because it’s a legal contract. If you don’t have a legal contract, you don’t have a legal contract. Now, does that mean we’re going to prosecute the drafters of the contract? Those are two separate questions. Prosecuting the drafters of the contract or the basic legality of the instrument that somebody is purporting to enter into. So apart whether we prosecute people, the contract itself, may not be a contract that would be recognized in any court of law is something that could be enforced.

I think that be a problem for people who may have a high degree of confidence in the code, and it may work a lot, but when it doesn’t, that’s when you need the legal system, that’s when you need that assurance. And if somebody takes it from, you steals it from you what, what do you have? You have if it’s not a legal contract, if it’s not binding. So I think there’s issues both were enforceability and there’s other issues in the legality of the instrument.

Laura Shin:

So you said, whether or not to prosecute the developer is a separate issue, but is that something that you think is possible?

Dan Berkovitz:

This is a facts and circumstances situation where it depends on the facts and the circumstances of what people are doing when they’re developing the code. It’s a highly factually dependent.

Laura Shin:

Okay. But the way you answered that makes it sound then like, again, as you said earlier, it would be more likely you would go after something more like a fraud type situation. Is that what you were trying to apply?

Dan Berkovitz:

Traditionally that’s, that’s what we have done. Correct.

Laura Shin:

So Commissioner Berkowitz, we’ve been having this very interesting exchange about what the CFTC does cover in DeFi. You did say recently in a speech that you felt DeFi does not offer the benefits and productions of traditional markets because of this lack of intermediaries. And then you actually said that you thought DeFi markets for derivatives are a bad idea. So does that mean that you think the CFTC should bring enforcement actions to shut down these many different DeFi projects that exists? Or is there some way that participants who would like to register with CFTC could try to do so if, for instance, the Commodity Exchange Act were modified in some fashion?

Dan Berkovitz:

Thank you for asking that, Laura. I do want to clarify. Unlicensed DeFi is a bad idea. I didn’t say that all DeFi is a bad idea, but unlicensed DeFi, particularly without intermediaries, is a bad idea, in my opinion. Of course, if DeFi proponents, operators, or entities who want a DeFi platforms to exist want to come in to the CFTC and say, you know we understand that you have to trade a futures contracts and swaps on registered facilities and we would like our facilities to be in compliance with the Commodity Exchange Act. How can we do that? Certainly, part of our mission is to support responsible innovation and fair competition.

We have other missions to prevent systemic risk and to ensure market integrity, but we actually have a statutory responsibility to promote responsible innovation and fair competition. So innovation such as DeFi, as long as it’s done responsibly, which I mean regulated, we have a statutory obligation to work to see that can happen. Fair competition as well. We promote competition amongst not just market participants, but amongst the different ways of trading the instruments. But it should be fair competition. And by fair, the regulatory playing field is level. We don’t have one regulated market and other unregulated market, so absolutely. We should work. There’s advantages to DeFi, as I mentioned before. If you have a protocol that ensures some particular event won’t happen that contract operates in such a way that the person’s margin has to stay at a certain level, that they have to have certain amount of collateral, and you can show that this is hardwired into the protocol, and that you don’t need five people in some surveillance department, or five people in some back office somewhere, you can do it by code. Fantastic. Great. We can work to accommodate that.

nNow, as we also talked about the way the regulations are written, it really was written in terms of a fully intermediated market. So there may be things that we would have to work on to accomplish that within the current regulatory structure. I believe the way to do it is to engage with us in the dialogue, say, how can we come into compliance? We want to operate a facility. We have all this great innovation, how can we make it work within the regulatory arena? We’d be welcoming of that effort and that initiative and devote resources to to make it happen. We’ve very much encouraged innovation in this space

Laura Shin:

And Commissioner Quintenz, Commissioner Berkovitz and I have covered a lot of material here, but I did want to also get your opinion for the way that the rules and regulations of the CFTC are structured currently. Who do you think is the natural entity to regulate when it comes to many of these DeFi projects?

Brian Quintenz:

Well, I don’t think there is one. think that’s the challenge. Let me say that I agree with Commissioner Berkovitz in terms of what the law says and what our regulations say. But I also want to take a step back from my own perspective and my own philosophical perspective, and look at first principles. Which is how DeFi and the properties that it has, and the freedom and liberty to transact in the financial marketplace. How DeFi encourages that and supports that, how that really directly relates to an open and free and transparent financial system. We talked about how the market’s evolved over time and how our rules evolved over time to match those in order to ensure the integrity of a transaction so that leveraged defaults didn’t cascade through the system.

That is a challenge that DeFi is addressing. It’s doing it, though in an unintimidated way, through very transparent code. If we look at what an ultimate free market should be, it should be in an environment where there are very low or zero barriers to entry. Where there is a fierce competition for innovation and to create efficiencies and where there is open access to be able to either build or take advantage of that value. Those are all the things that we see in the DeFi space. I think I’m a little reluctant to put the regulations as we have them today onto the DeFi space and impede what I believe is a very remarkable amount of innovation that has attracted the best and brightest minds and a lot of capital and intellectual property.

Most of it is occurring through very transparent code that any individual can audit. That promotes an enormous amount of personal responsibility. When we really start seeing the significant intersection of DeFi and the financial system, or DeFi and our legacy, futures and derivative space. And I think we’re starting to see some of that, but I think a lot of the innovation is occurring within its own ecosystem in DeFi right now. That’s when I think the CFTC, hopefully we don’t wait until then, but that’s when we really need to take a look at our ruleset again, and Congress needs to take a look at the law, and say, you know products are products and the legal standard for products applies to anything, but we’ve created a law and a set of regulations around one financial system paradigm.

This is a completely new financial system paradigm that does have some risks, but tries to solve, in my view, tries to solve for those risks in a transparent, open way that provides a lot of access. And whose principles, I think, match with the foundational principles of this country. The thing that’s also going to pose a challenge for this space is exactly what Commissioner Berkovitz had said is that it is under our law unlawful to enter into, not just offer, but to enter into, and off-exchange derivatives contract. Taking the CFTC completely out of this for a second, even if the agency did nothing with regards to that kind of activity, I don’t think large financial institutions are going to come into this space and engage with those kinds of products because of a fear of potential liability.

If the DeFi space really wants to attract institutional activity, that’s going to be a problem that we have to kind of work to solve for. If it doesn’t care, or if certain projects don’t care about institutional money or having an institutional focus, then maybe we’ll see at what point, given all of the CFTC responsibilities and given the legacy of hundreds of trillions of dollars of derivative market activity that we do supervise, and where to put DeFi in that priority list. And my opinion should be fairly low given what we already oversee and how interconnected that is directly to the food that we eat and the gas that we put in our cars. You know, we’ll see at what point the CFTC ends up taking action.

Laura Shin:

Okay. So it sounds like you’re kind of on the side of maybe having Congress update the Commodity Exchange Act, or just somehow creating some sort of new regulatory regime that makes sense for DeFi.

Brian Quintenz:

I think that’s going to take a long time. I think Congress by design works very slowly, unless there is a significant crisis for which it needs to respond. In that case, who knows what the success is of the ultimate product that’s produced. But my hope would be, as we see the innovation, as we see the access, as we see the transparency, you know, take place in DeFi, and realize that a lot of the risks that we are solving for as regulators in the intermediated space are being solved for in the DeFi space already, that there is a rethink of the of the Commodity Exchange Act to allow for that activity to either continue to occur on its own, or to be brought into the regulated system. But to me, it feels a little early to engage in an overly negative way across the space given the innovation that we see in the principles that apply there.

Laura Shin:

So recently, Uniswap Labs announced that it was removing certain tokens from the interface that this company, the centralized company, has created to access the decentralized protocol. And those types of tokens, were, for instance, tokenized stocks, mirror stocks, options, and derivatives. And of course, this caused a little uproar on crypto Twitter. Do you think that this kind of compliance of basically these types of regulations that you’re both kind of saying in certain regards can be outdated, obviously for this new model. Do you think that that could drive more DeFi creators and founders to either go the anonymous route or to locate in other jurisdictions, thus taking those jobs to these other economies?

Brian Quintenz:

I think we want to capture as much innovation within the United States as we can. And I think that hopefully, how we apply the law and how we apply our rules allow that innovation to expand at a rapid pace without endangering the participants in it. But to your point in your example, I think that gets to some of my questions, as I think about this space — about what’s the decentralized part versus the centralized part. And while I think you said Uniswap Labs de-listed certain products, the Uniswap protocol as a decentralized piece of infrastructure, I guess, is still offering those because it’s decentralized. To me, that goes to the centralized aspect versus the decentralized aspect. The challenge that is going to be for the CFTC to apply its rules to the decentralized area in the first place.

Dan Berkovitz:

Let me just add a couple of things. One is, as both Brian and I have been saying, that the threshold question regarding the legality of the contracts themselves, as Brian’s noted, and I totally agree, it’s going to be a barrier to institutional participation in these markets. Whatever level of activity there may or may not be the, the purpose of the financial system, it’s not just to trade crypto assets. The purpose of the financial system is to provide methods for raising capital for American businesses and for risk management for American businesses and consumers, so thatthat businesses can manage the risks of their their commercial activities. So Americans can have retirement and protect their assets, grow their assets, and protect them in retirement. For DeFi to be a part of the mainstream financial system — and mainstream by fulfilling those functions, institutional participation, the liquidity of the large financial institutions, is going to be critical.

And for American businesses, it’s going to be absolutely critical to enter in a contract. So there are certain are. There’s no legal question too. The legality question, until that’s addressed somehow, it’s going to be extraordinarily difficult for this industry to grow. My belief is that the ones who are successful at addressing the legal issues and bringing default into the regulatory sphere, rather than the ones who are trying to figure out which best offshore jurisdiction to go to, to make the most money are going to be the ones that succeed in the United States with the largest financial system and the largest market in the world. We have the strongest capital formation markets. We have the strongest derivative markets, and to a large degree, it’s because it’s a regulatory system and people have confidence that when they put their money into it, they’re not going to get cheated.

Is there cheating? Are there Bernie Madoff’s? Yes. Okay. But that’s rare, and people still have confidence. Our markets just survived the, the pandemic, the disruption, and the volatility caused by worldwide shut down and people have confidence in the US market and the US system. And it’s because of our regulations. Our regulations are designed to protect investors. They’re not designed to protect the intermediaries. They’re designed to protect investors. If you look at the entities in our markets today, the largest entities, centralized exchanges, on our market CME and Intercontinental, CME was a disruptor. CME go back 30 years ago. CME was a market that was trading hogs. And what did they do? They innovated, they traded financial products, and they demanded regulation. They were one of the entities that supported the expansion of the CFTC jurisdiction into financial commodities in ’74, because they wanted the stamp of regulation and confidence that that brings 

Intercontinental Exchange, Jeff Sprecher started that as an unregulated exchange trading natural gas swaps in the manner that I was describing in an unregulated market. And because of the concerns about the integrity and the acceptance of an unregulated market, they decided they would go the regulated route, and they supported the regulation of their markets. They were operating an unregulated market and ICE, under the leadership of Jeff Sprecher said we want to do regulation. And look, look where they are now. They own the New York Stock Exchange. So they and CME were both disruptors in their days, but they went the regulated route. I really believe that the entities in this market who want to succeed and who will succeed in being and adopting all these wonderful innovations and bringing it to American consumers and American businesses are the ones who are going to do it and figure out how to do it the regulated way. Not the ones who are going to run to the most accommodating offshore jurisdiction that has no regulatory system. I think that is the way to go. And that’s the path to success.

Laura Shin:

And it also sounds like you think going the anonymous route won’t work because institutions will want to trade on something that has clear legality.

Dan Berkovitz:

The interaction between these platforms and the traditional platforms, we need to know, the CFTC needs to know, who is trading on these platforms. there is transparency. The blockchain is wonderful on transparency, but it’s pseudonymous. You don’t know who is doing it. You just know which string of bits there is. Okay. So the interaction with our regulated markets, we need to know who’s doing that type of trading, crypto trading, whether somebody has a large position. You can’t have, like in our markets, there’s position limits on oil there’s position limits on a lot of hard commodities. Wee need to know who is in these markets. 

So for both the legal certainty reason, the institutions aren’t going to come in, I believe, until the legal certainty is solved. Plus, there’s going to have to be some acceptance of some degree of a CFTC marketability to know the identities of the traders in these markets that affect that could have an impact on key commodities. We have to know who’s trading oil. We have to know who’s trading cotton or wheat to ensure the integrity of these markets for American businesses.

Laura Shin:

All right. So we could spend so much more time talking about DeFi cause I did have additional questions. Before we go, we do have to also cover the Bitcoin ETF. The Bitcoin community, and the wider crypto community, have been waiting for a Bitcoin ETF for some time. SEC commissioner Hester Peirce recently said that a Bitcoin ETF should have been approved a long time ago and that its rejection previously shows a double standard being applied to crypto. And additionally, former CFTC chairman Timothy Massaad said that he believed a Bitcoin ETF would be good for investors and regulators because it could improve the trading integrity on crypto exchanges. What do you think about Commission Peirce’s and former Chairman Massaad’s remarks?

Dan Berkovitz:

I would just say we made the determination, the CFTC made the determination back in the year 2016 to permit the Bitcoin futures contract — with a number of conditions regarding the integrity of the spot market in which those prices were based. So we made a determination that under our regulations, under the standard in the Commodity Exchange Act, that the contract was not susceptible to manipulation. I fully defer to the SEC on whether the standard that they’re using for whether there’s sufficient integrity under the spot price to support an exchange-traded fund — there independent view at this date and time, I’m sure they’re considering all the appropriate factors, so I would just defer to the SEC on their determination under their statute.

Brian Quintenz:

I agree with Commissioner Berkovitz that this is something that is squarely within the SEC’s purview. I think talking about the decisions that the CFTC has made with regard to Bitcoin futures may shed some light on how I view this generally. But Dan’s right. And I think it was December of 2017, the CFTC allowed, or did not object to exchanges listing Bitcoin futures contracts under a standard that the indexes to which they settled were not readily susceptible to manipulation. In doing so, we didn’t place any value judgements on whether or not it was appropriate for market participants to be purchasing Bitcoin futures. We were concerned with: is the index readily susceptible to manipulation that this product is going to settle to?

And our determination was that it did meet that standard because at least one of those indexes was a mathematical formula that took the volume-weighted average price across multiple crypto exchanges over five minute periods over an hour, and then averaged them. Which means that could you manipulate that kind of index and that construction, maybe, if you had enough capital, I think with enough time and enough money anything’s manipulatable. I think we all know that. But I think we’d also be able to tell exactly who did it and where, and and find them and hold them accountable for it. So from my own perspective, I’m proud to have been involved with a listing of Bitcoin futures in a process that did not put a value judgment — one way or another with technology-neutral and met the standards of our act, which said the index to which settles is not readily susceptible to manipulation. How that applies to the SEC and whether or not value judgements are a part of their process or not, or whether or not there are concerns about a product reflecting the entire ecosystem in which the underlying contract or product is traded.

I don’t have a lot of familiarity with that. But I do think that an ETF product on a crypto asset solves for a lot of institutional hesitancy, where there is probably demand. And it gets to the accounting treatment of this, which kind of reflects back to my days as an investment manager, because I think in your conversation with Congressman Emmer, you talked about these sitting on balance sheets as intangible assets, which means they can never be written up and they are usually, and they are regularly tested for impairment, which means that if they trade below the purchase price, they are negatively impaired. So there is no upside from an income statement or balance sheet perspective in maintaining a crypto asset itself on your balance sheet. But if you gain that exposure through an ETF, it becomes a security, which is marked to market in real-time, and you don’t have to worry about the custody issues. There are broad implications for this. And I hear about demand all the time, and given that it is a commodity on which futures contracts are already listed, I can’t understand, but also nor speak to the hesitancy at our sister agency.

Laura Shin:

That’s interesting. I have raised that issue about the accounting a few times, and this has affected obviously companies like Tesla when they’re reporting their earnings because they do hold Bitcoin on their balance sheet. I do find it fascinating because, just speaking as a journalist, but to me it doesn’t really make sense. So I do find that interesting. And I like the idea that a Bitcoin ETF could resolve those accounting issues for corporations that are interested in getting exposure to Bitcoin in their treasuries. Well, this has been such a fascinating discussion. I didn’t even get to, I don’t know, some huge percentage of my questions. So we’ll have to have you back. In the meantime, where can people learn more about each of you? 

Brian Quintenz:

CFTC.gov. Our biographies are up there. All of our speeches, statements, testimony to the extent we’ve given it, articles, the press office does press releases. That’s a great resource if you want to learn more about us and our philosophies and how we think about space

Laura Shin:

Why don’t you each give your Twitter handles as well?

Brian Quintenz:

It’s it’s @CFTCQuintenz

Dan Berkovitz:

I think I’m the same. Yeah. I do want to engage in the dialogue. I really believe in openness and public participation. Feel free to contact me or my office happy — I’ll be happy to discuss these issues with the folks out there. They’re important issues.

Laura Shin:

Great. All right. Well, thank you both so much for coming on Unchained.

Thanks so much for joining us today. To learn more about commissioners Dan Berkovitz and Brian Quintenz, check out the show notes for this episode. Unchained is produced by me, Laura Shin, with help from Anthony Yoon, Daniel Nuss, and Mark Murdock.

Unchained Podcast