CFTC Commissioner Johnson Calls for Strengthening Regulatory Framework in Light of Market Developments
Commentary by Steven Lofchie
CFTC Commissioner Kristin N. Johnson offered recommendations to strengthen the regulatory framework by addressing "notable fragilities within asset classes among critical financial market intermediaries and more generally across the financial market ecosystem."
In a speech before the Salzburg Global Finance Forum, Ms. Johnson highlighted the following:
- Banking Sector Disruptions. Ms. Johnson stated that the "runs" of Signature Bank and Silicon Valley Bank demonstrated how "highly correlated and deeply interconnected financial products and platforms have altered the financial markets ecosystem." She stated that the banks’ failures underscored the importance of banking entities’ relationships with depositors and their role as a custodian of customer deposits. Ms. Johnson argued that preservation of customer assets and addressing conflicts of interest "transcends regulatory silos. . .".
- The Rise of Nonbank Financial Institutions ("NBFIs"). Ms. Johnson warned that exposure to NBFIs by traditional financial institutions, through credit lines and loans or common asset holdings, can create losses for financial institutions if the counterparties do not honor their liabilities. Ms. Johnson advocated for increasing oversight of systemically important financial institutions and new sources of risk.
- Confidence in Financial Systems. Ms. Johnson said that new requirements on the segregation of consumer funds for banks, would increase customers confidence in the security of their funds. Ms. Johnson called on the CFTC to consider potential parallel customer protection rules for certain derivatives clearing organizations that do not rely on intermediation. She added that parallel protections will become more important as market participants incorporate non-intermediated market structure. Ms. Johnson also highlighted the importance of requirements on (i) disclosure of conflicts of interest and (ii) fitness standards for individuals in executive roles to ensure "reputable and well-rounded governance."
- Vertical Integration. Ms. Johnson stated that the recent bankruptcies and related involvement with crypto assets demonstrated the need for additional risk management measures. Ms. Johnson warned that additional risks are presented by vertical integration. She noted IOSCO’s guidance on crypto markets, which calls for "accurate and transparent disclosures" by crypto asset service providers on their roles and capacities to their clients.
- Collateralization and Market Requirements. Ms. Johnson advocated for regulators to reexamine collateralization and margin requirements to address counterparty risk in the financial system. She cautioned that if market participants are not prepared to satisfy collateral demands, efforts to raise cash could result in strains on liquidity in stressed markets and amplify shocks.
Ms. Johnson called on Congress to authorize the CFTC to conduct "effective due diligence" on firms seeking to purchase 10 percent or more in equity interest of any CFTC-registered exchange or clearinghouse. She encouraged the CFTC to evaluate corporate governance and risk management processes of any entity seeking to acquire a significant equity ownership stake in other CFTC-registered entities.
Commentary
The premise of Commissioner Johnson's remarks seems to be that there are changes in our economy or technology that make the current state of regulation inadequate. But the failures of the various banks were quite old-fashioned: A fast and large rise in inflation wiped out much of the value of the holdings of securities and also made it more expensive for them to maintain deposits; the banks had very poor risk management in that they not only borrowed short and loaned long, their short borrowings were very flighty, and regulatory oversight was, even by the regulators' own admissions, not that strong.
Likewise, the Commissioner points to the fact that the failed banks made excessive loans to digital asset companies, which turned out to be bad credits. But making bad loans is not a new risk; nor is being overly concentrated in loans to a single industry. Banks that are very concentrated in other industries, such as real estate loans, may also be feeling pain. At the end of the day, these are the routine risks of banking.
Calls for more regulation obscure the reality that both the failed banks and the regulators missed the basics.