Keynote Speech of CFTC Commissioner Sharon Y. Bowen before the Quadrilateral Meeting at the European Central Bank (Frankfurt, Germany)
June 24, 2015
Thank you for the introduction and good evening everyone. It’s a pleasure to be here in Frankfurt to speak to market participants, regulators and observers on this side of the Atlantic. We all share one global market in finance these days, and that market cuts across a broad landscape of different commercial, regulatory, and political systems.
In many respects, our global financial markets mirror the complexity and interconnected web of the internet. There has been an excellent series in The Washington Post, my new hometown newspaper, about the mishmash of networks and protocols that make up the internet. It highlights the challenges this creates for cybersecurity and information infrastructure. Our financial markets are similar to the internet in that they have grown organically and through individual ingenuity. And fitting them together from a financial or regulatory perspective provides no shortage of challenges when they span the globe.
Now, as many of you know, my agency, the Commodity Futures Trading Commission is in the midst of discussions with European Union and other regulators about a number of issues. These discussions are complex, multiparty, and ongoing. While I will not go into the details, I will share my thoughts on some of the inherent challenges these issues pose. Let me first note that my remarks today are my own, and do not reflect the views of my fellow Commissioners or the CFTC staff. It’s been a long day for many of you, so I’ll try to keep my remarks somewhat brief and then field some questions from the audience and be a little more interactive.
We are at an interesting time in financial regulation. The major foundations of our regulatory system have been set and we are in the middle of building that system out. As we do, we continue to face questions about how that system will prevent or mitigate the effects of a future crisis and ensure that risk does not accumulate in hidden, opaque pockets only to blossom into another market crisis.
I know that some have criticized these regulatory reforms as putting brakes on the economy, of holding it back. Well, if those brakes keep us from crashing into another financial brick wall, we will all be thankful.
We can do better. The regulatory system we are building towards is not perfect, but it is far better than a few years ago and can still be enhanced further. And we have to enhance it further. We must be vigilant as to how we can improve our regulations so that they address risks, but in a way that is as efficient as possible.
The challenge of getting our own domestic system correct in the U.S. is less difficult compared to the challenge of making sure the international regulatory regime works smoothly and efficiently. All of our governments have their own unique challenges for financial reform based upon our cultural, legal, and economic histories. In that regard, I am pleased to be here in the EU to learn from your experiences and share our own.
The core of the success of our financial system and indeed its problem is the inherent drive for increasing profitability. The drive for profits is a foundational tenet of our economy. It is essential for future growth. But, in the 2008 collapse, that drive for profits and lack of regulation led to the creation of subterranean pools of risk that ate away at the foundations of our economic and financial highways, unseen by all but a few, until they collapsed in a giant economic sinkhole, one that, worldwide, we’re still trying to climb out of. Over the past couple of decades, that drive for profit has led to extensive manipulation of financial and commodity benchmarks, yet again in a space that was largely unregulated.
Profit may drive our economy and growth, but regulations, rules of the road, are needed to make sure risk-taking does not get out of hand.
Areas where risk can accumulate must be examined to make sure adequate safeguards are in place. One critical financial highway is our settlement, payment and clearing systems. When they experience disruption, the shocks are widespread and significant.
Consequently, the subject of clearinghouse default risk has received a lot of attention recently. Clearinghouses reduce risk in the system by centralizing credit risk and reducing dependency on counterparties. But such a central role also has its own risks. The failure of a clearinghouse, while highly unlikely, would be devastating, and that possibility has been the subject of many articles and commentary.
In April, the CFTC’s Market Risk Advisory Committee, which I sponsor, looked at risk management techniques used by clearinghouses as part of its inaugural meeting. Several MRAC members noted the importance of having transparency so that members have confidence that appropriate measures are in place to address the potential default of a clearinghouse member, since their members are exposed to the risk of the clearinghouse.
Everyone in finance remembers the chaos surrounding the 1987 crash or, for the younger members in the audience, Lehman’s 2008 bankruptcy. It was a mess; in fact, a hot mess in today’s parlance. It demonstrated not just the interconnectedness of our financial institutions, but also the difficulty of resolving an entity across international boundaries, where regulations and bankruptcy laws differ. We cannot assume that everything will go perfectly, that we will effortlessly implement a default plan. Risk management protocols need to be designed and tested with the understanding that they need to be flexible. They need to be able to account for potential obstacles that arise. And equally important, people need to be trained to be able to use them so that the risk of errors can be minimized.
James Madison, one of the framers of America’s Constitution, once wrote that “If men were angels, no government would be necessary.”1 I have heard one woman in finance state that if we had a “Lehman Sisters” instead of “Lehman Brothers,” we may not have had the severity of the financial crisis and subsequent taxpayer bailout. Whatever the reason for excesses that led to the crisis, we know people are going to push the boundaries of financial regulation. We know people are going to continue to take risks and sometimes make bad decisions. We know events can unfold in unforeseen ways that roil financial markets. If we were perfect, there would be no need for default plans in the first place. But this is the world we live in, and we have to make sure our plans account for our own limitations.
And while we’re talking about logistical issues and the failings of human instinct, let me say a few words about ways to improve the retail foreign exchange market. This is a topic I’ve been focused on all year. The Swiss Central Bank’s decision in January to remove the cap on the Swiss Franc triggered chaos in the currency markets and nearly caused one domestic retail foreign exchange dealer to fail. Simply put, it makes absolutely no sense to me that retail fx trading is the least regulated part of the over-the-counter swaps market. Retail fx caters directly to retail investors unlike the bulk of the swaps market, which is traded by sophisticated financial and commercial institutions. The National Futures Association, the U.S, self-regulatory organization for much of the swaps market in America, has taken some good initial steps to increase margin requirements on foreign retail exchange dealers. But these steps, which include requiring investors to now post 5% margin on certain currency pairs, up from 2%, I regard as merely the first step.2
The time has come to comprehensively regulate this market. Retail commodity trading should occur on regulated exchanges, just as retail securities trading does. Too much retail foreign exchange trading currently occurs over-the-counter. Exchange trading would increase transparency and provide retail investors a fair and open market. It would safeguard retail customer’s funds.
I do not think these ideas require new legislation – instead, we can implement these proposals within our current rulemaking authority. Ideally, of course, whatever the CFTC does in this space should not be substantially different from the rest of the world. Investor protection is a global imperative and harmonization would protect our most vulnerable investors.
Let me now turn to another topic that is prominent in the news everywhere today: preventing market manipulation. Just last month, the CFTC, other U.S. regulators, and the Financial Conduct Authority charged one major financial institution with manipulation of global foreign exchange benchmark rates. Sadly, this was just the most recent example of a financial institution trying to manipulate major international benchmarks. As you all know, European regulators have responded to this serious issue with a number of proscriptive regulations. I certainly do think we need to take a look at how to make this part of our financial markets function better. Benchmarks are essential for price discovery and are heavily relied upon by market participants. While the system has clearly had issues, steps have been taken to improve governance, increase transparency, and look for ways to base benchmarks on actual transactions as much as possible. I know, here in Europe, lawmakers are considering additional regulation of benchmarks. I am open to the idea that further steps may be necessary to improve oversight of benchmarks. We will be following what evolves from the tri-party talks the European Union is having and I know discussions will continue on how to address regulation of benchmarks across borders. I think it should be possible for regulators to take steps that ensure the market is fair, without damaging the vibrancy of the market.
Market manipulation must be addressed wherever it occurs. Dodd-Frank gave us new powers to fight market manipulation and we have been using them. Just a few weeks ago, for instance, the CFTC initiated an action against a trader in England for spoofing the E-mini S&P 500 contract, which is a stock market index futures contract based on the S&P 500 index. Spoofing is the practice of sending in bid offers for products that you intend to cancel before they are executed. That case is particularly noteworthy because some of the alleged behavior occurred around the time of the flash crash on May 6, 2010.
Let me turn to another topic that is frequently discussed today, and that is the subject of liquidity. There has been a lot of talk about liquidity in the last few months, including whether we are seeing a notable drop in liquidity. Needless to say, it’s important that we have sufficient market liquidity – without liquidity, everything runs less well after all. In an effort to gain additional insights into what is happening with regards to market liquidity, the CFTC’s Market Risk Advisory Committee, which I sponsor, discussed this subject in our meeting earlier this month. I don’t want to go into too much detail about our meeting, but I do encourage you to watch it online if you’re curious about the subject.3
That said, two things were apparent to me. First, the lack of a common definition for liquidity is a major obstacle to improving liquidity. Many speakers at MRAC had extremely different opinions about what constitutes strong liquidity. Absent agreement on what liquidity actually is, regulators will be hard-pressed to craft and implement policies to improve liquidity. At the very least, people need to be more precise about what they really mean when they say liquidity is down or we need more liquidity.
Second, the alleged drop in liquidity is not due solely to changes in financial regulations. While the new regulations enacted as part of Dodd-Frank, Basel III, or European Market Infrastructure Regulation (EMIR) may be playing a role in changing liquidity, many participants didn’t focus on regulations as being the prime cause for a drop in liquidity. We need more study of this subject, however, and we should be quick about it.
To return to the topic of manipulation, however, let me note that, we have prosecuted many other cases of misbehavior with our new authority. I believe that engaging in robust enforcement of our rules is at the heart of our mission. People lose confidence in the markets if they think they are being manipulated. A lack of confidence in markets will only discourage people from trading, thereby reducing liquidity and harming markets and investors. Additionally, manipulation of crude oil, heating oil, or natural gas can artificially increase prices, costing consumers money and impacting growth.
It is not enough to just chase market manipulations through enforcement actions. We need regulations that discourage people from trying to manipulate in the first place. Strong civil and criminal penalties are one such deterrent, as is increased CFTC oversight and surveillance of the markets. Position limits, which the Commission continues to work on, can prevent the accumulation of large, outsized positions that might create market power. Our universe of self-regulatory organizations can help police the markets and market participants to guard against wrongdoing. But I believe there is another tool that could help reduce the risk of manipulation, and that is a robust governance regime.
Good governance protocols and rules are at the heart of how any fund or corporation operates. They lay out the norms of a corporate entity and also help establish what the culture of that company will be. Strong governance protocols encourage employees to follow the rules and inform senior management when something seems amiss. With weak governance protocols, on the other hand, employees may not think it’s important to report issues or, worse, fear reprisal for flagging problems. Strong governance is the conscience of a company – it encourages thoughtful consideration of the rules and helps keep employees from crossing regulatory and legal lines, including using trading strategies that might be manipulative.
The CFTC was tasked to issue regulations on governance under Dodd-Frank. This rulemaking requirement was one of the first things we acted on. In October 2010, a little under three months after Dodd-Frank became law, we issued a proposed rule on governance. It provided guidelines on conflicts of interest and also crafted a system to improve the governance of a number of our registrants. However, nearly five years later, we have neither finalized that governance proposal nor issued a new proposal. It is time for us to act on this rule.
I believe completing the rule on governance is critical for two reasons. First, the governance of our registrants affects how the entities that run our markets function. The governance proposal covered a number of major topics - from compensation policies for public directors of registered entities’ boards of directors4 to an expertise standard for members of those boards.5 The proposal even required that boards of directors of registered entities engage in an annual performance review.6 Governance standards set an important floor for how markets should operate.
Second, I believe this rule can and should be part of a broader effort to improve culture. We have a culture problem in finance at present.7 As a Commissioner of the CFTC, I’ve seen a significant number of settlements and enforcement actions in the last year. Some of those violations are committed by individuals deliberately seeking to defraud investors or pursue manipulative schemes. Other times, however, the violations come from large organizations that have previously violated the rules. Both are problems, but we should be particularly troubled by one entity engaging in repeated rule violation, or as it is sometimes called, recidivism.
A strong governance rule would be a major tool to deter rule-breaking and address risks. Culture flows from the top – when you have a strong, independent, and involved board of directors, it’s more likely that issues and risks will be addressed before they either become problems or cause a regulation or law to be broken.
In that regard, I was heartened to read the Fair and Effective Markets Review that the Bank of England, Exchequer, and Financial Conduct Authority published earlier this month. The review, which was ordered last summer, has proposed a number of ideas to improve the conduct of persons in finance and thereby reduce recidivism in the industry. I was particularly happy to see that one of the proposals was to “raise standards, professionalism and accountability of individuals,” including “new expectations for training and qualifications standards” for personnel in the fixed income, commodities, and currency markets.8 As I’ve said previously, I agree we need to establish some rigorous professional standards in these markets. My staff and I are continuing to review these recommendations and I would hope that we can mirror some of them in the CFTC’s governance rule.
Completing our governance rule is important because it addresses a critical part of our mandate. The 2010 governance proposal was filled with a number of good ideas, but I think it can be enhanced. It can at least be an intermediary step towards creating model rules and best practices for improving culture in the broader financial industry.
First, we need to craft some qualitative standards for board membership. A key element of the previous proposal was a quantitative standard for board membership: 35% of the members of boards of directors of our registrants were required to be public directors, and all boards, regardless of size, had to have at least two public directors. Quantitative standards have their merits, but I think we need some qualitative standards as well.
Quantitative and qualitative standards for board membership can work together to ensure boards’ meaningfully independence. One way is to require a holistic review of the board’s independence at regular intervals. Or, we can require certifications by the public directors each year to stockholders that they are truly independent. We could approach it from a resource standpoint by asking a board to certify that it is providing adequate resources to improve culture and the tone at the top, or that it craft plans for improving the overall culture of a company. We could even ask a board specifically to explain how it is ensuring that its employees are not engaged in manipulative behavior.
Second, I think this rule should require the board to give active attention to issues of culture. The 2010 proposal mandated the board of directors to perform an annual self-review. I think this should include a consideration of issues of culture. If a company has been penalized for market manipulation in the recent past, it should be especially incumbent upon a board to improve the culture to prevent future instances.
Third, we need to try and harmonize governance across entities as much as possible, including across international boundaries. There’s no reason to complicate matters and propose governance requirements for American public corporations be substantially different from governance for a British exchange. If we can harmonize our rules on capital requirements or who qualifies as a systemically important institution, why would we not harmonize rules on how to improve the operations of our trading facilities or increase the independence of those facilities’ boards?
On that note, I’ve considered some of EMIR’s governance requirements as they apply to British clearinghouses, and honestly, I think many of these requirements could work for a variety of U.S. registrants. Again, principles of governance are universal, and some things that work for British clearinghouses could be applied to U.S. exchanges (DCMs) or swap execution facilities (SEFs). While the application of these principles might be slightly different for a CCP than for a SEF, the overall goal behind these principles remains the same: to manage risk. For instance, EMIR Article 26.1 states “A CCP shall have robust governance arrangements, which include a clear organisational structure with well-defined, transparent and consistent lines of responsibility, effective processes to identify, manage, monitor and report the risks to which it is or might be exposed, and adequate internal control mechanisms, including sound administrative and accounting procedures.”9 There’s nothing in there that couldn’t or shouldn’t be applied, for instance, to any U.S. SEF. Even some of the more specific requirements seem to be easily applicable. Under EMIR Article 28.1, a CCP must establish a risk committee and “[t]he advice of the risk committee shall be independent of any direct influence by the management of the CCP.”10 I think it would make sense to promulgate a similar requirement for U.S. DCMs or SEFs. In fact, I would hope that they look into adopting such a requirement into their rules governing their current regulatory oversight committees.
So, to return to how we begin, the message of this speech is that we’re all human beings with our own failings, regulators as well as market participants. When market manipulation happens, that’s a big problem, and it’s also a big problem when regulators fail to catch market manipulation. Yet, it’s an even greater failing when regulators or market participants see a problem and not take steps to prevent it from happening in the future. With clearinghouses, retail foreign exchange trading, and culture, we need to not only fix the problems that exist today but also prevent the problems of tomorrow. And in terms of retail foreign exchange trading and governance at least, the present system isn’t working, and we have no excuse not to fix them. Thank you for being here this evening. Please feel free to ask questions.
1 Federalist No. 51, available at http://www.ourdocuments.gov/doc.php?flash=true&doc=10&page=transcript.
2 Andrew Ackerman, “Regulators Boost Margin Requirements on FX Trades,” Wall Street Journal, Jan. 21, 2015, available at http://www.wsj.com/articles/cftcs-bowen-calls-for-review-of-retail-fx-rules-1421866479.
3 Available at https://www.youtube.com/watch?v=HKD07CxXUKU.
4 Proposed CFTC Governance Rule, 17 C.F.R. Part 40.9(b)(4), at 75 Fed. Reg. 63752, Oct. 18, 2010, available at http://www.cftc.gov/idc/groups/public/@lrfederalregister/documents/file/2010-26220a.pdf.
5 Id. at 63751.
6 Id. at 63752.
7 See Commissioner Sharon Y. Bowen, Commodity Futures Trading Commission, “Remarks of CFTC Commissioner Sharon Y. Bowen Before the 17th Annual OpRisk North America,” Mar. 25, 2015, available at http://www.cftc.gov/PressRoom/SpeechesTestimony/opabowen-2.
8 Fair and Effective Markets Review, Final Report, June 2015, at 7, available at http://www.bankofengland.co.uk/markets/Documents/femrjun15.pdf.
9 Regulation (EU) No. 648/2012 of the European Parliament and of the Council of 4 July 2012 on OTC Derivatives, Central Counterparties and Trade Repositories, Official Journal of the European Union, L 201, July 27, 2012, at 30, available at http://eur-lex.europa.eu/legal-content/EN/TXT/PDF/?uri=OJ:L:2012:201:FULL&from=EN. Some of the same concepts discussed in this section underlie the U.S. governance proposal. See Proposed CFTC Governance Rule, 17 C.F.R. Part 40.9(b)(5), 75 Fed. Reg. 63747-48, Oct. 18, 2010, available at http://www.cftc.gov/idc/groups/public/@lrfederalregister/documents/file/2010-26220a.pdf.
10 Regulation (EU) No. 648/2012 of the European Parliament and of the Council of 4 July 2012 on OTC Derivatives, Central Counterparties and Trade Repositories, Official Journal of the European Union, L 201, July 27, 2012, at 31, available at http://eur-lex.europa.eu/legal-content/EN/TXT/PDF/?uri=OJ:L:2012:201:FULL&from=EN.
Last Updated: June 24, 2015