I appreciate the opportunity to speak to you today at this important event. Over its 21 year history, ISDA has provided strong leadership in the development, standardization and growth of the derivatives industry. ISDA has also been integral in aiding decision-makers in Washington D.C. in crafting policies to uphold the legal and regulatory certainty that these products need to survive and thrive. Indeed, ISDA was a key voice in the passage of the Commodity Futures Modernization Act of 2000, which reinforced the legal certainty of over-the-counter (OTC) derivatives and provided needed relief to the regulated futures markets. For all of this, I commend your organization and appreciate the opportunity to appear before you today.
This morning I would like to address the accelerating globalization of the derivatives markets and what challenges this brings to regulators as well as the markets themselves. In his remarkable bestselling book, “The World is Flat”, Thomas Friedman of the New York Times describes how certain technological and political events over the last two decades have dramatically reshaped how people conduct business in our global economy. With the fall of communism and the development and proliferation of personal computers, the Internet, browsers, email, fiber-optic cables, and technology standards, Friedman believes that the global economy has entered into an era of unprecedented transformation—the likes of which may even surpass the invention of the printing press, the rise of the nation-state and the industrial revolution. Without regard to borders or government ideologies, individuals and businesses today have the tools and abilities to communicate with each other and allocate capital and intellectual assets to where those resources can be utilized most efficiently with minimal cost. This technological and communications revolution has become the great equalizer or “flattener” around the global economy, empowering individuals around the world to compete successfully with more established “brick and mortar” businesses. Most notably, this has provided an on-ramp to the global economy for India and China with their sizeable educated and low-cost workforce. Anything that can be digitized, from a company’s payroll to an individual’s PowerPoint presentation, can be outsourced over the Internet to a willing and educated worker located elsewhere, often continents away.
This has major implications for the American Worker. Friedman notes that 30 years ago, it was preferable to have been born a B+ student in Indianapolis, Indiana, rather than an isolated genius in Bangalore, India. Today, he argues, it’s more advantageous to be a genius in India, because that genius can now innovate at a global level without ever having to leave his homeland. That is what the flat world makes possible.
As I read about Friedman’s premise and reasoning, I began to think about the flattening of the world in terms of the U.S. futures and derivatives industry. Not surprisingly, I came to the conclusion that this global industry may be one of the “flattest” of them all due to several reasons I want to explore with you. This “flat” dynamic will likely present challenges to all of us and in my view, will require regulators to rethink how we have traditionally approached market regulation in the past.
My flat world “aha” moment came during a conversation I shared a few years back with Charlie Carey, Chairman of the Chicago Board of Trade (CBT) and Bernie Dan, its CEO and President. They were describing to me their electronic trading platform—LIFFE Connect. At the time, one of its superior features enabled traders from most anywhere around the world to get the same speed of execution for trades, whether they were located in London or LaSalle Street. In fact, due to this feature, they described how a futures trading community was beginning to form in Gibraltar thanks in part to its advantageous tax status and high quality of life. In other words, for execution purposes, technological advancements made physical location a marginal factor in whether you succeeded in the trading of derivatives. This made me think back to Friedman’s analogy—in today’s trading environment, would I rather be a mediocre open-outcry trader in Chicago or a brilliant electronic trader in Gibraltar? Clearly a flat world gives the advantage to the Rock over the Windy City.
Although this may be obvious to many of you, this epiphany struck me as particularly significant in an industry where physical location had meant everything in the past. Your location in the pit determined whether you had the sightlines to succeed or not. The pit itself limited the number of people who could participate directly in a market. The law required that the trading of futures contracts be confined to certain registered exchange locations, most notably in Chicago and New York. Physical locale not only determined whether you succeeded in this business but also whether you could even directly participate in the first place.
At the founding of the futures industry, it was necessary to have such location requirements and limitations to ensure that the markets functioned efficiently with the proper government oversight. But technology, as it became clearer to me during my “aha” moment, was a powerful, undiscriminating equalizer for those who were on the outside looking in. As long as you have the proper legal environment, a computer and adequate bandwidth, you can compete.
The derivatives industry is at the forefront of this global flattening revolution. Although there are many reasons why this is the case, I want to identify the five significant events that, in my view, helped flatten the competitive playing field in these markets and how these events will continue to reverberate for the months and years to come in determining how regulators oversee these markets. Although much of my discussion is focused on events in the exchange-traded world due to my responsibilities in that area, the concepts and conclusions apply to all derivatives regardless of form.
1. The Birth of Financial Futures
May 16, 1972—On this date, financial futures were born, beginning the flattening process in this industry over thirty years ago. The first architects of these products understood that the risk-transferal concepts that had worked in the agricultural futures markets for nearly 150 years had interchangeable parts that could be deconstructed, rebuilt and applied to other financial products where economic risk may be present. With the collapse of the Bretton Woods monetary accord in 1971, Nobel Prize-winning economist Milton Friedman saw how to put these concepts to work and published a prescient article in which he predicted that the end of the Bretton Woods system would lead to the creation of a successful derivatives market in foreign currencies.
When President Nixon closed the gold window on August 15, 1971, the demand for risk management in financial products blossomed. Professor Friedman’s article served as part of the intellectual foundation on which the CME established the International Monetary Market (IMM) in 1972 to trade foreign currency futures. The volatility engendered by the dismantling of the Bretton Woods system created not only a vibrant exchange-traded market in foreign currencies, but the beginnings of the now-dominant interbank currency market, which today is the deepest, most liquid financial market in the world.
The development of financial futures, as compared to physical futures, also eliminated most of the logistical difficulties of delivering the underlying commodity, enabling quicker innovation of these products and their eventual migration to electronic trading. Gone was the need for warehouses and barges as settlement through electronic debits and credits now ruled the day. Although the start of electronic futures trading was still twenty years away, it would not have been possible without the innovative and flattening force that was the birth of financial futures.
2. Electronic Trading
June 25, 1992—Electronic futures trading began, ushering in the second flattening event to the futures industry. On this date, the Chicago Mercantile Exchange (CME) launched the first electronic platform, Globex, which traded a modest 2,000 contracts that day. Although volume on Globex grew slowly at first, the introduction of an E-mini S&P 500 futures contract in 1997 paved the way for an explosive expansion in electronically traded products. Before the launch of this contract, open outcry trading accounted for 95 percent of the volume on U.S. futures exchanges. By 2003, electronic trading had captured half of that total volume, and today represents over 60 percent of the market.
Of course, electronic trading is a worldwide occurrence and a vast majority of foreign exchanges are electronic due to their modern beginnings. Eurex, one of the world’s largest derivatives exchanges, began and remains only electronic. In 1998, LIFFE—now Euronext.liffe after its purchase by Euronext—closed its open-outcry trading after losing the industry’s first battle “pitting” the floor against the electronic format—no pun intended. Recently, ICE Futures exchange, regulated by the UK Financial Services Authority (FSA), converted from open-outcry to electronic and now competes head-to-head on energy products with the historically open-outcry New York Mercantile Exchange (NYMEX). In reaction to this competition, this week NYMEX began to list some of its energy complex on CME’s Globex platform. I will come back to the regulatory concerns raised by this competition a little bit later.
Electronic trading is an enormously flattening force because it does not artificially limit the number and location of traders wanting to participate in a market. If you have a computer, you can plug and play from anywhere in the world. Electronic trading has also significantly lowered the cost of entry for exchanges and traders wanting to compete in this space. Since 2000, the Commission has registered eight new exchanges for trading; all eight chose electronic platforms over open-outcry.
December 5, 2002—The day the CME went public; my third flattening event. Those of us on the sidelines have been amazed by the spectacular growth of this company’s stock, which was initially offered at $35 and now hovers near $450 per share. Its current market capitalization makes it the largest exchange in the U.S., including both equities and derivatives, and ranks it above such other notable blue-chip companies as General Motors. The success of CME’s IPO, as well as several other exchanges, indicates that shareholders place a great deal of value in this new exchange model.
The public listing of exchanges is significant in a flat world because exchanges can more quickly and effectively make competitive decisions than before in their member-driven organization. A public offering also unlocks the capital that had been built into the business model of an exchange and enables the exchange to use this asset for global growth opportunities. A good case in point is the New York Stock Exchange (NYSE), which went public on March 14 of this year. Within a couple of months, the IPO provided the organization with the will and the way for optimizing new growth opportunities with its announced merger with Euronext. Most would agree that this opportunity would not have been possible under their former mutualized organization.
4. Development of Common Standards
May 23, 1985—On this date, ISDA officially incorporated and published its first definitional standards for swap agreements, beginning the fourth flattening trend in the derivatives world. Common standards are important in a network economy because they force competitors to focus resources on competing and adding value to the marketplace versus arguing over the rules of the game before the competition even starts.
Since ISDA was formed and the first standardized swap agreement was issued in the mid-1980s, the global implications of these agreements for the financial services community have been enormous. Immediately, by standardizing the terms of contracts, OTC participants could trade globally, minimizing concern over the legality of their contracts. By 1987, the notional value of outstanding OTC contracts was $865 billion.
Over time, ISDA has continued its push for common standards as evidenced by the publications of the 1992 and 2002 Master Agreements in several languages. Global market participants have reaped huge time and cost saving benefits through these standardized protocols, which, in conjunction with ISDA’s commitment to Financial products Mark-up Language, became the foundation allowing these products to more easily migrate to electronic processing. Now the vast majority of interest rate derivatives are completed in less than 20 minutes, compared to the five days it took just a few years ago. Through its commitment to further standardization and efficiencies, ISDA has been an influential force in the flattening of this industry.
5. The passage of the Commodity Futures Modernization Act (CFMA)
December 21, 2000—the passage of the Commodity Futures Modernization Act—the fifth and final flattening event I want to discuss today. This legislation was as much a reaction to the earlier events I have described as it was a catalyst in the further growth and globalization of this industry.
When the CFTC was formed in 1974, Congress designed a rules-based regulatory structure, modeled after the securities laws, to commence oversight of the recently designed financial futures contracts. The law required that the trading of all commodity futures contracts occur on a registered futures exchange under the exclusive oversight of the CFTC. This regulatory structure ensured that trading of standardized futures contracts occurred in specific locations under the watchful eye of a Federal regulator.
But as electronic trading and globalization began to reshape our industry in the latter half of the 1990s, the rigidity of this regulatory approach became unworkable for both the regulator and industry alike, and both parties began to contemplate what sort of regulatory framework should take us into the new Millennium.
The CFMA was the result of these efforts in 2000. Although our industry has witnessed our share of industry scandals over the years and ensuing reactive legislation, the CFMA was not advanced in the shadows of wrongdoing but, instead, crafted after extensive hearings regarding these broader global trends. As a result, I believe it provides a good model for how to best approach regulation in an increasingly flat world.
First and foremost, the CFMA recognized that flexibility is paramount to regulating in this modern environment. A regulatory structure must be adaptable and tailored to market risks in order for regulators to keep pace with, but not unnecessarily stifle, market innovation. The nature of the modern, flat marketplace is to innovate, compete and arbitrage opportunities with lightning speed. But overly-burdensome regulation will increasingly threaten to send these electronic marketplaces overseas, outside of the United States’ oversight and tax basin, unless regulators are careful. In fact, John Thain, CEO of the NYSE Group, testified this year before Congress that 23 out of 25 IPOs in 2005 occurred outside the United States compared to 2000, in which nine out of every 10 dollars raised in public offerings were done stateside.
The CFMA recognized this need for flexibility by adopting a sliding scale of risk-based regulation for exchanges and participants, depending on a product’s susceptibility to manipulation and the sophistication of its traders. This tiered structure has allowed a variety of innovative trading models to blossom, including publicly-traded exchanges such as the CME and CBT and exempt markets such as ICE and the Chicago Climate Exchange.
On this flexibility theme, the CFMA adopted a principles-based approach to regulating, rather than a rules-driven one, to enable participants in these markets to use “best practices” for achieving statutory requirements. While the CFTC monitors whether a core principle is ultimately met, the exchanges, with their hands-on experience, are given discretion to tailor their rules to their special circumstances.
The authors of the CFMA also understood that in the modern economy, a successful market requires a clear and predictable legal framework for trading. As a result, the bill provided important legal certainty to over-the-counter derivatives through the exclusion of these products from the CFTC’s jurisdiction. Any legal doubt to whether a party is able to perform its obligations under a derivatives contract could severely dampen the ability for this market to grow. This means a nation’s laws —whether derivatives statutes, contract law, or bankruptcy law—must be clearly drafted to allow for the proper functioning of such private instruments without hindering market discipline, demand or innovation. I continue to strongly support the legal certainty provisions contained in the CFMA, and believe their inclusion in 2000 has kept this business vibrant.
The CFMA has also permitted exchanges to unbundle the different segments of their vertical business model and outsource some of the functions for efficiency purposes. The trading facility, the clearing house and self-regulatory duties were now being viewed separately from a business and regulatory standpoint. To reflect this development, the CFMA created a new registration category for clearing houses with its own set of core principles that would enable markets to either maintain or outsource their clearing functions. Additionally, the CFMA specifically enabled the delegation of self-regulatory functions to recognized third parties. These provisions, working in tandem, lowered the barriers to entry for competitors by enabling exchanges to form without devoting significant resources to these capital-intensive functions. Of those eight exchanges that have registered since 2000, all eight have delegated their regulatory responsibilities as well as all or some of their clearing functions to third parties.
Coordination among Federal regulators is an equally important component of the CFMA. One of the major reasons behind the exclusion of OTC derivatives from our jurisdiction was the fact that other Federal regulators were already overseeing many of the entities trading these products. Congress’ desire for us to coordinate our regulatory efforts can be seen throughout the Act, including the joint oversight structure for security futures products with the SEC as well as the oversight of retail forex coordinated among several other regulators.
These three themes of flexibility, legal certainty and shared regulatory coordination run throughout the CFMA and provide important guidance as we address other regulatory concerns that may arise in this flat derivatives world, such as the current one between ICE Futures and NYMEX.
Last February, ICE Futures, the U.K. regulated electronic futures exchange, began to list the West Texas Intermediate (WTI) crude oil futures contract in direct competition with NYMEX, utilizing a CFTC “no action” letter to gain electronic screen access to U.S. customers. In issuing “no action” relief, the CFTC staff must find that the foreign exchange is subject to a “bona fide” foreign regulatory authority. The FSA-registered ICE Futures received such “no action” relief in 1999 and has been providing screen access to U.S. customers since that time.
Unlike other “no action” contracts, however, the ICE Futures WTI contract was unique from a regulatory point of view because this was the first contract to cash-settle off an existing U.S. futures benchmark. This caused concerns among our surveillance staff since one market had the potential to be used to manipulate the other. It also raised some eyebrows because the product was labeled “West Texas” and thus was arguably a U.S. product marketed at U.S customers within our agency’s interest. Since its inception in February, the ICE WTI futures contract to date has captured 32 percent of the overall WTI market share with presumably a good portion of that volume coming from U.S. customers (see below graph). This led policymakers to ask the question: should a foreign board of trade be required to register in the U.S. once its U.S. contacts become “significant?” This is something that the Commission has struggled with for some time, dating back to our 1998 unsuccessful concept release effort on the subject when electronic trading was first taking off.
To address our surveillance concerns, the Commission and the UK’s FSA recently began sharing information that allows our agencies to effectively monitor the entirety of the WTI market. In addition, the Commission, in a recent closed meeting, instructed its staff to study and make recommendations to the Commission determining when a FBOT is no longer located outside the U.S. and must register with the agency as a U.S. exchange. The agency has also scheduled a public meeting for June 27 in Washington D.C. to discuss these issues and last week put out for comment in the Federal Register a discussion paper on foreign boards of trade.
As the Commission continues its review, I will take my policy guidance from the themes of the CFMA that I have outlined today: flexibility, legal certainty and shared regulatory coordination. As markets become more integrated and global, agencies must remain flexible and tailored in their approach or fear losing these markets to other jurisdictions. Already, leaders at NYMEX have indicated that one of their options may be to move their operations to London in order to compete. This would not be a positive development for the United States and regulatory flexibility will be one of the keys to prevent this from occurring.
Legal certainty is also important in this exercise. There are many foreign exchanges and member firms that make business decisions relying on the rules and terms set out in the CFTC’s “no action” letters. I believe the “no action” process has worked exceptionally well over time. But should evidence suggest that it has outgrown its usefulness, the Commission must be clear and concise in constructing guidance and/or rules, understanding that our actions may reverberate throughout the industry.
And lastly, foreign regulatory coordination is vital. Agencies like ours do not have the resources to sufficiently monitor the breadth of the global marketplace and its participants. We must rely on the expertise of other regulators, both domestic and foreign, in fulfilling our public mission. This does not mean that the CFTC should subrogate its interests—quite the opposite—the CFTC must continue to vigorously monitor that its core principles are being met. However, the means for accomplishing this mission may involve coordination among those regulators abiding by the highest global standards. The CFTC has long been a leader in the international community for its early appreciation of the “mutual recognition” concept among foreign regulators, dating back to the inception of our Part 30 regime for foreign firms in 1986 and the no action process beginning in 1999. I am hopeful that this agency continues to place significance in this “mutual recognition” concept as we move forward on this issue.
Despite the challenges and upheaval of a flattening world, I want to leave you with a sense of optimism for our industry and these times. The modern network economy provides exciting opportunities to leverage the collective global intellect for the betterment of our nation and the world at large. This spring, buried under the news in Iraq, the high price of gas, and the Enron trial, was a story, in which the United Nations, the World Bank and several Wall Street firms collaborated to create the world’s first weather derivative for drought emergencies in Ethiopia. Despite the minimal press, the implications of this product, if successful, have the potential to revolutionize the delivery of aid to the developing world by ensuring it reaches its recipients before a humanitarian calamity begins. I point this out as one good example of why I remain positive. It is the creative intelligence of organizations like ISDA, empowered by the flat world dynamic, which will continue to bring this sort of human advancement and market innovation in the future.
Again, thank you for allowing me to speak to you today.
Last Updated: July 22, 2007