I appreciate today’s opportunity to address NFA’s workshop for CPOs and CTAs. For over two decades, NFA has provided valuable regulatory leadership in our industry with a proven track record of protecting the integrity of the marketplace as well as its participants.
Regulators are often known for understatements so I will begin with one: This is an interesting time in the futures industry. In the last week, it was announced that, subject to regulatory approval, the CME will buy the CBOT for $8 billion, forming a $25 billion futures exchange with over twice the market capitalization of the New York Stock Exchange and that trades 88 percent of the futures contracts in the U.S. This combination is to the futures industry what a merger of GM and Ford would be to the auto industry. It is truly breathtaking from a historic and financial vantage.
Also in the last month or so, we learned of the implosion of the $9 billion hedge fund Amaranth due to an enormous spread position in natural gas that went disastrously wrong. What was remarkable about the $6.6 billion loss to the fund—larger than the exposure of Long Term Capital Management—was the fact that the markets barely hiccupped in digesting this news.
Dickens might say of these events that “it was the best of times...it was the worst of times,” but even from the neutral standpoint of this regulator, I can certainly agree that the times in this industry are extraordinary.
Today I would like to address the regulatory significance of these events and whether any regulatory actions are needed in response. But to set the stage, I would like to describe the CFTC’s regulatory requirements and safeguards as they pertain to commodity pool operators (CPOs), commodity trading advisors (CTAs) and hedge funds.
Hedge funds and commodity pools in particular serve a vital role in the efficient functioning of the futures markets by contributing important liquidity and pricing information to the marketplace. The CFTC has long recognized the market significance and risks of these types of collective investment vehicles and has thus required the registration of certain CPOs and CTAs, dating back to the CFTC’s founding 31 years ago. Currently, there are approximately 1,800 CPOs and 2,600 CTAs registered with CFTC. Once registered, CPOs and CTAs must comply with certain disclosure, reporting, and record keeping requirements and become subject to periodic examination. This “disclosure” regime is meant to ensure that prospective and on-going participants in commodity pools receive all relevant information to allow them to make informed investment decisions. This program is administered by our hosts today, the National Futures Association, which serves as the independent self-regulatory body of the industry.
Pools also benefit from the overarching regulatory protections that serve all market participants. The CFTC’s primary mission under the Commodity Exchange Act (CEA) is to ensure that the commodity futures and options markets operate in an open and competitive manner, free of price distortions. The CFTC fulfills this obligation through a comprehensive, multi-faceted program that is designed to identify and mitigate the potential for manipulation and other market abuses, and to ferret out and punish illegal behavior.
CFTC staff closely monitors, on a real-time basis, trading on the exchanges to detect unusual activity or price aberrations that may indicate manipulation. The cornerstone of our market surveillance program is the Large Trader Reporting System, which requires traders, including hedge funds, to file daily reports concerning their own and their customers’ positions in a particular contract in an attempt to detect and deter manipulation.
When the CFTC’s surveillance staff identifies a potentially problematic situation, the CFTC engages in an escalating series of communications to work to resolve the situation. The traders are advised of the CFTC’s concern regarding the orderly expiration of the futures contract. This “jawboning” activity by CFTC staff is usually quite effective in resolving most potential problems. Should more action be needed, however, the CFTC has broad authority to limit, liquidate or halt trading through its emergency powers. Fortunately, most issues are resolved without emergency action. In fact, the CFTC has only taken emergency action four times in its history but this authority represents an important hammer in our toolbox.
Should a violation of our Act occur, the CFTC aggressively pursues any entity, including CPOs and CTAs, that intentionally seeks to disrupt or undermine the integrity of our markets,. The CFTC’s Division of Enforcement investigates and prosecutes individuals and entities for violations of our Act, including manipulation, false reporting, and trade practice abuses. Over the past five years, the Commission has prosecuted 85 actions against CPOs and CTAs.
In addressing systemic risk and market integrity issues posed by firms and other traders such as hedge funds, the CFTC mandates several tiers of financial safeguards for those entities trading in our markets to ensure that the financial distress of any single market participant does not have a domino effect on the overall market. This is primarily accomplished through the financial protections of an exchange’s clearinghouse, the central counterparty to all futures transactions and as a result, a single point of failure in the marketplace needing significant protections.
These protections begin with the clearing members of the DCO, which must be registered futures commission merchants (FCMs) with their own mandated financial protections in place. The safeguards include the posting of customer and clearing firm margin based on the risk of given positions, the required segregation of such funds from other assets of the firm, and mandated capital requirements of the FCMs. At the clearinghouse level, guarantee funds and other credit enhancement devices are used as the safety net of last resort should the first levels of protection fail. Thankfully, such an event has never occurred in the history of our markets, which is a credit to the robust nature of the regime.
CFTC staff also conducts financial surveillance of the clearing system to monitor the adequacy, reliability and resiliency of its financial safeguards. They do this by analyzing information from monthly financial reports of FCMs, large trader position information, and other relevant market and financial information to identify actual and potential financial risks facing all DCOs and their clearing members and firms. The value added of the CFTC’s oversight of FCMs and clearing firms, in addition to the exchanges’ oversight, is that the CFTC can see exposures across markets. This helps to compliment and provide redundancy to the self-regulatory efforts of the exchanges and ensure that identified risks in the system are being minimized and addressed properly.
With that structural background, I would like to make some general observations about the recent Amaranth situation, which turned into a real-life stress test of these protections. Amaranth was not registered with the CFTC as a CPO due to a regulatory exemption granted for limiting its participants to high net worth individuals. Although exempt from registration, Amaranth remains subject to the anti-fraud and anti-manipulation provisions of the CEA. In reviewing the aftermath of Amaranth, the CFTC will closely study whether any of the activities leading up to Amaranth’s insolvency violated our statute and if wrongdoing is detected, the CFTC is prepared to take swift enforcement action.
However, despite the stress to the system incurred by Amaranth’s falter, the CFTC’s regulatory regime – as well as those of the exchanges, clearinghouses and intermediaries – worked as intended and the impact of this failure did not spread systemically beyond the firms involved. Upon observing the mounting losses at Amaranth, the CFTC’s first step was affirming that the protective levies to the clearing system were holding. And indeed they were. The enormity of the losses suffered by Amaranth from its positions on the NYMEX and off-exchange did not impact its clearing FCM, JP Morgan Futures, the other customers of JP Morgan, or the NYMEX clearinghouse. At all times, Amaranth’s account at JP Morgan Futures was fully margined and JP Morgan met all of its settlement obligations to the NYMEX clearinghouse. This comes on the heels of last year’s Refco scandal and insolvency, in which no futures customers’ funds were lost thanks to the resiliency of these regulatory safeguards. Both of these market events, horrific for many reasons, did have a silver lining—they showed that the futures market regulatory structure succeeded in preventing a broader market catastrophe.
But there are limits to these regulatory protections. Our statute does not provide for the CFTC’s regulation of the types of investments that pools and traders can make, nor does it impose limits on the risk appetite of a given fund or trader. Such restrictions would be difficult, if not impossible, to oversee and would distort the functioning of the price discovery market by sending false price signals to the central marketplace and by curbing the effectiveness of market discipline and risk taking. Markets must be allowed to function efficiently within appropriate regulatory parameters and government authorities should not be involved with regulating winners and losers.
But I would like to take off my regulator’s hat and simply assume the role of an observer of the financial services sector for a moment to warn the folks in the hedge fund world that the storm clouds are brewing on the horizon.
The biggest hedge fund story of last week came from Washington. Senator Chuck Grassley, chairman of the powerful Finance Committee, expressed alarm at the risks that hedge funds pose to pension holders. He asked several regulators—including our Chairman, Reuben Jeffery, and the principals of Treasury, Labor, and the SEC—to report on transparency issues regarding hedge funds. Senator Grassley’s call followed news that the employee pension funds of the states of New Jersey and Pennsylvania, and of San Diego County had all invested money in Amaranth.
But Senator Grassley’s comments are just the tip of the iceberg. Looking at just a couple days’ worth of our recent news clips, I found the following:
Item 1: The U.S. House of Representatives recently passed a bill that would require the President's Working Group on Financial Markets to study the impact of the $1.2 trillion hedge fund industry on the financial markets and make recommendations on legislative changes.
Item 2: The Connecticut Department of Banking has mobilized a new enforcement unit to look at the conduct of “big market players,” including hedge funds.
Item 3: The President of the European Central Bank says an international body with global reach is needed to provide necessary oversight of hedge funds. Jean-Claude Trichet said “none of us are fully satisfied with the present situation of relying on major financial institutions to ensure their counterparts outside of regulatory oversight are fit and proper and reliable.”
Item 4: Fitch Ratings noted in a new report that investor pressure is mounting to show how hedge funds can diversify risk and increase returns to investors.
Item 5: A study by the Yale International Center for Finance cites “significant bias” may distort the reporting of hedge fund returns.
And the list of stories goes on. I was interested to see another, more positive, story in the Wall Street Journal last weekend. It said that some funds are looking at starting some kind of oversight body – perhaps something akin to the National Futures Association – that could help the industry self-regulate itself.
I strongly agree that a share of responsibility falls with this industry to police itself and that the hedge fund industry would benefit from some type of system of formalized self-regulation. All industries reach a critical mass in their development when a common interest arises in protecting the status and standards of a given profession. Whether it is the legal community or the financial services sector, self-policing helps raise the standards of those in the field and keep bad actors at bay. The development of a self-regulatory system by those directly involved in the industry will also lessen the likelihood of a heavy-handed, comprehensive regulatory system that these newspaper stories appear to portend. Hedge fund trade associations have already taken positive steps in this direction with the development of certain industry best practices. But more may be needed in order to shore up the industry’s standing in the financial services sector over the long term, including developing a more formalized mechanism for administering and enforcing certain best practices and standards.
In addition, I believe that financial regulators should continue to study the risks that this industry may pose to the overall marketplace. Given the size and leverage of some of these funds, regulators should be primarily concerned that a single insolvency has the potential to lead to a systemic event. The President’s Working Group, consisting of principals from the Treasury Department, SEC, Federal Reserve and CFTC, is the proper body to study the risks that hedge funds may pose in the markets and have already begun to look at some of these issues. In light of Senator Grassley’s letter to individual members of the PWG, there will no doubt be further discussions on whether additional government involvement is necessary beyond what is currently in place.
Now I turn to the other major event I mentioned earlier—the merger of the CME and the CBOT. This will have broad policy and market ramifications given the shear magnitude of the combination. Three government agencies will be principally involved with the manner in which this merger goes forward. First, the merger itself will need the blessing of the Antitrust Division of the Department of Justice as they scrutinize whether this combination has anti-competitive implications under the Hart-Scott-Rodino Act. The Antitrust Division of Justice has a specialized Networks and Technology branch that looks at these types of mergers and the CFTC has offered its economic and legal expertise as they analyze this transaction under the antitrust laws.
As the exchanges’ primary regulator, the CFTC’s principle role will be ensuring that, as the merger is being approved, the resulting regulated contract market meets all of its statutory obligations under the Commodity Exchange Act, including requirements that it has the proper rules, regulatory structure and internal financial controls in place to protect the market and its participants. Although the agency does not have direct authority to approve or disapprove mergers, the CFTC does have limited antitrust authority to affect the manner in which the ongoing exchange conducts its business by requiring an exchange to refrain from imposing any “material anticompetitive burden on trading” or adopting any rule or taking any action that results in an “unreasonable restraint of trade.” In addition, the SEC, in its oversight of public companies, will also have a role by ensuring that these public companies file the proper disclosure forms for this type of transaction and that the shareholder meetings and ultimate corporate structure are in compliance with the securities laws.
The bottom line is that this transaction will play itself out over several months with regulators closely scrutinizing each step of the way. What will this mean for the markets and its participants, including commodity pools? As a regulator, my primary focus will be to ensure that participants and markets remain protected from wrongful activity and within these parameters, that fair competition thrives in this global industry—whether through the entry of regulated foreign exchanges through CFTC’s “no action” process, or the designation of new exchanges and trading facilities domestically. To date, the CFTC has approved 17 foreign exchanges to trade products with certain U.S. customers. Domestically, there are 14 regulated futures exchanges and 12 exempt trading facilities all competing in the same space. This is not to mention the $285 trillion over-the-counter derivatives market. I believe that this environment, with its low barriers for entry to new markets and products, will keep this industry competitive, thriving and innovative for many years to come.
I appreciate you allowing me to speak today and will open it up for any questions you may have.
Last Updated: July 22, 2007