I appreciate the opportunity to address this distinguished audience today. This event is an important forum for gaining a better understanding of the manner in which the energy markets work as well as how public policy affects their functioning. Today I have been asked to provide you with my assessment of how financial regulation may be trending in Washington, especially as it impacts the energy markets.
Without a doubt, the largest structural change affecting the oversight of our markets in the last decade is global competition brought on by the cyber-revolution. Without leaving their desks, traders now have a variety of choices on where to trade financial products, regardless of physical borders. This competition has significantly lowered costs and spurred innovation. In addition, the abundance of affordable technology and bandwidth has made trading location almost irrelevant from a latency point of view. Traders can now plug in and trade from virtually anywhere in the world.
Technology allows a world marketplace to exist but for the rigid laws and regulations that hamstring its development. Unfortunately, regulation often lags behind these global market trends and regulators frequently find themselves defensively playing catch-up as problems unfold. Regulators may attempt to meet these challenges by adopting detailed rules, but the breakneck pace of innovation inevitably changes the landscape, making the rules outdated almost upon enactment, and the vicious cycle repeats itself.
How do policymakers avoid this quagmire? What tools are needed to help regulators anticipate problems before they arise? How can regulators carry out their missions when products are being traded across several regulatory jurisdictions both domestically and globally? These are difficult policy questions and unfortunately, there are no easy answers.
This discussion is being driven by the concern that Wall Street may be losing its long-held title of global financial center to London. Treasury Secretary Hank Paulson and other public figures have expressed concern over these competitive developments that are affecting the U.S. capital markets and are seeking out the reasons behind them. Recently, the independent and bipartisan Committee on Capital Markets Regulation (Capital Markets Committee), chaired by Glenn Hubbard, Dean of the Columbia Business School, and John Thornton, chairman of the Brookings Institution, released its interim findings for enhancing the competitiveness of the U.S. capital markets. The report found that these U.S. markets are losing ground globally with a significant amount of capital formation migrating abroad. The report found that only five percent of the value of global initial public offerings was raised in the U.S. in 2005, compared to 50 percent in 2000. Over the same period of time, there has been a significant increase in investment funds going to private equity firms, which do not bear the regulatory or disclosure burdens of the public marketplace. In 2005, these firms received more than $200 billion in capital commitments, most likely at the expense of exchange-traded markets.
I recognize, as did the Capital Markets Committee, that these trends may be explained by natural market realignments as the rest of the world catches up to Wall Street. Just as manufacturing became less American-centric decades ago, capital markets are globalizing as market discipline rations capital to the most efficient jurisdictions around the world. But the report goes on to state that excessive regulation and litigation may also be contributing to this shift overseas with the key word being excessive. Don’t get me wrong. Regulation and litigation are necessary for maintaining market accountability. But excessive regulation and litigation can warp their functioning and work against the public interest. This is what we must guard against and what the Capital Markets report attempts to address.
Unfortunately, no silver bullet exists to fix the situation. The Capital Markets report makes several recommendations falling into four broad categories: shareholder rights, regulatory process, public and private enforcement and Sarbanes-Oxley. Policymakers will have to study and adopt measures in all four areas in order to begin righting the ship. But for today’s purposes I want to focus on one recommendation in particular because it is one that the Commodity Futures Trading Commission (CFTC) has significant experience with and one that I think would benefit these markets greatly. That is the call for a regulatory regime utilizing risk-based principles.
Adding further credence to this recommendation, just released this week was a study of the U.S. financial services industry, commissioned by New York City Mayor Bloomberg and U.S. Senator Schumer, which also touts the virtues of principles-based regulation, among other recommendations. I was disappointed, however, that the study—while recognizing the progressive structure of the UK’s Financial Services Authority (FSA)—did not bother to mention that the U.S. futures industry is thriving under a principles-based approach, including two futures exchanges in New York City.
Before turning to the specifics of risk-based principles, history can provide some important guidance. Similar to the capital markets of today, the U.S. futures markets a decade ago began facing significant competitive threats from emerging all-electronic foreign exchanges. When several of them petitioned the CFTC to place their trading screens in the U.S., the Commission had to grapple with the difficult choice of subjecting the American futures markets to global competition or adopting a more protectionist stance against foreign rivals.
The futures industry came to this global crossroads earlier than the capital markets partially due to the nature of the marketplace. Futures products—whether energy, financial, or agricultural—have long been used as tools for international trade and finance. Also, the relative lack of retail participation in these markets allowed the Commission to address these global policy matters without the added customer protection complexities.
Ultimately, the Commission made the right call in 1999 by allowing foreign exchanges access to U.S. customers, but it came with some political risk. Foreign futures exchanges at the time enjoyed distinct advantages over their U.S. rivals. These exchanges were more nimble and cost-effective organizations due to their size, ownership structure and all-electronic format. They also did not face the same layers of rules and laws that had developed over the years to support the open-outcry format that dominated in the U.S.
The CFTC understood that providing access would exacerbate these competitive advantages enjoyed by foreign exchanges. So in affirming its stance to allow greater foreign competition, the Commission agreed to address its regulatory approach in an effort to level the competitive playing field between U.S. and foreign exchanges. And with this promise began one of the driving motives behind the regulatory reform movement of the Commodity Futures Modernization Act of 2000 (CFMA).
The CFMA was historic for its progressive and global approach to regulation. Fortunately, this legislation did not emerge from the shadows of scandal. It was crafted during a time of relative stability in the markets and as a result, the CFMA reflects the long-term developments we continue to witness in the financial services industry—enhanced competition brought on by globalization and technology.
At the same time, the United Kingdom (UK) was capping off a similar exercise with the passage of the Financial Services and Markets Act of 2000. Despite these two separate efforts from different sides of the Atlantic, both governments came to the same conclusion: a principles-based oversight regime—compared to the traditional rules-based one—provides a more effective regulatory approach for financial services in this global technological age.
The reason that British and U.S. lawmakers reached the same conclusion is simple: a principles-based approach offers a flexible structure that focuses on identified public risks while allowing for coordinated global oversight. Six years of experience with a principles-based regime at the CFTC has validated these attributes. But they have also highlighted some of the limitations of this approach.
In general, a principles-based approach requires regulated entities to meet certain high level principles in conducting their business operations. Under the Commodity Exchange Act (CEA or Act), both exchanges and clearing houses must meet a separate set of statutory “core principles” and must continually adhere to them. For each principle the agency may set out acceptable practices that serve as safe-harbors for compliance. Conversely, the CEA allows for industry and self-regulatory organizations (SROs) to formulate their own acceptable practices and submit them to the CFTC for approval. With a few exceptions, there are no longer prescriptive regulations that dictate the exclusive means of compliance. Rather, exchanges have the choice of following CFTC-approved acceptable practices or adopting their own measures for complying with the overarching principle.
Such an approach has the advantage of being flexible for both the regulated and regulator. As technology and market conditions change, exchanges may discover more effective ways to meet a mandated principle. Although the regulatory mission remains static over time, the means for achieving it evolves as innovation occurs or circumstances change.
A second advantage to principles regulation is its focus on risk. The Capital Markets Committee also recognized the importance of risk-based regulation in its report. Risk-based regulation is advantageous because it inherently requires regulators to incorporate cost-benefit judgments into their decision-making. This provides greater certainty that both industry and public funds are utilized appropriately. Focusing on risk also helps regulators to prioritize their responsibilities and leverage limited resources to their best advantage. For example, regulators can task their audit staff according to risk, spending time on firms that pose the greatest threat to the integrity of the marketplace and devoting less time on firms whose failure would be less likely to cause a contagion event or harm customers. This approach also provides greater incentive and accountability for firms in managing their risk in a more comprehensive and qualitative manner, instead of relying slavishly on a checklist of rules promulgated by a regulator.
Principles-based oversight also has a significant advantage over rules-based regimes because it drastically enhances the regulators’ ability to work cooperatively with other regulators around the world. For this reason, several jurisdictions worldwide have adopted this approach, including the UK and Australia, with even more nations seriously contemplating its implementation in the near future. Principles compliment the mutual recognition concept that many international regulators have adopted in building a more seamless global regulatory structure. Mutual recognition provides that one nation is willing to allow a regulated foreign entity to offer its services domestically as long as the foreign jurisdiction is abiding by comparable laws and regulations. Comparable in this instance does not mean identical but rather similar in approach.
Principles are very effective at providing a baseline to which this global comparison can be made. Because principles focus on outcomes and risk, regulatory jurisdictions are able to make this analysis without getting bogged down in whether the methods and means are exactly the same. Principles have been an effective yardstick at the CFTC as we make these determinations on whether to recognize foreign exchanges in the U.S.
U.S. energy markets have benefited from all three of these regulatory attributes—flexibility, risk sensitivity and global compatibility. Last February, the all-electronic ICE Futures exchange, headquartered in London and regulated by the UK’s Financial Services Authority (FSA), began trading a light crude oil futures contract, in direct competition with the pit-traded crude benchmark of the New York Mercantile Exchange (NYMEX), utilizing a CFTC recognition letter to allow U.S. customers to directly trade this product. Listing of the ICE Futures light crude contract was unique from a regulatory point of view because it was the first to peg itself to an existing U.S.-regulated futures contract. This caused concerns among CFTC surveillance staff that regulators were not able to observe the entirety of a trader’s position in both markets, widening the possibility of trading abuses.
Under a strict rules-based approach, the CFTC might have required ICE Futures to register in the U.S. regardless of its regulatory status in the UK Such an approach would have resulted in duplicative regulation without furthering the public mission. But principles-based oversight allows a more tailored solution, enabling the CFTC to determine whether British law is broadly comparable to the principles set out for U.S. exchanges. In such an exercise, principles provide valuable benchmarks as regulators look to approve foreign exchanges under mutual recognition regimes. Principles also help regulators identify the risks in such arrangements, allowing them to condition such approval based on alleviating these risks. In the case of ICE Futures, its relief required that the exchange provide the CFTC with access to its books, submit to U.S. jurisdiction, and have in place information sharing and cooperative market surveillance between the affected regulators. As a result, the CFTC and the FSA now share trading data, allowing a more comprehensive regulatory view of the crude oil market and a coordinated enforcement effort should problems arise.
The over-the-counter (OTC) energy markets have felt the reverberations from this regulatory shift. As these markets have evolved over time, the tiered regulatory structure put in place by the CFMA has allowed the agency to keep pace with them depending on the risks presented. For example, the Intercontinental Exchange (ICE), based in Atlanta, is an exempt energy market under our Act, which provides the CFTC with certain limited authorities depending on the nature of the trading. As this audience knows, ICE is prominent in the trading of natural gas swaps that are pegged to regulated NYMEX futures contracts. This competition has led to significant innovation over the last several years both in the OTC and regulated marketplaces. From a risk perspective, this competition raises the possibility that traders could take positions on one market in order to profit off positions on the other. To address this concern, the CFTC has utilized its authorities to request information from ICE regarding trader position data for these pegged contracts on an ongoing basis similar to what we receive from large traders on regulated exchanges. This has allowed our surveillance staff a more comprehensive view of this marketplace. Again, these tailored actions developed from risk considerations—primarily protecting the financial integrity of the regulated marketplace and the price discovery process for energy products. The flexible structure of the CFMA has enabled this to occur without the need for additional legislative authority.
While principles-based oversight has these mentioned advantages, it comes with certain limitations as well. Principles-based regulation is not meant for all markets, especially emerging ones where the certainty of rules is needed by regulators and industry. This approach works best in mature, self-regulated markets where developed relationships between the regulated and regulators exist. Otherwise, the trust and expertise is not present to allow the system to function effectively.
Like any tool, principles-based regulation also requires proper training and maintenance. We may have traded in a Model T for a Ferrari, but if we don’t know how to drive it and the tank is empty, it is useless. Adopting a principles-based approach requires significant training of staff who may have worked for many years under the certainty of rules compliance. With principles-based regulation, staff must employ their experience and judgment in making sound regulatory decisions. It is more qualitative than quantitative and this adjustment takes time. Early in the transition, staff can occasionally be paralyzed by their fear of making the wrong call and this can lead to a regulatory impasse. But with proper training and assurance from leadership, most CFTC staff have found this new regulatory approach to be empowering.
Maintenance for this tool requires proper funding for the agency. The CFTC is currently at critical levels in its funding and staffing, which jeopardizes our ability to uphold the public mission. Despite record exchange trading volumes, employee levels at the CFTC are at the lowest in the agency’s 30-year history. Unless the necessary funds are dedicated to our mission, this regulatory tool could end up sitting idle, gathering dust, while these markets and investors become increasingly susceptible to market manipulation and fraud.
In addition to these limitations, I want to address some claims by critics of principles-based regulation, claims I believe to be myths. And the best debunking evidence I have to offer is the experience of the CFTC staff. Here are a few of the most cited:
Myth 1: Industry cannot function under a principles regime because it wants the certainty of rules.
It is true that this industry, like all industries, wants to be certain that it is in compliance with the law. Exclusive rules are one way in which to provide that assurance. However, principles do not exist in a vacuum. They come with guidance or acceptable practices that provide industry with the pathway to compliance. Although sometimes viewed as exclusive of each other, a principles regime is really a balanced hybrid of both rules and principles. When the CFTC transitioned to principles after the passage of the CFMA, there was a detailed review of our rulebook. Some rules were deleted but many became acceptable practices for principles. With their systems in place, most, if not all, exchanges continued to meet the new principles by compliance with these transitioned acceptable practices. But the new system offered registrants a choice. For those wanting absolute legal certainty, a principle’s acceptable practices guarantee compliance. However, the statute specifies that acceptable practices are not the exclusive means for meeting a principle, giving regulated entities the choice of adopting alternative means for meeting a principle. But this flexibility comes with some risk. The CFTC has the ability to determine, on the basis of substantial evidence, that the regulated entity is not meeting the core principle and may request that the regulated entity amend its practices to come into compliance. In reality, this rarely occurs because there is a strong desire for compliance with the law, which encourages industry and CFTC staff to conduct early and informal discussions regarding new compliance methods. Unlike the more adversarial relationships of the past, this informal collaboration has been extremely helpful for regulators and industry in gaining an understanding of each others’ desires and concerns.
Myth 2: Enforcement agencies cannot fulfill their missions without the certainty of rules-based compliance.
The audience may find this statement slightly amusing given the successful track record of the CFTC’s enforcement division in the energy trading space over the last several years. It is true that principles encourage a more collaborative relationship with the regulated entity but when wrongful activity occurs, this collaboration on the front-end must be complimented with strong enforcement on the backside. This bookends philosophy has been a powerful approach in preventing and deterring wrongful activity in the industry. In 2003, three years after the passage of the CFMA, the Commission filed 64 cases; this was a larger number than any of the previous 10 years. In 2004, the Commission filed 83 cases, breaking the previous year’s record. Principles-based regulation has not hindered the Commission in responding fluidly to the new instruments of fraud and manipulation, which evolve as rapidly as the marketplace itself. It is also important to recognize that principles do not affect how wrongful activity is defined. Fraud, manipulation, false reporting and trade practice abuse are all well-defined legal concepts in statute and case law that are not affected by the transition to principles. Most principles focus on ensuring that the controls and processes are in place to prevent such wrongful activity. However, the definitions of such activity are unaffected by the new approach.
Myth 3: Principles-based oversight means less regulation.
Many in the press tend to treat principles-based regulation as deregulation. This is oversimplifying the approach. It is true that as market risks are analyzed, some regulatory requirements may lessen as a result. Many have at the CFTC. But there have been times when oversight has increased under this approach in an attempt to alleviate heightened risks in certain critical areas. For example, the CFTC is presently completing a comprehensive review of certain registered derivatives clearing organizations (DCOs). These registrants must comply with a set of 14 core principles dealing with such matters as financial systems and controls, recordkeeping, treatment of funds, and default rules. Before this new regulatory approach was enacted in 2000, the CFTC did not distinguish between its oversight of clearing houses and exchanges despite distinct risks between the two. The new approach recognizes that the heightened systemic risk concerns with DCOs requires that the CFTC devote more resources to their oversight and this has occurred as a result. It is also an area where the Commission has purposely kept more detailed regulations, possibly at the expense of flexibility, to ensure that the protections are in place to properly address the risks inherent to the clearing system. Indeed, the safeguards were recently tested with the financial difficulties of Refco, Motherock and Amaranth. Despite these significant events, most industry observers agree that the CFTC’s market protections worked exceedingly well in preventing a systemic event or a loss of segregated customer funds.
This has been our broad experience with principles-based oversight but I want to conclude by suggesting that other regulators, including the Securities and Exchange Commission (SEC), could greatly benefit from such a change in their oversight framework. Like it or not, the flattening of the global economy will soon require regulators to adopt compatible regulatory structures. The principles approach is the most likely regulatory standard to emerge because it greatly improves the abilities of regulators to address these cross border questions without having to reconcile the multitude of laws and regulations among nations. It also facilitates tight cooperation among domestic agencies by allowing them to speak the same pliable regulatory language.
But don’t take my word for it. The proof lies in the performance of the U.S. futures industry—both domestically and overseas—under such an approach. From the passage of the CFMA in 2000 to 2005, volume on the U.S. futures exchanges has grown 240 percent, compared to the 21 percent increase on U.S. securities exchanges. Today the largest U.S. exchange is located in Chicago, not New York City, with CME’s market capitalization at roughly $20 billion compared to the NYSE at $15.5 billion. While U.S. capital markets have been losing IPOs overseas, U.S. market share on trading volume in the global futures industry has grown from 34 percent in 2000 to 42 percent in 2005. By all measures, this industry has been enormously successful competing on a global scale. I hope others will take notice of this success and understand that the principles-based approach, while not the reason behind such achievement, has played a significant role in allowing this growth to occur.
Again, I appreciate the opportunity to explore this subject in depth with you today and I would be happy to open it up for questions from the audience.
Last Updated: April 2, 2010