I appreciate Dan Roth and the staff of the National Futures Association (NFA) for inviting me to address this conference. These forums are extremely important in educating our registrants on compliance issues to ensure that these markets continue to grow while we protect customers from wrongdoing and fraud. Equally important, such gatherings educate the regulators on ways to improve and tailor our oversight of this important industry.
The United States financial markets remain the envy of world due to their dynamism, efficiency, deep liquidity, transparency and sound regulatory foundation. And among all U.S. market sectors, the futures industry has become one of the crown jewels. From 2000 to 2006, volume on the U.S. futures exchanges has grown 328 percent, compared to the 16 percent volume increase on the U.S. stock markets over that time. Today the largest U.S. exchange—as valued by shareholders—is located in Chicago, not New York City, with CME’s market capitalization at roughly $18 billion, nearly $5 billion more than the NYSE-Euronext. While U.S. capital markets have been losing listings overseas, U.S. market share of global futures trading volume has grown from 34 percent in 2000 to 43 percent in 2006. By all measures, the U.S. futures industry has enjoyed enormous success competing on a global scale.
Many attribute part of this success to the growth of the hedge fund industry, which has been equally spectacular. In the last five years, hedge funds have doubled in numbers to over 9,000 today. Since the hedge fund industry was brought into the public’s view in 1998 with the collapse of Long Term Capital Management (LTCM), this industry’s assets under management have grown more than four-fold to over $1.4 trillion today. This increase in size and number is only matched by the expanding breadth, complexity, and strategies of the instruments traded. Information from the CFTC’s large trader reports confirm that hedge funds and other money managers account for a significant amount of the trading on our markets.
However, such success often breeds skepticism and this is certainly true in Washington, DC. The growth of hedge funds has gotten the attention of lawmakers and regulators over the last several years, resulting in a public discourse on what governmental actions, if any, are need in this area. The forums have been diverse—ranging from regulatory roundtables to Congressional hearings but the themes are consistent. Policymakers want to know whether the risk of contagion is higher as a result of these large market participants? Are retail investors, either directly or through pension holdings, being exposed to misunderstood risks through hedge fund investments? Is market discipline working to self-regulate the marketplace or is more needed, especially as it relates to quality of the information being given to stakeholders? These are important policy questions deserving of a public discussion.
In March, the U.S regulatory community responded in unison by releasing the President’s Working Group (PWG) Principles on Private Pools of Capital. The PWG, created in the wake of the 1987 stock market crash, is led by the Secretary of the Treasury and consists of the Chairmen of the Federal Reserve, the SEC and the CFTC. Over the years, this Group has taken on a consensus-building role of the U.S. regulatory community in order to address pressing financial topics that span jurisdictional lines.
This report builds on the recommendations of a 1999 PWG study after the collapse of LTCM and sets forth ten broad principles regarding the hedge fund community, attempting to address the expectations and responsibilities of all the relevant stakeholders, including investors, regulators, hedge fund managers and advisers, and counterparties and creditors.
The PWG report begins by noting that the current regulatory structure is working well, citing their 1999 report that states, “[i]n our market-based economy, market discipline of risk-taking is the rule and government regulation is the exception.” But the March study goes on to say that the maturing and growth of this industry requires regulators to provide additional guidance in this area.
In its release, the PWG wisely recommended principles rather than detailed rules. Principles are an effective means for identifying the desired public outcomes that regulators are striving to achieve but allow for flexibility in how these benchmarks are attained amid the differing regulatory structures. Principles also enable oversight authorities to speak a common regulatory language across jurisdictional lines and establish clear accountability measures in carrying out their missions. The outcome focus of principles also gives regulators a greater ownership stake in achieving the final regulatory objective, thus increasing the odds that a consensus solution can take hold. The CFTC is quite familiar with the effectiveness of principles as a regulatory tool, having successfully adopted a principles-based approach in 2000. In fact, the CFTC is the only member of the President’s Working Group that upholds its public mission using this progressive regulatory approach.
The PWG’s ten broad principles highlight the responsibilities of each of the relevant stakeholders in this sector. The principles instruct the first group—regulators and supervisors—to clearly and concisely put forward their intentions regarding counterparty risk management practices and actively monitor and enforce these goals. Regulators are also encouraged to adjust their policies as needed in addressing these risks and utilize their anti-fraud and anti-manipulation authorities to uphold the integrity of the markets they oversee.
The principles also call on regulators to work with their foreign counterparts to develop consistent and coordinated policies. Indeed, U.S. financial regulators will continue their collaborative work with the International Organization of Securities Commissions and the Financial Stability Forum on developing international standards in this area.
The PWG report goes on to stress that the second affected group—counterparties and creditors—should implement policies and commit adequate resources to sound risk management practices, including effective due diligence, credit exposure oversight, stress testing, and establishing prudential credit terms and policies. These controls are an important safeguard to the financial health of the firms as well as the overall financial system.
The third group of stakeholders—investors and fiduciaries—are advised to responsibly weigh the suitability of such investments depending on investment objectives and risk tolerance. The report holds fiduciaries to the highest standard of diligence due to their responsibilities to the investors they represent. The report reaffirms the PWG’s view that such investments should remain limited to sophisticated investors and not the retail public.
The last category addressed by the principles is the private pools themselves. Hedge funds are urged to create and maintain information, valuation, and risk management systems that provide counterparties, creditors, and investors with appropriate, accurate and timely information. Adopting these practices improves the efficiency and discipline of the markets while providing investors the necessary information to make sound decisions.
These principles are remarkably simple and therein lies their beauty. So often in Washington, we get the cart before the horse by jumping to solutions before the problem is properly identified. This report lays out the risks that hedge funds may pose to the marketplace and public and challenges its stakeholders to address these risks, beginning with the market participants themselves. Where market forces and discipline fail, regulators will be ready to fill any gaps with policies aimed at protecting the public.
As a member of the PWG, the CFTC must be held accountable to these standards, and I strongly believe that we are actually “ahead of the curve.” 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 commodity pool operators (CPOs) and commodity trading advisors (CTAs), dating back to the CFTC’s founding 32 years ago. Currently, there are approximately 1,600 CPOs and 2,600 CTAs registered with CFTC. Once registered, CPOs and CTAs must comply with certain disclosure, reporting, and recordkeeping requirements and become subject to periodic examination. This oversight regime, administered by the NFA, 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. These CFTC policies certainly further the transparency principles of the PWG report that attempt to address some of the asymmetric information concerns regarding funds and its investors.
Pool investors 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. Again on this front, the agency is aligned with the PWG principles that encourage enforcement agencies to utilize their anti-fraud and anti-manipulation authorities in protecting the markets and its participants.
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.
The evolution of the marketplace has led to recent changes in this oversight. Intercontinental Exchange (ICE), based in Atlanta, is an exempt energy market under our Act. 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 recently 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. These tailored actions developed from risk considerations—primarily protecting the financial integrity of the regulated marketplace and the price discovery process for energy products.
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 our 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 modern history but this authority represents an important hammer in our toolbox.
Should a violation of our Act occur, the CFTC aggressively pursues entities, including CPOs and CTAs, that intentionally seek to disrupt or undermine the integrity of our markets. The CFTC’s Division of Enforcement investigates and prosecutes those who allegedly violate our Act, including charges stemming from manipulation, false reporting, and trade practice abuses. Over the past five years, the Commission has prosecuted over 85 actions against CPOs and CTAs.
In addressing systemic risk and market integrity issues posed by traders such as hedge funds, the CFTC mandates several tiers of financial safeguards 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 Derivatives Clearing Organization (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 testimony 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 by 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. Again, this CFTC oversight of risk management and counterparty risk controls of firms and clearinghouses is addressed by one of the principles on systemic risk adopted in the PWG report.
These CFTC safeguards have been tested through several real life incidents throughout our history—most recently with the $6 billion Amaranth hedge fund failure. Despite the stress to the system incurred by Amaranth’s falter, the CFTC’s regulatory safeguards – 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 in their other trading 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 followed the 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 our regulatory protections. Our statute does not and should 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 outside the protections I mentioned. Such restrictions would be difficult, if not impossible, to oversee and would distort the price discovery function of the market by sending false price signals to the central marketplace and by curbing the effectiveness of market discipline and risk-taking.
The speculative participation of hedge funds is necessary for the futures markets to perform their vital role of transferring risk to those who are willing to accept it for a price. A 2005 CFTC study shows that when a commercial trader buys or sells, it will often be a managed money trader, such as a hedge fund, who takes the other side of the transaction. This observation is consistent with the notion that managed money traders provide important liquidity in our markets. Markets must be allowed to function efficiently within appropriate regulatory parameters and government authorities should not be involved with picking market winners and losers by inappropriately curbing risk-taking by funds. Such activities would certainly run counter the PWG’s guidance in this area.
I will close by reiterating what the President’s Working Group report attempts to convey: that all stakeholders share in the responsibility of protecting this marketplace from wrongdoing. The principles not only instruct regulators but call on others—investors, fiduciaries, creditors, counterparties and hedge funds themselves—to adopt sound practices that improve the market’s ability to discipline itself. I agree with the PWG that market discipline is the rule, and that government regulation should be the exception. But failure of this industry to abide by these best practices and principles will undoubtedly lead to other failures and resulting public cries for oversight. I encourage everyone around the room today to do their part by encouraging your organization and industry to abide by these principles and keep this industry a vibrant and successful part of our financial community.
Last Updated: April 2, 2010