The theme of this conference is particularly timely. Without question, global competition is fierce. Each week brings news of merger activity in the financial services industry. I would argue that markets have evolved more in the last 5 years than over the last 25.
This shifting global landscape has caused market regulators from around the world to reassess traditional regulatory models. Here in Europe, regulators are implementing the Markets in Financial Instruments Directive (MiFID) in order to facilitate a more competitive and efficient single European market in financial services. In the UK, the Financial Services Authority (FSA) has announced an initiative to convert a larger slice of its rulebook to more flexible principles.
In the U.S., policymakers are focusing on whether current regulatory structures are having a negative effect on U.S. market competitiveness. Treasury Secretary Hank Paulson, citing the findings of three independent studies, has raised concern that U.S. capital markets are losing ground globally with a sizeable share of that business migrating abroad.
Despite the different approaches, all of these government initiatives recognize that the manner in which we regulate matters and global businesses in the new economy have a choice of where they transact their deals.
In past speeches, I have referenced Thomas Friedman’s bestselling book, The World is Flat, to describe how globalization and technology have fundamentally changed the way business is conducted around the world. Friedman argues that, without regard to borders or government ideologies, individuals today have the technological tools to communicate with each other and allocate capital and intellectual assets to where those resources can be utilized most efficiently. This technological revolution has become the great equalizer or “flattener” around the globe.
No where are these “flattening” forces more evident than in the financial services sector. This is aptly described in the IBM study entitled, The Trader is Dead, Long Live the Trader. This survey of long-term trends in our industry found that technology is leveling the information and speed advantages that firms have traditionally enjoyed and as a result, profits are being squeezed. Technology has democratized the markets, bringing enhanced data, speed and market transparency to all traders, lessening the value added of the traditional intermediation model. The IBM study foresees that financial firms will increasingly seek profits through either assuming more risk or mitigating the risk of other market users.
As firms take advantage of these new opportunities, the lines of financial businesses are blurring significantly. From a functional vantage, it is difficult to tell the difference between brokers, hedge funds and exchanges as each tries to poach the other’s business. Exchanges have begun to bypass brokers to directly connect large market users—many of them hedge funds—to trading facilities. Similarly, brokerage firms want a piece of the risk assumption and mitigation action as many of them now own exchanges, clearing houses and hedge funds in order to compete for this business.
As these major structural changes occur, how do regulators keep pace? To be honest, keeping pace is optimistic—realistically, I am hoping we can keep the industry’s taillights in view. While the private sector views globalization as an opportunity, regulators are grudgingly adapting to the modern economy. In another ongoing survey by IBM, 95 percent of the financial industry interviewed thought globalization to be a growth opportunity rather than a threat. Of the five percent who felt threatened, nearly all were regulators. Why is this? Because regulators understand that globalization shakes the core foundation of their regulatory models.
Regulators no longer live in a “bright-line” jurisdictional world. Determining where an electronic exchange is located is difficult, if not impossible, with servers, boards of directors, customers, clearing and self-regulators scattered around the globe. Former Federal Reserve Chairman Alan Greenspan noted that “[o]rganizing financial exchanges in a geographic place doesn't seem necessary...[t]he only market out there...is cyberspace.” How does the modern regulator, defined by the quirks of its nation’s laws and history, function in an interconnected global economy?
To say the least, it is difficult—but I think the key for regulators is not only to work harder, but work smarter.
When I came to the Commission nearly five years ago, I challenged myself, and our agency, to adhere to this “smart” oversight philosophy. The smart regulation concept, developed by former Harvard professor and OMB regulatory czar, John Graham, seeks to promote the adoption of regulations that are effective, less costly and tailored to specific risks and societal outcomes. The smart regulation approach does not necessarily mean more regulation or less regulation. There will be times when the risk analysis and public sentiment justify a greater regulatory involvement. But regulators are obligated to weigh the costs to the public as well as the benefits of implementing regulations, and to do so in a timely, informed and open manner.
Although there are many attributes to the smart regulation paradigm, I want to focus today on three key principles. Smart regulation must be 1) outcome-driven; 2) risk-based; and 3) globally collaborative.
There has been much debate recently on the relative benefits of outcome-based principles versus rules. There is a developing consensus in the U.S. that principles-based regulation is a model worthy of study, noting that the UK markets are flourishing under such an approach. Certainly, the FSA should be applauded for its leadership in this area. But rather than fly to London, Washington policymakers need only drive across town to the CFTC, where our Commission has been successfully utilizing a principles-based approach for seven years. And the U.S. futures industry has been thriving under principles since the passage of the Commodity Futures Modernization Act (CFMA) in 2000.
A principles-based system requires markets to meet certain public outcomes in conducting their business operations. For example, U.S. futures exchanges must continuously meet 18 core principles—ranging from maintaining adequate financial safeguards to conducting market surveillance—in order to uphold their good standing as a regulated contract market. Such an approach has the advantage of being flexible for both regulator and regulated. As technology and market conditions change, exchanges may discover more effective ways to meet a mandated principle.
While principles-based oversight has many advantages, which I will save for another speech, it is not a silver bullet. Principles regulation is not meant for all markets, especially emerging ones where developed self-regulation does not exist and the certainty of rules is needed. Furthermore, it is important to note that a principles approach does not obviate the need for rules. Rather, a principles system is a hybrid of desired public outcomes complimented by specific rules aimed at achieving those ends. Each regulatory authority—depending on the maturity of its markets—will need to find the optimal balance between the flexibility of principles and the legal certainty provided by rules.
But smart regulation extends beyond the debate over rules versus principles. Not all principles and rules are created equally. Authorities must have a regulatory thermostat that adjusts the agency’s focus as critical threats to the public rise.
Risk analysis serves as that calibrating tool and is the second key to smart regulation. 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. Instead of a one-size-fits-all approach, regulators can assign their staff according to risk, spending more time on firms that pose the greatest threat to the integrity of the marketplace and devoting less on firms whose failure would be less likely to cause contagion or harm customers.
The last point—and apropos of today’s topic—is that smart regulation requires close collaboration and information sharing among global regulators. No matter the size of the agency, individual regulators do not have the resources to sufficiently monitor the breadth of the global marketplace. We must rely on the expertise of other regulators, both domestic and foreign, in fulfilling our public mission. This does not mean that agencies should abdicate their interests. Quite the opposite—each must continue to vigorously monitor that our public mission is being met. However, in today’s global economy, the means for accomplishing this mission must involve close coordination among the world’s regulators.
Indeed, regulators are working together more today than in years past. Forums such as the International Organization of Securities Commissions (IOSCO), the Committee of European Securities Regulators (CESR), and the Financial Stability Forum are shining examples of how regulators can successfully collaborate in the development of international standards and information sharing arrangements.
The CFTC has long been an international leader for its involvement in these types of organizations as well as its early appreciation of the “recognition” concept among foreign regulators, dating back to the inception of our Part 30 recognition regime for foreign firms in 1988 and the “no action” recognition process for foreign exchanges in 1996.
For foreign brokers, CFTC rule 30.10 allows the CFTC to exempt a foreign firm from U.S. registration based upon that firm’s “substituted compliance” with rules of its home jurisdiction that are “comparable” to those under the Commodity Exchange Act. The CFTC has made clear that under this approach, comparable does not mean identical as long as certain public outcomes are met under the foreign regime. Should the comparability analysis expose risks to our markets, the CFTC may condition the order to address those threats.
For foreign exchanges, the CFTC developed a “no action” recognition process in 1996 that enables foreign exchanges to place trading screens in the U.S. once the CFTC has made the determination that the foreign jurisdiction is abiding by comparable laws and regulations. Again, and it is worth underscoring for those regulators considering this approach, comparable does not mean identical.
This recognition concept has been recently tested at the CFTC. Last year, ICE Futures exchange, headquartered in London and regulated by the FSA, began trading a light crude oil futures contract in direct competition with the crude benchmark of the New York Mercantile Exchange (NYMEX), utilizing a 1999 CFTC “no action” letter to allow its U.S. members to directly trade this product.
Listing of the ICE Futures contract was unique from a regulatory point of view because it was the first to peg itself to an existing regulated U.S. 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 less flexible approach, the CFTC might have required ICE Futures to register in the U.S. regardless of its regulatory status in the UK. Such a path would have resulted in duplicative regulation without furthering the aggregate public mission. But the smart regulation philosophy allows for more tailored solutions, enabling the CFTC to determine whether British law is broadly comparable to the principles set out for U.S. exchanges.
In such an exercise, the mentioned factors of smart regulation play an important role. A principles framework is highly complimentary to the mutual recognition process because principles provide valuable benchmarks as regulators look to the comparability of foreign jurisdictions. Rather than getting bogged down in a checklist of each nation’s rules, principles keep the focus of regulators in the right spot: achieving regulatory outcomes.
In addition, risk determinations are important to the foreign board of trade recognition process, as regulators often condition such recognition on mitigating identified public threats. In the specific 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 any problems arise.
With several years of experience under our belts, these recognition programs have worked exceedingly well with no major market mishaps or reports of customer abuse from either regime. Nor have our staff seen evidence of regulatory arbitrage. This speaks volumes when you consider the vast numbers of firms and exchanges that have been recognized, including 150 foreign firms and 19 foreign exchanges.
In such a financial crowd, numbers sometimes speak louder than words. So I’ll leave you with some pretty impressive figures. From the passage of the CFMA in 2000 to 2006, volume on the U.S. futures exchanges has grown 328 percent, compared to the 16 percent volume increase on the three major U.S. stock markets over that time. Today, the largest U.S. exchange as valued by shareholders is located in Chicago with CME’s market capitalization at roughly $19 billion. While U.S. capital markets have been losing business overseas, U.S. market share on 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 under this progressive regulatory regime. I am pleased that other regulators are beginning to move in this direction, and I hope the CFTC’s experience with smart regulation can be a worthy model for others to consider.
Last Updated: April 2, 2010