October 19, 2015
As Prepared for Delivery
Thank you for that warm introduction. I’m very pleased to be here. And I’m pleased to be joined by these distinguished individuals.
I’d like to express my gratitude to the World Federation of Exchanges and the Qatar Stock Exchange for hosting this important Annual Meeting and inviting me to speak.
It’s nice to see those of you I already know, and in my brief time in the radiant city of Doha, I’ve had the pleasure of meeting many others here already. I had the pleasure of meeting with the WFE Board of Directors, as well as the WFE Working Committee, earlier today and we had some very good discussions. I look forward to getting to know more of you – and having productive conversations now – and in the future.
Since becoming Chairman of the Commodity Futures Trading Commission or CFTC, I have been very focused on international outreach and cooperation. It’s something that has been a big part of my career well-before serving in the United States government. I had a long career working as a corporate lawyer with a strong international focus. I spent five years in Hong Kong as well as a couple of years in London. And during my years based in the United States, I worked all over the world – including throughout Latin America. So to me, international cooperation is not just an important component of our work – it’s fundamentally necessary given the realities of today’s markets.
International outreach is also something that’s very important to my fellow Commissioners. Both Commissioners Giancarlo and Bowen, who bring excellent market experience and judgment to the Commission, are going on international trips in the coming months, and they are committed to a continued international dialogue.
Today I would like to talk about some of the issues on our agenda at the CFTC – but I would like to do it in the context of a general challenge with which I know you are quite familiar. And that is: how do we deal with market evolution and innovation? This is something everyone who runs – or regulates – an exchange must consider.
The challenge may be somewhat different for those of us in larger, relatively more developed markets – as compared to smaller markets. But in a global era, what each of us does affects the other.
Those in smaller markets may be faced with a challenge of defining the role of local financial markets in a global economy:
Regulators, particularly in larger markets, are often playing “catch up” to the forces of innovation. We must often look backward and address the causes of past failures or problems. However, we also must be looking ahead. And we must recognize that what we do as regulators – in response to a market failure or otherwise – can change market structure even further.
Our core objectives as a market regulator include:
I believe sensible regulation that achieves these objectives is necessary to provide a strong foundation for financial markets, one on which markets – large and small – can grow and innovate. And today I want to talk about how we achieve these objectives in the context of some particular issues on our agenda. These issues include:
The CFTC and Innovation in the Futures Market
Let me begin by saying a few words about the CFTC, and generally, the state of the U.S. derivatives markets we regulate. Today, we have over 4,000 futures and options contracts – on a wide range of underlying commodities and indices.
The largest part of our futures market, by volume, consists of financial futures on interest rates, currencies and equities, including some of the largest benchmark derivatives contracts in the world. In addition, we recently were given responsibility to oversee the U.S. swaps market, which accounts for about 35 to 40 percent of the global swaps market.
The innovation in these markets over the last few decades has been quite astounding. For a century, modern futures were limited to futures on storable agricultural products. Then people realized a product didn’t have to be harvested; you could transact in the “future” price of live cattle, for example. Futures were expanded to other physical goods—energy products, metals—and to intangible products as well, such as interest rates, stock indices, and currencies.
Innovations in the market have forever changed the traditional distinctions between futures and other products – such as securities. One former chairman of the U.S. Securities and Exchange Commission famously described that distinction to a CFTC official years ago by saying,: “It’s pretty simple. Anything that is a security or a financial instrument is ours. Anything that has four legs is yours.” Well, it turned out to be not so simple.
The quantum leap from physical commodities to financial – and less tangible – instruments required the development of futures contracts that did not require physical delivery. Leo Melamed, one of the pioneers of the futures markets, wrote that the introduction of cash settlement was tantamount to breaking “the genetic code of futures.” Cash-settlement is now the standard design in futures markets around the world, whether developed or emerging. Many of the largest contracts by volume – such as the e-mini S+P 500, the Eurodollar (in the US), and a number of contracts listed in your countries – such as KRX’s Kospi 200, and NSE’s Nifty futures– are based on this design.
This innovation has brought great benefits to the global economy. Businesses of all kinds can hedge routine commercial risk, whether it is related to the corn harvest, fluctuations in world oil prices, volatility in interest rates, or the ups and downs of equity prices.
I believe the framework of regulation created by the CFTC provided a foundation for growth and innovation. That framework required transparency and integrity in the trading process – key elements that give market participants confidence. It prohibited manipulation, broadly defined. And it included a framework for product approval that has focused on upholding our core principles. When a new contract is presented to us, we ask whether it is susceptible to manipulation. We do not make a normative judgment as to whether the product is needed or beneficial. Let the market decide those questions.
Indeed, Melamed credits the agency with making cash delivery possible. It was not just that the CFTC didn’t stand in the way. He writes that, “this new era [of cash delivery] would most likely never have transpired without the existence and courage of the CFTC.”1
The structure of the U.S. futures markets has facilitated, and in turn been shaped by, these regulations. Our rules require all futures contracts must be traded pursuant to the rules of the exchange. This and open access have helped bring all buyers and sellers to a common platform, and in the process, created large liquidity pools. The arrival of these participants has attracted even more buyers and sellers – a dynamic many of you might describe as “liquidity begetting liquidity.”
The Financial Innovation Spiral and the High Speed Train
Now let me move from futures to the over-the-counter swaps markets. Of course, the 2008 financial crisis made obvious the need for regulation of these markets. For me, that made chairing this agency, starting last year, an unusual twist of fate. I started my career thirty years ago as a lawyer helping to draft the original ISDA master agreements and related documentation. That documentation gave rise to the standardized swaps industry we now regulate.
Before I discuss how we are implementing that responsibility, I want to note a few ideas put forward by the economist Robert Merton twenty years ago, in the context of some observations about derivatives. I think they are a useful way to think about regulation and innovation, particularly in the context of the recent crisis.
Merton wrote of the “financial innovation spiral,” in which product innovation pushes the financial system to maximize efficiency. As new products, such as futures and swaps, become more standardized and move from intermediated and bilateral trading to centralized markets, transaction costs decline and further innovation may occur. But this can also cause strain – or even conflict – between product innovation and infrastructure, which sometimes requires regulators to step in.
He used the analogy of the building of a high speed passenger train that runs on the existing train tracks. The high speed train is a great innovation, but the existing tracks are not designed to handle the increased speed. If the high-speed train crashes, it not only destroys the train, and causes losses for its users – but it can also destroy the tracks for everyone else. Society at large suffers, because there are a great number of people who depended on the slower passenger or freight trains that now cannot run. And thus the need for policy to safeguard the system, protect against a breakdown, and balance these competing goals.
I think this is a useful way to think about a regulator’s role when it comes to innovation. And it’s a useful way to think about our role in the case of swaps. Indeed, insofar as swaps have been a significant innovation, you might say that the reckless trading activity by firms like AIG caused the high speed train to crash. Large parts of the derivatives markets, especially exchange-traded derivatives, worked pretty well prior to – and even during – the financial crisis. But AIG’s excessive CDS risk, coupled with problems in its securities lending business, nearly caused it to go under in the days after Lehman’s failure. It wrecked the tracks for everyone.
At that time and in those circumstances, the consequences of an AIG failure could have tipped our economy into a great depression. As a result, the U.S. government committed $182 billion to its rescue. I spent five years at the U.S. Treasury Department working to get all that money back— which we did, with a profit.
If AIG’s trading was like a train crash, that $182 billion was just to pull away the wreckage. It didn’t repair the tracks. We are still recovering from the crisis, which caused enormous suffering for families around the world and destroyed trillions in household wealth. And now, our task is to repair the tracks – by creating a regulatory framework for OTC swaps.
Reforms of the Swap Market
I look upon what we are doing today to regulate the OTC swaps market as having similarities to the implementation of securities regulation in the United States following the Great Depression. The framework that was put in place starting in the 1930s has proven tremendously successful for our securities markets. Many of its mandates were revolutionary at the time. However, back then many felt those requirements would be the death knell of capitalism. When the Securities Exchange Act of 1934 was passed, the President of the New York Stock Exchange said it was “a menace to national recovery.” History has proved otherwise. Today, the requirement that public companies make periodic reports, and the basic trading requirements of our securities laws are about as controversial as seat belts.
Similar to that experience, I believe the framework that we – and the other G-20 nations – are creating today for swaps will provide a basis for further growth of our derivatives markets. There are many similarities in the basic principles. Today, the U.S. – and a large number of jurisdictions represented in this room – are requiring greater pre-trade and post-trade transparency for swaps. We are requiring central clearing as a tool to monitor and mitigate risk. And we are requiring oversight of major market players and greater reporting.
In all these areas, what we do will affect the structure and evolution of the derivatives and related cash markets. And so we must not simply look back and correct the failings of the past. We must create a framework that works going forward; one that recognizes that evolution or change is inevitable.
One theme that runs through many issues we face is, to what extent should regulation of OTC swaps follow the model that exists for the futures market? The products are similar and in some cases interchangeable. And the framework of regulation in the futures market has generally been quite successful. It withstood the test of the financial crisis. Central clearing, pre- and post-trade transparency, regulated exchange trading, risk management at both the exchange and clearing member level, and protection of customer assets, are all important features of our futures market today, but were largely absent from the swaps market prior to the crisis.
In the 2010 Dodd-Frank Act reform, the U.S. Congress sought to strike a balance, by creating a framework to achieve the basic regulatory goals I cited at the outset—such as promoting transparency and minimizing the potential for systemic risk—while at the same time recognizing there are differences between swaps and futures. This intent is reflected in the Commission’s approach to swaps regulations.
Our framework adheres to certain regulatory principles that are found in futures and other markets. But it does not direct that we force swaps into the futures market mold.
The CFTC has already completed most of the necessary rules, so let me give you a few examples of this approach. We require central clearing, but not for all products. From the standpoint of clearinghouse resiliency, we do not want all swaps to be cleared. Some swaps should remain bilateral because of a lack of liquidity or other risk characteristics. And there will always be new products that should not necessarily be cleared. Mandating clearing for all swaps would expose clearinghouses to excessive risk and potentially limit innovation.
We have mandated clearing of interest rate swaps in four currencies and credit default swaps. The percentage of transactions in our swaps market that are centrally cleared has increased from that 15 percent before the crisis to about 75 percent today.
The importance of striking the right balance is also illustrated in our proposed rules on margin requirements for uncleared swaps. The purpose of this rule is not to penalize the uncleared market so that all swaps are driven onto clearinghouses.
But we recognize that significant risk can build up as a result of bilateral, uncleared trades, particularly given that many of the largest financial institutions represent a large portion of the market. This can potentially lead to increased systemic risk. And so we need margin requirements, set at levels to reflect the fact that the liquidation of positions may be harder when swaps aren’t cleared.
Product Innovation Today
Let me turn briefly to product innovation today in the derivatives market. Here, it’s helpful to ask ourselves:
One of the most successful innovations in recent years has been VIX futures, essentially, derivatives on volatility. Contracts based on volatility indexes are now listed for trading at multiple exchanges around the world represented here today, including Chicago Board Options Exchange, Eurex, Euronext, the Hong Kong Futures Exchange, and the National Stock Exchange of India. And while ETFs and other Exchange Traded Products are not products under our jurisdiction, their growth is in part attributable to the ability to hedge exposures in the futures market.
The regulatory framework for swaps is still very new, so we will see what innovation it leads to. But already, we are seeing swap futures being listed in multiple jurisdictions.
I also want to address a new innovation that has been in the news of late: and that is Bitcoin. We have actually taken a number of steps regarding Bitcoin, and I believe what we have done is consistent with the framework I’ve articulated.
Bitcoin raises many important issues for law enforcement agencies, tax authorities, and other regulators. The CFTC’s jurisdiction is implicated when it is used in a derivatives contract in our markets. We recently allowed trading of a Bitcoin swap. Here, we applied the same basic principles as we do to other products. That is, we did not object to a bitcoin swap being traded as long as the contract—which was based on an index of bitcoin exchanges-- was not susceptible to manipulation, and the platform was duly registered.
We have also provisionally registered a swap execution facility that trades the Bitcoin swap, and we are currently reviewing an application for a Bitcoin-related clearinghouse.
We also brought an enforcement action against a platform operator for illegally offering Bitcoin options— the platform operator failed to register. So while we have permitted the trading of a Bitcoin swap where our basic requirements were met, we have no tolerance for actors that break the rules, whether in the name of innovation or otherwise.
Bitcoin also raises interesting possibilities with respect to the application of blockchain technology in financial markets, which I know many of you are thinking about. I would be quite interested in hearing your thoughts about this.
One area where I think we need to be careful not to inhibit innovation is with respect to oversight of benchmarks. Many of our largest contracts are based on key benchmarks, such as LIBOR, the S+P 500, or WTI oil prices.
Benchmark integrity has been a priority issue in our enforcement efforts. We brought the first case against a global bank concerning LIBOR manipulation in 2012, and we have imposed penalties on many of the world’s largest banking institutions for manipulation of LIBOR, foreign exchange rates and ISDAfix.
We have also actively supported the development of voluntary principles for the administration of benchmarks to ensure integrity and transparency, through the work of International Organization of Securities Commissions (IOSCO).
We need to make sure, however, that the efforts to ensure integrity in the administration of benchmarks – particularly when it comes to very large benchmarks –do not have an adverse effect on innovation. Our actions as regulators should not discourage the development of new benchmarks and new methodologies for calculating benchmarks.
And in this regard, I do have some concern about the cross-border implications of the approach to benchmark integrity being considered in Europe, which would require direct government regulation of benchmark administrators. This approach could prohibit Europeans from trading instruments in non-EU countries that are based on benchmarks not subject to direct government regulation. We do not directly supervise benchmark administrators in the U.S., nor do most other countries in the world. And I believe there are good alternatives to direct supervision to ensure integrity, such as through enforcement actions or new product review.
We strongly support the goal of those in Europe who want to ensure benchmark integrity, but I hope we can achieve that goal in a way that does not impose requirements or costs in non-EU countries that make it hard to develop and introduce new benchmarks or new benchmark methodologies.
Algorithmic Trading and Technological Risk
We face another set of challenges when it comes to electronic trading and technological change generally. Almost all trading in the futures market today is electronic in some form. For many of you, the futures markets that were launched in your countries started with electronic trading. However, some of us have witnessed the transition from trading in open-outcry pits or on the floor to electronic trading. This transformation is the most critical market innovation in the past three decades. And it reflects the creative thinking and huge investments of many of the exchanges assembled here.
In the markets we regulate, automated or algorithmic trading accounts for more than 70 percent of trading over the last few years. The percentage of algorithmic trading is high not just in financial futures; we see it in physical commodity futures as well.
The structure of exchange traded futures markets has likely contributed to the growth of electronic trading. These markets have single exchange platforms and benchmark contracts with robust two-sided order flow coming into a single, transparent central limit order book. Anyone can choose to be a market maker and provide liquidity. Over time, that has democratized market roles. And automation lets participants respond quickly to market changes, which is especially valuable in markets that are increasingly interconnected across asset classes and national borders.
I know many of you are thinking about the issues raised by the growth of automated trading. We should consider its impact on liquidity, fairness, volatility and systemic risk. We should consider whether speed combined with complexity increases the possibility of breakdowns and disruptions. And finally, given the very fast, very technologically dependent markets of today, we must give greater consideration to intentionally disruptive effects – and threats – posed by cyber attacks.
All these issues deserve greater study and discussion. I hope all of you as exchange leaders will help promote this dialogue. We are also doing so. The CFTC, together with the Federal Reserve Board, the Federal Reserve Bank of New York, the Treasury Department and the Securities and Exchange Commission are sponsoring a conference starting tomorrow in New York, to discuss the current structure of the U.S. Treasury market, which will get into issues of automated trading. This is the reason I am speaking this evening rather than tomorrow morning – and I am very appreciative of the WFE for being so accommodating.
That brings me to what we, as regulators of the U.S. derivatives markets, intend to do about these issues in the short term. The CFTC has already taken a number of steps to respond to the development of automated trading in our markets, as have our exchanges. We have required exchanges to establish risk control mechanisms to prevent market disruptions, including mechanisms that pause or halt trading. We have required clearing members to establish risk-based limits for all accounts based on factors such as position size or order size, and required automatic screening of orders for compliance with risk limits if they are automatically executed. And we have taken action against new forms of manipulation that can come with automated trading, such as spoofing.
Currently, we are focused in particular on looking at the operational risks that arise from the automation of order origination, transmission and execution. We are considering proposing additional standards to minimize the potential for disruptions and other operational problems that may arise.
This may include some additional standards for pre-trade controls at multiple levels--the exchange, clearing member and trading firm level. We are also considering standards on the development and monitoring of algorithmic trading systems, and on controls to minimize self-trading. The standards we are considering are principles-based, not prescriptive. I believe what we are considering would be consistent with the best practices followed by many firms already.
We are also looking at the adequacy of disclosure by exchanges of market maker and incentive programs. I suspect this is an issue that many of you have thought about, and I am interested in hearing your ideas.
In the same vein, I expect that we will propose soon some further requirements to address cybersecurity and system safeguards generally. We want to make sure exchanges and clearinghouses are doing adequate testing related to cybersecurity risks and general technological disruptions. These will again be principles based rather than prescriptive. These operational and technological risks to me are some of our greatest challenges today.
National Regulators in an Era of Global Markets
Let me turn to a third and final type of innovation we face as regulators. And that is, how do we deal with global markets, when our authority is based on national jurisdiction? This is particularly a challenge in the regulation of swaps.
There has been a loud cry for harmonization as the G-20 nations implement their leaders’ commitments to regulate the OTC swaps market. But it’s easier said than done. It’s important to have some perspective: there is practically no area of financial regulation today where the rules are harmonized across borders. It is not the case with the laws on secured lending, securities regulation or mergers and acquisitions – I could go on and on.
But the swaps market became a global market before it was regulated. Market participants were used to transacting without regard to national laws and regulations, so it is perfectly understandable why they expect the same to be true today.
I believe we are in fact making good progress toward achieving reasonable consistency in the regulation of OTC swaps. The mere fact that the G-20 Leaders agreed to the same basic reforms was a significant achievement. And we must recognize that these reforms are being implemented by nations—or unions of nations—each of which has its own legal traditions, regulatory philosophies and political processes. Not surprisingly, this has led to differences in the timing and manner of implementation of these reforms.
There are many ways in which we are working on achieving greater consistency. Substituted compliance or deference by one regulator to the laws of another jurisdiction is an important tool in this process. The CFTC has granted substituted compliance in certain areas – and will continue to do so as other jurisdictions develop their laws. But there are also areas where we must require compliance with U.S. law without deferring.
The work of international groups, like IOSCO, is also helpful in facilitating the sharing of information on regulatory approaches and suggesting international standards. I strongly encourage this Federation to continue to give its input to IOSCO and other groups. But a national regulator must still engage in careful rule-making in accordance with local law requirements.
The fact that markets may be in different stages of development is a special challenge. I know some regulators in smaller markets have suggested that they should not move forward as quickly with the G-20 OTC swap commitments. But in a global market, there is the concern that businesses will seek to take advantage of regulatory arbitrage. And I also strongly believe that creating a sensible regulatory foundation early on contributes to the growth of strong markets and the avoidance of costs down the road.
A key area of focus today is clearinghouse regulation and recognition. I know many of you are interested in this so I will say a word about it. As you may know, the European Commission has not yet granted equivalence to our clearinghouses.
I believe there is an ample basis for the European Commission to declare us equivalent, and I think this should have been done some time ago. We have already worked out a substituted compliance framework with respect to the application of our laws to European clearinghouses, which was one of their key concerns. But we are continuing to discuss some concerns that the European Commission has pertaining to differences in our regulatory systems and, in particular, differences related to margin methodologies.
We are having constructive discussions, and I value greatly my good relationship with Commissioner Jonathan Hill. But I have noted previously that margin methodologies are complex and have many parameters. In addition, they are only one part of overall risk mitigation. And that is why I think the European Commission should not focus on one or two particular aspects of margining in this process – such as one day versus two day minimum liquidation periods – but rather look at overall outcomes. Our rules are consistent with existing international standards—the PFMIs. In addition, many jurisdictions that have already been granted equivalence follow practices similar to ours. We do not wish to change standards that will simply increase costs in our market without adding a commensurate benefit. We will continue to work on this, and I am hopeful we can reach agreement soon.
Before I conclude, let me just say this: I’ve talked a lot tonight about the challenges that we as regulators faces when dealing with innovation. I know that all of you who operate exchanges are grappling with many of the same issues. You are on the front lines of these matters. And so the dialogue between exchange operators and market regulators is very important to creating sound regulatory structures.
Market evolution and innovation shape what we do, and in turn what we do as a regulator can affect market evolution and innovation. Sensible regulation is a requirement for strong, healthy markets—markets that thrive and continue to evolve and innovate. Like my fellow regulators everywhere, our challenge is to adapt our regulatory framework so that we continue to achieve our core regulatory objectives—preventing fraud and manipulation, promoting integrity, transparency and fairness, and preventing systemic risk—as markets evolve.
Thank you and I look forward to your questions.
1 Melamed, Leo. Leo Melamed on the Markets.(New York: John Wiley & Sons, Inc., 1993) 77-78.
Last Updated: October 19, 2015