September 24, 2009
Good morning. It’s an honor to be here today to discuss the regulatory reform efforts that are underway in Washington and at the Commodity Futures Trading Commission (CFTC). Not since the Commodity Exchange Act (CEA) and the securities laws were passed in the 1930s has there been a time when events have coalesced, as they have over the past year, to bring into such sharp focus the need for harmonizing regulation and closing regulatory gaps. Policy makers have an historic opportunity to reshape financial markets oversight to better serve the public by strengthening regulation where needed and eliminating inefficiencies where possible. Organizations such as ICI perform a valuable service by promoting the interests and understanding of the U.S. fund industry and deliver a critical voice in this dialogue.
Congress created the CFTC in 1974 as an independent federal agency with the mandate to regulate commodity futures and options markets in the United States. At that time, most futures trading took place in the agricultural sector. Contracts on products such as wheat, corn and cattle were traded in open outcry pits where traders wearing colorful jackets flashed hand signals and jostled each other for position. Over time, increasingly complex financial products were developed. While agricultural trading still makes up about eight percent of the market, and open outcry trading still exists, today’s markets encompass a vast array of financial contracts traded at lightning speed through electronic networks.
Since 1974, the CFTC’s mission has been to protect market users and the public from fraud, manipulation, and abusive trading practices related to the sale of physical and financial futures and options, and to foster open, competitive, and financially sound markets. The CFTC endeavors to ensure the economic utility of the markets through a strong regulatory oversight program that includes market surveillance to detect and prevent manipulation and other market anomalies, and by ensuring the financial integrity of the clearing process. Through effective oversight, the CFTC facilitates the important hedging and price discovery functions that the futures markets were designed to serve.
Although the regulated futures exchanges and futures firms have performed well throughout the financial crisis, there is widespread belief that measures should be taken to prevent a recurrence of the run up in commodity prices that occurred last year, and broad consensus that more transparency must be brought to the markets, especially the over-the-counter (OTC) markets.
I am sure by now many of you are familiar with the Over-The-Counter Derivatives Markets Act of 2009 (Proposed Act), the draft legislation delivered to Congress in August on behalf of the Administration. The CFTC’s Chairman, Gary Gensler, has endorsed the Proposed Act, which would enhance transparency and close regulatory gaps by comprehensively regulating both derivatives dealers and the markets in which they trade. Specifically, the Proposed Act would, among other things:
• Eliminate the current exclusions and exemptions from the CEA and the securities laws to bring OTC swaps in all commodities under full regulation;
• Require the registration and regulation of swap dealers and major swap participants, including capital, margin, reporting, recordkeeping, and business conduct rules;
• Require that standardized swaps be traded on regulated exchanges or alternative swap execution facilities and cleared by clearinghouses regulated by the CFTC or the Securities and Exchange Commission (SEC);
• Require that non-standardized swaps be reported to a registered swap repository;
• Require the timely and public dissemination of information on standardized swaps, including price, trading volume, and other trade information; and
• Authorize the CFTC to adopt rules and regulations requiring the registration of foreign boards of trade that provide direct access to their trade execution systems to participants located in the U.S.
In accordance with Chairman Gensler’s recommendations, the Proposed Act would also give the CFTC clear authority to establish position limits and grant related hedge exemptions for all contracts listed on regulated exchanges. In order to prevent traders from avoiding position limits by moving to a related exchange or market, the Proposed Act would empower the agency to set limits on swap contracts that perform a significant price discovery function with respect to the regulated markets, and to require that limits be aggregated across all markets and trading platforms, including foreign exchanges that have received no-action relief from the CFTC to offer look-alike contracts to U.S. customers.
Shortly after the Proposed Act was delivered to Congress, Chairman Gensler submitted additional draft legislation to the Commission’s authorizing committees that would enhance the Administration’s proposal in several respects by, for example, clarifying the insolvency regime for OTC swaps. By anyone’s measure, the Proposed Act, which runs 115 pages long and contains multiple amendments to the CEA and the securities laws, presents a daunting task for Congress. The process will require analysis by both the agricultural and banking committees, and possibly others. A number of hearings have already been held, with many more to come. If the legislation passes in its present form, or something close to it, it will require the CFTC and the SEC to adopt uniform interpretations and issue joint rulemakings on many of its points, such as how to define what constitutes a standardized swap. If the two agencies cannot agree, the Proposed Act provides that the Treasury shall issue the rules.
Also included in the Administration’s framework for regulatory reform was a request to the CFTC and the SEC to submit a report to Congress by September 30, 2009, identifying conflicts in how the two agencies regulate similar financial products and to either explain why those differences further important policy goals, or recommend resolutions. Toward that end, for the first time ever the agencies held joint meetings earlier this month and heard from a wide range of participants including exchanges, firms, self-regulatory organizations, former CFTC and SEC commissioners, academics, and consumer groups. As a result of the discussions a number of differences for potential harmonization were identified.
• Principles-based versus rules-based regulatory oversight;
• Prior approval of products and exchange and clearinghouse rules in the securities markets versus self-certification in the futures markets;
• Differing standards for customer protection—suitability for the securities markets, which could be elevated to fiduciary obligations under the Administration’s reform plan, versus a know your customer/risk disclosure regime for the futures markets;
• Differing insider trading rules;
• Differing standards for prosecuting market manipulation;
• Differing bankruptcy and customer funds protection regimes, with Security Investment Protection Act insurance for securities customers versus segregated funds protection for futures customers;
• Fungibility and competition among execution platforms, with a national market system for securities markets versus non-fungible execution and clearing for futures markets;
• Differing risk-based portfolio margining models and possible cross-margining of futures and securities products; and
• Mutual recognition of entities regulated by foreign jurisdictions.
Other areas for possible harmonization or collaboration that were discussed included simplifying compliance and registration for dual registrants; harmonizing definitions for sophisticated investor categories; forming a joint agency task force on market fraud; drafting joint agency guidelines on the use of prosecutorial discretion; and establishing a joint advisory committee to identify and quantify emerging regulatory risks. On that last point, Chairman Shapiro and Chairman Gensler last week requested appropriations from Congress to fund a joint committee.
Some of the issues I’ve outlined are easier to resolve than others; many present their own set of complex legal and/or market structure issues and would require legislation. Interoperability among clearinghouses and competition among execution platforms comes to mind.
Last, but certainly not least, many of the participants raised the need to create a mechanism for resolving jurisdictional disputes between the SEC and the CFTC. As mentioned, the Administration’s proposal provides that the Treasury should serve that role. There is a growing list of derivatives products that straddle jurisdictional lines and the Administration’s proposal would require a host of new joint rules and interpretations. I share the frustrations of those who complain that the agencies’ inability to resolve jurisdictional disputes or harmonize regulations for similar products creates capital inefficiencies and needless delays in bringing beneficial financial tools to the marketplace. Despite a Memorandum of Understanding entered into between the agencies last year, designed specifically, in part, to speed the consideration and approval of novel products, we have continued to struggle. And, if history is any guide, having a third regulatory body serve as a tie-breaker is not a panacea. The agencies’ inability to develop true risk-based portfolio margining for security futures products (SFPs) despite the encouragement of the Federal Reserve Board in 2001 is illustrative. Seven years later, in the 2008 Farm Bill, Congress directed the members of the President’s Working Group on Financial Market to work to ensure that the CFTC and the SEC authorize risk-based portfolio margining for SFPs and security options by September 30, 2009, and to resolve issues relating to the trading of foreign security indexes by June 30, 2009. To date, we have been unable to reach agreement on these issues. I am hopeful, however, that under the new spirit of cooperation between our commissions and the leadership of Gary Gensler and Mary Shapiro we will be able to make real progress. We must not waste this opportunity.
A final topic I’d like to touch on is one that is unique to the futures markets—that of position limits and hedge exemptions—but which is related, in part, to products traded on securities exchanges. Since the early 1990s, there has been an influx of new traders into the futures markets, including investors seeking exposure to commodities as an asset class through passive long-term investment in commodity index funds. Since that time, the Commission has granted hedge exemptions from federal position limits to swap dealers who offset their net price risk resulting from a combination of OTC activities, which may include acting as counterparties to index traders, as well as to traditional commercial entities such as airlines hedging their fuel costs through customized swaps, and speculators seeking to gain price exposure.
As prices escalated in 2007 and 2008, concerns were raised about whether money flowing into the futures markets from index trading was artificially inflating commodity prices and whether speculators were exceeding position limits and accountability levels by entering into transactions with swap dealers. To better understand the activities of index traders and swap dealers and their potential to influence futures markets, the Commission, last year, began requiring these entities to disclose their OTC activities to the CFTC. The Commission now quantifies and publishes index investment data on a quarterly basis and hopes to do so eventually on a monthly basis.
In addition, in March 2009 the CFTC published a concept release seeking public comment on whether to eliminate the bona fide hedge exemption for swap dealers and replace it with a more limited risk management exemption for their on-exchange activity. The Commission followed this up with three days of public hearings in July and August to discuss whether the agency should set position limits in all commodities with finite supply, with special emphasis on energy contracts. We heard from a number of market users, including index funds, and discussed how we might aggregate position limits across markets, as well as the criteria that should be considered for any exemptions from the limits. Commission staff is still in the process of reviewing the comments and the hearing testimony. Nevertheless, as an interim step the Commission announced that it was withdrawing two no-action letters which had granted relief from federal speculative limits in wheat, corn, and soybeans to entities offering index fund investment strategies.
The issues surrounding position limits and hedge exemptions are enormously complex. Every market has its own characteristics so what works for soybean markets, for example, may not be appropriate for natural gas markets. Trading linked to commodity indexes, exchange traded funds and exchange traded notes presents a difference set of questions. Should positions related to such trading be governed by their own set of rules given the passive nature of the activity? How do we determine the appropriate level of passive investment in the markets—should it be based on percentages, numerical limits, or some other methodology? Should hard positions limits be imposed in all physical commodities and if so, should they be imposed on exchange trading without similar limits in place for OTC markets? I am especially concerned that doing so will have the perverse effect of driving large portions of the market away from centralized trading and clearing at the very time we are urging all standardized OTC activity to be traded on-exchange or cleared. Likewise, I am concerned that, without global standards, trading will move to other financial centers around the world.
It goes without saying that achieving these reforms will take time and will require substantial additional resources for personnel and technology. The CFTC will continue to work with legislators, the Administration, and the SEC on all of the recommendations for enhancing and harmonizing the regulatory framework we are tasked with implementing, and to protect the crucial risk management and price discovery functions that well-functioning futures and options markets provide.
Last Updated: June 11, 2010