October 14, 2009
It’s an honor to be here today at the 5th annual Chief Regulators Conference to discuss the current regulatory environment and the reform efforts that are underway in Washington and at the Commodity Futures Trading Commission (CFTC). This conference could not come at a more crucial time for market regulators. 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. This audience more than anyone understands the challenges for regulators. The questions surrounding most issues are enormously complex and require thoughtful resolutions. Comprehensive financial reform will not be easy, but I believe decision makers must move forward to restore confidence in the system.
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 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 commission merchants have performed well throughout the financial crisis, there is widespread belief that the CFTC’s regulatory authority should be extended to cover over-the-counter (OTC) derivatives. There is also broad consensus that more transparency must be brought to these markets. The current Commission supports comprehensive regulatory reform including full regulation of the OTC markets. This regulatory framework would cover both OTC derivative dealers and the OTC derivative markets in which they trade.
I am sure by now that many of you are familiar with the framework introduced in May by the US Treasury Department to regulate the OTC derivatives market. Since that time Congressional committees have begun considering their own proposals. Some common themes include:
• Eliminating the current exclusions and exemptions from the CEA and the securities laws to bring OTC swaps in all commodities under full regulation;
• Requiring the registration and regulation of swap dealers and major swap participants, including capital, margin, reporting, recordkeeping, and business conduct rules;
• Requiring 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);
• Requiring that non-standardized swaps be reported to a registered swap repository; and
• Requiring the timely and public dissemination of information on standardized swaps, including price, trading volume, and other trade information.
By anyone’s measure, the proposals being considered, which contain multiple amendments to the CEA and the securities laws, present a daunting task for Congress. The process will require analysis by both the agriculture and banking committees, and possibly others. A number of hearings have already been held, with 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, and who qualifies as a major swap participant. This seems to be the beginning of a long process, with a conclusion most likely not to come until 2010.
Another part of the Treasury framework for regulatory reform called on the CFTC and the SEC to submit a report to Congress 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 in early September with the participation of all nine sitting commissioners and heard from thirty panelists, including exchanges, firms, self-regulatory organizations, former CFTC and SEC commissioners, academics, and consumer groups. The mandates of the two agencies are very different so naturally there are features that are unique to the markets we each oversee, but the focus of the Report, which should be released in the next day or two, is on the issues which have emerged through deliberations identifying areas of blurred jurisdictional lines, or places where regulatory gaps may exist. The Report reviews and analyzes the current statutory and regulatory structure for the CFTC and the SEC in the following areas: (i) product listing and approval; (ii) exchange/clearinghouse rule approval under rules-based and principles-based oversight; (iii) risk-based portfolio margining and bankruptcy/insolvency regimes; (iv) linked national markets and common clearing versus separate markets and exchange-directed clearing; (v) market manipulation and insider trading; (vi) customer protection standards applicable to financial advisers; (vii) regulatory compliance by dual registrants; and (viii) cross-border regulatory matters.
Some of the issues outlined are easier to resolve than others. Many present their own set of complex legal and/or market structure issues and would require legislation. 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.
International coordination is also essential to ensure comprehensive regulation of the OTC derivatives markets. We must not leave gaps in our regulatory structure that allow traders to evade one country’s regulations by taking their business elsewhere. The CFTC has been working not only with our fellow regulators here in the US, but with our international counterparts to prevent opportunities for regulatory arbitrage. Last month, CFTC Chairman Gary Gensler spoke at a conference held by the European Commission in Brussels on the OTC derivatives markets. Through discussions with regulators in Europe, we have found that proposals in the US and Europe are complementary. However, there are a few differences in our approach, which I will highlight for you today.
First, the US proposals would bring all segments of the OTC derivatives markets under the oversight of regulators, such as commodity derivatives, interest rate swaps, and credit default swaps (CDS). In Europe, the initial approach was to focus on bringing oversight and transparency to transactions in CDS. While it is still not clear if the European Commission’s proposals will go beyond CDS to cover other OTC derivatives markets, we are pleased that recent pronouncements from the European Commission have suggested a willingness to cover OTC derivatives more broadly.
Second, the US proposals explicitly cover the dealers of OTC derivatives, requiring the registration and regulation of swap dealers and major swap participants, and as I mentioned previously, the imposition of capital, margin, reporting and recordkeeping requirements, as well as business conduct rules. From the EU, we have not seen proposals to directly regulate swap dealers as part of the EU’s discussion on OTC derivatives.
Third, the US proposals require that standardized swaps be traded on regulated exchanges or alternative swap execution facilities. While the EU has acknowledged that the “next logical step” for standardized derivatives would be for trading of such contracts to take place on exchanges, Europe has not discussed mandating the use of exchanges. In fact, the European Commission has noted the many advantages in terms of market efficiency that would result from allowing the regulated markets and OTC markets to compete.
Fourth, the US proposals require that standardized swaps be moved to clearinghouses regulated by the CFTC or the SEC. The European Commission in its pronouncements has noted the considerable reduction of counterparty risk and other benefits inherent in using clearinghouses. However, the European Commission has not stated that it will mandate the use of a clearinghouse for standardized swaps. Instead, discussion in Europe has focused on providing capital incentives to move the standardized derivatives to clearinghouses. With regard to CDS, the European Commission received a commitment from large industry members to clear certain CDS, those in which the underlying reference entity is a European institution, in a clearinghouse located in Europe.
Fifth, the US proposals require that non-standardized swaps be reported to a registered swap repository. The European Commission appears to be on the same page as the US administration in this regard, having noted the clear value in terms of increased transparency and operational efficiency that comes from the use of a central repository of trading data. I look forward to reading the European Commission’s proposals on derivatives oversight, which are set to be released on October 20th. The European Commission has also asked for the opinion of the public and a body of national securities regulators in Europe on the need to establish a central trade repository located in Europe.
Sixth, the US proposals grant the CFTC and SEC the authority to set position limits and large trader reporting requirements for OTC derivatives that perform or affect a significant price discovery function with respect to regulated markets. I have not seen proposals regarding position limits from Europe.
These differences between the US proposals and EU proposals to date are important, but we are largely in agreement in overall policy objectives, as we are with many of our colleagues around the globe. The recent G-20 meeting in Pittsburgh produced a number of statements in the communiqué regarding derivatives markets, and international regulators are cognizant of the commitments made by our world leaders to be implemented by the appropriate regulatory bodies. These issues have become priorities for international organizations like the International Organization of Securities Commissions (IOSCO) and the Financial Stability Board (FSB). I will just briefly highlight these statements for you. The G-20 Report directs countries to:
• Promote energy market transparency and market stability as part of the broader effort to avoid excessive volatility;
• Improve regulatory oversight of energy markets by implementing the IOSCO recommendations on commodity futures markets and calling on relevant regulators to collect data on large concentrations of trader positions in oil on national commodities futures markets;
• Ask relevant regulators to report back on progress toward implementation;
• Direct relevant regulators to also collect related data on OTC oil markets and to take steps to combat market manipulation leading to excessive price volatility;
• Further refine and improve commodity market information, including through the publication of more detailed and disaggregated data, coordinated as far as possible internationally;
• Commit to act together to raise capital standards, to implement strong international compensation standards aimed at ending practices that lead to excessive risk-taking, to improve the OTC derivatives markets and create more powerful tools to hold large global firms to account for the risks they take commensurate with the cost of their failure; and
• Finally, require that all standardized OTC derivative contracts be traded on exchanges or electronic trading platforms, where appropriate, and cleared through central counterparties by end-2012 at the latest. OTC derivative contracts should be reported to trade repositories. Non-centrally cleared contracts should be subject to higher capital requirements.
IOSCO was asked to help national governments design and implement these policies, conduct further analysis including with regard with to excessive volatility, make specific recommendations, and to report regularly on progress. The FSB was asked to assess implementation and whether it is sufficient to improve transparency in the derivatives markets, mitigate systemic risk, and protect against market abuse. I am confident that US financial regulators will continue to communicate with regulators in other jurisdictions to realize these important agreements.
One 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. And trading linked to commodity indexes, exchange traded funds and exchange traded notes presents a whole new and different set of questions for us as regulators.
It goes without saying that market regulators have their hands full. Achieving these reforms will take time, but I believe we need to enhance transparency and close regulatory gaps to achieve improvements in the regulatory structure. Many of the initiatives we have tackled over the past year have been designed to strengthen our regulatory oversight and thereby enhance public confidence in the markets we regulate. There is no doubt that public confidence in the markets is crucial. We must strive to bolster that confidence and strengthen market integrity.
The CFTC will continue to work with legislators, the SEC, the Administration, and our global counterparts to coordinate all of the recommendations for enhancing and harmonizing the regulatory framework we are tasked with implementing.
Thank you so much to NYSE Regulation and FINRA for organizing this conference and for the invitation to be here today.
Last Updated: June 11, 2010