TESTIMONY OF BROOKSLEY BORN
COMMODITY FUTURES TRADING COMMISSION
BEFORE THE COMMITTEE ON BANKING AND FINANCIAL SERVICES
UNITED STATES HOUSE OF REPRESENTATIVES
SEPTEMBER 18, 1996
Mr. Chairman and members of the Committee, thank you for inviting me to appear on behalf of the Commodity Futures Trading Commission ("CFTC" or "Commission") at today's hearing on the impact on the U.S. banking system of Sumitomo Corporation's recent copper-trading activities. As you may know, I assumed the office of Chair of the CFTC less than one month ago. I am pleased today to make my first appearance before Congress in my new capacity and provide the Committee with information that may be useful in its review of Sumitomo's activities.
CFTC'S SUMITOMO EXPERIENCE
Sumitomo Corporation is a Japanese corporation which was trading in the copper market in London. It has not had any significant position in copper futures contracts in the United States since at least June 1995. If it had, the rigorous regulatory environment in the U.S. would have subjected Sumitomo Corporation to the CFTC's large trader reporting requirements, speculative position limits, and other constraints.
The Commission has taken action on four fronts as a result of events in the worldwide copper market during the past two years:
(1)an ongoing investigation, being conducted in cooperation with other interested domestic and foreign investigative entities, to determine if there have been any violations of the Commodity Exchange Act, through manipulation or other misconduct;
(2) heightened surveillance of the copper futures market which is international in scope and includes physical delivery to satisfy contracts;
(3) assessment of the potential financial consequences of the reported $l.8 billion in losses sustained by Sumitomo Corporation, which had substantial positions on the London Metal Exchange ("LME"); and
(4)renewed efforts to further international cooperation in response to market emergencies and in the surveillance of physical delivery markets in an increasingly global marketplace.
ONGOING CFTC INVESTIGATION
The Commission is currently conducting an investigation relating to activities in the copper markets. For reasons this Committee will understand, I am not at liberty to discuss this investigation publicly due to the sensitive and confidential nature of ongoing enforcement matters. However, I can assure you that the Commission is conducting a careful and thorough inquiry into the issues surrounding Sumitomo Corporation's copper trading, including the nature of the losses. This work will take some time. The issues are complex, and the information that must be examined is extensive and global in scope. We are diligently pursuing this matter in order to evaluate what happened and its impact on areas of legitimate enforcement concern to the CFTC.
This investigation involves information that exists and activities that occurred largely outside of the United States. Because this incident fundamentally occurred in a market outside our direct regulatory reach and largely through entities based in other jurisdictions, it would be difficult, if not impossible, for the CFTC to conduct an effective inquiry without the cooperation of our regulatory and law enforcement counterparts in the United Kingdom and Japan. We have been working particularly closely with the regulatory authorities in the United Kingdom, which have a substantial interest in these matters since the trading at issue occurred on the LME. That cooperation has been the product of several years of negotiations and has been very valuable to our efforts. We expect to maintain a close working relationship throughout the ongoing investigation.
Domestically, we are cooperating with other U.S. governmental entities as appropriate. As has been reported, the U.S. Attorney for the Southern District of New York is conducting an investigation, and our staffs have been cooperating fully. Also, there have been reports about financial arrangements involving U.S. banks related to Sumitomo's copper trading, and we are working in coordination with the Board of Governors of the Federal Reserve System on issues relating to U.S. banks.
HEIGHTENED CFTC SURVEILLANCE
The CFTC has long conducted market surveillance using large trader position reports and financial and other information available to the Commission. The CFTC requires reports from any futures trader whose positions exceed a specified threshold whether those positions are held for a customer or are proprietary in nature. We use this information to monitor for potential disruptive or manipulative market activity. The CFTC and U.S. exchanges, which have an affirmative obligation to prevent disorderly markets, review this information daily and take action as appropriate to prevent price distortion, congestion, squeezes or other abusive market activity. For most physical commodity markets, the maximum permitted size of speculative positions is established and enforced by the Commission and the exchanges. Under Commission oversight, the exchanges also enforce daily price move limits moves intended to dampen market volatility and to facilitate daily settlements. Thus, a market participant trading on a U.S. futures exchange would not have been able to amass huge positions as Sumitomo Corporation did without the Commission knowing about it and having an opportunity to take, or to urge the relevant exchange to take, appropriate steps to address any concerns raised by such positions.
The Commission's particular surveillance interest in the potential effects of world copper trading on U.S. markets long predates the recent losses by Sumitomo Corporation. The CFTC has had heightened surveillance interest in the global copper market since early 1995, when the LME added U.S. delivery points to its copper futures contract. The establishment of delivery points in the United States raised the likelihood that activity on the LME would have a more direct effect on U.S. copper prices than the mere operation of a foreign market in the same commodity. The CFTC, therefore, attempted to develop appropriate arrangements with the U.K. for access to information about LME market activity relevant to effective supervision of our market here at home. In particular, the Commission sought to exchange information with the U.K. Securities and Investments Board ("SIB") about large traders in each of the markets to ascertain whether a trader or group of traders was amassing a position large enough to affect adversely either an individual market or the world market as a whole. Such information also would have been useful in determining whether a sharp reversal in prices could have systemic risk implications. Discussions between U.S. and U.K. regulators began in January of l995, accelerated in April when the LME warehouses in the United States first opened, and continued in July, when these warehouses began to take on stocks of copper.
The Commission became more insistent about its need for information when, in late autumn of 1995, price volatility in both copper markets increased, significant backwardation occurred, and activity with respect to warehouse stocks appeared to be abnormal. Despite continuing price backwardation, where the current price of copper was higher than its anticipated price in the future, the stocks in LME warehouses continued to grow rather than being drawn down to meet the higher demand for current consumption as would be expected during a price backwardation. In addition, largely as a result of the growth of stocks of copper in LME warehouses, levels of stocks in Commodity Exchange, Inc. ("COMEX") warehouses dwindled.
The Commission attempted to obtain necessary surveillance information using all of the tools at its disposal including large trader reports, risk assessment, investigative tools and discussions with U.S. regulated firms with U.K. affiliates. We also engaged in extensive and intensified discussions with U.K. regulators concerning the composition and identity of large traders in the copper futures markets, the identity of the beneficial owners of copper warrants, the practices and possible effect on copper prices of LME warehouses, and the potential financial exposures of the largest market participants.
In December 1995, the Commission also formally instituted an investigation of the copper market. The U.K. officially joined cause with us in January of l996 and shared additional information that has facilitated our investigation. Our joint investigative efforts were instrumental in uncovering the losses allegedly caused by unauthorized trading on behalf of Sumitomo Corporation. Those joint efforts have continued to the present.
IMPACT OF LOSSES ON U.S. REGULATORY INTERESTS
When Sumitomo Corporation informed the Commission of its trading losses in the hours just prior to its public announcement on June 13, 1996, the Commission assessed the potential impact of Sumitomo's losses on firms and markets subject to its supervision. The announcement was timed to fall just prior to LME's June "prompt date" when Sumitomo Corporation would have to take delivery on, liquidate or roll forward its LME positions. Sumitomo appeared to be concerned that rumors were proliferating and the market needed time to absorb the loss announcement in light of Sumitomo's own substantial exposure to copper prices.
The Commission had closely monitored the removal of Mr. Hamanaka from his trading position at Sumitomo Corporation. As a result of our risk assessment activities undertaken prior to Sumitomo's announcement, we had also been in close contact with U.S. firms which had large positions in the copper market. On June 13, when contacted by Sumitomo Corporation, the CFTC took immediate steps to influence the contents of Sumitomo's planned announcement of almost $1.8 billion in losses. In order to calm the markets, we asked for and received assurances, which were made public in the two press releases issued later that day, that Sumitomo Corporation and Sumitomo Bank would stand behind Sumitomo's copper obligations, act responsibly in the marketplace, and cooperate in the ongoing investigation.
In recognition of other potential domestic regulatory interests, on the evening of June 13 and the morning of June 14, the CFTC notified the other members of the President's Working Group on Financial Markets--the Board of Governors of the Federal Reserve System, the Department of the Treasury, and the Securities and Exchange Commission--about Sumitomo's announcement and conveyed additional relevant information to them. In the following weeks, senior staff of Working Group members attended Commission surveillance meetings where the copper market was discussed, and the Commission made a presentation on the copper market at a meeting of the principals of the Working Group on July 22, 1996.
The CFTC's surveillance system not only provided an early warning of potential problems in the copper market, but also permitted the Commission quickly to assess the potential risks to U.S. markets and their participants flowing from the Sumitomo losses. In investigating the potential impact of Sumitomo's announcement, the CFTC first assessed the extent of any direct impact in the U.S.: that is, the impact on U.S. firms trading copper in U.S. markets and the extent of the exposure of U.S. firms carrying positions for Sumitomo Corporation. The CFTC then assessed the potential indirect impact: that is, financial risk to U.S. firms with foreign affiliates which were trading copper on the LME or which held LME-related positions over-the-counter.
The Commission's large trader reporting system made it possible for us to determine quickly that neither Sumitomo Corporation nor any related firms had large positions in any U.S. market and that Sumitomo was not acting as a broker for U.S. customers. In addition, the Commission quickly determined the identity of U.S. firms with large positions in copper. Separately, we reviewed those regulated firms that had reported LME trading affiliates that could cause material exposure to the regulated firms. As a result, the Commission was able quickly to assess the exposure of the largest regulated firms and customers with positions on the U.S. copper market. The CFTC rapidly assessed the risk to clearing firms carrying the 20 largest exposures in the U.S. copper market from a limit price move (20 cents) and an expanded limit move (40 cents) on the COMEX to determine whether losses of that size were manageable by the firms.
The CFTC also invoked the companion international regulatory and market agreements for information sharing on large exposures and related risks developed after the failure of Barings Plc. and signed in March 1996 by regulators from 14 countries and by 49 exchanges from 18 countries around the world. Our first concern was the potential exposure of U.S.-based firms that were carrying positions on the LME for Sumitomo Corporation through affiliates in London. We wanted to assess the security of those positions, the speed with which they could be reduced, and the general disposition or diversification of risk among market participants related to those positions.
Over the weekend following the Sumitomo announcement, the CFTC confirmed that U.K. regulators did not believe the situation would result in a default or that the solvency of Sumitomo Corporation was in doubt. Instead they believed that the primary risk was potentially severe fluctuations in the price of copper. Thereafter, the Commission received more detailed information essentially substantiating that assessment.
By June 17, 1996, the Commission had received from U.K. authorities the names of U.S.-based firms with the largest exposures on the LME, and by June 18, we had received data on the actual market positions of those firms. Separately we also had obtained information on the firms moving copper out of the LME Long Beach warehouse. The information indicated that some of Sumitomo's futures exposure was being moved to clearing members more financially secure than those originally holding it.
Having clarified the scope of exposure to Sumitomo's losses, the CFTC then asked U.K. regulators about general exposure of U.S. firms to fluctuations in copper prices through their U.K.-based affiliates. The U.K. agreed to exchange information on excess capital at U.S. affiliates with both the CFTC and SEC. The information we obtained allowed us to conclude that excess capital of U.S. firms with exposure to the LME through U.K. affiliates would be sufficient to weather a significant adjustment in copper prices.
INTERNATIONAL COOPERATIVE EFFORTS
In addition to our cooperative efforts to deal with the immediate aftermath of Sumitomo Corporation losses, the Commission and U.K. regulators are also cooperating on addressing the more general issues posed by recent events.
SIB review of the LME. The SIB has recently announced a public review of the LME and the metals market generally and has requested the views of more than three thousand market participants and international regulators, including the CFTC. The Commission has provided information comparing the regulation of U.S. markets with that of the LME. For example, unlike our markets and other U.K. markets, the LME does not require the collection of variation margin and daily settlement of trades. The LME also permits the carrying forward of certain historic prices, thus allowing credit risks to go unsecured and potentially undetected in a manner that is not possible when trading on U.S. futures markets.
Information sharing. The events in the copper market underscore the benefit of our cooperative ties with foreign regulators. This cooperation is reflected in numerous memoranda of understanding that we have entered into with regulators in the U.K. and certain other countries governing information sharing for enforcement, regulatory and financial purposes; in recent multilateral agreements; and in many bilateral discussions, both formal and informal, that we have had over the years to address matters of common concern.
Once a market event leads to investigative or enforcement activity directed at sanctioning past conduct, the tools for international information sharing and the related procedures for such sharing are fairly well spelled out. In contrast, routine information sharing for supervisory purposes is relatively new to the international community, and the production and review of surveillance information by certain markets is uncommon and in early stages of development.
For this reason, following the default of Barings Plc. last year, the Commission led international efforts to develop a large exposure information sharing arrangement. The resulting Declaration on Cooperation and Supervision of International Futures Exchanges and Clearing Organizations ("Declaration") has been signed to date by regulators from 15 countries. This agreement contains a mechanism whereby the occurrence of certain events affecting an exchange member's financial resources or positions triggers the ability of a signatory to request information from another signatory. A companion arrangement among exchanges and clearing organizations, developed under the auspices of the Futures Industry Association's Global Task Force on Financial Integrity, has been signed by over 50 organizations representing over 20 jurisdictions.
Sumitomo's losses created the first opportunity for the Commission to invoke the Declaration to facilitate our access to vital market exposure information in the U.K. In this situation where there had not been a default and the markets were competitors, it was important that information sharing take place between the regulators, not the exchanges. The experience has confirmed the merits of our approach of favoring regulator-to- regulator information sharing to complement any market-to-market information sharing agreement. It has also confirmed the wisdom of agreeing in advance concerning the grounds for requesting and receiving information needed to manage market disruptions.
Our experience with the events in the copper market has helped us identify additional areas which merit further Commission action to increase international cooperation. Issues concerning the scope and relevancy of requested information can delay the ability of the Commission and other relevant regulatory authorities to obtain needed surveillance information. Accordingly, in bilateral discussions with the U.K. SIB, we have concluded that addressing these issues in advance of a crisis would help to eliminate delays in the future and would make the arrangements currently in place more effective.
Because this issue is of relevance to other regulators involved in bilateral and multilateral information sharing arrangements, on Monday of this week in Montreal, the Commission and the SIB presented a proposal to the Technical Committee of the International Organization of Securities Commissions ("IOSCO") to develop a mechanism for streamlining the process by which information is shared under such arrangements, and IOSCO has agreed to take this project forward. We believe that it would be useful to provide specific guidance as to the types of information that regulators should share during particular market events, such as periods of market volatility or financial integrity emergencies. The development of such guidelines would facilitate the prompt sharing of relevant information in two ways. First, it would assist the requesting party to state precisely the nature and scope of information it is requesting. Second, it would provide notice to the responding authority of the types of information it should expect to provide in response to particular market events and thus facilitate a prompt response. Based on our meetings with international regulators in Burgenstock in August 1996 and at the IOSCO meeting earlier this week, it is our understanding that other jurisdictions concur that such an initiative could materially improve the information exchange process.
Conference on physical delivery markets. Recent events in the copper market have demonstrated that trading in physical delivery commodity markets involving international commodities, international participants and in many cases foreign delivery points can raise special market integrity and surveillance concerns. Although IOSCO has facilitated international efforts to address market integrity issues as to equity and financial instruments, it has not focused to date on the special supervisory issues raised by commodity or physical delivery markets.
Accordingly, the Commission has initiated discussions with officials at the SIB and the Japanese ministries responsible for supervising commodity futures markets concerning the possibility of co-sponsoring an international conference for regulators of physical delivery markets. The Commission believes that a discussion of the particular concerns raised by physical delivery markets on a multilateral basis is timely, as many jurisdictions currently maintain or are contemplating establishing such markets. Further dialogue on these issues could significantly enhance the supervision of these markets internationally. On September 5, 1996, the Commission, the Japanese Ministry of International Trade and Industry ("MITI"), and the U.K. SIB announced an agreement to cosponsor a conference on these issues. The Commission and the SIB reported on this initiative to the Technical Committee of IOSCO this week, and a number of other jurisdictions indicated their support of the conference.
Views of U.S. exchanges. As the Commission examines the special concerns raised by the interrelationship of the world's futures markets and the participants in those markets, we believe that U.S. exchanges--which have a long and successful history in handling market and credit risk--can make a special contribution to the enhancement of surveillance, contract design and clearing protections throughout the world's markets. Accordingly, in July 1996, the Commission wrote to U.S. futures exchanges and clearing houses to solicit their views on the unique characteristics of physical delivery markets from a market surveillance perspective and the regulatory elements essential to keeping these markets free from manipulative influences. We also understand that many market participants are responding to the SIB's request for comment on their recently announced review of the LME and the metals markets generally. We expect to take these responses into account in the course of pursuing our proposed international discussions and other activities aimed at facilitating the flow of information and enhancing market protections around the globe.
We believe that recent events in the copper markets have confirmed that the CFTC has the surveillance and enforcement authority necessary to foresee and to react to major market events. We further believe that these events have demonstrated the need for continued cooperation among international regulators as an essential component of efforts to maintain the highest level of market supervision and customer protection. No one regulator has all of the information or resources necessary to supervise internationally active firms and exchanges, and cooperation among market authorities is not only desirable but vital. The CFTC initiatives I have described to you today are premised upon this principle. The Commission intends to continue its efforts to insure that the international regulation of these markets is comprehensive, complementary and cooperative.
Again, I want to thank you for inviting me to appear before the Committee today to discuss these important issues with you.