"Risks to the Grain Futures Markets"
REMARKS OF BROOKSLEY BORN
COMMODITY FUTURES TRADING COMMISSION BEFORE THE
MILLERS' NATIONAL FEDERATION ANNUAL MEETING
April 28, 1997
I am pleased to be here today and to have the opportunity to speak to this important group of agricultural processors. I understand that members of the Millers' National Federation represent one of the largest groups of hedgers using the agricultural futures markets, and it is an honor to address such a distinguished group of our markets' participants.
In my remarks today, I would like to address the proposed legislation currently pending in Congress to amend the Commodity Exchange Act, the law governing futures and option trading. These bills -- if adopted -- could have a significant impact on both exchange-traded and over-the-counter derivative markets. It is an appropriate time to reexamine the Commodity Exchange Act to determine whether it continues to be effective and efficient in regulating our futures markets, and I commend Congress for doing so. These markets have changed over the years, and the Act may require amendment to reflect those changes. The CFTC is committed to working with Congress, the futures industry and market participants to craft legislation that modernizes the Act while protecting the public interest and providing market participants with strong, safe and transparent futures markets.
The debate over the policy issues in these legislative proposals often focuses more on the interests of those who make the markets than on the interests of those who depend upon the soundness and integrity of the marketplace. But of course it is the interests of those who use the markets for price discovery purposes or to hedge against possible loss through price fluctuations that caused Congress long ago to declare that regulation of these markets is "imperative" to protect the national interest in the commerce affected by these markets.
The pending legislation could dramatically alter the regulatory framework applicable to our futures exchanges. Both the House and the Senate bills include a provision exempting so- called professional markets from nearly all provisions of the Commodity Exchange Act. Federal oversight of the futures exchanges could be eliminated as long as exchange trading was limited to entities with a net worth of $1 million. These traders include small businesses, proprietorships, partnerships, pension funds, mutual funds, and commodity pools of individual investors, as well as large institutions. The exchanges estimate that approximately 90 percent of their current trading volume is on behalf of such entities. Therefore, it is likely that simple exchange rule changes could convert many markets into professional markets subject to no meaningful federal oversight.
This exemption could lead to pervasive deregulation of our futures exchanges at a time when the rest of the world is looking to the U.S. for a regulatory model. The exemption could create U.S. futures exchanges with less government regulation than any other significant futures exchanges in the world. All significant foreign exchanges are currently subject to government oversight and regulation, and the Commission is working with foreign regulators to agree upon international best practice standards for regulating futures markets. The proposed professional markets exemption would likely deal a serious blow to the United State's leadership role in fostering safer and more efficient markets world-wide. If the United States were to permit unregulated markets here, other countries would likely follow suit, creating a far riskier global environment for U.S. investors and for our own markets.
The deregulation of exchange trading possible under the professional markets exemption would greatly restrict federal power to protect against manipulation, fraud, financial instability and other dangers. While the bills preserve CFTC jurisdiction to bring fraud and manipulation cases after the fact, that limited authority might provide only an illusion of protection. The Commission would be stripped of many of its regulatory tools designed to prevent those abuses from occurring and to detect them when they do occur.
For example, statutory and regulatory requirements designed to detect and deter fraud and cheating of market participants, such as those relating to exchange audit trails, competitive trading and open pricing, would cease to exist. Many of the customer protections currently in place were added by Congress in 1992 after the 1989 FBI-CFTC investigation revealed the existence of widespread cheating of customers -- including large institutional customers -- in the pits of the Chicago exchanges. The 1992 legislation added tougher audit trail standards, dual trading prohibitions, exchange governance requirements, floor trader registration requirements, and ethics training requirements. None of these protections would be required for the professional markets envisioned in the pending legislation.
The proposed professional markets provision also sweeps away many regulatory tools designed to safeguard market integrity. There would be no Commission surveillance of the professional markets, and requirements such as speculative position limits, large trader reporting, and exchange recordkeeping would be eliminated. Thus, the Commission would not have the data to analyze aberrational price movements on the markets, including suspected price manipulation. Exchanges also would not be subject to any of the current legal standards relating to their contracts, rules or governance.
The Commission supervises 64,000 commodity professionals who trade on the floors of the exchanges or deal with customers. If these persons were to trade only on the exempted professional markets, the federal standards applicable to them, including registration, fitness standards, risk disclosure to customers, recordkeeping and sales practice standards, would be abolished, leaving customers without meaningful governmental protection.
Statutory and regulatory standards relating to the financial integrity of the markets and their participants would be eliminated. The standards abolished would include segregation of customer funds, net capital requirements, financial reporting, margining of accounts and special bankruptcy protections. In sum, the bills could eliminate seventy years of government protection of the integrity of our markets.
The bill pending in the Senate, unlike the House bill, would not permit deregulation of futures markets in certain domestic agricultural products, including wheat, presumably on the grounds that it would be too dangerous to do so. The Commission believes that futures markets in other products -- energy, metals, tropical agricultural products, and financial instruments -- deserve the very same level of regulatory protection as agricultural products.
Moreover, the Commission is extremely concerned about whether it would be able effectively to regulate and to protect markets in agricultural products that would trade side-by-side on the same exchange with totally unregulated markets. Such a trading environment existed prior to 1974 when only certain domestic agricultural products were regulated under the Commodity Exchange Act. Widely publicized failures of futures commission merchants dealing in the unregulated markets and other problems in the unregulated markets prompted Congress in 1974 to place futures trading in all commodities under the CEA's protections. The current legislation once again could leave regulated agricultural markets exposed to the dangers of the unregulated markets. For example, the Commission seriously questions whether the funds related to regulated and unregulated trading should be handled by the same clearinghouse. Significant public policy concerns would be raised by subjecting funds relating to the regulated market to the risks of trading in the unregulated markets.
The Commission also is concerned about the impact of unregulated markets on the liquidity of the regulated agricultural markets. The unregulated markets might siphon off speculative trading from the regulated agricultural markets, thus reducing their liquidity and usefulness.
These same concerns were expressed by a coalition of agricultural interests which opposed the professional markets provision in testimony before the House Subcommittee just over a week ago. This coalition includes the American Farm Bureau Federation, American Soybean Association, National Association of Wheat Growers, National Barley Growers, National Cattlemen's Beef Association, National Corn Growers Association, National Cotton Council, National Grain Sorghum Producers, National Milk Producers, National Pork Producers, and USA Rice.
The Commission is committed to the principle that professional exchange markets are entitled to a lower level of regulation than markets open to the general public. We recognize that sophisticated institutional traders do not require the same degree of protection as unsophisticated and inexperienced individuals. As part of its ongoing effort to eliminate unnecessary regulatory burdens, the Commission established a pilot program exempting professional exchange markets from a number of regulatory requirements in November 1995. The Commission adopted that program after an extensive rulemaking procedure and after receiving input from many interested parties -- including market users. To date, no exchange has opted to participate in that program. The Commission would welcome a dialogue with the futures industry and other interested groups on the issue of reduced regulation for professional markets.
The exchanges have said that they should be able to operate in the same unregulated environment as the over-the-counter markets -- a result that the pending legislation is designed to achieve. There are differences between these markets, however. Exchange trading involves important public interest considerations that require a higher level of regulation than over-the-counter markets. The appropriate regulatory framework must depend on an analysis of the characteristics of the particular market.
The use of centralized clearing in exchange trading, for example, creates a concentration of financial risk not present in bilateral over-the-counter transactions. That concentration of risk poses more serious systemic threats to our economy than the decentralized risk of the over-the counter market.
While both exchanges and the over-the-counter markets perform a vital public service in providing hedging opportunities, there is also a strong public interest in protecting the price-discovery and price-basing functions uniquely performed by exchanges. The prices established by the futures exchanges affect trillions of dollars of commercial transactions and ultimately the retail prices for many commodities. This price-discovery function requires protection even if particular sophisticated traders do not.
Merely restricting participation in the futures markets to large institutions is insufficient to protect these important public interests and cannot justify abandoning the protections of the Act. In fact, it is the large institutions which have the power to do the greatest harm to the markets through attempts at manipulation, price distortions, and financial irresponsibility. To demonstrate this point, one needs only refer to the effect on the price of copper by Sumitomo Corporation's trading, the financial repercussions from the collapse of Barings Plc., Metallgesellschaft's enormous loss in the oil market, the Feruzzi's manipulative activities in the soybean market, and the Hunt brothers' attempt to manipulate the world market in silver.
The U.S. futures exchanges also have argued that they are entitled to deregulation because they are suffering from competitive pressures. However, our exchanges are the strongest, most dynamic and most innovative in the world. Their volume of trading in 1996 was the second highest in history, and the Chicago Board of Trade -- the world's largest futures exchange -- set a world record in volume and enjoyed a 26% increase in profits. In the past decade, trading on U.S. exchanges has more than doubled -- an increase of 130%. The Commission approved 92 new futures and options contracts in fiscal year 1996. Exchange trading in the U.S. has thrived under our current regulatory system, which has assured market participants around the world that our markets are fair, safe and transparent.
While the over-the-counter derivative market has also grown quickly over the past decade, that market both complements and competes with futures exchange markets by providing large institutions with a choice of custom-designed, bilateral instruments as an alternative to standardized contracts without counterparty credit risk. Traders on the over-the-counter market often hedge their resulting exposure on an exchange and thus bring business to the exchanges.
The exchanges have argued that self-regulation would be adequate to protect their markets. It is certainly true that self-regulation by the exchanges is currently a critically important aspect of our regulatory system. However, since 1922, federal regulatory authority has been an essential bulwark of the integrity and fairness of the futures markets, supplemented but not supplanted by industry self-regulation. The Commodity Exchange Act currently sets the standards for exchange self- regulation, and those standards would be eliminated under the professional markets exemption. In their place would be left only the commercial self-interest of the exchanges. That self- interest at times conflicts with the interests of market participants, the interests of agricultural and commercial entities that rely on exchange prices or the interests of the American consumer. That is why federal regulation is necessary.
Here I should note an issue of particular interest to the members of the Millers' Federation. As many of you may know, in December 1996 the Commission notified the Chicago Board of Trade that the delivery terms of its corn and soybean futures contracts no longer accomplish the statutory objectives of permitting delivery in a manner that will tend to prevent or diminish price manipulation, market congestion or the abnormal movement of these commodities in interstate commerce. The Commission also stated its view that the delivery terms of the CBOT's wheat contract also warranted full review and asked the CBOT to undertake such a review and report to the Commission in 120 days. The CBOT last week notified the Commission that it had not been able to come up with a recommendation for delivery terms of its wheat contract in the 120-day period and would continue to study the issue. The Commission continues to be concerned about the delivery terms of the wheat contract and is considering soliciting public comment on this issue.
The U.S. has had more than 70 years of successful futures market regulation -- regulation that has produced the most competitive, most dynamic and most innovative futures markets in the world. The pending legislation would discard this regulatory framework on the theory that the self-interest of private market participants will protect not only those participants but the marketplace as a whole. However much free market economists may applaud a laissez faire approach to futures markets, this approach would be at best a profoundly dangerous experiment. A corollary of a laissez faire approach is caveat emptor -- let the buyer beware.
The Commission believes that the regulatory regime is crucial if these markets are to continue to serve their critical price discovery and hedging functions. It is committed to working with the industry, market users and Congress to keep the markets strong and fair.