ORAL TESTIMONY OF BROOKSLEY BORN
COMMODITY FUTURES TRADING COMMISSION
COMMITTEE ON AGRICULTURE, NUTRITION, AND FORESTRY
FEBRUARY 11, 1997
Mr. Chairman and members of the Committee, thank you for inviting me to present the views of the Commodity Futures Trading Commission on S. 257, a bill to amend the Commodity Exchange Act. I request that my written testimony be included in the record of the hearing. With me here today are the other four Commissioners, Joseph Dial, John Tull, Barbara Pedersen Holum and David Spears. My testimony represents the unanimous view of all of us.
The Commission welcomes this Committee's review of the Commodity Exchange Act. Rapid changes in the futures and option markets in the U.S. require periodic review of the Act and of the Commission's regulations to ensure that they continue to serve the important missions of maintaining the competitive strength, fairness and integrity of the markets and protecting market participants and the public from manipulation, fraud, and other abuses. The Commission is dedicated to reducing unnecessary regulatory burdens while at the same time preserving important public interest protections and has proposed or adopted a number of amendments to streamline its regulations.
As stated in our written testimony, the Commission supports a number of the provisions in S. 257 and commends the bill's sponsors for these thoughtful improvements to the Act. The Commission, at the invitation of Chairman Lugar and Senator Leahy, has proposed modest amendments to the Act which would significantly enhance the Commission's enforcement powers. Those proposed amendments to the Act are not currently included in S. 257, and we urge this Committee to consider their inclusion.
I will focus my oral comments on four aspects of the bill which the Commission believes would likely result in the pervasive deregulation of our futures and option markets and thus would pose grave dangers to the public interest. These changes would radically alter the regulatory system that has allowed our futures markets to become the strongest and most respected in the world and would leave those who use and rely on the integrity of our markets exposed and unprotected.
1. Professional Markets
The Commission strongly opposes the provision of the bill that would create a broad exemption from the Act for professional exchange markets. This provision would lead to widespread deregulation of our futures exchanges by eliminating federal oversight as long as exchange trading was limited to entities including small businesses, proprietorships, pension funds, mutual funds, insurance companies, and commodity pools of individual investors, as well as large institutions. The exchanges estimate that approximately 90 percent of the trading volume on their markets currently is on behalf of such entities. We believe that simple rule changes on the part of U.S. exchanges could convert them into professional markets subject to no federal regulation under the bill's provision.
This legislation would create U.S. futures exchanges with less government regulation than any other significant futures exchanges in the world. For more than a decade, the Commission has played a vital role in encouraging other countries to adopt necessary regulatory regimes for futures exchanges, and they are doing so. The bill would send a signal that the U.S. no longer is willing to act as a world leader in protecting the economy and the public from the risks these exchanges pose. Furthermore, the bill would allow exchange trading with far less government oversight and regulation than the London Metal Exchange at the same time that the United Kingdom is strengthening its regulatory protections to prevent a reoccurance of the Sumitomo debacle.
The bill would eliminate all of the protections of the Act that Congress has adopted over the years except for its prohibitions against fraud and manipulation. Indeed, the Commission would lose virtually all the regulatory tools necessary for effective enforcement of even those prohibitions.
The Commission's market surveillance over the 11 U.S. futures and option exchanges would be eliminated, as would requirements such as speculative position limits, large trader reporting, and exchange recordkeeping. Thus, the Commission would be unable to analyze aberrational price movements on the markets, including suspected price manipulation. Exchanges would not be subject to the current legal standards relating to their futures contracts, rules or governance. Standards for trading in these markets such as the requirement of open trading and audit trail would also be eliminated.
The Commission currently supervises 64,000 commodity professionals who trade on the floor of the exchanges or deal with customers. The standards applicable to them, including registration, fitness standards, risk disclosure to customers, 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 its participants would also be eliminated. These standards include segregation of customer funds, net capital requirements, financial reporting, margining of accounts and special bankruptcy protections.
As part of its effort to reduce unnecessary regulatory burdens, the Commission established a pilot program exempting professional exchange markets from a number of regulatory requirements in November 1995. To date, no exchange has opted to participate in that program. The Commission believes that such a pilot program would provide the necessary experience to determine the appropriate regulatory regime for professional exchange markets and has asked the exchanges for suggestions for improving the program.
The exchanges have said that they should be able to operate in the same unregulated environment as the over-the-counter markets. However, exchange trading involves important public interest considerations which require a higher level of regulation than over-the-counter markets. Exchanges create a concentration of financial risk not present in bilateral over-the-counter transactions and therefore pose a more serious systemic threat to our economy. 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 what we all pay at the grocery store and at the service station, what we pay for our silverware, our copper plumbing and our lumber. That is why Congress created the CFTC and provided it with powers to protect the public interest in these markets.
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 hurt us all by their attempts at manipulation, by causing price distortions or by financial irresponsibility. To demonstrate this point, I need only refer to the financial repercussions from the collapse of Barings Plc., the effect on the price of copper by Sumitomo Corporation's trading, Metallgesellschaft's enormous loss in the oil market, and the Hunt brothers' attempt to manipulate the world market in silver.
The U.S. 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 set a new world record. During fiscal year 1996, U.S. exchanges launched 92 new contracts approved by the Commission. Indeed, 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 U.S. exchanges point to the decrease in their percentage of world trading, that is principally a function of the recent creation of new futures exchanges in countries around the world in emulation of the U.S. success. Most of that foreign trading supports local cash markets and does not compete directly with U.S. futures contracts. Despite the growth of foreign markets, U.S. trading volume has also continued to grow at a healthy rate.
The bill would not permit deregulation of futures markets in certain domestic agricultural products, presumably because it would be too dangerous to do so. The Commission believes that futures markets in other products -- for example, crude oil and heating oil, copper and silver, coffee and sugar, and financial instruments -- deserve the very same level of regulatory protection. Furthermore, the Commission is extremely concerned about whether it would be able effectively to regulate and to protect markets in agricultural products which would trade side-by- side on the same exchange with totally unregulated markets.
2. Treasury Amendment
The Commission agrees that the Treasury Amendment provision of the Act needs to be clarified and has submitted a proposed provision at the invitation of Chairman Lugar and Senator Leahy, which we urge the Committee to consider favorably.
Unlike the Commission's proposal, the bill's provision would for the first time deregulate exchange trading in futures on the Treasury Amendment instruments as long as the exchanges exclude some element of the general public. These products constitute more than 70 percent of the trading on the Chicago Board of Trade and nearly 40 percent of all U.S. futures exchange trading. With respect to such markets, the bill's provision would not even preserve the Act's prohibitions on fraud and manipulation, despite the fact that the Commission's most recent manipulation case involved CBOT's U.S. Treasury note futures contracts.
The bill's Treasury Amendment provision would also for the first time endorse the sale of futures and option contracts to members of the general public without the protections of the Act. Fraud in this area is rampant. The Commission has brought 19 cases involving fraudulent off-exchange sales of foreign currency futures and options since 1990, involving more than 3200 customers who had invested over 250 million dollars. In light of this situation, more regulatory power may be needed -- certainly not less.
With respect to over-the-counter transactions in Treasury Amendment futures and options between sophisticated traders, it is the Commission's view that federal law should prohibit fraud and manipulation, whether enforced by the Commission or other federal authorities. The bill does not include such prohibitions.
For these reasons, the Commission opposes the bill's provision on the Treasury Amendment.
3. Private Transactions
The Commission has provided legal certainty to the over-the-counter derivatives market by the careful and responsible exercise of the exemptive authority granted to the Commission by Congress in 1992. The bill would codify those exemptions. While the Commission has no plans to modify its exemptions, the Commission opposes transforming them into a blanket statutory exemption. Both the Commission and the President's Working Group on Financial Markets have been watching and evaluating this enormous and evolving $53 trillion market. The bill would eliminate all regulatory flexibility to respond quickly if developments in that market required.
4. Contract Designation and Rule Approval
The bill's provisions on contract market designation and exchange rule approval are both unnecessary and unwise. The Commission, as part of its commitment to streamline its rules and to reduce unnecessary burdens, has proposed fast-track approval regulations that would permit most new contracts and exchange rules to go into effect within 10 or 45 days. This approach is far preferable to the bill's provisions, which would effectively eliminate the Commission's ability to improve defective contracts and rules before they go into effect, to insure their compliance with the law, to seek public comment if they impact on important public interests and to coordinate with other interested government agencies.
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Thank you very much for the invitation to express the views of the Commission. I would be happy to answer any questions you may have.