REMARKS OF BROOKSLEY BORN
COMMODITY FUTURES TRADING COMMISSION
FUTURES INDUSTRY ASSOCIATION'S
INTERNATIONAL FUTURES INDUSTRY CONFERENCE
Boca Raton, Florida
March 18, 1999
It is a pleasure to be here this morning to address the members of the Futures Industry Association. I look forward to an extremely interesting conference this year as the industry addresses many of the issues confronting it in this era of profound change.
It is difficult to imagine a time of greater change in this industry. Electronic trading systems are replacing floor trading at exchanges around the world. The ultimate role of intermediaries in these new systems is not yet clear. Moreover, instantaneous international communication and transactional capabilities are creating truly global markets. Consequently, domestic exchanges and industry professionals are eager to offer their products and services to customers abroad, while foreign exchanges are just as eager to offer their products to U.S. customers. While futures exchanges are grappling with these technological developments, the number and type of derivative products offered over-the-counter continues to mushroom even as the volume of transactions in that market increases exponentially. Furthermore, technological and market developments are driving many OTC derivatives market participants to express an interest in adopting trading and clearing systems that would cause the OTC market to resemble more closely the exchange-traded markets.
Technological advancements are no doubt the single biggest source of change in the industry. In October 1996, in my first speech as Chair of the CFTC, I addressed the need for our industry to embrace technological innovation and to use that innovation to continue to be the world leaders in futures exchanges. Since that time, many foreign futures exchanges have abandoned their trading floors in search of faster and cheaper trade executions through directly accessible electronic trading systems. In addition, new fully electronic U.S. exchanges are being launched. In 1998, the new Cantor Financial Futures Exchange became the first fully electronic-based U.S. exchange. When its recently adopted rule changes become effective, it will provide for direct electronic-access by members and certain other traders. Another aspiring U.S. exchange, FutureCom, has an application pending before the Commission to become the first Internet-based futures exchange.
In the face of these developments, U.S. futures exchanges constantly confront the question of whether open outcry trading will remain a viable alternative in the 21st century. It remains true that the very liquid and efficient trading floors in Chicago and New York can still execute more trades per minute than currently operating electronic futures trading systems. Moreover, the U.S. exchanges are employing new technologies to increase the efficiency and to reduce the costs of open outcry trading. Some exchanges and their members are experimenting with electronic order routing systems. Pilot programs are testing the use of handheld trading units. Advanced computer software is being used to enhance exchanges' market surveillance.
U.S. exchanges have also improved their existing electronic trading systems and have successfully integrated electronic and open outcry trading in some contracts. The Chicago Mercantile Exchange pioneered this innovation when it offered concurrent electronic and open outcry trading of the "E-mini" version of its S&P 500 futures contract. That development also opened the way for some firms to offer on-line trading access to the E-mini on Globex2. The Chicago Board of Trade also now features concurrent electronic and open outcry trading in many of its financial contracts.
The ability to compete effectively in a dynamic and changing world ultimately depends on the actions of the domestic exchanges and market participants. In a climate of change, a willingness to innovate is crucial to continued success. Our exchanges have always been world leaders, and I am confident that they will continue to innovate in ways that will ensure that they remain the most competitive and most dynamic futures markets in the world.
Although the exchanges and industry participants must take
responsibility for lowering costs and providing competitive services,
the Commission is committed to reducing regulatory costs and burdens
on our exchanges and market participants. In my remarks here last
year, I outlined several of the major regulatory reform initiatives
that the Commission had undertaken to modernize and streamline the
regulatory regime we administer. Our efforts have continued in the
last twelve months. Some of the many proposed and final rules issued
in the last year include:
Many of these initiatives were in direct response to requests from industry representatives. Although our staff is continually reviewing our rules to determine other areas where we can reduce or eliminate regulatory burdens, we can be most effective through working closely with the industry. I reiterate my call for members of the industry to provide the Commission with additional suggestions for improving our regulatory framework.
While the Commission has spent considerable time and effort on its regulatory reform program, it has also devoted considerable resources to addressing the difficult and rapidly evolving regulatory issues associated with technological innovation in the industry. The Commission must adapt its regulatory framework to accommodate a variety of proposed alternative trading systems, including Internet-based exchanges, non-intermediated exchanges and proprietary exchanges. At the same time, however, the Commission must ensure that it has sufficient regulatory tools to protect against fraud, customer abuse, market manipulation and financial disruption in this new electronic age. The recent actions of the Commission in approving the CFFE electronic system and the side-by-side electronic and open outcry trading at the Chicago exchanges and the work of the staff on the FutureCom application are a significant beginning in doing so. We also continue to make progress in permitting electronic media to be used for certain types of recordkeeping, customer disclosure, filings with the Commission, and communications by industry professionals both with the Commission and with their customers. I know we have more to do. I again urge the industry to work with us to identify areas that need our attention.
Further along these lines, I am pleased to announce that the Commission has just issued a proposed new rule to allow foreign exchanges to place electronic terminals or automated order routing systems in the U.S. This rulemaking tackles cutting edge technological issues. It also addresses the difficult issue of how best to accomplish our regulatory mandate of protecting U.S. customers in an increasingly global market. The proposal seeks to avoid imposing undue or duplicative regulatory requirements on exchanges by taking into account, where appropriate, the foreign regulation of the exchange seeking access to the U.S. market. I know many of you here today have an interest in this rulemaking, and we look forward to your comments.
Another challenge facing the industry and financial regulators today is the rapid growth of the over-the-counter derivatives market. The volume of trading in that market has exploded in the last five years and now is estimated by the Bank for International Settlements to be $70 trillion in notional value worldwide. In addition, the market has grown in diversity, with the development of a multitude of new products and increased interest in new market mechanisms. Last year at this conference I announced that the Commission would issue a concept release to initiate a study of the changes in the OTC derivatives market and of whether the Commission's current regulation of that market requires updating in light of significant market developments. Although Congress eventually passed a six-month moratorium preventing the Commission from acting on its study, many of the regulatory issues identified in the concept release became front-page news last September when a very large hedge fund, Long-Term Capital Management L.P., nearly defaulted on $1.25 trillion in notional value of exchange-traded and OTC derivatives contracts.
The LTCM episode demonstrates the unknown risks that the OTC derivatives market may pose to the U.S. economy and to financial stability around the world. It also illustrates the lack of transparency, excessive leverage, and insufficient prudential controls in this market as well as the need for greater coordination and cooperation among domestic and international regulators.
I welcome the heightened awareness of these issues and believe it is critically important for all financial regulators to work together closely and cooperatively on them. We must urgently address whether there are unacceptable regulatory gaps relating to trading by hedge funds and other large OTC derivatives market participants. To that end, the President's Working Group on Financial Markets, which consists of the Secretary of the Treasury and the Chairs of the Federal Reserve System Board of Governors, the Securities and Exchange Commission and the CFTC, is currently working on two studies relating to the regulatory response needed for hedge funds and the OTC derivatives market. In addition, the G-7, the G-22, the International Organization of Securities Commissions ("IOSCO"), the Basle Committee on Banking Supervision, and many foreign governments are focusing on regulatory issues raised by LTCM and other highly leveraged institutions.
While there appears to be an emerging consensus among many market participants and government authorities about the need for greater transparency in the OTC derivatives market, more study is needed to determine how best to enhance transparency. In my view, at the least, hedge funds and other large highly leveraged institutions should be required to provide their investors, counterparties and creditors with disclosure documents and periodic reports concerning their OTC derivatives positions, exposures and investment strategies. In addition, serious consideration should be given to requiring OTC derivatives market participants to file large trader position reports with one or more federal agencies charged with oversight of the OTC derivatives market. If such reporting and disclosure requirements had been in place in the U.S., some of the difficulties relating to LTCM might have been averted.
As we struggle with the many challenges posed by technological innovation, growth of new markets, diversification of financial products and trading systems, and the reality of a truly global financial marketplace, Congress has indicated that it intends to undertake a comprehensive review of the Commodity Exchange Act in connection with the reauthorization of the Commission that is due on September 30, 2000. I believe it is very timely to reexamine the Act to determine whether it continues to provide an effective and appropriate framework for government oversight of our rapidly changing futures and option markets.
Congress is also working on financial services modernization bills in both the House and the Senate. If passed, these bills will fundamentally alter the way financial products and services are offered in this country. For example, securities firms and insurance companies could combine with commercial banks to create financial conglomerates selling all types of financial products. These changes could further blur the definitional lines among financial products and their providers.
As Congress begins its debate on changes to the Commodity Exchange Act and financial services modernization, I would like to offer a few personal views on certain fundamental principles that are necessary to ensure the continued strength and integrity of our futures and option markets. The Commission and its predecessor have overseen the nation's futures markets for more than 70 years. Government oversight of these derivative markets traditionally has been exercised according to the nature of the market and the market participants and products involved. This exercise of functional market oversight creates consistency of regulation without regard to the entity trading the product. It also fosters market and product expertise by the regulator that can then be applied even-handedly to all market participants. A market-based approach also allows the regulator to address comprehensive market issues such as market integrity, manipulation, fraud, and systemic risk.
The benefits of functional market oversight apply equally to exchange-traded and over-the-counter derivatives. While the nature of and participants in the over-the-counter derivatives market may warrant a different degree or kind of regulation from the exchange-traded derivatives markets, the size and nature of the OTC market create a potential for systemic risk to the nation's financial markets. Moreover, as OTC market participants seek to clear swaps and express interest in various forms of screen-based trading, the distinctions between exchange-traded and OTC derivatives markets begin to blur. There is simply no justifiable basis to claim that entity-based supervision of OTC derivatives dealers alone is sufficient to oversee this market. While such supervision is important to the safety and soundness of many of the large dealers, we cannot overlook the fact that many participants in the OTC derivatives market -- including many hedge funds and other highly leveraged institutions -- are not subject to government oversight. Equally important, an entity-based regulatory approach does not provide oversight of the market generally, which may be particularly dangerous in a market that is currently as opaque as the OTC derivatives market.
I also believe that as Congress examines the CEA it should give careful consideration to the statutory treatment of equity derivatives. Greater legal certainty is needed for equity swaps, and the SEC and many swaps dealers have argued that they should be exempted from the Commodity Exchange Act. If that is to be done, an appropriate regulatory framework for such activity would need to be developed. It would seem reasonable to include at a minimum prohibitions against fraud, insider trading, and manipulation and possibly margin requirements. In addition, if Congress were to take such action with respect to over-the-counter transactions in equity derivatives, it should seriously consider permitting futures on equity securities to be traded on the futures exchanges.
I would also like to see Congress provide the Commission with clear and unequivocal enforcement authority to pursue off-exchange foreign currency fraud imposed on the retail public, which has reached epidemic proportions. Clarification of the law in this area should not be held hostage to efforts of certain market participants to avoid Commission jurisdiction over sales of foreign currency derivatives to the retail public or over certain foreign currency trading systems.
Finally, as Congress considers changes to the CEA, I hope it will give serious consideration to removing the provision of the Act that requires periodic reauthorization of the Commission. The Commission will celebrate its 25th anniversary next year, and I believe there can no longer be any doubt that it is necessary and appropriate to have an independent regulatory agency overseeing the nation's futures and option markets. The periodic reauthorization process consumes an enormous amount of time and resources by both the industry and the Commission that could otherwise be focused on business and regulatory innovation. While I believe strongly in the importance of Congressional oversight of the Commission, that oversight is and should be exercised routinely. Congress does not need a reauthorization provision to change the Commodity Exchange Act whenever it believes it is necessary to do so.
Again, thank you for the opportunity to share my views on the challenges confronting the U.S. futures industry and its regulator, the CFTC. I would be happy to answer your questions.