COMMODITY FUTURES TRADING COMMISSION†
U.S. HOUSE OF REPRESENTATIVES
COMMITTEE ON AGRICULTURE
SUBCOMMITTEE ON RISK MANAGEMENT AND SPECIALTY CROPS
MAY 18, 1999
††Mr. Chairman and members of the Subcommittee, I am pleased to be here this morning to testify concerning issues that Congress should consider as it begins the process of reauthorization of the Commodity Futures Trading Commission ("Commission" or "CFTC"). It is an appropriate time to undertake a comprehensive review of the Commodity Exchange Act ("CEA") to assure that it continues to provide an effective framework for government oversight of our rapidly changing futures and option markets.
It is a time of profound change in the futures 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. 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 types of derivative products offered over-the-counter ("OTC") continue to mushroom even as the volume of transactions in that market increases exponentially. Furthermore, many OTC derivatives market participants are expressing an interest in adopting trading and clearing systems that would cause the OTC market to resemble exchange markets. In the face of these developments, it is important to review the CEA and the Commission's current regulations to modernize and to streamline oversight of these critically important markets.
Technological advancements are no doubt the single biggest source of change in the industry. In the last few years, a number of foreign futures exchanges have abandoned their trading floors in search of faster and cheaper trade executions through directly accessible electronic trading systems. Exchanges that once physically existed only overseas now can be accessed from personal computers anywhere in the world -- including the United States. Some foreign electronic exchanges now want direct electronic access to U.S. traders. In response to this development, the Commission recently issued a proposed new rule to allow foreign exchanges to place electronic terminals or automated order routing systems in the United States. This rulemaking tackles cutting-edge technological issues. It also addresses the difficult issue of how best to accomplish the statutory mandate of protecting U.S. investors 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.
U.S. exchanges are responding to foreign competition and technological developments by improving their electronic trading systems and successfully integrating electronic and open outcry trading in some contracts. The Chicago Mercantile Exchange ("CME") 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, CME's electronic trading system. The Chicago Board of Trade ("CBT") also now features concurrent electronic and open outcry trading in many of its financial contracts.
New, fully electronic U.S. exchanges are being launched. In September 1998, the new Cantor Financial Futures Exchange ("CFFE") became the first fully electronic-based U.S. exchange. The Commission recently permitted CFFE to implement rule changes which provide for direct electronic access by members and certain other traders. Specifically, CFFE's new direct-access rules allow CFFE clearing members and their affiliates, Coffee, Sugar & Cocoa Exchange ("CSCE") members, New York Cotton Exchange ("NYCE") members, and CFFE members designated as market makers to enter orders for proprietary and customer accounts through terminals provided by CFFE. In addition, authorized customers of CFFE clearing members are able to access CFFE products, subject to position limit and credit checks, through an interface with their clearing members.
In addition to its innovative trading system, CFFE represents a novel alliance between the NYCE, which performs all of CFFE's regulatory responsibilities, and Cantor Fitzgerald Securities, which performs all of the trade execution functions. While CFFE memberships are held by members of NYCE and CSCE, CFFE has significantly reduced the need for intermediaries by making trading privilege licenses available to market participants fully guaranteed by clearing members for the relatively modest sum of $2000. CFFE is owned 90% by NYCE and CSCE members and 10% by NYCE and CSCE themselves.
Another aspiring U.S. exchange, FutureCom, has not yet been designated as a contract market in any commodity, but has an application pending before the Commission to become the first Internet-based futures exchange in the world. FutureCom, as proposed, would be structured unlike any existing exchange. All its members would be clearing members, would have their trading accounts held by the exchange and would be directly linked to the trading system. Members' account balances and positions would be updated in real-time, and members would be prevented from entering any orders for which they did not have the requisite margin in their accounts. Each FutureCom member would be directly financially responsible to FutureCom for its own trades. FutureCom would not be owned by its members, as all U.S. exchanges other than CFFE are, but would instead be organized as a limited partnership among the organizers of the exchange and would be run on a for-profit basis.
FutureCom's use of the Internet and its membership structure would create a new model for participation in U.S. futures exchanges. Using the Internet to transmit trade and financial information would facilitate direct access by the public and would result in the elimination of a significant role for intermediaries. Since each FutureCom member would provide for its own access to the Internet and thus to FutureCom, functions traditionally performed by a futures commission merchant ("FCM") would not be needed by a member to access and trade on FutureCom.
The radically different proposed structure of FutureCom has presented the Commission with the challenge of how best to apply laws and regulations designed for an intermediated, open outcry trading environment to an electronic direct access system. The Commission staff has been working with FutureCom to determine whether it can provide the necessary protections for the trading public and the market itself in light of the unique aspects of the proposal. There are still unresolved issues surrounding FutureCom's application, and therefore it has not yet been presented to the Commission by the staff. However, it is inevitable that an exchange, whether based in the U.S. or abroad, will eventually emerge that uses the Internet as its communication medium and offers direct access to customers around the globe.
While automated trading systems may diminish certain regulatory concerns that the Commission has relating to trading abuses in open outcry trading, automated trading raises other regulatory issues such as system capacity and security which are not applicable to the open outcry environment. We currently have insufficient experience with electronic systems accurately to identify all of the risks they may pose.
As seen in the CFFE and FutureCom examples, technology is contributing to ongoing changes in exchange governance and organization. New exchange ownership structures are emerging that are intended to improve exchanges' ability to engage in effective strategic planning and implementation. Membership organizations are being abandoned by some foreign exchanges in favor of public stock ownership, raising serious issues concerning whether such demutualized, profit-oriented exchanges can adequately continue to perform the self-regulatory role exchanges traditionally have played. Some U.S. exchanges have stated that they too are exploring whether such an ownership structure is feasible. In the face of these developments, both Congress and the Commission need to examine whether the CEA and Commission regulations, which have their underpinnings in self-regulatory membership organizations, remain sufficient and appropriate for these alternative governance structures.
Moreover, as technological enhancements fuel the development of direct access electronic trading systems, investors increasingly will be able to gain access to markets without having to trade through an intermediary, and the role of intermediaries may diminish. The need for fitness standards and customer protection measures which underlie the Commission's current registration scheme for commodity professionals may become less important with greater direct access and diminished discretion associated with automated trading. However, other issues such as whether direct access trading is appropriate for all types of investors need to be examined. Congress and the Commission need to consider whether the statutory and regulatory frameworks that have served well for intermediated trading need to be adapted to direct access electronic trading.
During the past three years the Commission has devoted considerable resources to addressing the difficult and rapidly evolving regulatory issues associated with technological innovation in the industry. In addition to its work on the matters described above, the Commission continues to make progress in permitting electronic media to be used for certain types of recordkeeping, disclosure to customers, filings with the Commission, and communications by industry professionals both with the Commission and with their customers. Certainly many rules still need to be modified to adapt to the changing nature of the industry. Congress also needs to address the implications of technological innovation as it considers reform of the CEA. Any changes to the CEA and the regulatory framework, however, must also ensure that the Commission has sufficient regulatory tools to protect against fraud, customer abuse, market manipulation and financial disruption in this new electronic age.
Although Congress may very well need to adapt the statutory framework to the changing nature of futures trading, significant relief may be achieved through Commission rule amendments. The Commission is committed to reducing regulatory costs and burdens on our exchanges and market participants. The Commission has undertaken a number of major regulatory reform initiatives to modernize and streamline the regulatory regime it administers. Many of these initiatives resulted from industry proposals that were first raised during the legislative debate that occurred in this Subcommittee two years ago. Some of the many proposed and final rules issued in the last two and a half years include:
I hope that members of the industry will continue to provide the Commission with additional suggestions for improving its regulatory framework.
OTC Derivatives Market and Hedge Funds
Another challenge facing the industry and financial regulators today is the rapid growth of the OTC 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, this virtually unregulated market has grown in diversity with the development of a multitude of new products, entry by new market participants and increased interest in new market mechanisms. Last year the Commission issued 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. 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 address whether there are unacceptable regulatory gaps relating to trading by hedge funds and other large OTC derivatives market participants.
The Presidentís 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 SEC and the CFTC, is currently working on a study relating to the OTC derivatives market and has just completed a study of hedge funds and other highly leveraged institutions. As a member of the President's Working Group, I am pleased to endorse the recommendations contained in its report on hedge funds entitled "Hedge Funds, Leverage, and the Lessons of Long-Term Capital Management," transmitted to the Speaker of the House of Representatives on April 28, 1999. The report identifies as a central issue excessive leverage in the financial system and the lack of available information about it. The report provides important recommendations about each of the four main issues raised by the near insolvency of LTCM -- the need for increased transparency, the need to eliminate excessive leverage, the need for better prudential controls and the need for enhanced international cooperation and harmonization of regulations.
The report recognizes the critical importance of heightened transparency in the markets by recommending greater disclosure and reporting by hedge funds. It calls for all hedge funds to report detailed financial information, including information about their exposure to market risk, on a quarterly basis. For hedge funds that are CPOs, the report recommends that such reporting should be accomplished through amendments to CFTC reporting rules. The Commission staff is preparing recommendations for rule amendments to require such reporting by CPOs. For hedge funds that are not CPOs, the report recommends that Congress should enact legislation that authorizes mechanisms for such disclosure. The hedge fund financial information would be provided not only to regulators but also to the public. It would thus be available to hedge fund investors, counterparties and creditors to assess the creditworthiness of the hedge fund. It would also be available to regulators and market participants to help assess market integrity and financial stability. In addition, the report recommends that all public companies should be required to report publicly their exposure to highly leveraged financial institutions.
The report also emphasizes the need for enhanced risk management efforts by regulated entities such as FCMs and enhanced oversight of those efforts by regulators. It endorses the view that prudential supervisors and regulators should promote the development of more risk sensitive approaches to capital adequacy.
In addition, the report recommends that regulators should have expanded risk assessment powers relating to unregulated affiliates of securities broker-dealers and FCMs. To effect this recommendation, the report recommends a change to the CEA to grant the CFTC expanded reporting, recordkeeping, and examination authority for material unregulated affiliates of FCMs. This authority would provide the CFTC with needed information about the potential risks that an unregulated affiliate might pose to its related FCM and to the financial system. I commend this recommendation to the Subcommittee and urge that enabling legislation should be adopted.
Finally, the report recognizes the need for international cooperation among regulators to encourage the adoption and implementation of international standards governing hedge funds and credit exposure to them. The President's Working Group also agreed that, if these measures prove to be inadequate, serious consideration should be given to the direct regulation of hedge funds and other highly leveraged institutions, including such measures as capital requirements. In addition, direct regulation of derivatives dealers should be considered and indeed is being currently studied by the President's Working Group in the context of its ongoing study on the OTC derivatives market.
Although it is appropriate to await the recommendations of the President's Working Group study on OTC derivatives before endorsing additional specific changes to the CEA, it is clear that developments in the OTC market have implications that may merit further changes to the statutory framework. As mentioned earlier, some OTC derivatives market participants are now interested in the development of automated trading and clearing systems that would closely resemble the regulated exchange markets. For example, the Commission recently granted a petition of the London Clearing House ("LCH") to allow an exemption from the Commission's regulations which would permit clearing of swap transactions for the first time. LCH plans to establish "SwapClear," a proposed facility for clearing swap transactions that otherwise satisfy the terms and conditions for swap transactions imposed by the Commission's regulations. The Commission's order exempts certain swap agreements submitted for clearing through SwapClear from most provisions of the Act and Commission regulations and provides a similar exemption to specified persons who engage in certain activities with respect to such agreements. Such swaps clearing operations may provide substantial benefits to the OTC derivatives market, including imposing controls on excessive extensions of credit, reducing counterparty credit risk and increasing transparency.
As the OTC derivatives market evolves to resemble traditional futures and option exchanges, new regulatory concerns about the market will arise, and increased parity in treatment of the OTC and exchange markets will be necessary. Both Congress and the Commission need to grapple with the question of where such parity is appropriate and how it may best be achieved. One important principle should inform this review. CFTC oversight of derivatives markets traditionally has been exercised according to the nature of the market, the market participants and the products involved. This approach to 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 market regulation apply equally to exchange-traded and OTC derivatives. While the nature of and participants in the OTC 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 financial risk. 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.
Entity-based supervision of OTC derivatives dealers alone is not sufficient to oversee this market. While such supervision is important to the safety and soundness of many of the large dealers, 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 large and opaque as the OTC derivatives market. Market regulation such as that conducted by the CFTC and the SEC is an important component of market oversight and public protection. Institutional supervisors focus on the trees; market regulators see the forest. Both are needed to protect important public interests.
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 CEA. If that were to be done, an appropriate regulatory framework for such activity would need to be developed. It would seem reasonable to include prohibitions against fraud, insider trading, and manipulation and margin requirements. In addition, if Congress were to take such action with respect to OTC transactions in equity derivatives, it should seriously consider permitting futures on equity securities to be traded on the futures exchanges.
Congress should also provide the Commission with clear and unequivocal enforcement authority to pursue off-exchange foreign currency fraud imposed on members of the retail public, which has reached epidemic proportions.
Finally, as Congress considers changes to the CEA, it should 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 there can no longer be any doubt that it is necessary and appropriate to have an independent regulatory agency overseeing the nationís 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 CEA whenever it believes it is necessary to do so.
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Thank you for the opportunity to share my views concerning important matters confronting the U.S. futures industry, the CFTC, and the Congress which should be considered during the reauthorization process. On a personal note, this is my last appearance before this Subcommittee as Chairperson of the CFTC. My last day in office will be June 1, 1999. I would like to thank you, Mr. Chairman, and the members of the Subcommittee for your courtesy and cooperativeness during my tenure and to express how much I have enjoyed working with you. I would be happy to answer your questions.