"Caveat Emptor -- Let the Buyer Beware"


April 11, 1997

I am pleased to be here today and to have the opportunity to address this important group of representatives of the end user community on current public policy issues facing the futures industry. It often seems that the debate over these issues focuses more on the interests of those who make the markets in these products than on the interests of those who depend upon the soundness and integrity of the marketplace. In my view, however, those entrusted with the responsibility to invest and deal prudently with the funds of others, whether those funds belong to their employer, a public or corporate pension plan, a mutual fund, private trust, or other source, have the greatest possible interest in careful and rigorous evaluation of the marketplace in which they do business.

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. Those markets have changed over the years, and the Act may well 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.

These legislative proposals are of significant interest to end-users of derivatives, particularly those who use exchange- traded derivatives. The futures markets have served as an invaluable marketplace for hedgers and risk managers in very substantial measure because of the strong regulatory protections inherent in our regulatory framework.

The pending legislation could dramatically alter the regulatory framework applicable to our futures exchanges. The legislation pending in both the House and the Senate includes a provision exempting certain professional markets from nearly all provisions of the Commodity Exchange Act. This exemption could lead to pervasive deregulation of our futures exchanges. Federal oversight of the futures exchanges could be eliminated as long as exchange trading was limited to certain so-called "appropriate persons." 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 appropriate persons. Therefore, it is likely that simple exchange rule changes could convert many markets into professional markets subject to no meaningful federal oversight.

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 to deter fraud and cheating of market participants, such as those relating to exchange audit trails, open trading and open pricing, would cease to exist. Notably, many of the customer protections currently in place were added by Congress in 1992 after the 1989 FBI-CFTC sting operation 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 trails 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 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.

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 the current legal standards relating to their contracts, rules or governance.

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 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 market participants -- including end 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 appears designed to achieve. I am sure that, as users of both exchange-traded and over-the-counter derivatives, many members of this audience fully understand and appreciate the differences in these markets. From the Commission's perspective, exchange trading involves important public interest considerations that require a higher level of regulation than over-the-counter markets. All markets are not the same, and 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 interesting 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 to 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, and the Hunt brothers' attempt to manipulate the world market in silver.

Moreover, I am sure that many of you would agree that regulation of the futures markets is no less necessary to protect large institutions than retail investors. The Office of Technology Assessment, an independent research arm of Congress, issued a report in 1990 after the 1989 CFTC-FBI sting operation that uncovered widespread fraud on the floors of the Chicago futures exchanges. The report states,

There is a view that because futures markets are used primarily by large, sophisticated institutions, abuses could easily be detected by the victims themselves and corrected by free market forces. The current large-scale indictments, admissions of guilt, and plea bargaining provide evidence to the contrary. Institutional investors in futures markets represent millions of Americans through pension, life insurance, and mutual funds; the ultimate victims in futures market fraud are these people.

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%. These exchanges introduced 92 new contracts approved by the Commission 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 that 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.

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 to preserving trader confidence in these markets. It is committed to do what it can to keep the markets strong and fair for all users.