"RISK MANAGEMENT AND THE FUTURES MARKETS"
REMARKS OF BROOKSLEY BORN
COMMODITY FUTURES TRADING COMMISSION
SPARKS COMPANIES, INC.
SIXTH ANNUAL WASHINGTON POLICY CONFERENCE
MARCH 31, 1997
I am pleased to have the opportunity to be with you today and to speak on risk management and the futures markets. Risk management is an increasingly important issue for agricultural producers, particularly since passage of the Federal Agricultural Improvement and Reform Act -- or "FAIR" Act -- in April 1996. As you all know, the FAIR Act lifted production controls and is gradually phasing out price supports for many agricultural commodities. In the future the government will not intervene in the open market to try to stabilize agricultural commodity prices. Nor will USDA be handing out deficiency payment checks. Instead, progressively lower transition payments will function as a price support mechanism for six more years. As a result of this market- oriented new direction in public policy for U.S. agriculture, the federal financial safety-net will soon be gone, and agricultural producers will have to manage their production and price risks themselves.
In my opinion, this shift in government policy will make it more important than ever for producers of agricultural products to have effective risk management tools. With the passage of the FAIR Act, there is now a strong economic reason for farmers to explore methods to shift their risks. And there definitely is a need for education about risk-shifting mechanisms, creating a challenge for both the public and private sectors.
The Congress has set the course for public sector participation in this educational process. Section 192 of the FAIR Act directed the Secretary of Agriculture, in consultation with the CFTC, to "provide such education in management of the financial risks inherent in the production and marketing of agricultural commodities as the Secretary considers appropriate." Commissioner Joseph Dial of the CFTC has been active as our liaison with USDA on Section 192 of the FAIR Act and has attended numerous meetings to help implement the goals of Section 192.
There are many ways in which agricultural producers can manage their risk, several of which you have already heard about today. One method for managing price risks is to hedge on our futures markets. Trading on futures exchanges involves trading in inherently complex and risky instruments, and agricultural and other businesses should not trade in these markets unless they fully understand them and the risks involved. The exchanges do provide risk-shifting opportunities for the educated and careful trader, and I hope these markets will be a valuable risk-shifting tool for this new era in agriculture.
Proposed legislation is currently pending in Congress to amend the Commodity Exchange Act, the law governing futures and option trading. In my view, these bills -- if adopted -- could have a significant impact on the risk-management tools available to agribusinesses and others. 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. I appreciate the effort undertaken by Congressman Ewing and Senators Lugar, Leahy and Harkin to address these difficult and important issues. The CFTC remains committed to working with Congress, the futures industry and the commercial interests that use the futures markets to craft legislation that modernizes the Act while protecting the public interest and providing market participants with strong, safe and transparent futures markets.
I would like to take this opportunity to discuss why the CFTC strongly opposes one of the provisions in the pending bills -- the professional markets exemption. 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 professional markets exemption could 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 their futures exchanges, and they are doing so. The bills -- if enacted -- would send a signal that the U.S. is no longer willing to act as a world leader in setting the standards to protect the economy and the public from the risks these exchanges pose.
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. The bills preserve CFTC jurisdiction to bring fraud and manipulation cases after the fact. But that limited authority might provide only an illusion of protection since the Commission would be stripped of its regulatory tools designed to prevent those abuses from occurring and to detect them when they do occur.
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 not have the data 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 contracts, rules or governance. Standards for trading on these markets such as the requirements of open and competitive trading, open pricing and audit trail would also be abolished.
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 -- and the markets themselves -- without meaningful governmental protection. Even large institutions can be the victims of fraud and other abuses on these markets, as the Commission's case docket amply demonstrates.
Statutory and regulatory standards relating to the financial integrity of the markets and their participants would also 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 Senate bill, unlike the House bill, would not permit deregulation of futures markets in certain domestic agricultural products, 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. Furthermore, 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. For example, clearing both regulated trades and unregulated trades might render an exchange's clearing house vulnerable to financial instability from unregulated trades with no applicable financial standards. Moreover, the unregulated markets might siphon off speculative trading from the regulated agricultural markets, thus reducing their liquidity.
In the current debate about the professional markets exemption, it has been overlooked that 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. 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 an appropriate level of regulation for professional exchange markets. The Commission remains open to a dialogue with the futures industry and other interested groups on the issue of reduced regulation at the same time that we stoutly oppose the elimination of regulation.
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 would likely achieve. 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. 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 -- as I am sure you all appreciate -- 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. 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 do the greatest harm to the markets through attempts at manipulation, price distortions, and financial irresponsibility. To demonstrate this point, I need 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, and the Hunt brothers' attempt to manipulate the world market in silver.
The U.S. futures exchanges 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 set a new trading record as the world's largest exchange. The CBOT has recently announced profits for 1996 of $19 million, or a 26 percent increase over its 1995 profits. The Chicago Mercantile Exchange continues to be the second largest exchange in the world. In the past decade, trading on U.S. exchanges has more than doubled -- an increase of 130%. During fiscal year 1996, U.S. exchanges launched 92 new contracts approved by the Commission. In fact, 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 share of world futures trading, that is 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 relates to local cash markets in the foreign country and does not compete directly with U.S. futures contracts. Despite the rapid growth of foreign markets in the past decade, U.S. trading volume has continued to grow at a healthy rate during the same period.
While the over-the-counter derivative market has also grown quickly over the past decade, it is clear that that market complements futures exchange markets as well as competing with them, 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 do 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. The Commission could not adequately regulate these markets with its limited resources absent the enormous contribution to the regulatory effort by the exchanges and the National Futures Association.
Nonetheless, 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 Commission's oversight role over the exchanges and its supervisory role over commodity professionals remain necessary to the effectiveness of the regulatory regime. Self-regulation alone is insufficient to maintain the integrity of our markets, as the Commission's ongoing regulatory efforts and the Commission's enforcement docket demonstrate.
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. In its place, we are asked to trust 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.
It is my strong hope that our futures markets will continue to be available to all of you as safe and effective markets in which to hedge your price risks. The Commission is committed to work with Congress to try to modernize the Commodity Exchange Act while maintaining important protections for these markets. We also look forward to working with the agricultural community on risk management as we enter a new era in agriculture.