A Regulatory Perspective on Internal Trade Controls
Joseph B. Dial, Commissioner
Commodity Futures Trading Commission
Futures Industry Association
21st Annual International Conference
Boca Raton, Florida
March 14, 1996
Being assigned to a panel at Boca is a little like getting fixed up with a blind date. Sometimes you get a "Miss Texas" kind of topic and sometimes you get one with a "nice personality." This year, I feel that I really lucked out, because internal trading controls is clearly a very timely and important issue for the futures industry and regulators alike. I will try to cover four areas and do so rather briefly: (1) why trading controls are so important; (2) options for regulators in promoting effective trading controls; (3) CFTC actions in this area; and (4) the Commission's response to industry "best practices" guidelines.
The Importance of Internal Trade Controls
To understand why trading controls are so important to the financial industry, you only need to scan the headlines -- or you could ask the former management of Barings, Metallgesellschaft, Orange County, Kidder Peabody, etc. Perhaps the better question is: how can such monumental foul-ups happen? One reason is that financial markets have become more sophisticated and more competitive. Spreads are narrower, profitable arbitrages harder to find. In such an atmosphere, traders in search of better returns may be tempted to take unnecessary risks. Management may be an accomplice in creating this atmosphere if it stresses production over prudence or offers incentive compensation plans that allocate large upside rewards to successful traders, while exposing the firm to all the downside risks. Also, the drive to cut costs and save expenses can sometimes lead to false economies. Barings probably saved a few thousand in salary costs by relying on Nick Leeson to police his own trading. It turned out to be one of the worst bargains in the history of banking. Finally, management must overcome the natural human tendency to focus attention on the unprofitable division or department and ignore the profitable units as long as they keep generating substantial revenues. As recent events illustrate only too well, especially profitable units should be targeted for risk management review to be certain the profits are not masking an impending disaster.
Trading controls are important to regulators for a variety of reasons. A failure of controls can contribute to violations of antifraud, segregation, capital, trade practice or other rules we are bound to uphold. It can harm customers we are charged with protecting. It can interfere with the ability of the futures markets to perform their economic functions of hedging and price discovery. In some cases, Barings for example, a failure of controls can be serious enough to create potential aftershocks that reverberate across several countries.
Options for Regulators
Regulators have several options in dealing with trading control issues. The most obvious -- and in my view, the least desirable -- is to directly impose narrow, specific standards. I do not say this in a rhetorical sense only. For example, on February 23, 1994, the Commission held an open meeting to consider publishing in the Federal Register proposed rules regarding Risk Assessment for Holding Company Systems, as authorized by Section 4f(c) of the Futures Trading Practices Act of 1992. At the time, I was outspoken in my public comments on the excessive regulatory burden that the proposed rules would impose on FCMs. The FCM community responded to my request that they be "very forthcoming during the comment period." As a result, the Commission later approved a more reasonable and balanced approach to implementing new rules regarding risk assessment recordkeeping and reporting requirements for FCMs.
In my mind, this is an example of a regulator establishing result-oriented general principles -- setting sensible goals, but letting the people who run the business from day to day figure out the best and most economical way to reach those goals. A closely related approach is for regulators to cooperate with industry-driven efforts. After all, we are all seeking the same result -- avoiding internal control failures. If the industry devises a system that achieves that goal, so much the better. The regulator should -- and the CFTC certainly does -- stand ready to share its ideas and make any other contribution it can toward furthering those industry efforts.
CFTC Actions Involving Trading Controls
The Commission currently has rules that set general performance standards relating to internal controls. These must be good enough to permit firms to keep books and records current, prepare statements of financial condition, meet their obligations to the market, and meet regulatory financial requirements.
In the aftermath of Barings, the Commission, in conjunction with the U.K.'s Securities and Investments Board, called and co- chaired a meeting of regulators from 16 countries responsible for supervising the world's major futures and options markets. The meeting gave rise to the Windsor Declaration calling for a program of international action in four areas: (1) cooperation between market authorities; (2) protection of customer positions, funds and assets; (3) default procedures; and (4) regulatory cooperation in emergencies.
Progress continues on the Windsor initiatives. For example, the International Organization of Securities Commissions (IOSCO) has added its endorsement and urged its members to take all necessary and appropriate steps to promote the measures agreed upon in the Windsor Declaration.
Most recently, here tomorrow, more than 30 markets and a number of related regulators will be signing agreements on sharing large exposure information.
Domestically, after Barings, the CFTC directed U.S. exchanges to review their rules, systems and procedures to assure they are sufficient to address the potential adverse consequences of a major firm failure. We also organized an industry-wide "stress test" of the existing individual and cooperative systems for responding to a market disruption. The Commission also updated its Market Disruption Contingency Plan, which outlines procedures for the agency to follow in the event of extreme market volatility, financial emergency or physical disruption and has written to each market asking it to do a self-assessment of its risk management systems.
Other CFTC-supported initiatives include developing large exposure information sharing agreements among regulators, developing generally accepted risk principles that will assist financial institutions in improving risk management procedures and internal controls, and creating a plan to provide further guidance and dialogue with financial services firms on risk management, account supervision, and operational and financial controls.
CFTC Response to Industry "Best Practices" Guidelines
As I noted earlier, the Commission strongly supports industry self-regulatory efforts in all areas, including internal controls. I would particularly like to commend the FIA for its good work in convening the "Global Task Force on Financial Integrity" -- and for keeping "best practices" a live and lively issue through efforts such as this panel. The CFTC will continue its cooperation in support of industry best practices -- with the FIA, and with other organizations, such as the Group of Thirty, the Basle Committee on Banking Supervision, and the Derivatives Policy Group.