THE WINDSOR ACCORD AND REGULATORY COOPERATION
AMONG LATIN AMERICAN AND CARIBBEAN NATIONS
Joseph B. Dial, Commissioner
Commodity Futures Trading Commission
Inter-American Development Bank
July 16, 1996
I would like to thank IADB and my friend, Jesse Wright, for inviting me to speak on "The Windsor Accord and Regulatory Cooperation Among Latin & Caribbean Nations." In light of recent events involving a possible sequel to Baring's trading losses, namely the Sumitomo Corporation, you have certainly picked a timely topic.
Before becoming a Commissioner in 1991, I spent 25 years traveling in Latin America. The goods and services I exported into the region were primarily agricultural products in nature. On a number of my visits I served as a market development consultant for USDA. Those efforts put me in contact with cabinet ministers and central bank officials. As a result, I have many friends in Latin America and still have a keen interest in the economic development of that area.
Today, I would like to share with you some thoughts on: (1) the Barings Bank failure; (2) the Windsor Accord, which arose in the aftermath of Barings; (3) some of the follow-up activities implementing the Windsor initiatives; and (4) what these matters can teach us about international regulatory cooperation, especially as applied to Latin American and Caribbean countries.
The Barings Failure
The trading strategy that sank Barings started with relatively modest initial losses in financial derivatives transactions by Nick Leeson, the head trader at Baring Futures Singapore. Rather than owning up to his mistakes, Leeson tried to trade his way out of these losses. In effect, he kept doubling his bets, taking ever larger and riskier positions in an attempt to get even. Finally he got caught in a huge position, based on the assumption that the Nikkei 225 Index would trade within a certain range. That assumption proved disastrously wrong when the Japanese stock market plunged in the wake of the January 1995 Kobe earthquake. The market losses topped $1.4 billion and bankrupted Barings.
Of more interest than Leeson's trading strategy, however, is the corporate culture that allowed Leeson to pile up such huge losses undetected. Barings' fundamental error, according to the report by the U.K. Board of Banking Supervision, is that its true market position "was not noticed earlier by reason of a serious failure of internal controls and managerial confusion within Barings." This failure of internal controls -- which gave Leeson control of both trading and back office functions -- effectively put the fox in charge of the chicken coop.
Barings' home office compounded the error by continuing to send more and more money to Singapore to fund Leeson's positions, without understanding -- or questioning -- his strategy. Because of Leeson's apparent success, albeit achieved with a pair of scissors and a copy machine, no one showed the initiative or nerve to peek behind the curtain of lies he had woven. During the recent CFTC Symposium on Internal Controls, Singaporean regulators went straight to the heart of the matter when they said that Barings management naively believed it had found a low-risk, high-return route to wealth, a veritable goose named Nick who could lay golden eggs.
The Windsor Accord
Once the immediate post-Barings damage control efforts subsided, regulators from 16 countries met at Windsor, England, to discuss strengthening the supervision of international futures markets to address certain problems that came to light during the Barings collapse. The meeting concluded with publication of the "Windsor Declaration," which recommended a program to carry forward action in four areas:
Before I go into some of the actions taken to follow up on these initiatives, let me add a large caveat. Barings is not the first, or the only, firm to come to grief due to the actions of a rogue trader -- and I'm sure it won't be the last. By the same token, the Windsor Accord is not the first, or the only, effort to respond to such a situation through better business and regulatory practices and stronger international cooperation.
Windsor Accord Follow-up Activities
Both the Barings collapse and the Windsor response are part of an ongoing continuum. The Windsor Accord built upon foundations already laid by regulatory organizations -- primarily the International Organization of Securities Commissions (IOSCO) -- and by self-regulatory groups, such as the Basle Committee on Banking Supervision, the Group of Thirty, the Derivatives Policy Group, and others. Once the Accord was issued, these entities either continued parallel efforts aimed at the same types of problems highlighted in the Windsor Declaration or actually incorporated the Windsor principles into their own ongoing efforts. In this context, the efforts of two organizations deserve particular attention.
The Windsor Accord did not give rise to any ongoing organization to oversee carrying its principles into practice. On the regulatory side, that task has fallen to IOSCO, the primary international cooperative regulatory organization responsible for financial derivatives. IOSCO has assigned Windsor-related projects to existing IOSCO Working Groups in areas such as defaults, client asset protection and cooperation among market authorities.
On the self-regulatory side, a number of organizations have embraced the Windsor principles, as I alluded to earlier. Of particular note, in March 1995 the U.S. Futures Industry Association (FIA) organized a Global Task Force on Financial Integrity, including representatives from 17 jurisdictions around the world. The Task Force was charged with addressing post-Barings issues in areas such as protection of market participants' assets, internal controls and information sharing.
In June 1995, the FIA Global Task Force issued a series of 60 recommendations for futures and options exchanges, clearinghouses, brokers/intermediaries, and customers. Subcommittees were then formed to implement key proposals. The Implementation Subcommittee on Information Sharing between Exchanges and Clearinghouses was charged with developing a domestic and cross-border information sharing agreement for exchanges and clearinghouses. This effort culminated in March of 1996, when 49 exchanges and clearinghouses from 18 countries signed an information sharing Memorandum of Understanding. At the same time, regulators from 14 jurisdictions signed a complementary Declaration on Cooperation and Supervision of International Futures Exchanges and Clearing Organizations.
Under these agreements, certain triggering events affecting an exchange member's financial resources or positions will prompt information sharing among regulators, exchanges and clearinghouses. The agreements are designed to strengthen the financial integrity of the world marketplace and minimize the opportunity for difficulties in one market to be transferred to other markets. In June 1996, six additional organizations signed onto the MOU, including three Japanese exchanges and Brazil's Bolsa Mercadorias & Futuros, the first Latin American exchange to join.
In the U.S., other post-Windsor initiatives have included:
At the CFTC's request, U.S. exchanges conducted a "stress test" to identify and work through the issues that would be created by a hypothetical $100 million default.
In September 1995, 19 U.S. futures and securities clearing organizations finalized the Unified Clearing Group, an organization that will share information and enhance financial integrity across all U.S. financial markets.
In April 1996, the CFTC amended its financial rules to require the gross collection of exchange-set margins for omnibus accounts carried by foreign brokers, enhancing customer protection by moving more segregated funds into the hands of normally better-capitalized clearing brokers.
Parallel with an FIA Global Task Force project, the Commission has asked several U.S. exchanges to develop a model exchange disclosure document that would give market users information about exchange market mechanisms, sources of financial support and default procedures.
The Commission is working with the SEC and the six large brokerage firms that make up the Derivatives Policy Group on establishing a framework for verifying firm internal control systems, including the implementation of management controls.
The CFTC also has hosted various roundtable discussions -- day-long symposiums on issues related to the Windsor objectives. Most recently, these have included: (1) a September 1995 Roundtable on the Commission's Net Capital Rule, particularly addressing concentration of credit risk; and (2) a June 1996 Interactive Symposium on Internal Controls and Risk Management Practices.
Finally, the Commission continues its efforts to negotiate bilateral agreements or other arrangements with regulators in other countries, providing for enforcement cooperation and/or financial information sharing. To date, the Commission has negotiated 16 such agreements with regulators from 14 other jurisdictions, including Brazil, Mexico and Argentina.
Lessons on International Regulatory Cooperation
The first lesson of Barings and similar events is that every country is inextricably linked to the global financial marketplace. You can no more insulate your economy from events in that marketplace than you can build a wall around your border to keep out the weather. Capital moves from country to country, time zone to time zone, with the tap of a computer key, as financial institutions with international operations seek the best returns. Following close behind legitimate business operations are the crooks and con artists, devising ever more sophisticated schemes of cross-border fraud. And to complete the picture, throw in the occasional rogue trader running up billion dollar losses.
The most recent example, of course, is the Sumitomo affair. It is way too early to draw any conclusions about Sumitomo and Mr. Hamanaka's activities in the copper market. That must await the results of various investigations. At present, it is reported that the U.K.'s Securities and Investments Board and Serious Fraud Office, the CFTC, the FBI, and Japan's Ministry of Justice -- not to mention lawyers for a growing host of private litigants -- all are looking into the matter. But even a superficial glance at the Sumitomo affair brings home the global nature of today's financial marketplace. It involves a Japanese corporation, trading copper futures on a London exchange, with delivery points in various other international locations, from Rotterdam to Long Beach, and a market impact felt in copper using and producing nations around the world, from China to Chile.
If regulators hope to keep pace with such developments, they must cooperate with each other, and with self-regulatory bodies, in addressing shared problems and concerns. I would urge regulators in Latin America and the Caribbean to embrace international regulatory cooperation through participation in IOSCO, through bilateral and multilateral Memoranda of Understanding, and via other formal and informal means such as COSRA.
Financial disasters like the Barings and Sumitomo affairs can teach us valuable lessons, but they can also leave us with a somewhat distorted picture of financial derivatives. Making a decision about the economic benefits of derivatives trading based only on the performance of rogue traders would be like planning an ocean cruise based on the experience of the Titanic. Nick Leeson and Yasuo Hamanaka, like the captain of the Titanic, did not use good judgment to chart a prudent course of action. It is the principal actors in these dramas that caused the disasters, not the derivative instruments or the vessel.
I know that most of you are experts concerning economic matters in Latin American and Caribbean countries. You are aware that the economies in this area are growing -- some at phenomenal rates. They are becoming more industrialized and more closely integrated into the global financial marketplace. To compete effectively in this marketplace, growing economies must attract foreign capital to help finance development. There are many other competitors bidding to attract these same investment dollars -- and it could be derivatives that tip the scales one way or the other. All other things being equal, a sophisticated, institutional investor will prefer a stock or a bond that has a derivative product available to transfer the risk in the underlying asset. Thus, a sound and stable derivatives market may be a key ingredient necessary for successful capital formation in any developing economy.
Fostering a successful derivatives market presents financial regulators with a difficult balancing act. The regulatory system must be flexible enough to allow exchanges or OTC markets to create innovative products and approaches as they compete in the global arena. On the other hand, a regulatory system that is too lax can lead to a financial disaster that destroys investor confidence and dries up foreign investment overnight.
Any regulatory system will be the product of the host country's culture, traditions and legal system. Nevertheless, I would offer a couple of general suggestions. First, in seeking to create a new regulatory system, or refine an existing one, a great deal can be learned from older, more developed systems. Remember, however, U.S. futures markets have been around for about 150 years, and the U.S. regulatory system has been developing gradually for some 75 years. Attempting to duplicate that system would take too long and likely result in a program far more elaborate than necessary. A wiser course would be to pick and choose -- take the best elements of existing systems and modify them to fit domestic political, legal and economic conditions.
A regulator must learn to be creative and resourceful in getting the most out of its budget allotment. One way to stretch scarce financial resources is to rely to the extent possible on industry self-regulatory organizations (SROs) -- both the exchanges themselves and, where possible, industry-wide SROs like the U.S.'s National Futures Association (NFA). The CFTC has kept pace with the geometric growth of U.S. futures markets, while growing at a very modest rate itself, by relying on self-regulation by SROs, subject to CFTC oversight. For example, when the CFTC was created in 1974, the agency directly registered all commodity industry professionals. Today, we have delegated that job to the NFA.
Another key strategy of the CFTC in keeping pace with market growth has been the reliance on ever more sophisticated technology to make up for limited staff size. The CFTC's market surveillance program, for example, is highly computerized. Likewise, in the enforcement area, specially designed computer programs help CFTC and exchange compliance staffs search for suspicious trading patterns that may indicate rule violations. These programs can complete in minutes a search that formerly would have required investigators to spend weeks going through paper records one by one.
Finally, it is important to make sure there are no booby traps in the legal system of the host country of an emerging derivatives market. For example, an otherwise well-designed system could be sabotaged by tax policies that impose unfair or disproportionate burdens -- either on derivatives market users in general, or on foreign investors.
Let me conclude by saying, the lessons of the past have led us to develop the regulatory structures of the present. As we move forward into the global marketplace of the future, our challenge will be to refine those structures with an eye toward improving international regulatory cooperation. Through both bilateral and multi-lateral agreements, dozens of exchanges and clearing organizations, along with their regulators, have pledged to cooperate in protecting the financial and market integrity of exchange-traded derivatives.
IADB too can play an important role in this great effort. As one of the primary lending agencies in the world for emerging nations, IADB has a unique opportunity to set the use of derivative instruments on a solid foundation. The task would apply to the public and private sectors in those countries in your sphere of influence that have no derivative markets, or markets in the initial stages of development and operation. The steps you can take to accomplish this task are as follows:
(1) Urge the governments you work with to initiate the process of developing a legal framework within which derivative instruments can operate in their respective countries.
(2) Impress upon the executive and legislative branches of those governments the absolute necessity for a federal regulatory agency with comprehensive jurisdiction over derivatives trading.
(3) Provide the funds for the research and development efforts necessary to carry out steps one and two.
(4) Finally, initiate an educational program with a long-range horizon that will cover the economic advantages and disadvantages of derivatives. Make this program available to IADB personnel and policy-makers in both the public and private sectors of the countries you serve.
Such efforts will help the countries you deal with to travel the global marketplace with greater opportunities for financial success and fewer chances of encountering economic icebergs.