The U.S. Commodity Futures Trading Commission's

Plans for Derivatives Regulation

Remarks of

Joseph B. Dial, Commissioner

Commodity Futures Trading Commission

Fourth International Conference on Derivatives Regulation

Institute of Advanced Legal Studies

University of London

London, England

October 25, 1996


I would like to thank the Institute of Advanced Legal Studies for inviting me to participate in this Fourth International Conference on Derivatives Regulation, and for giving me the opportunity to visit London. I must agree with Samuel Johnson, who said, "When a man is tired of London, he is tired of life; for there is in London all that life can afford." I find this to be particularly true when one is on government per diem.

The title of my remarks is, "The CFTC's Plans for Derivatives Regulation." I will cover five main topics -- international regulatory cooperation, the regulatory fallout of the Sumitomo affair, pending U.S. legislation affecting the CFTC, audit trails, and recent CFTC initiatives concerning the Internet.

International Regulatory Cooperation

Like every other financial regulator, the CFTC is vitally concerned with international cooperation. Every day, the global financial marketplace becomes more tightly integrated. Capital moves from country to country, time zone to time zone, with the tap of a computer key, as international conglomerates seek the best returns. And just as capital knows no borders in today's financial marketplace, neither does fraud. Following close behind legitimate business operations are the crooks and con artists, devising ever more sophisticated schemes of cross-border fraud. If regulators are to have any hope of keeping pace with these developments, they must cooperate with each other and with industry self-regulatory bodies.

The CFTC's plans for international regulatory cooperation encompass both bilateral and multilateral efforts. Bilaterally, we have to date entered into some 25 agreements for enforcement cooperation and/or financial information sharing with regulators in 15 other jurisdictions. Negotiations with additional regulators are ongoing. I think it is significant that the most recent agreement, signed with New Zealand regulators on September 16th, marks the tenth anniversary of the first such information sharing agreement -- a September 1986 pact among the CFTC, the U.S. SEC, and the U.K. Department of Trade and Industry.

But CFTC cooperation with U.K. authorities has more behind it than just history. It is a vital, ongoing process. This is evidenced not only by joint responses to specific events like Barings or Sumitomo -- which I will discuss in a moment -- but also by general initiatives like the current program of joint visits of international financial conglomerates. This initiative of U.S. and U.K. banking, securities and derivatives regulators is intended to establish a framework for enhancing the financial supervision of internationally active multipurpose financial institutions.

Turning to multilateral cooperative efforts, the most obvious recent example is a whole series of government and private sector initiatives implementing the May 1995 Windsor Declaration. As you know, the Windsor Declaration, signed by futures regulators from 16 jurisdictions, grew out of joint CFTC/SIB efforts to address key issues resulting from the failure of Barings Plc.

The Final Report of the Windsor Co-Chairs, released just last month, lists an impressive array of concrete steps, taken in a remarkably short period of time, to implement the Windsor recommendations. Without going into the details -- they are probably familiar to most of you -- I would note that these initiatives include: large exposure information sharing; market crisis procedures; enhanced transparency of market protection and procedures; and client asset protection measures. Taken together, these steps should minimize the systemic effects of any future market disruptions, along with enhancing existing regulatory safeguards.

There are a couple of other recent and very significant multilateral regulatory initiatives to be covered. However, because they relate directly to the Sumitomo affair, let me defer them for just a moment and mention two final points on regulatory cooperation.

First, the CFTC's cooperative efforts include not only our fellow regulators, but industry self-regulatory bodies as well. Thus for example, in the wake of Barings, we worked closely with the Futures Industry Association Global Task Force on Financial Integrity as it formulated over 60 recommendations designed to improve the financial integrity of the futures industry for all participants.

At the exchange level, we are working with futures exchanges to expand the scope of "stress testing," designed to explore how well existing structures would handle the consequences of a major firm failure. The initial round of post-Barings stress tests was undertaken by U.S. exchanges, at the urging of the CFTC. We are now exploring the feasibility of cross-border stress testing.

My final point on international cooperation is to note that the CFTC's cooperative efforts extend not only to regulators with highly developed systems, like the SIB, but also to those who are just developing futures regulatory programs. Earlier this week in Chicago the CFTC hosted its sixth annual Training Seminar on the Regulation of Derivative Products, Markets and Financial Intermediaries for International Market Authorities, attended by over 80 regulators from 26 countries.


Turning to Sumitomo, the CFTC has taken action on four fronts as a result of events in the worldwide copper market over the past two years. First, we have initiated an investigation, which remains ongoing, to determine whether there have been any violations of the Commodity Exchange Act, through manipulation or other misconduct. The investigation involves a variety of difficult and complex issues and is likely to drag on for many months. The CFTC is cooperating with other interested domestic and foreign authorities, and we have been working especially closely with U.K regulators.

Second, we have heightened our market surveillance with respect to the copper market. The CFTC is unique among futures regulators in having an extremely comprehensive large trader reporting system. The system requires regular reports from any futures trader whose positions exceed a specified threshold level, whether those positions are proprietary or held for customers. With this system in place, no trader could amass a Sumitomo-size position in U.S. markets without setting off regulatory alarms and tripwires. The CFTC has urged other regulators to consider adopting similar systems, that would facilitate the identification of large positions which could trigger market integrity or financial integrity concerns.

Third, the CFTC assessed the potential financial consequences of the Sumitomo losses for U.S. firms and markets. Data from our large trader reporting system, along with information gleaned through international information sharing agreements, confirmed there was no immediate danger to U.S. firms or markets.

Fourth and last, the CFTC undertook renewed efforts to enhance international cooperation in response to market emergencies and to improve the surveillance of physical delivery markets in a global marketplace. This brings me to the two additional multilateral efforts that I promised earlier to cover in the context of Sumitomo.

The first effort involves information sharing. Sumitomo provided the first concrete test of the large exposure information sharing arrangements implemented in response to the Windsor recommendations. These arrangements were embodied in a March 1996 Declaration, signed by 15 regulatory bodies, along with a companion MOU among more than 50 exchanges and clearing organizations in 20 jurisdictions. The good news is: these information sharing arrangements worked. The bad news is: they could have worked better.

It isn't hard to see how difficulties can arise in such a system. Say there is a market emergency with cross-border implications, and regulator "A" needs information from regulator "B." A makes a very broad request, to assure it gets all the information it might need to fulfill its responsibilities. B may not fully appreciate why A is asking for all this data and just what A plans to do with it. While these questions are being resolved, the information exchange is delayed.

To address such problems, the CFTC and the SIB have jointly proposed to IOSCO a framework to provide further guidance in implementing information sharing agreements and procedures for identifying the types of information, based on the market event, which may need to be shared on a fast-track basis. The market events could include, for example: (1) a financial crisis at a firm (e.g., Barings); (2) a major market move caused by supply/demand factors (e.g., the 1987 market crash) or political actions (e.g., the Gulf War); or (3) price distortions or unusual volatility in a particular contract (e.g., Sumitomo).

Looking to our hypothetical, information sharing between A and B will be expedited because: (1) A will know the precise nature and scope of the information it should request; (2) B will have advance notice that the information A is requesting is appropriate; and (3) both parties will know what types of information should be maintained and shared for regulatory purposes. IOSCO has accepted the CFTC/SIB proposal and has begun work to develop this new framework to improve international information sharing.

The second Sumitomo-related development will take place right here in London on November 25th and 26th. The Sumitomo affair, as you know, involved a physical commodity, copper, and a physical delivery market. Existing international cooperative arrangements were designed primarily with financial futures and options in mind. However, Sumitomo brought to light a number of unique problems not normally encountered in market events involving financial futures and options, which generally are cash settled. We discovered that international arrangements designed for financial instruments delivered via wire transfer don't always work as well in situations where delivery involves warehouses, railroads, trucks and boats. Therefore, the CFTC, SIB and the Japanese Ministry of Trade and Industry, have invited regulators of physical delivery markets from 15 other jurisdictions around the world to an international conference in London next month to share their thoughts and ideas on the special supervisory issues raised by such markets.

Pending U.S. Legislation

The CFTC's regulatory responsibilities are set out in its authorizing statute, the Commodity Exchange Act. Those responsibilities change from time to time as that statute is amended. Last month, separate bills were introduced in the Senate and in the House of Representatives to amend the Commodity Exchange Act. The sponsors of both bills have stated that the aim of the legislation is to help keep U.S. futures markets competitive in the global marketplace.

The sponsors have also characterized both bills as "discussion document[s]." Because they were introduced so late in the Congressional session, there is no prospect of action on these proposals before the current session of Congress ends later this year. However, putting the bills on the public record gives interested parties an opportunity to study their provisions and to provide comments and suggestions in anticipation that the same or similar bills will be reintroduced at the beginning of the next Congressional session in January 1997.

I included this topic in my remarks simply to put you on notice that changes in U.S. commodities laws are in the works. It is far too early in the legislative process for me to burden you with a description of the contents of these bills. So let me just make these points: (1) the bills do not seek any fundamental restructuring of U.S. commodities laws -- the basic structure and functions of the CFTC would remain intact; (2) the CFTC has expressed concern regarding some provisions of the legislation, as introduced, but we have pledged to work with Congress in a "cooperative and constructive manner" to assure effective regulation of markets and protection of customers; (3) the final form of any legislation will be the product of much discussion, deliberation and negotiation -- it will be different, perhaps very different, from the versions first introduced; and (4) nevertheless, I believe it is very likely that legislation amending the Commodity Exchange Act will be enacted during 1997.

Audit Trails

Legislative changes can create dilemmas for regulators and markets alike. The CFTC and U.S. futures exchanges are still struggling to deal with a provision included in the last Commodity Exchange Act amendments, adopted in 1992. That provision imposed new, tougher audit trail standards, requiring exchanges to capture unalterable, continual, independent, and automatic or similarly reliable audit trail times for trades, and to sequence all trades in a precise manner.

When these new standards were created in 1992, the Chicago Board of Trade and the Chicago Mercantile Exchange were engaged in a research project aimed at creating a hand-held "electronic trading card." It was anticipated that this technology would be in place by the time the new, stricter audit trail requirements took effect in October of 1995. Unfortunately, the project ran into the kind of glitches that often seem to plague cutting edge technologies. The electronic trading card was not ready on schedule and -- though development continues -- it is unclear exactly when it will be available.

The 1992 statute authorizes trading restrictions in the event the new standards are not met, but it also includes escape valves for the exchanges. There is both a practicability requirement and an exception for cases where the Commission determines that circumstances beyond the control of an exchange prevent compliance despite the exchanges's good faith efforts. At this point, the systems have been tested and re-tested and the two Chicago exchanges -- despite tremendous progress -- have not fully met the new standards. Absent compliance, the Commission could impose trading restrictions on the exchanges.

In an effort to stimulate helpful discussion in this area, the Commission, on October 16, in Chicago, hosted a Roundtable Discussion on Exchange Order and Trade Automation. Expert panels made up of market users, financial market experts, exchange officials, and academics held a wide ranging discussion of exchange automation issues. The Roundtable's aim was to help identify important obstacles and benefits in exchange automation issues and to address the practicability of further automating order delivery and trade transmission systems. Even without hand-held devices in the trading pits, automating the systems that bring orders to those pits could significantly improve audit trail performance. Based on the Roundtable, and on exchange practicability submissions, the Commission will determine what action to take next.

Internet Issues

The impact that automation is having on the Chicago futures trading pits is simply one reflection of a communications revolution that is affecting every facet of modern life. Spectacular growth in the use of personal computers, data systems, the Internet, and proprietary on-line services, is revolutionizing the financial services industry. Private investors and industry professionals alike are: enjoying real- time access to trade data and market news; experimenting with new ways to gather, store and communicate information; and performing increasingly complex analyses of trade and market data.

Regulators too must embrace this revolution -- and not just by passively responding as they try to keep pace with each new trend. Regulators must become active participants. We must discover how the communications revolution can make regulation better, cheaper more efficient -- and we must respond to the enforcement challenge posed by those who would use technology to provide new window dressing for the same old frauds and scams.

The CFTC has undertaken a number of initiatives in this area. Without going into detail, let me quickly list three of them.

(1) In October of 1995, the Commission launched its Internet Website Home Page. We have since steadily expanded the nature and variety of information available and are currently generating over 3,000 "hits" per day.

(2) In August of 1996, the Commission's Division of Enforcement set up its own interactive home page. This gives Internet users both direct access to a comprehensive listing of individuals and firms that have experienced enforcement problems, and the opportunity to communicate directly with our enforcement staff concerning suspected wrongdoing. The leads generated by this service, along with our staff's direct surveillance of the Internet, have resulted in a number of Internet-related investigations and enforcement actions.

(3) Also in August, the Commission's Division of Trading and Markets published an Interpretation, along with proposed rule amendments, concerning the use of electronic media by commodity pool operators and commodity trading advisors. The intent is to find ways whereby CPOs, CTAs and their associated persons can use electronic media both for meeting disclosure and reporting obligations to their customers and for filing required documents with the Commission.


In closing I respectfully submit for your consideration the following thought. The seamless structure of the global marketplace for exchange-traded derivatives presents regulators with serious challenges and, at the same time, multiple opportunities.

The challenges come as regulators seek to expand our present international cooperative arrangements. Resolving cultural differences that, in turn, result in varying degrees of oversight and enforcement be no easy task. Nonetheless, I believe the ultimate goal of those who regulate exchange-traded derivatives should be to agree on appropriate minimum universal regulatory standards that will serve the public interest and guard against a systemic failure of the futures industry. Banking regulators have made great strides toward accomplishing a similar goal for their industry. They did not do it overnight, nor will we.

The forthcoming London Conference on Supervision of Physical Delivery Commodity Markets will be a significant milestone in the long, arduous process of defining these universal standards and then finally agreeing upon them. Each step along the way we should be guided by a vision of securing the financial and market integrity of futures exchanges worldwide without hindering their ability to transfer risk efficiently and economically.