Joseph B. Dial, Commissioner
U.S. Commodity Futures Trading Commission
Oversight of Exchanges and Clearing Houses
Asia Pacific Futures Regulators' Forum
December 4, 1996
I am delighted to participate in the Asia Pacific Regulators' Forum. I bring you greetings from the CFTC's Chairperson, Ms. Brooksley Born. On her behalf and my own, I would like to congratulate Mr. Alan Cameron, Chairman of the ASC, and his fine staff, for the outstanding job they have done in organizing and hosting this forum. Likewise, it is an honor to be a co-presenter with Chairman Munir Majid of the Malaysian Securities Commission.
I will be brief in my "presentation on regulation and oversight of futures exchanges in the USA," so that there will be ample time for the scheduled "open discussion on approaches in other jurisdictions, the problems incurred and ideas for change." Rather than reciting an extensive overview of the U.S. regulatory system -- most of you are probably familiar with it from other conferences like this -- I will give you a lawyer's one-sentence version and then move on to some topics that will, I hope, stimulate an interesting discussion.
The U.S. system is the most elaborate futures regulatory scheme in the world, encompassing rules for contract design, market integrity (including market surveillance, transparency and large trader reporting), financial integrity (including minimum net capital and segregation of customer funds), registration of commodity professionals, customer protection and cooperation with other regulators. Part of the reason the U.S. system is so comprehensive is because it has been around a long time, and so has had the opportunity to react to a lot of problems and crises.
As younger derivatives markets in other countries experience similar cycles of growth and development, they and their regulators may face similar problems. Furthermore, as these markets become more closely linked with each other in a global marketplace, we see greater potential for systemic effects -- the chance that problems in one market will spill over into markets in other countries. In such an environment, it is important to encourage cooperative efforts to move toward a greater common international consensus on "best practices" among derivatives markets and their regulators. As long as we can reach agreement on appropriate minimum regulatory goals or standards, each regulator should have the freedom and flexibility to find the best way of reaching those goals within the confines of its own legal, cultural and market system.
To lay the groundwork for a discussion of best practices, let me review several market problems encountered in recent years -- in both the U.S. market and the global marketplace -- along with some of the lessons learned, or to be learned, from these episodes. I will then propose a few questions to get the discussion going.
In early 1985, Volume Investors, a minimally capitalized clearing member of a U.S. futures exchange, which primarily cleared business for local traders, accumulated large short positions in gold options. When gold prices made an extreme move, Volume couldn't meet its obligations, triggering a default. The Commission considered a number of responses to account for the different, non-linear nature of options risk in our regulatory regime. Specifically, we considered price limits, capital concentration charges, more intensive surveillance, coupled with early warning notices concerning excessive financial risks, and improved margining of options positions. Ultimately, improved surveillance, early warning and margining procedures were developed.
The 1990 collapse of Drexel, Burnham Lambert, as a result of risks undertaken by its parent company taught us that our financial surveillance regime needed to account for risks emanating from outside the regulated entity. That same issue is currently being addressed by consolidated supervision requirements in the European Union.
The growth and collapse of the "silver bubble" in late 1979 and early 1980 was ultimately tied to an alleged conspiracy by a group of traders, led by members of the Hunt family. As prices escalated, the Commission and the exchange weighed various options for intervention by market regulatory authorities. Among other things, the Commission considered the efficacy of raising margins versus imposing limits on position sizes. The initial choice -- raising margins -- actually produced an effect opposite to what was intended. Margin increases actually forced smaller traders out of the market and further concentrated market power in the hands of the manipulators. The Commission later adopted regulations requiring U.S. exchanges to impose speculative position limits in all contracts not already subject to such limits.
Turning to the global arena, the two most obvious recent crises are the Barings and Sumitomo episodes. I won't recount the underlying facts of either event -- I'm sure they are familiar to all of you. But what are the lessons they teach us?
When the CFTC staff began to sort out the implications of the Barings collapse for U.S. firms, one problem stood out. Unlike the U.S., many major market jurisdictions, such as Japan, do not require that customer funds and positions be held separate from their carrying broker's proprietary funds, and do not prohibit offsetting firm obligations against those of the firm's customers. Thus, in addition to large exposure information sharing, market crisis procedures, and enhanced transparency, the goals agreed upon in the post-Barings Windsor Accords included improved client asset protection measures.
Turning to Sumitomo, we learned that physical delivery markets are susceptible to unique problems that may not be adequately addressed by international cooperative arrangements designed primarily with financial futures and options in mind. Just last week in London, the CFTC, the U.K.'s SIB and Japan's MITI hosted a conference for regulators of physical delivery markets from around the world to discuss those unique problems. The conferees agreed on a range of key elements in enhancing standards and best practices in three key areas: (1) contract design, so that contract terms will correspond with prevailing cash market practices, making contracts less susceptible to manipulation; (2) market surveillance, so that regulators will have in place appropriate mechanisms to detect and prevent market manipulation or disruption; and (3) information sharing, so that regulators will have in place effective systems for sharing market information where events in one market have the potential to affect other markets. Further efforts toward achieving the goals of the conference will be undertaken by two working parties drawn from the participants: a working party on contract design chaired by the CFTC; and a working party on market surveillance and information sharing jointly chaired by SIB and MITI. To the extent anyone wants further details on the London Conference, I am sure there are people in this room who were there in person and would be willing to share with us some first-hand insights.
One final problem, which is common to Barings, Sumitomo, and a number of other recent well-publicized episodes, is the phenomenon of the "rogue trader." The most basic lesson taught by rogue traders is always the same -- the importance of effective internal management controls.
With these examples of various domestic and international market problems in mind, perhaps we can turn to a discussion of the lessons we can learn from these episodes and your views
concerning approaches to achieving greater international consensus on regulatory best practices. Let me pose a few questions:
(1)Are derivatives markets in the Asia-Pacific region subject to any unique or unusual problems that would interfere with reaching consensus on best practices or responding to threats to the integrity of the financial system?
(2)How can we effectively establish and enforce appropriate minimum standards for derivatives regulatory systems around the world?
(3)What are the most important areas of "best practices" where international regulators need to find greater common ground?
(4)What are the most significant obstacles that stand in the way of reaching consensus on those best practices?
(5)In today's global financial marketplace, what factors pose the most serious threats to systemic financial integrity?
(6)What can regulators do to respond to those threats?