Keynote Address by
Joseph B. Dial, Commissioner
Commodity Futures Trading Commission
FIA/SFE Asia-Pacific Futures Forum
December 6, 1996
Good morning. I would like to thank the Futures Industry Association and the Sydney Futures Exchange for inviting me to participate in this ground-breaking conference. The ongoing economic boom and the growth of derivatives markets in the Asia- Pacific region make this a most timely and topical gathering.
Today, I would like to share with you some thoughts on the globalization of the financial marketplace and the special needs that process creates -- a need for international cooperation and a need for a certain level of regulatory compatibility. I will touch on the cross-border systemic effects of major market events, which add a note of urgency to the need for cooperation and compatibility, and I will conclude with a look at the lessons these issues hold for the Asia-Pacific markets.
Globalization Demands Cooperation
The term, "global marketplace," is relentlessly evolving, from a clever catch-phrase to an immutable fact of economic life. Every day, financial markets around the world become more tightly integrated. Capital moves from country to country, time zone to time zone, with the tap of a computer key, as financial institutions with multi-national operations seek the best returns. And just as capital knows no borders in today's financial marketplace, neither does misconduct. Following close behind legitimate business operations are the criminals and con artists, devising ever more sophisticated schemes of cross-border fraud. But the threat posed by these cross-border con men is dwarfed by the threat from within -- the damage caused by rogue traders operating inside the ranks of otherwise respectable institutions.
If regulators ever hope to keep pace with these kinds of developments, they must cooperate with each other, and with industry self-regulatory bodies, in addressing shared problems and concerns. The CFTC is firmly committed to international regulatory cooperation. We have entered into some 25 bilateral agreements, for enforcement cooperation and/or financial information sharing, with regulators in 15 other jurisdictions. The most recent agreement is a pact signed with New Zealand regulators this past September.
In addition, the CFTC pursues international regulatory cooperation: through active participation with other regulators in ongoing multilateral forums, like IOSCO; and through ad hoc efforts, like the Windsor Accords and last week's London Conference on Physical Delivery Markets. We also maintain close ties with industry self-regulatory organizations, including both the exchanges themselves and broad-based self-regulatory groups like the U.S. National Futures Association.
The CFTC, of course, is not alone in recognizing the need for international regulatory cooperation. This is evidenced by the broad participation we see in IOSCO, in the Windsor Accords, in the London meeting, and in conferences like this Asia-Pacific Futures Forum, which I understand will become an annual event in future years.
Cooperation Requires Compatibility
Clearly, the will to cooperate is there. But effective international regulatory cooperation requires more than just good will and noble intentions. There must be sufficient regulatory common ground -- some minimum level of compatibility among different regulatory systems.
If we are to overcome the obstacle of incompatibility, we must try to understand its origins. Where do the sources of this problem lie? Incompatibilities among regulatory systems may be based on differences in legal or economic systems, business practices, or even cultural traditions. But I submit that many of the differences among regulatory systems are simply a matter of experience.
Regulatory systems that have been around longer, systems that have accumulated more experience, tend to be more developed, more elaborate. The U.S. regime, which traces its regulatory history back to the 1920s, is the prime example. The U.S. has, perhaps, the most elaborate derivatives regulatory system because we have the most experience. Let me hasten to point out that I am using the term, "experience," in the sense of the old Texas farmer who said, "experience is what you think you have until you get more of it." Or, as Oscar Wilde put it, "experience is the name everyone gives to their mistakes."
It should come as no surprise that in derivatives regulation, as in any other aspect of life, experience is a great teacher -- and bad experiences make for unforgettable lessons. Outright disaster teaches the most memorable lessons of all. In California, the building codes are based on that state's experience with earthquakes. Florida's standards owe their structure to hurricanes. The same principle holds true in the world of financial regulation, where the disasters are usually man-made.
Let me cite a few examples of negative experiences that have helped to shape the U.S. regulatory system. Market manipulations, corners and various trade practice abuses in U.S. agricultural futures markets in the 1920s and 30s gave rise to the Commodity Exchange Act. The Act was then administered by the Commodity Exchange Authority, a sub-agency within the Department of Agriculture. The Act authorized comprehensive rules for contract design, reporting, recordkeeping, financial integrity and market surveillance in the agricultural markets. The Goldstein Samuelson gold options fraud in the early 1970s, which caused $70 million dollars in customer losses, is credited with inspiring the Congress to create the CFTC in 1974 as an independent regulatory agency with jurisdiction over all futures and options trading, including precious metals and financial instruments. The 1987 stock market break gave rise to coordinated circuit breakers in U.S. securities and stock index futures markets. Trade practice violations disclosed in 1989, after an FBI "sting" operation in the Chicago futures pits, provided the impetus for stricter rules regarding exchange trade practices and audit trails.
Clearly then, because regulatory systems react to bad experiences, the U.S. system owes its current complexity -- at least in part -- simply to the fact that it's been around long enough to accumulate more of those bad experiences. Other mature regulatory systems respond in similar ways to the same kinds of influences. The Sumitomo affair, to cite just the most recent example, has prompted the U.K. Securities and Investments Board to undertake a comprehensive review of its regulatory system as applied to the London Metal Exchange.
Nor are such problems unique to more mature regulatory systems. Newly developing markets, including those in the Asia- Pacific region, have learned similar difficult lessons. In China, for example, allegations of speculative excesses, manipulation and other trading irregularities have prompted a series of regulatory actions affecting that nation's developing derivatives markets.
In 1994, the government banned futures trading in a number of commodities and closed or merged dozens of exchanges, leaving only 15 to run "on a trial basis." In March of this year, the China Securities Regulatory Commission (CSRC) issued a decree banning banks and securities houses from trading commodity futures and ordering state-run enterprises to limit their trading to products relevant to their businesses for hedging purposes. In October, the CSRC approved the first in a reported further series of exchange mergers that may leave only four or five of the larger exchanges surviving. The Beijing-based Financial Times reported that the purpose of the merger was "aimed at standardizing [China's] futures markets and promoting standard and high quality trading."
Just this past June, the Philippine Securities and Exchange Commission suspended the registration of the Manila International Futures Exchange based on findings of massive fraud perpetrated on customers. The exchange remains closed.
In Hong Kong, the 1987 crash had a much more profound effect than the U.S. decision to adopt circuit breakers. At the Hong Kong Futures Exchange, members on the losing side of trades in the Hang Seng Stock Index Futures Contract simply walked away from their obligations and the exchange experienced a major default. In return for a government support package sufficient to meet the defaults, the Hong Kong government obtained resignations from all members of the exchange board and major reforms were instituted.
Systemic Effects Add Urgency
The 1987 crash provides a handy transition to the issue of systemic effects. The Hong Kong Futures Exchange may have suffered the most in 1987, but exchanges everywhere were affected. Regulatory compatibility assumes ever greater importance as globalization of the marketplace continues, because events in any one market always have the potential to cause wider systemic effects in other markets. In that sense, the 1987 crash was a wake-up call, reminding us that all participants in the global financial marketplace are together in the same boat. Without adequate internal safeguards to compartmentalize risk, a big enough hole anywhere in the boat can sink all of us.
More recently, we have received additional, pointed reminders about the dangers of systemic effects and the interconnected nature of world financial markets. The Barings affair involved the Singapore office of a British bank, trading in both the Singaporean and Japanese futures markets, with financial fallout that threatened affiliate firms in the U.S. and several other countries -- and for good measure, a Dutch firm stepping in at the last minute as the "white knight." The Sumitomo matter involves a Japanese firm, trading on U.K. and (until they exited complaining of too-strict regulations) U.S. markets, British and U.S. brokerage firms, copper warehouses around the world, from Long Beach to Rotterdam to China, and an ongoing investigation by authorities from Japan, the U.K. and the U.S.
While the occurrence of these episodes is troubling, the ultimate outcome of both has actually been quite encouraging in two respects. First, the global financial marketplace did weather both storms with no systemic ill effects. Second -- and most importantly -- regulators have responded to the red flags raised by Barings and Sumitomo by taking positive, coordinated action to address the problems these two episodes brought to light.
Barings, of course, gave birth to the Windsor Accords. The Final Report of the Windsor co-chairs (the CFTC and the SIB), released in September, lists an impressive array of concrete steps, taken in a remarkably short period of time. Without going into the details, which 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 help to minimize the systemic effects of any future market disruptions.
The Sumitomo affair is far from over -- the investigations are still going strong -- but here too, we can point to some very positive results. For one thing, 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 took place in London just last week. 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 (MITI), invited regulators of physical delivery markets from 15 other jurisdictions around the world to an international conference in London to share their thoughts and ideas on the special supervisory issues raised by such markets.
The conference produced a consensus among regulators of physical delivery markets to improve cooperation and work toward regulatory compatibility in three key areas:
(1) Contract design -- so that commodity contract terms will correspond with prevailing cash market customs and practices, thereby reducing the likelihood that the contracts would be susceptible to manipulation;
(2) Market surveillance -- so that each regulator will have in place appropriate market oversight mechanisms to detect and prevent market manipulation or disruption -- including reports of the positions of large traders in OTC and cash markets as well as futures; 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.
The Lesson for Asia-Pacific Markets
Let me conclude with a couple of observations from the viewpoint of a regulator representing the most experienced derivatives regulatory system -- the system that has been around the longest and has, therefore, had the most opportunities to react to breaches of market and financial integrity. I would invite my colleagues from countries with developing derivatives markets to learn from our mistakes.
I am not suggesting that you seek to duplicate the U.S. regulatory system. That would produce more rules than necessary for what in many countries is an infant futures industry. But I do suggest that you look to the more established regulatory systems for guidance. Make sure that you have in place appropriate minimum standards in areas such as contract design, market surveillance, reporting and recordkeeping, market transparency, safeguarding customer funds and assets, protecting the financial integrity of the trading process, protecting customers from fraud, protecting markets from manipulation and trading abuse, and sharing information with your fellow regulators in other countries.
In my opinion, regulating a futures market with anything less than these minimum standards creates more risk for the global futures industry than is prudent. It is important to note that I am not alone in holding this point of view. Since August of this year, I have visited five other countries in the Asia- Pacific region. In each one I have met with executives of firms that service the global futures industry. Without exception, they have agreed that implementing appropriate minimum regulatory standards is a worthwhile goal.
By working together in the future as we have in the past, we will be able ultimately to achieve an appropriate level of regulatory compatibility. The good will that is already present among derivatives regulators, when combined with sufficiently compatible regulatory systems, can enhance the economic efficiency of exchange-traded derivatives around the world. It is both our challenge and our opportunity to seek, through this process, a lasting foundation for a safe, secure and successful global derivatives marketplace.