"Greater China: A Regulatory Perspective"
Joseph B. Dial, Commissioner
Commodity Futures Trading Commission
MFA/FIA East West `97 Conference
April 10, 1997
I would like to thank the Managed Futures Association and the Futures Industry Association for inviting me to participate in a second panel of this historic conference. Yesterday, when I participated in the panel on Japan, I observed that it might seem odd to include a US regulator in a discussion of the regulatory perspective on another country. However, as I said then, I believe my presence here is entirely appropriate as a symbol of both the need for, and the growing reality of, international regulatory cooperation. In my remarks this morning, I will discuss the benefits of international cooperation to achieve appropriate minimum regulatory standards in the global derivatives marketplace, and then describe a few recent examples of such international cooperation.
Benefits of International Cooperation to Achieve Appropriate Minimum Regulatory Standards
The term, "global marketplace," is relentlessly evolving from a clever catch phrase to an immutable fact of economic life. To prove that we all really do live and work in a truly global marketplace, one need look no farther than this audience and the many different countries, institutions, regulators and businesses represented here. In today's environment of interlinked markets, round-the-clock trading, and cross-border capital flows, it is vital for derivatives regulators to cooperate with their counterparts in other countries to address common concerns. For this cooperation to be truly effective, however, there must be sufficient common ground -- some minimum level of compatibility among regulatory systems.
I doubt that anyone here would disagree with me that regulatory compatibility at some level is a desirable goal -- the benefits of simplicity, economy and efficiency are obvious. The real question is -- what should that level be? Some would suggest achieving compatibility in the derivatives market by imposing a bare minimum of regulatory protections. In fact, several US futures exchanges are urging our Congress to pass proposed legislation that would deregulate some 90 percent of all futures trading in our country. Proponents of this approach would seek to attract business to the marketplace through offering a more "wide-open" environment with minimal government oversight and, in the short run, lower costs for regulatory compliance. Basing regulatory systems on this lowest common denominator approach has been aptly described as the "race to the bottom."
I believe this course of action is ultimately self-defeating. I believe that if you set out on a race to the bottom, that is exactly where you will arrive -- and you will get there without the market and financial integrity protections a successful market demands. I believe appropriate minimum regulatory standards should include credible and enforceable rules to protect markets and market users. These rules should cover such areas 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 fellow regulators in other countries. I believe international regulators, and the markets they oversee, should embrace these standards -- not just as a matter of what is right and just and fair, but also as a matter of pure self-interest.
The self-interest involved in setting meaningful regulatory standards is a function of both the dangers of standards that are inordinately low and the benefits of standards that are sufficiently high. Low standards or lax enforcement may lower the cost of regulatory compliance, but experience shows such standards create an environment that fosters fraud, trade practice abuses, rogue traders, manipulation and financial defaults. It is these breaches of ethical practice and financial integrity that, in the long-run, impose an exorbitant cost on market participants and the general public. No regulatory system can completely prevent these occurrences, but the dangers of a system that makes such behavior easier to accomplish or harder to detect should be crystal clear to everyone in this room. Some of the examples from recent history are so famous, or infamous, that only a single word is needed to describe the entire event -- Metallgessellschaft, Barings, Sumitomo -- all involving losses in excess of a billion dollars. I will not belabor the obvious by adding more items to that list, but I'm sure each of you could come up with a few more examples of your own.
The benefits of higher standards can be summed up in one word -- "confidence." Hedgers and speculators alike must have confidence in the market and financial integrity of the futures contracts they are trading or they won't use them. They know that markets with more effective regulatory protections are less likely to experience fraud, manipulation, and defaults -- and better able to weather any crises that do occur. Markets with more effective regulatory protections are also better able to attract the big institutional users, such as pension and retirement funds. These hedgers are subject to strict fiduciary requirements allowing them to participate only in financially secure, well-regulated markets.
I believe the case for appropriate minimum regulatory standards is quite compelling -- so compelling , in fact, that regulators around the world are working hard, through a variety of mechanisms, to make those common standards a reality. Let me share with you a few recent examples of international regulatory cooperation in action.
Recent Examples of International Regulatory Cooperation
International regulatory cooperation can take the form of bilateral or multilateral efforts. Bilaterally, the CFTC for example, has entered into some 25 agreements over the past 10 years, providing for enforcement cooperation and/or financial information sharing with regulators in 15 other jurisdictions. These agreements have proven very helpful in addressing a variety of problems, but bilateral agreements alone are not enough. The interlinked nature of today's global marketplace creates the potential for systemic problems affecting multiple firms and exchanges in multiple jurisdictions.
To deal with such systemic problems, multilateral efforts are required. An excellent example of such a multilateral effort is the Windsor Accords, which grew out of joint efforts by the CFTC and the UK's Securities and Investments Board (SIB) to address key issues arising from the Barings failure. Without going into the details, which are probably familiar to most of you, the Windsor initiatives addressed issues such as: large exposure information sharing; market crisis procedures; enhanced transparency of market protection and procedures; and client asset protection measures.
Credit for the success of the Windsor Accords is not due to the CFTC and the SIB alone. Such ad hoc efforts can fade from memory, their goals unfulfilled, without ongoing external support. In the Windsor example, that support came from two sources. First, IOSCO, the umbrella organization that includes international derivatives regulators, agreed to incorporate the Windsor initiatives into its long term program. Secondly, a parallel private sector effort, in the form of the FIA Global Task Force on Financial Integrity, formulated over 60 recommendations designed to improve the financial integrity of the futures industry for all participants.
Another ad hoc effort, aimed at addressing the regulatory issues arising out of the Sumitomo affair, was the November 1996 London Conference of regulators responsible for overseeing physical delivery commodity markets. The conference brought together authorities from 17 countries, including the Peoples Republic of China (PRC). I described the London Conference initiatives in my remarks during the Japan panel yesterday and I will not subject you to a repetition. However, I would like to highlight a couple of significant points. First, like the Windsor Accords, the London Conference initiatives have succeeded in gaining support from both IOSCO itself and from private sector authorities -- in the form of the IOSCO Consultative Committee.
Second, as I mentioned yesterday, it was announced at the March 1997 International Regulators Conference in Boca Raton, that six additional countries had signed the Declaration on Cooperation and Supervision of International Futures Markets and Clearing Organizations, bringing the total signatories to 20. While Hong Kong is one of those signatories, the Peoples Republic of China is not. However, regulators from the PRC did attend this year's Boca Raton conference, for the first time ever, helping to open some very important channels of communication with the CFTC and other regulators. I see this as a very encouraging sign of increasing international engagement that will, I hope, lead the PRC to sign on to the Boca Declaration in the future.
Another recent example of international regulatory cooperation involves the first ever cross-border stress test performed on February 28, 1997. The test involved regulators, exchanges and clearing organizations in both the US and the UK -- nine organizations all told. The test scenario -- the hypothetical default of a firm on a US exchange, which in turn precipitates a default on a UK exchange -- gave participants a chance to test the emergency procedures and cross-border risk management mechanisms developed in response to the Barings default. The purpose of this stress test was to help the participants focus attention on their responsibilities in an emergency and the steps they must take to identify and contain a market crisis. Such exercises prove invaluable as they help regulators and exchanges to spot weaknesses in their emergency response systems -- ranging from issues as simple as a wrong phone number for an emergency contact to something as complex as how to determine the true amount of capital available to a corporation entangled in a web of interlocking subsidiaries and affiliates.
My final example illustrates both the importance of common minimum regulatory standards and the benefits of international regulatory cooperation. It is an example that is especially appropriate for this panel and this city. On March 28,1997, the CFTC approved a proposed linkage arrangement between the Hong Kong Futures Exchange and the Philadelphia Stock Exchange. The link will allow foreign currency options listed on the Philadelphia Stock Exchange to be cross-listed on the Hong Kong Futures Exchange so that customers will be able to establish a position on one exchange and offset it on the other. This first ever linkage arrangement joining a securities exchange and a futures exchange was made possible in part because of the CFTC's openness to creative approaches and new ideas. But we were able to carry that attitude forward and approve the linkage arrangement only because the regulatory system governing the Hong Kong Futures Exchange embodies appropriate minimum standards sufficient to assure our staff that US customers will receive appropriate protections in trading through the linkage.
In closing, let me simply reiterate the central theme I want to leave with you this morning. In today's environment of interlinked markets and cross-border systemic risk, we are all in the same boat. We all share one common goal -- to enhance the market and financial integrity of the futures industry within our respective jurisdictions, as well as around the world.
As regulators, we have a responsibility to secure the good ship "Global Marketplace" as it plies the world-wide waters of exchange-traded derivatives. With meaningful common regulatory standards, we can improve the sea-worthiness of the vessel market participants depend on to navigate today's volatile economic seas. Furthermore, such common standards would enhance our ability to detect and deter illicit business practices that may be lurking out of sight beneath the surface. If, in spite of our best efforts, a rogue trader like a Leeson or a Hamanaka looses a torpedo, a well coordinated emergency response plan will allow us to seal off the damaged area quickly and sail on.
The international community of regulators has wisely heeded the wake-up calls we received from the Barings and Sumitomo events. The Windsor Accord and the London Conference initiatives are clear evidence of our resolve to work together to attain our common goal.