Remarks of Commissioner Barbara P. Holum
New York State Bar Association
Committee on Commodities and Futures Law
November 17, 1998
Good afternoon, Ladies and Gentlemen. I am pleased to be here today. This is an interesting time for our industry as dramatic changes are sweeping the financial markets. The CFTC and the markets are faced with an abundance of public policy issues; some of which I think it is safe to say have been viewed as controversial. Resolution of these important issues will affect, among other things, the way futures are traded and the way futures markets are regulated. Today, I will share with you some of my views on the CFTC's role in the OTC derivatives debate, the evolving and growing markets, the impact of technology on the upcoming reauthorization hearings, and the interrelationships between markets and financial services regulators. The views I am expressing today are my own, and are not the views of the CFTC.
For reasons that I will discuss in greater detail, the upcoming reauthorization of the CFTC presents a promising opportunity for policy makers to explore all of the alternatives available for restructuring regulation of futures and options trading. While part of this focus, rightly so, will be on over-the-counter markets, it is equally important to reexamine the regulatory architecture governing on-exchange markets as well. Indeed, with the banking industry also seeking reform of the banking laws, Congress will have an opportunity to conduct a comprehensive review of regulation of the entire financial services industry. As part of that process, it is important for the regulatory community to maintain an open and unbiased approach in its search for the most efficient model for regulation. We as regulators should not attempt to confine business innovation within an artificial or predetermined structure. Only through an open approach to market regulation will the financial services industry be able to innovate and remain competitive.
The CFTC issued its concept release on OTC derivatives in early May of this year. That release itemized OTC market topics and sought comment on the advisability of expanding regulation into many areas not currently regulated. I dissented from the issuance of the concept release because it seemed to me that the release, as defined by its breadth and scope, implied an agenda for heightened regulation. In my judgment, the release went beyond the scope of regulatory review by exploring regulatory areas inapplicable to an OTC market. In fact, the concept release raised a real risk of increasing legal uncertainty and encouraging migration of the market offshore.
I also believed that independent action by a single regulator or supervisor was inappropriate given the multi-jurisdictional nature of the OTC market. The Commission's 1992 study of the OTC markets, prepared in consultation with other financial regulators, concluded that the "systemic and public policy issues suggested by these [OTC] products are not confined to any single market or the province of any single regulator" and that coordination among all financial regulators was extremely important. I believe that the study's conclusions are equally as relevant today.
Congress, also recognizing the need for a coordinated effort, has requested a study of the OTC derivatives market by the President's Working Group on Financial Markets. The Working Group includes the Secretary of the Treasury, the Chairman of the Federal Reserve Board, and the Chairmen of the Securities and Exchange Commission and the Commodity Futures Trading Commission as well as other banking supervisors and economic advisors. The Working Group was established in 1988 to bring a coordinated and consistent approach to the regulation and supervision of financial markets, financial products and financial market participants. Since being reactivated in 1994, one of the top priorities of the Working Group has been to address the regulatory and supervisory issues associated with the growing OTC derivatives market.
Separately, Congress has requested a study of the Long Term Capital Management incident. Long Term Capital Management is a hedgefund trading primarily in the OTC market. The situation with LTCM, predominately due to a breakdown in credit analysis, can and should be distinguished from the debate surrounding the Commission's role in the OTC market. What is important here is that the Federal Reserve not only had notice of LTCM's difficulties, but also had an opportunity to consider whether intervention was needed to avoid systemic risk. In my judgment, the essential surveillance function was met in that the Federal Reserve had an opportunity to make a determination on how best to proceed, and did so without the expenditure of public funds. Basically, the system worked.
Until recently a consensus existed that the current regulatory structure, and the cooperation of supervisors, regulators and industry participants, was adequate to address the systemic risks and public policy concerns raised by OTC derivatives. This coordinated regulatory environment has worked well over the past several years as evidenced by the phenomenal growth in the markets. Unfortunately, the cooperative effort that facilitated the success of the OTC derivatives markets has broken down, but hopefully this is only a temporary setback. A single regulator cannot and should not presume to fit a $30 trillion OTC derivatives market into a single regulatory framework.
Critical comment on the OTC concept notice appears to focus on its far-reaching approach to overall OTC market regulation. The concept release seemed to advocate a functional approach to OTC derivatives market regulation, as opposed to a more entity-based form of supervision, as carried out by banking regulators. The concept release seemed to place emphasis on fraud and sales practice, with little if any mention of issues relating to the OTC market's economic performance or the need for an improved level of market transparency. In this respect, critics have been quick to point out that this emphasis may be misplaced because the OTC derivatives market is generally made up of sophisticated, professional participants. Comments questioning the lack of balance in the concept release seem justified, at least as measured by its division of questions among topical subjects. Out of a total of 75 questions, over one-fifth (17 questions) sought comment on sales practice and registration issues. By comparison, only six questions sought comment on reporting and self-regulatory issues, and the word "transparency" was only used once.
Congress recognized the risks associated with the OTC concept release and sought to address them in a series of hearings throughout last summer. We are very fortunate to have members serving on our authorizing committees that are knowledgeable and willing to devote many hours of their time to solving this difficult problem. In fact, the number of hearings held and the hours spent on this topic, as well as the stature of regulators, supervisors and industry representatives testifying may be unprecedented. Chairman Lugar observed at one such hearing that his student interns "were starstruck by such a galaxy of people all appearing at the same table, . . . led on, of course by Brooksley Born, . . . but including Alan Greenspan, Larry Summers and Art Levitt." Several Committees of Congress, including the Senate Agricultural and House Banking and Financial Services Committees, held hearings with the clear purpose of restoring confidence in the market by ensuring that the regulatory landscape would not be altered without full debate in Congress.
When Congress saw that the goal could not be realized through cooperation within the regulatory community, Congress did not hesitate to propose legislation. The result of course is the moratorium recently enacted by Congress as part of the appropriations bill. This moratorium prohibits the Commission from issuing any rule, regulation, interpretation, or policy statement that restricts or regulates activity in swaps or hybrid instruments currently exempt under CFTC regulations. It continues to permit the CFTC to grant exemptive relief from regulation under the Commodity Exchange Act. Congress made it clear that adoption of the moratorium was designed to maintain the status quo pending Congressional review during CFTC reauthorization.
One added benefit of the numerous hearings was the sharing of ideas and information by all of the financial regulators, bank supervisors, representatives of exchanges, swap associations and end users called to testify. It seemed clear to me that for the most part the regulators recognized the need to work together in considering changes in the current regulatory structure. Technological advances have contributed to the elimination of barriers between markets both institutionally and geographically. The issues facing the financial markets cannot be addressed independently within the confines of one agency. Just as the banking industry embarks upon HR 10 in an effort to modernize banking laws, laws governing all financial markets likewise should be modernized. The issuance of the concept release, and the resulting debate concerning the policy implications, will have a strong influence on reauthorization.
In my judgement, the CFTC's exemptive actions have performed as intended by permitting the OTC market to grow. This is born out by data of the International Swap Dealers Association showing that the notional value of OTC derivatives grew from about $5 trillion in 1992 to more than $36 trillion by mid-1998. While OTC derivatives may be used by a wide range of end-users, OTC dealing activity is concentrated among a relatively few financial firms worldwide. As the GAO reported in its November 1996 study, 15 firms accounted for most of the OTC dealing activity in the US. Significantly, GAO data indicate that bank dealers, at 69 percent of total, accounted for the largest share of activity.
Congress previously has undertaken actions to provide legal certainty in the OTC community and to ensure the sanctity of contracts negotiated in that market. Congress most likely will continue on this path with a view to ensuring a strong US presence in this growing market, ever conscious that Draconian action would run a risk of simply moving the market offshore. This, as Chairman Greenspan has observed, would have the perverse effect of probably reducing, rather than increasing, supervisory and regulatory oversight.
One characteristic distinguishing the OTC derivatives market has been the negotiation of individual contract terms and the role of counterparty creditworthiness, factors taken into account in the CFTC's past exemptive actions. In sum, these characteristics produce non-standardized instruments that do not lend themselves to exchange trading. As the market continues to grow, however, there is likely to be an increasing level of standardization, which will continue to blur the distinction between on-exchange and off-exchange instruments.
I view the CFTC's upcoming reauthorization as a unique opportunity to bring our rules and regulations current with our evolving markets. For this reason alone, this may prove to be the most important reauthorization in the Commission's short history. The issues obtaining immediate focus include those relating to jurisdiction and the overall scope of regulation. It is relatively easy to identify focal issues for reauthorization, such as: 1) resolving the dispute over the regulatory environment for OTC derivatives; 2) revisiting the Shad-Johnson Accord (the provision found in Section 2(a)(1)(B) of the Act that generally prohibits futures trading on narrow-based stock indices); 3) defining the scope of the Treasury Amendment (the provision found in Section 2(a)(1)(A)(ii) of the Act that limits the CFTC's jurisdiction to transactions in foreign currencies conducted on a board of trade); and 4) ensuring a level playing field for the futures exchanges. In my view, the current reauthorization should be viewed as an opportunity to revamp the overall financial market regulatory structure. Even though the OTC market has received an abundance of attention over the past few months, I am personally committed to taking a very close look at possible changes in the regulation of our on-exchange markets as well.
Congressional efforts to restore confidence in the OTC market will likely serve to identify competitive issues regarding exchange trading of derivatives. I believe that now is the time to consider what changes can be made to ensure the competitive position of our futures exchanges in the domestic and global financial market arenas. With new technology for tracking trades, there are good arguments for less rather than more regulation of floor trading activity. Additionally, I would support less regulation of exchange-traded financial futures as suggested by Chairman Greenspan during the OTC hearings last summer.
The model for OTC regulation recommended in the Commission's 1992 OTC study acknowledged that the systemic and policy issues surrounding the OTC market are not confined to any single market or the province of any single regulator. In support of that assessment, I would encourage either emphasizing or expanding the importance of the President's Working Group in coordinating regulatory policy for OTC derivatives markets.
The primary focus in this whole debate should not be whether swaps are futures, but what is best for all of the financial markets. This is not the time for turf battles with one agency taking steps to carve out a piece of the pie for itself, because of fear that another financial regulator is attempting a jurisdictional grab. OTC derivatives transactions cross jurisdictional boundaries. Financial market participants are often subject to bank supervision as well as SEC and CFTC regulation. Moreover, the products traded often have characteristics that cross regulatory boundaries. Therefore, a more comprehensive, inter-jurisdictional approach to oversight is now appropriate.
More sophisticated technology such as electronic trading systems and the Internet have expanded access to markets and market users globally. It is clearer now, more than ever before, that the world markets are inextricably linked. These trends raise complex and novel issues that could profoundly affect the integrity and competitiveness of U.S. markets and firms engaged in providing services globally.
The CFTC recognized the need for an advisory committee to discuss the many highly technical and complex competitive and regulatory issues facing U.S. markets and firms doing business abroad. Earlier this year, the CFTC established the Global Markets Advisory Committee, commonly referred to as GMAC. The members of the Committee are those U.S. markets, firms and market users most directly involved in and affected by global operation.
GMAC will advise the Commission in designing its regulations and in crafting its domestic and international policies to keep pace with these global changes. Continued global competitiveness of U.S. markets and firms is an important goal of GMAC.
GMAC has been divided into three working groups: Working Group I, on Electronic Terminals (currently focusing on the important issue of foreign terminal placement), is chaired by Mr. Leo Melamed of Sakura Delshur; Working Group II, on impediments to cross-border business, is chaired by Mr. Gary Seevers of Goldman Sachs; and Working Group III, on IOSCO issues, is chaired by Mr. Bob Wilmouth of NFA. Each of the working groups met in September and will present reports on their various work projects to the full GMAC at its meeting scheduled for December 9. I am very pleased to have such an esteemed group of individuals serving on GMAC.
In conclusion, regulatory oversight must adjust along with the changing business environment of the financial services industry. I am confident that all financial regulators and supervisors, the Congress and the industry will work together to craft an oversight policy that accommodates and encourages continued growth and innovation in the U.S. derivatives markets both on and off-exchange.
I am happy to answer any questions.