William J. Rainer
Commodity Futures Trading Commission
22nd Annual Chicago-Kent College of Law
and Commodities Law Institute
October 28, 1999
The question that I will address this morning is: "Must the CFTC change the way it regulates the financial futures markets?"
The answer is an unequivocal "yes," and it is the dramatic changes in the markets themselves that demand such reform.
Ten years ago, when the CFTC issued the swaps policy statement, the differences between swaps transactions and financial futures transactions were reasonably clear. Swaps were bilateral, tailored, and individually negotiated over the phone. Moreover, there were no clearinghouses for swaps. Since then, however, we have witnessed an inexorable creep towards standardization. And, with today’s technology, it has become increasingly difficult to find language that will preserve meaningful distinctions between the OTC swaps and financial futures.
This convergence of the two markets has blurred the differences between swaps and futures, and attempts to differentiate the two are not only an increasingly futile exercise but have also created legal uncertainty in the OTC market and have distracted us from the task of reforming regulation of the futures markets.
Therefore, in examining both the OTC derivatives market and the exchange traded financial futures market, we must carefully analyze whether or not the broad statutory goals, set forth many years ago in the Commodity Exchange Act, can continue to drive the correct regulatory policy.
Shortly after I took this job, I studied Section 3 of the Act and found three basic purposes for the regulatory structure currently administered by the CFTC: (1) to protect the price discovery function; (2) to prevent the manipulation of commodities through corners, squeezes and similar schemes; and (3) to assure an effective vehicle for risk transference. Implicit throughout is the need to provide suitable customer protection from abusive trade practices and fraud.
Do these purposes fit the financial futures and derivatives markets today? Let’s examine them one by one.
First, price discovery: With respect to financial futures, such as the bond contract, there is no critical price discovery role, at least not in the classic sense, as there is in the case of a physical commodity such as cotton. Users may rely on the price information of the bond contract, but the government bond market does not discover the long bond price through the bond future. The cotton industry, on the other hand, does discover its price through the cotton futures contract. Simply stated, there is no case for regulating financial futures on the basis of price discovery.
Second, manipulation: The long list of attempts to manipulate physical commodities is well known. Indeed, the need to prevent manipulation is the primary reason this agency and its predecessor came into being. Manipulation continues, as we recently witnessed in the case of copper.
But what is the record of manipulation in the financial arena? We now have more than 20 years of experience with the bond contract and foreign currencies, and about as much experience with other financial futures. The CFTC’s enforcement record contains only two minor cases of attempted manipulation in any of these instruments, which is remarkable; but one must remember the size of these markets: T-bonds alone trade 350,000 to 400,000 contracts a day.
While we cannot discount to zero the chances that someone may come up with a successful manipulation scheme in the future, I am skeptical whether, in light of this experience, the public policy objective of preventing the remote possibility of manipulation warrants the current level of regulation for financial instruments.
Third, risk transference: "Risk transference" is a function of these markets and therefore a valid reason for regulation. Again we must ask how much regulation is required to achieve an effective result. That is to say, there are only a few ways to hedge agricultural products, but financial market practitioners typically have at their disposal a wide array of effective risk management tools available in a number of different markets.
Finally, we need to determine the suitable level of customer protection. The financial futures markets are open to the widest variety of participants: from Goldman Sachs or Morgan Stanley to the relatively inexperienced individual speculator. The over-the-counter swaps market is almost entirely a sophisticated market, composed mostly of professional dealers and institutional investors. Historically, because our regulatory policy has been transaction based, we have had a "one-size-fits-all" approach to rules protecting customers. Again, the question is do the facts support current regulatory policy? We recognize that similar to the OTC market, the financial futures markets are also predominantly institutional. We may need to make new judgments with respect to the appropriate level of customer protection.
The CFTC’s statutory goals and regulatory policy today fit neither the financial futures markets nor OTC derivatives. The CFTC has focused on the common element of futurity in the instruments we regulate. One of the fundamental shifts that the CFTC needs to make is to recognize that financial futures are not the same as metals futures, energy futures or agricultural futures. Financial futures cannot be isolated from the rest of the global financial markets, and we should regulate from that perspective.
The awkward fit between U.S. regulatory policy and the markets would not matter – and until recently has not mattered very much – as long as the public interest did not suffer. But today at least three vital priorities are not being met, namely: (1) the need to enhance economic efficiency and competition; (2) the need to encourage innovation in technology for the markets; and (3) the need to mitigate systemic risk in the rapidly growing OTC markets by encouraging developments such as clearinghouses.
The national interest in fostering economic efficiency and competition in the OTC derivatives market can only be accomplished by establishing clear legal certainty for over-the-counter derivatives. The CEA was not designed to regulate the OTC market. The benefits from such legal certainty are self-evident and warrant no further comment here.
Our economy will profit from the efficiencies created by technological advances – trades will be consummated faster and with lower costs, and this will lead to a decrease in the cost of capital. National and international markets will also gain from the development of a clearinghouse for these markets – among other benefits, netting helps decrease systemic risk while achieving more efficient use of capital. These are all areas that are being addressed through the auspices of the President’s Working Group on Financial Markets.
But in formulating a comprehensive approach to address the public policy priorities for OTC derivatives, it is the profound challenge of the CFTC to address those same priorities for the financial futures markets.
The CFTC’s regulatory policy must ensure that there is a balance between the regulatory environment for OTC derivatives and the level of regulation applied to the financial futures markets. These markets are simply too important to the nation’s economy to ignore the potential damage from disparate regulatory structures.
The financial futures markets by any measure are huge, take for example the bond contract and the Eurodollar contract. The bond contract trades a notional value of about $35-40 billion a day; the Eurodollar contract usually trades more than $300 billion a day.
As we tailor policy to fit the three fundamental priorities of efficiency and competition, technological advances, and reduction of systemic risk, it is important that the financial futures markets receive commensurate regulatory adjustments. The government must not inadvertently pick winners and losers as we attempt to reshape the regulatory landscape for all financial markets.
Consequently, the CFTC must embark on a process that may result in major deregulation of the financial futures markets, beginning with those contracts that compete directly with OTC derivatives. No rule or regulation will escape scrutiny. While the financial futures markets are most in need of regulatory reform, all of our contract markets would benefit from a lighter regulatory hand. The CFTC intends to withdraw from approving contract designations and will soon issue proposed regulations to permit exchanges to adopt new rules without prior approval. These are key elements in our overall plan to move from being a frontline to an oversight regulator.
In adopting an oversight role, the CFTC will consider a number of alternative market models. In the past, we have issued rules authorizing the establishment of professional markets, and while these proved unsuccessful, some may think this idea worth revisiting. Establishing "pro markets" might appear to be the easiest or quickest way to achieve competitive equilibrium between exchange and over-the-counter markets, but this design may have negative effects on cost and liquidity. The efficiency of the futures markets and their depth of liquidity for risk management activity rely upon their public nature. We should be very careful about creating a regulatory climate that would force exchanges to become exclusively professional markets to remain competitive.
There is no doubt that some of these objectives will be difficult to achieve, but our nation’s priorities in the area of financial regulation dictate that we start to examine and regulate products, entities and exchanges on a rational basis and not be bound by tradition.
Since I know that there are many other hot topics that I have not addressed – from the policy modifications required to change the CFTC from frontline to oversight regulation to the importance of information sharing with international regulators – I’ll stop here and open the floor for a few questions.