JOHN E. TULL, JR.
COMMODITY FUTURES TRADING COMMISSION
HOUSE COMMITTEE ON APPROPRIATIONS
SUBCOMMITTEE ON AGRICULTURE, RURAL DEVELOPMENT,
FDA, AND RELATED AGENCIES
MARCH 14, 1996
Mr. Chairman and Members of the Subcommittee:
Thank you for inviting me to present the President's fiscal 1997 budget request for the Commodity Futures Trading Commission.
CFTC'S BUDGET REQUEST
As you know, the President's fiscal 1997 budget request for the CFTC is $56,601,000 and a staff ceiling of 600. This request represents an increase of $3 million, or 5.6 percent, over the fiscal 1996 level.
First, on behalf of the Commission, I would like to express our appreciation for the increased funding that Congress provided in fiscal 1996. This increase will enable the Commission to meet its statutory responsibilities, ensure an appropriate level of enforcement and oversight, and keep pace with important market developments. In particular, we have targeted the additional $4.6 million you appropriated in fiscal 1996 for strengthening our enforcement and market surveillance programs.
The Commission recognizes that this Subcommittee and the Congress face especially difficult appropriations decisions this year. Nonetheless, we believe that the modest increase we have requested for fiscal 1997 is essential to enable the Commission to continue to strengthen its enforcement and market surveillance programs as well as carry out its other responsibilities fully and effectively.
Overview of Funding Levels and Operational Effects
In order to put our fiscal 1997 budget request in perspective, I would like to review briefly the CFTC's activities and its appropriations history over the past few years in the context of market developments. As you know, the Commodity Futures Trading Commission is responsible for ensuring the integrity of the futures and option markets, protecting customers from fraud and other trading abuses, and monitoring the markets to detect and prevent price distortions and manipulations. We oversee 261 futures commission merchants and some 65,000 commodity professionals.
These obligations have become more challenging in the face of dramatic market growth and innovation. Since 1992, the last time Congress significantly increased the agency's statutory responsibilities, the volume of U.S. futures and option trading has increased by over 40 percent, from 359 million contracts to 505 million contracts in fiscal 1995. During that same time period, the number of actively traded contracts has grown by over 40 percent. Innovation in exchange-traded futures and options has paralleled the development of increasingly novel and complex over-the-counter derivative instruments. Furthermore, futures and option markets around the world have become more closely linked.
In addition to these significant market developments, an expanded Congressional mandate has significantly increased the CFTC's duties. In 1992, Congress recognized the need to modernize the regulatory framework for futures and option markets and enacted the Futures Trading Practices Act, which reauthorized the Commission and gave it important new tools and responsibilities for regulating today's markets. The 1992 Act created new, ongoing responsibilities for the CFTC in many areas, including audit trail enhancements, exemptive authority for a variety of over-the-counter derivative instruments, registration requirements for floor traders, ethics training for market professionals, and risk assessment for holding company systems. Last year, Congress reaffirmed these obligations by passing a one-line reauthorization for the Commission, which authorized appropriations through fiscal 2000.
Despite its increasing responsibilities, the CFTC's budget remained essentially flat from fiscal 1992 to fiscal 1995. Consequently, the Commission reduced personnel, substantially cut non-staffing expenses, and delegated additional duties to self- regulatory organizations. The CFTC also deferred computer upgrades and systems development for market surveillance and other activities. In short, the Commission and its staff were stretched to the limit and it became extremely difficult for us to provide the oversight and enforcement presence on which market users and the economy at large depend.
In fiscal 1996, the Commission, the President, and the Congress recognized that more resources were required, and the Congress increased the Commission's appropriation by about nine percent over fiscal 1995. This increase was absolutely necessary to enable the Commission to meet its statutory responsibilities and keep pace with market developments. In the current fiscal year, we will maintain our lean structure so that we can allocate virtually all of our $4.6 million increase to two items at the top of our agenda -- continued strengthening of our enforcement program and enhancement of our automated market surveillance system. Approximately half of the $4.6 million increase will fund non-discretionary pay increases and new enforcement personnel; the other half will fund the surveillance system upgrade. These priorities, along with the Commission's other major accomplishments in the last year, are reviewed in detail below.
In fiscal 1997, the increase we have requested will be used to continue enhancing our enforcement and surveillance programs. Two-thirds of the dollar increase would go to the enforcement program; the balance would be largely directed to the surveillance program. Our fiscal 1997 request would put the CFTC at a staffing level of just one percent over fiscal 1992. This modest addition to our funding is well justified and will benefit agricultural producers and processors, financial services firms, energy concerns and many other sectors of the economy that depend on the price discovery and risk-shifting functions of futures and option markets.
As I have noted, a strong, effective enforcement program is one of the Commission's top priorities. Our goal is to send a strong message that fraudulent activity and other violations of the Commodity Exchange Act will be promptly and thoroughly investigated and vigorously prosecuted. During fiscal 1995, the Commission brought a number of significant enforcement cases and imposed over $11 million in civil penalties and other remedial sanctions. Cases brought since the Commission last appeared before the Subcommittee include:
Prudential: In June 1995, the Commission filed an administrative complaint against Prudential Securities and a former Prudential employee alleging that the individual violated the anti-fraud provisions of the Commodity Exchange Act in connection with his handling of futures and options accounts. Prudential was charged with failing to supervise its employee and, aided and abetted by the individual, with violating recordkeeping provisions of the Act and regulations. Prudential settled the allegations against it by agreeing to the entry of a cease and desist order, payment of a $725,000 civil monetary penalty, and undertaking to review its policies and procedures.
Metallgesellschaft: In July 1995, the Commission filed and simultaneously settled an administrative action against MG Refining & Marketing, Inc. (MGR&M) and its affiliate, MG Futures, Inc. (MGFI), U.S. subsidiaries of the German conglomerate, Metallgesellschaft. The Commission entered findings that MGFI failed to report material inadequacies in its internal controls and to file certified financial reports, and that MGR&M sold illegal off-exchange futures contracts, all in violation of the Commodity Exchange Act and regulations. In settling the charges, MGR&M and MGFI agreed jointly to pay a $2.25 million civil monetary penalty. MGFI and MGR&M also agreed to certain remedial sanctions, including establishing a special oversight committee to conduct a review of MGFI's internal control systems and MGR&M's policies and procedures concerning the marketing, offer and sale of off-exchange contracts.
Refco: In December 1994 and January 1996, the Commission filed and simultaneously settled administrative actions against Refco, Inc. for violating segregation, capital, and reporting requirements, failing to supervise diligently its employees, and for violating prior CFTC cease and desist orders. In addition to agreeing to revise its internal procedures and reporting lines, Refco agreed to pay a total of more than $2 million in civil monetary penalties.
Initiatives to Strengthen the Enforcement Program
In the last year, while working on these important cases and investigations, the Commission has made significant strides in strengthening and improving its enforcement program. The Commission has appointed a new Director and Deputy Director for the Division of Enforcement, and under this new leadership, has reorganized the Division into four investigation and litigation teams. The teams are designed to make maximum use of the Division's resources and intensify its investigative and prosecutorial efforts. The Commission also is in the final stages of hiring new attorneys and support staff for the Division with the additional funds made available in fiscal 1996. These structural changes and additional staff are important components of the Commission's program to enhance its enforcement presence.
The Division also is revitalizing its in-house training program for enforcement personnel. To that end, the Division conducted a two and one-half day training seminar in September 1995 for enforcement professional staff from all offices and will continue with additional training programs in fiscal 1996.
In conjunction with these personnel and structural changes, the Commission also is refocusing its enforcement priorities. In addition to seeking to increase the number of investigations and cases, the Commission is concentrating its enforcement resources on matters that will have the greatest deterrent impact against fraud and other wrongdoing in the marketplace. The Division is reexamining every aspect of its work, from case selection and internal procedures to strategies and theories of litigation. This reexamination is designed to ensure that the Division's work is as efficient, as effective and as fair as possible. Additional staff will be assigned to significant investigations in order to complete them more quickly or expand them where appropriate. New staff also will provide flexibility for responding to urgent matters -- for example, when the Commission must act rapidly against an individual or firm to prevent the loss of customer funds -- without disrupting other ongoing work. By focusing on a variety of measures of effectiveness, the Commission expects to enhance both the efficiency and the deterrent value of its enforcement program.
The Commission's other top priority for fiscal 1996 is to modernize its market surveillance computer system. Since its inception in 1974, the Commission has collected daily reports on the activities of large futures traders so that it can effectively monitor markets during periods of price volatility and enforce the anti-manipulation prohibition, speculative position limits, and other provisions of the Commodity Exchange Act. In 1984, the Commission initiated a process to more fully automate its surveillance system, including its large trader reports for futures. However, because the volume of options trading at that time was so low, the Commission required reports on the activities of large options traders only once a week, and that information only reflected traders' positions on one day.
For a number of reasons, the Commission has determined that its surveillance system must be upgraded and modernized. First, as I have noted, markets have grown rapidly. Since 1984, futures trading volume has increased from 149 million contracts to 409 million contracts. Even more dramatically, options trading volume has increased ten-fold, from 9 million contracts to 95 million contracts in fiscal 1995. Thus, as options volume has grown, our overall surveillance picture has become less complete; today, nearly 20 percent of total contract volume is not reflected in our daily reports. This incomplete picture is no longer acceptable.
Second, our current computer system has nearly reached its capacity for handling the growth in futures-related data alone and clearly lacks the capacity to handle both futures and options data. Thus, the CFTC has been contemplating a new system simply to keep pace with futures data. Computer systems currently available can accommodate options data in a much more cost effective way, making fiscal 1996 a sensible year to begin the process for adding options data.
Finally, the failure of Barings PLC underscored the value of a comprehensive, up-to-date large trader reporting system. As I will discuss in more detail below, the Barings crisis was triggered by a trader who accumulated large losses in overseas futures and options markets. One of the CFTC's first actions in responding to the crisis was to check our large trader reporting system to see whether the firm or any affiliated entities held significant futures positions in U.S. markets. Fortunately, they did not. Nonetheless, in drawing lessons from the Barings experience, we determined that it is crucial to add daily large trader reports for options so that our surveillance picture will be more complete in the future and we will be better prepared to address a Barings-type situation in U.S. markets.
For these reasons, the Commission has underway an upgrade of its surveillance system that will involve redesigning software and programming major portions of the system to incorporate both futures and options data and analytical tools for comprehensive market surveillance. The CFTC has committed to the full cost of this project in its fiscal 1996 budget. By the end of the fiscal year we expect to begin collecting preliminary data for the system. The new system will begin operating in fiscal 1998.
In addition to its enforcement and market surveillance functions, the CFTC's mandate also requires it to oversee the activities of futures and options exchanges, the National Futures Association (an industry self-regulatory organization), and market professionals. These oversight activities are designed to protect customer funds, prevent trading and sales practice abuses, and ensure the financial integrity of regulated firms. Ongoing oversight activities include financial and sales practice audits; rule enforcement reviews; trade practice investigations; reviewing margin, clearance and settlement rules; and ensuring that firms carrying customer funds are adequately capitalized and have properly segregated customer funds from firm funds.
The Commission and its staff have devoted considerable time to ensuring compliance with the enhanced audit trail standard that became effective in October 1995 for higher volume exchanges. The enhanced audit trail standard, which was mandated by the Futures Trading Practices Act of 1992, requires these exchanges to demonstrate that their trade records are unalterable, continuous, independently timed, and properly sequenced to the extent practicable, or to make a good faith effort toward meeting the standard. In late 1994 and early 1995, the Commission tested each exchange's audit trail system. At the request of the exchanges, the Commission thereafter provided recommendations for system improvements. Each exchange was informed that adoption of the recommendations would place the exchange within a "safe harbor" for good faith compliance with the enhanced standard. Two of the four exchanges tested adopted all of our recommendations and the Commission has determined that they currently are in good faith compliance with the October 1995 standard. The other two exchanges adopted many, but not all, of the Commission's recommendations. Therefore, these exchanges will be retested shortly to determine whether the improvements made will enable their audit trail systems to meet the October 1995 performance standard.
In addition, the Commission has been actively involved in reviewing the development of various automated trading and audit trail systems, including a Chicago Mercantile Exchange and Chicago Board of Trade joint project to develop AUDIT, an automated hand-held trading card system, and other projects to create electronic order routing systems.
Designation of New Contracts
The Commission also reviews proposed futures and option contracts to ensure that they are not susceptible to manipulation and meet all the requirements of the Commodity Exchange Act. In fiscal 1995, the Commission approved 38 new futures and option contracts, generally within 90 days. In fiscal 1996, the number of new contracts submitted to the Commission has skyrocketed. In the last five months alone, the CFTC has approved almost 50 new futures and option contracts.
In fiscal 1995, the Commission has approved several innovative futures contracts that are designed to benefit many sectors of the economy. For example, the Commission approved area yield futures contracts, which provide a vehicle for crop insurance companies and other cash market participants to hedge financial risks related to yield fluctuations of major U.S. crops. The Commission also approved two electricity futures contracts, the first contracts ever designated for this commodity. These contracts are designed to meet the specialized hedging needs of firms in the electrical energy industry, including utilities that are becoming more actively involved in cash market transactions as a result of ongoing deregulation.
In the financial arena, the Commission approved futures contracts designed to meet the hedging needs of institutions exposed to risk arising from changes in the yield differentials among long-, medium-, and short-term debt obligations. In addition, the Commission approved contracts based on the debt and equities of emerging markets in Latin America. These contracts give international portfolio managers and other institutional investors a means of hedging portfolios containing sovereign debt of emerging nations. The Commission also approved cross-rate currency contracts designed to deal with the hedging needs of institutions having exposure to foreign currency exchange rate risks not involving the U.S. dollar.
Oversight of Margins on Stock Index Futures
In March 1993, the Federal Reserve Board (FRB) delegated to the Commission the authority to review margin levels for stock index futures and options. During fiscal 1995, Commission staff monitored and reviewed nearly 150 changes to margin levels for stock index futures and option contracts and prepared an annual report to the FRB on the Commission's exercise of this delegated authority. The Commission also continues to conduct briefings for other federal financial regulators and shares information with the SEC and bank regulators on a monthly basis.
The Commission's activities related to the international marketplace have continued to increase with the rapid growth of foreign futures and option markets and the globalization of financial services activities. Derivative products are now traded around the clock and around the globe, in more than twenty foreign jurisdictions, including at least six major markets and many emerging markets. At the same time, technological advances have increased the connections among markets and the rapidity with which market events can be transmitted from one market to another. U.S. markets are forging trading linkages with their foreign counterparts, futures commission merchants under our oversight are becoming increasingly multinational, and large customers have world-wide operations.
To assure adequate customer and market safeguards in this increasingly global environment, the Commission must keep abreast of developments around the world and create and implement a variety of coordination mechanisms with foreign regulators. These include information-sharing, joint enforcement activities, mutual recognition agreements and financial surveillance. The Barings crisis illustrated the importance of these international cooperative efforts.
The Commission played a major role in protecting the interests of U.S. customers and firms that were placed in jeopardy by the financial collapse of Barings PLC, a British merchant bank with world-wide affiliates and operations. The collapse, which came to a head in February and March 1995, was caused by a total failure of internal controls that allowed one of the firm's traders to accumulate huge losses in futures and option markets in Singapore and Japan. The CFTC was particularly concerned about the potential impact of the failure on U.S. markets and U.S. firms doing business with the Barings enterprise. Although Barings had minimal direct involvement in U.S. markets, a number of U.S. firms were active in the markets that came under stress due to Barings' losses. CFTC officials and staff were in frequent contact with U.S. and foreign regulators, exchanges and firms through "command centers" that operated around the clock. Among other things, we worked to ensure that margin funds provided by U.S. firms to foreign markets would not be used to cover Barings' losses and to devise systems to permit the transfer of U.S. customer or firm positions at foreign exchanges that had no rules for such transfers. The Barings failure demonstrated the importance of mechanisms to contain risk, provisions to ensure the viability of clearing arrangements during periods of extreme stress, and formal and informal lines of communication among regulators and exchanges around the world.
In the wake of the Barings crisis, the CFTC and the United Kingdom's Securities and Investments Board jointly hosted a meeting in Windsor, England in May 1995, to address international regulatory issues. At the conclusion of the meeting, regulators from 16 countries issued a statement, known as the Windsor Declaration, outlining steps to be taken to strengthen the arrangements for supervising international futures markets. The recommendations set forth in the Declaration address: cooperation among market authorities; protection of customer positions, funds, and assets; default protections; and regulatory cooperation in emergencies. The Windsor Declaration begins a process that should diminish the adverse effects of a market crisis caused by the failure of a single participant and improve the ability of international financial markets to weather such a crisis.
The CFTC is taking steps domestically and internationally to implement the recommendations set forth in the Windsor Declaration. In furtherance of the recommendations, the CFTC organized an industry-wide "stress test" of the existing individual and cooperative systems for responding to a market disruption. The Commission also updated the CFTC Market Disruption Contingency Plan, which outlines procedures for the Commission to follow in the event of extreme market volatility, financial emergency, or physical disruption. Other CFTC- supported initiatives include developing large exposure information sharing agreements among regulators, developing generally accepted risk principles that will assist financial institutions in improving risk management procedures and internal controls, and creating a plan to provide further guidance and dialogue with financial services firms on risk management, account supervision, and operational and financial controls.
Other International Activities
The Commission's efforts to strengthen its bilateral relationships with foreign regulators are also continuing full speed ahead. In fiscal 1995, the Commission signed memoranda of understanding for cooperation and information sharing in enforcement matters with Australian, Mexican, Italian, and Argentinean regulatory authorities. In addition, we continued to exchange information and cooperate in enforcement matters with foreign regulatory, law enforcement and self-regulatory authorities in many countries.
The CFTC also helps emerging markets establish a firm regulatory foundation. Such assistance includes training regulators, commenting on proposed futures-related legislation and regulations, and assisting with the development of computer trading and surveillance programs.
REGULATORY COORDINATION AND REFORM
Regulatory coordination and reform remain an important part of the CFTC's agenda. The CFTC is a member, along with the Treasury Department, the Securities and Exchange Commission, and the Federal Reserve Board, of the President's Working Group on Financial Markets. The Working Group meets regularly to coordinate regulatory policy. In the last year, the Working Group has addressed the consequences of Barings and the Windsor initiatives, bankruptcy law changes to assure appropriate treatment of over-the-counter products, and many other issues of common concern.
In addition, we are working with other regulators and self- regulatory organizations on an ongoing basis to eliminate duplicative requirements and harmonize rules. For example, in fiscal 1996, the CFTC led a successful effort to eliminate duplicative audit activity by futures and securities regulators and self-regulators.
The Commission also believes that promoting voluntary efforts to improve overall supervision of the marketplace and foster effective self-regulation can reduce regulatory costs and the need for legislative mandates. To that end, the Commission continues to work with the SEC and the Derivatives Policy Group, which represents the six largest over-the-counter derivative dealers, on a voluntary oversight initiative aimed at coordinating financial reporting and risk assessment activities.
Furthermore, the Commission has promoted an ongoing dialogue with industry by holding public roundtables to discuss regulatory reform initiatives. Recent roundtables have addressed the disclosure framework for managed funds, risk-based net capital rules, and agricultural trade options. A roundtable on internal controls is planned for the near future.
These roundtable discussions have been more than just talk. They were followed by concrete action. After the roundtable on managed funds disclosure requirements, for example, the Commission issued final rules completely revamping the disclosure framework. We eliminated boilerplate and other information of limited value and reorganized important information into a shorter, clearer presentation that will be easier for industry participants to prepare and for investors to comprehend. Following the roundtable on net capital rules, the CFTC issued a proposal to harmonize its net capital rules with those of the SEC and industry self-regulatory organizations and is collecting the information needed to consider further changes.
The Commission also has demonstrated flexibility and concern for competitive issues in its regulatory program. For example, in response to petitions from the Chicago exchanges, the Commission has established a pilot program that will allow U.S. futures exchanges to create markets for sophisticated traders that will be exempt from many of the requirements of the Commodity Exchange Act. These less regulated markets will allow U.S. exchanges to compete more effectively with over-the-counter derivative markets and foreign exchange-traded instruments.
Finally, the Commission is actively working to address market participants' interest in using new technologies to increase their efficiency and competitiveness. These efforts include: consulting with industry representatives concerning current and prospective uses of the Internet for communicating with the public and with other futures professionals; creating a program for monitoring solicitation activity on the Internet; developing mechanisms for electronic filing of reports and other documents with the Commission; and developing other ways to facilitate innovative uses of computer technology in a manner consistent with customer protection.
The Commission is also expanding its own use of technology to enhance its communication with the public. The Commission has established a "home page" on the Internet and plans to expand this site to make additional information more widely available to the public.
The CFTC is committed to building on the achievements of the last several years to fulfill its congressional mandate and keep pace with a more complex, dynamic marketplace. To accomplish this goal and make essential improvements to our enforcement and surveillance programs, the Commission must have a modest increase in its fiscal 1997 appropriation. This increase will enable the Commission to heighten its surveillance in major market centers and ensure that its surveillance system upgrade stays on schedule. Additional funding also will enable the Commission's enforcement program to respond more quickly to fraud and other wrongdoing in the marketplace, provide a greater level of customer protection and better promote market integrity. Under these circumstances, the President's budget request is fully justified.