TALKING POINTS FOR COMMISSIONER TULL
FUTURES & OPTIONS MARKET REGULATORS MEETING
SEPTEMBER 5, 1996
Good morning, I would like to welcome all of you to this important meeting of international financial regulators. I realize that many of you, not least myself, have travelled from considerable distances to be here today, and I am certain that you will find this meeting to be a rewarding investment of your time.
As you know, Sumitomo has served as a catalyst for regulators to focus attention on special surveillance concerns of physical delivery markets. Market surveillance makes it possible to spot adverse situations in futures markets and to pursue appropriate remedial actions, in coordination with the involved exchange, to avoid disruption of these markets.
In these brief introductory remarks, I will discuss the U.S. approach to market surveillance of the futures and options markets. It is a model which has served us well in maintaining competitive markets, orderly trading, and equitable treatment for all who use the markets, and other regulators may wish to consider what aspects of our system may be appropriate in their own jurisdictions.
U.S. Surveillance System
The emphasis on active surveillance to detect and prevent price manipulation -- as opposed to relying upon after-the-fact prosecution to serve as the deterrent -- stems from the recognition that futures markets play an important role in discovering the price of a commodity, and they allow a producer or user of that commodity to hedge the price risks of commodity ownership. The U.S. Congress early recognized that futures markets are susceptible to price manipulation that would undermine the economic functions of futures markets. The fears of the U.S. agricultural commodity producers that market speculators could somehow reduce the value of their crop no doubt also had a role in creating the U.S. regulatory scheme.
While market surveillance is required to be performed by U.S. exchanges, subject to oversight by the CFTC, the Commission has determined to devote substantial resources to operating its own direct market surveillance program. In large part, this decision was made to assure that the Commission could better keep abreast of potential problems and significant market developments so that preventative actions could be taken to minimize the likelihood that a minor problem could become a market crisis, and to ensure that prompt remedial action could be taken when necessary.
To accomplish these objectives, a market surveillance program must determine when a trader's position in a futures market becomes so large relative to other factors that it is capable of causing prices to no longer accurately reflect legitimate supply and demand conditions. A surveillance program needs to collect, analyze and compare daily data concerning overall supply and demand conditions in the cash market, cash and futures prices and price relationships, and the size of hedgers' and speculators' positions in the futures markets.
CFTC staff prepares weekly surveillance summary reports for each futures and option contract that is approaching its critical expiration period. Potential problems are reviewed immediately by the surveillance staff, and are discussed with the Commissioners and senior staff at weekly surveillance briefings.
When the potential exists for market disruption or manipulation, CFTC staff contacts the brokers or traders who are significant participants in the market in question. These contacts may be for the purpose of asking questions, confirming reported positions, alerting the brokers or traders as to the CFTC's concern, or warning them to conduct their trading responsibly. We have found this "jawboning" technique quite effective in resolving many potential problems at an early stage.
It is important to note that the process of market surveillance is not conducted exclusively at the CFTC. As part of their requirements for designation as a central market, exchanges are required to maintain an effective market surveillance system. If a problem develops, it is usually handled jointly by the CFTC and the affected exchange. Relevant surveillance information is shared and, when appropriate, corrective actions are coordinated. The Commission customarily gives the exchange the first opportunity to resolve the problem itself, either informally or through emergency action. While the CFTC has the authority to order an exchange to take actions where the exchange has failed to act appropriately, most issues are resolved without the need for the CFTC to use such emergency powers.
At the heart of the CFTC's market surveillance system is its large-trader reporting system. In order to identify potentially disruptive futures positions, the CFTC staff uses its reporting system to collect and analyze data on large trader positions in all commodities. Each day, staff economists examine computer listings of large trader positions in actively traded markets, to identify positions that could pose the threat of manipulation.
Since traders frequently carry futures positions through more than one FCM, and since individuals sometimes control or have a financial interest in more than one account, the CFTC routinely collects information that enables its surveillance staff to aggregate related accounts. FCMs must file form 102s, which identify each new account with what we term a "reportable" position -- that is, a position sufficiently large to exceed predetermined thresholds at which traders must report that position to the CFTC. In addition, once a position reaches a reportable level, the trader is required to file a more detailed identification report, a form 40, to further identify accounts and reveal any relationships that may exist with accounts or traders.
Another element of the market surveillance program is the monitoring of compliance with CFTC or exchange speculative limit rules. These rules help prevent speculators from accumulating concentrations of contracts of a size sufficient to possibly disrupt a market. To monitor these limits, the market surveillance staff reviews daily large trader reports for potential violations. Although bona fide hedgers are exempt from speculative limits, to monitor that exemption in futures markets with federal position limits the CFTC requires commercial traders with futures positions in excess of speculative position limits to submit a monthly statement of cash positions. These statements show the total cash position of each trader, which reflects the amount of the trader's actual physical ownership of each commodity and the amount of the trader's fixed-price purchase and sales for which the trader has a legitimate cash risk.
Three Examples Demonstrating the Utility of the CFTC's Large Trader Reporting System
We believe that events such as the 1987 market break, as well as more recent market disruptions such as Barings and Sumitomo, each of which put our surveillance programs to the test, have shown the usefulness of our approach.
1987 Market Break -- Going back nearly a decade, we relied heavily on our large trader reporting system following the 1987 market break. The October 19, 1987 market break immediately triggered special CFTC market surveillance briefings and intensified surveillance efforts.
The CFTC scheduled a special briefing for Monday, October 19th, at which staff of the United States Securities and Exchange Commission was invited to attend. At the October 19th briefing, the Commission reviewed the largest futures positions and position changes in the CME's S&P futures contract. Following the briefing, CFTC surveillance staff monitored the stock-index futures markets and exchange actions intensively and provided the Commission with continuing updates concerning ongoing developments. Special tabulations of large-trader position data were compiled to monitor the magnitude and direction of institutional trading activity on stock index futures markets.
By the afternoon of Tuesday, October 20th, the Commission's surveillance staff had received for all stock index futures and option contracts the gross positions and changes in those positions of all clearing members, as well as the positions of all reportable traders, for Monday, October 19th.
Based on this surveillance data, the CFTC worked with the exchanges to take prompt action with respect to various stock index futures contracts, including temporary trading halts, daily price limits, and increases in applicable margin requirements. Moreover, following the market break, the CFTC undertook a thorough study of the events of October 1987, and the large trader data was the main source of information which the staff utilized to reconstruct what happened that month.
Barings -- More recently, during the Barings crisis, on Saturday, February 25, 1995, we immediately assembled a small swat team of CFTC staff which began the process of determining what U.S. interests were at risk in the event Barings declared bankruptcy or defaulted on its large positions in the Nikkei, Euroyen or Japanese government bond futures contract. Using our large trader reporting system, we quickly learned that Barings had only a small number of reportable positions on any U.S. market. Thus, we quickly eliminated any concerns we might otherwise have had that U.S. contract markets were at risk because of the Barings failure. We were therefore able to concentrate our efforts in protecting the funds and assets of U.S. customers trading on foreign markets through Barings affiliates.
Sumitomo -- The CFTC became concerned about activity in the copper market last Fall as a result of the size of the price backwardation that was developing on the London Metal Exchange and that was being arbitraged into the Comex market. Recently established LME copper warehouses in the U.S. had become a magnet attracting U.S. copper stocks both directly from U.S. producers and also out of Comex copper warehouses. Activity in the London copper market, allegedly related to an attempted market squeeze by Sumitomo Corp., had the potential to have spillover market and financial exposure effects on U.S. markets.
These events serve as an instructive example of the international scope of modern commodity market regulation. No one regulatory jurisdiction will have access to all relevant information. The CFTC and the SIB, therefore, jointly sought to assess the true and full nature of the copper price backwardation, i.e., whether it was a response to tight market fundamentals or whether it was a result of a market dominant position. The CFTC's large trader reporting system made it possible to quickly confirm that Sumitomo did not have large positions on any U.S. market. Moreover, even before the June 13th announcement by Sumitomo that it had incurred large losses on its copper positions on U.S. markets, the CFTC knew, through its large trader reporting system, which U.S. firms had large positions in the copper market. Following the June 13th announcement, the CFTC drew from its large trader reports the 20 largest exposures in the U.S. copper market and stressed those positions to determine potential losses on the COMEX. Thus, the CFTC was able to almost instantly assess the exposure of the largest U.S. FCMs and customers with exposures on the U.S. copper market.
In addition, for the first time, we were able to invoke the large exposure information sharing agreement developed after Barings and signed at Boca Raton earlier this year. In our view, this amply demonstrates the utility of including a regulatory gateway for sharing of information, along with the exchange-to- exchange agreement which was also signed in Boca.
By Monday, we had the names of who were the firms with the largest copper exposures and by Tuesday we had actual position data. We also obtained information on who was moving copper position from the Long Beach warehouse.
These events highlight the truly international nature of markets and firms that we as regulators are responsible for supervising. More importantly, it highlights the dire need for close cooperation among international regulators. No single regulator has all of the information or all of the legal and regulatory powers to comprehensively ensure the integrity of global markets.
Post-Sumitomo Cooperation by International Regulators
I am proud of the cooperative efforts undertaken by the CFTC and the U.K.'s Securities and Investments Board following news of Sumitomo's losses. This effort, which has been ongoing since 1995, has yet again reminded us of the vital need for close cooperation and information-sharing among international regulators and market participants, and we are very pleased by the cooperative efforts that have taken place between the U.S. and the U.K.
One area of future cooperation that perhaps needs to be considered arises with respect to the large number of jurisdictions which are developing new products, as it may be necessary to develop a dialogue concerning the essential elements of supervision of these markets on an international basis. I am delighted that the subject matter of today's meeting provides a possible starting point for such discussions, which can then be discussed further by specialized groups working under the auspices of IOSCO.
We note in this regard the outstanding work which IOSCO has already undertaken with respect to cash-settled futures products, where that organization developed a consensus among regulators with respect to criteria which should be followed concerning the designation of stock index futures contracts. In light of Sumitomo, we could encourage the commencement of similar work that regulators and exchanges should take into account with respect to the design of physical delivery contracts. Such standards would help ensure that proposed terms and conditions do not have deficiencies that could increase the likelihood of cash, futures, or option market disruptions and undermine the usefulness and efficiency of a market.
To this end, in the United States we are working on an "action plan" to further enhance U.S. market surveillance measures and to minimize global systemic risk. In July of this year, I sent a letter to the heads of all U.S. exchanges and clearing organizations in which I solicited the views on the unique characteristics of physical delivery markets and requested their suggestions on improvements which we could make to the current market surveillance regime.
Further, we are working with the SIB as that agency conducts its review of the LME. In this regard, we have contributed information comparing the regulation of U.S. markets and how the trading on and clearance and settlement of our markets compares to that of the LME.
Finally, we are also conducting bilateral discussions with the SIB with respect to expanding our already strong information sharing arrangements. As a result of these discussions, the CFTC has agreed to draft a concept document on guidelines which would identify, by category of market event, the types of information which may be necessary or useful in addressing the particular market or firm situation. These guidelines are intended to serve two functions: first, it will assist the requesting party in making more precise the nature and scope of information it is requesting; second, it will provide notice to the requested authority of the types of information it can expect to provide in response to particular market events, thereby avoiding misunderstandings. The CFTC is contemplating tabling this protocol for further international consideration at the next meeting of the IOSCO Technical Committee in September in Montreal.
[need to determine if it is premature to discuss followingat this time]
[The CFTC has proposed the possibility of co-sponsoring with the SIB and various elements of the Japanese government a meeting of major market regulators in order to discuss issues relevant to the proper supervision of futures markets with physical delivery contracts.]