Remarks of Commissioner Thomas J. Erickson
National Grain Trade Council
Thursday, February 10, 2000
Good morning. It is good to be back among friends here at the Council. I had thought about opening by saying, "I’m from the government, and I’m here to help." Knowing that few of you would take comfort in such a statement, let me try a variation on that theme: I’m from the government, and I need your help.
As you know, these are interesting and challenging times both at the Commission and in the industry at large. Over the past decade, derivatives markets have been invigorated by innovation. Factors like new technologies and the ever increasing globalization of the markets have changed the way the industry works and, indeed, the way we all think about the industry. Under the leadership of our new Chairman, William Rainer, the Commission has committed itself to moving from a frontline regulator to an oversight role. In the midst of all this, the Commission is currently engaged in what seems to be a perpetual reauthorization process – working with our congressional overseers to shape a CFTC that fulfills its mission to the public while at the same time allowing the type of innovation on which the industry thrives.
What I would like to do this morning is provide some context and, I hope, some perspective on all this change. First, I would like to outline a few of the initiatives the Commission has undertaken over the past several months in response to this changing world. I would then like to share some of my views on where the Commission and industry are headed and identify some of the challenges we are going to have to face together. For your part, I would like to encourage you to help me out by providing me with feedback about these issues – both here, today, and over the course of the coming months.
Let me begin by briefly describing some of what has been keeping us so busy since I arrived at the Commission last June. While some of the issues I will talk about may not seem to affect you directly, I think they do reflect the pace of change, the kind of creative thinking necessary to deal with this change, and the willingness of the Commission to work with the industry to develop workable solutions to difficult problems. I would also add that in the midst of all this change, it will be crucial for all who are interested in the Commission and the industry to take an active role in these processes or face the very real prospect of having decisions made for you by those who may not know your business.
Agricultural Trade Options
As you all undoubtedly know, in April of 1998, the Commission announced the creation of a three-year pilot program to permit the offer and sale of trade options on certain agricultural commodities. Trade options are off-exchange options offered to a commercial producer or user of the commodity; trade options on many agricultural commodities have not been permitted for over sixty years. The pilot program permitted qualified parties to engage in the trading of off-exchange trade options and was intended to respond to the increasing need for risk management tools among those in the agricultural community.
Needless to say, the program received a less than enthusiastic reception from the industry. However, the Commission continued to work with representatives from all corners of the agricultural community and eventually amended the rules to make them simpler and more flexible by, for example, permitting cash settlement and streamlining disclosure and registration requirements. The amended rules have just become final. I understand from conversations with several of you that the new program will be used and that a number of companies are in the process of completing applications to become trade option merchants.
I am hopeful that there will be sufficient participation to provide a strong regulatory justification for the introduction of these risk management tools to farmers.
Regulatory Relief for Domestic Futures Exchanges
In June of last year, the Commission received a petition signed by the Chicago Mercantile Exchange (CME), the New York Mercantile Exchange (NYMEX) and the Chicago Board of Trade (CBOT) requesting regulatory relief from certain statutory requirements for boards of trade designated by the Commission as contract markets. The exchanges asked for significant relief from various regulatory requirements in three parts. To date, the Commission has responded through two initiatives.
The petition first requested relief from the contract market designation process for new contract submissions. The exchanges have for years argued that the CFTC’s review of new contracts was at best redundant and at worst a substitution of the government’s judgment for what was rightly a business decision. In more recent years, the exchanges have added a new wrinkle, that the ability to list new contracts for trading without delay is vital to the exchanges’ competitiveness. On the other hand, the requirement that exchanges meet specified conditions in order to be designated as contract markets has been a part of the statute since 1974, when Congress amended the Act to provide for meaningful government review of all new futures contracts before trading could begin and of proposed amendments to the terms or conditions of existing contracts.
Attempting to balance these competing interests, in July of last year the Commission published a proposed rule regarding the procedures for contract designation. In January of this year, a final rule went into effect. Generally, the new rule permits the exchanges to list futures or option contracts for trading without prior Commission approval of the contract or its terms and conditions, including any subsequent amendments to those contracts. The exchanges are required to certify that the contract listed for trading meets the requirements of the Commodity Exchange Act (Act) and the Commission’s rules and to indicate that it is trading subject to this "self-certification." I would also note that this new listing procedure is an alternative to regular and fast-track procedures for contract market designation.
A second area in which the exchanges have requested relief is in the contract market rule review process. The exchanges proposed that domestic contract markets be required to provide only notice of new rules or rule amendments to the Commission ten days in advance of their effective date. In November of 1999, the Commission published a proposed rule that – like the contract designation rule – would permit exchanges to implement rule changes and amendments without prior approval provided the exchange certifies to the Commission that the rule changes are consistent with the requirements of the Act and regulations.
At the request of several agriculture organizations, the comment period for this proposed rule was extended to February 24, 2000, and, since the proposal remains pending and under Commission consideration, I really cannot say a great deal more about it at the moment.
I mentioned that the exchanges’ petition requested relief in three areas: with the third request, the exchanges asked, essentially, for the ability to immediately implement trading rules and procedures comparable to those of a foreign exchange with electronic terminals in the US, provided that the changed rules and procedures apply only to contracts that compete directly with comparable contracts on the foreign exchange.
The Commission has not yet taken any action on this part of the exchanges’ proposal, and I, for one, would have serious reservations about implementing such a change. The currently pending proposed rule I just discussed would permit exchanges to implement rule changes without prior approval provided the exchange certifies to the Commission that the rule changes are consistent with the requirements of the Act and regulations. Given that the scope of the Commission’s proposed rule is arguably broader than what the exchanges requested, I would not be comfortable permitting the exchanges to implement rule changes that mimic the rules of foreign exchanges but are otherwise illegal or inconsistent with the Act and regulations without guidance from Congress. In any event, with the rule change proposal that is currently pending, and any that might come along, it is my hope that the industry and Commission can work together to formulate rules with which we can all live.
Each of the three largest domestic futures exchanges within the last couple of months has announced a plan for "demutualization" – in other words converting from their traditional not-for-profit, membership structure to for-profit, stock corporations. The exchanges believe that by converting to a for-profit structure, they will be able to more rapidly develop and implement business strategies and respond to competition.
Each exchange’s plan has its unique facets, but generally, the plans provide for an exchange of membership interests for shares of stock in the new entity. Both the Chicago Mercantile Exchange and the New York Mercantile Exchange have proposed plans that would convert seats on the exchange to private shares of stock with an attached right to trade on the market. The Chicago Board of Trade’s plan proposes splitting the exchange into two, separate corporate entities, one providing the opportunity for open outcry trading, and the other providing a platform for electronic trading. Both new companies would be for-profit, and current members would have ownership interests in each.
The exchanges have come quickly and recently to the notion of demutualization. To date, none of the plans has come to a membership vote. However, in the cases of the CME and CBOT, votes are expected as soon as March of this year.
Under the direction of and in coordination with the efforts of Chairman Rainer, my office has undertaken an initial review of potential issues raised by conversion of our traditional exchange markets into for-profit – possibly publicly-held – corporations. Through this process, we have directed an internal review of the Act and regulations, and met with various interested parties to this fascinating transition. The primary objective for me has been to work with the industry to make certain that these structural changes do not become disruptive to the market or create unnecessary regulatory snarls. This is one of those changes that could come quickly and have profound effects on the broader market, and I am anxious to see how the industry responds.
We at the Commission were pleased to find that when the clocks rolled over into a new year, neither the industry nor the Commission experienced any significant Y2K problems. However, I am afraid there still may be one Y2K bug lurking out there – it is called "reauthorization."
Periodically, through the reauthorization process, the US Congress evaluates the work of the Commission and examines the Act in order to evaluate the effectiveness of the agency and to make necessary changes to the Act. The process has already begun: representatives from both the Commission and the industry have provided staff of the House and Senate Agriculture Committees with several days of briefings regarding the issues of the day.
Additionally, the Senate Committee on Agriculture this morning held its first hearing addressing the recommendations of the President’s Working Group on Financial Markets (PWG) for the regulation of derivatives. This morning, the principals of the PWG are advocating adoption of the recommendations – suggestions that, in the name of "legal certainty," would, in my opinion, be the beginning of the end of functional or market regulation in the United States. In my opinion, the recommendations of the PWG Report, if followed, potentially would further fragment regulation and leave gaps in the regulatory framework. I also tend to agree with the exchanges’ view that it could force our domestic exchanges to reconsider their designation with the CFTC.
I will say, however, that despite my reservations about its conclusions, the PWG Report makes an honest attempt to address one of the most vexing issues we face. In order to be successful, any resolution of the Commission’s reauthorization will have to achieve legal certainty, particularly in the area of OTC derivatives. For me, this means clearly defining the OTC derivatives market, stating the degree of regulation – if any – to be imposed on the various parts of the market, and clarifying the role of the various federal financial regulators in promulgating and/or enforcing any regulatory regime in the OTC market.
Do not misunderstand me, I am not an advocate for more or more onerous regulation. And I do not insist that the Commission have jurisdiction in all cases. I am concerned, however, that by drawing artificial jurisdictional lines around certain types of transactions, the PWG Report recommendations would create regulatory gaps – areas of commerce, possibly involving retail customers, where no regulator has jurisdiction. Also, and more broadly, I believe that to the extent Congress believes there is value in the functional regulation of derivatives, the federal government generally is better served by having a single regulator for transactions in instruments that are functionally identical. In this way, industry participants are ensured level playing fields and the "legal certainty" of consistent treatment.
I should also mention the work of the Commission in this regard. As I am sure Bob Petersen has reported to you, Chairman Rainer has organized an internal taskforce charged with taking a hard look at the Commission’s current regulatory framework in order to see how we might adjust it to meet the needs of today’s markets. The taskforce has worked with various industry participants, and I believe that the process of examining these regulations has been and will be of tremendous benefit to the Commission and the industry. It is difficult to say where the taskforce’s work might lead us, and we may not all necessarily agree with the end result, but I would once more emphasize that it is imperative for you all to participate in the process to the fullest extent possible.
The Promise of Technology in the New World
I have told you a lot about what is going on and what I think about it all, so it is probably fair of you to ask where I think things are headed. And my best, lawyerly answer is that it depends. I do have faith in the industry’s ability to devise instruments we have not yet imagined and vehicles for trading we cannot yet visualize. The common thread, I think, is that technology will continue to be the driving force for market innovation.
I noticed that the next speaker on today’s program is David Downey of Interactive Brokers. I admit, I am a bit reluctant to speak on topics so clearly within the expertise of the next speaker. Nevertheless, I thought I would go out on a bit of a limb and talk about technology and some potential regulatory implications. It is easy to do a superficial analysis of electronic trading and come to the conclusion that the US markets have been slow to adopt new technology, and that many of their more nimble foreign counterparts are currently enjoying the competitive and economic advantages of electronic platforms. While there may be a grain of truth to this, I think a more careful analysis indicates the extent to which electronic trading is making inroads in US markets and the promise new technology holds for these markets.
There are, today, several electronic trading platforms in use domestically, and the Commission is currently considering applications for two new electronic exchanges, one of which would be Internet-based. I think these facts reflect the possibilities of new opportunities for both existing and future exchanges. Given these possibilities, there are several questions that we will all want to consider. For example:
In the end, I view all the changes we are facing, both on a regulatory level and in the industry in general, as challenges embedded with tremendous potential. It is the industry’s job to harness new technologies, to embrace innovation, and to move forward. As regulators, our job is to ensure that our regulatory framework preserves the public interest in open, fair, and honest markets and to see to it that we do not create obstacles to innovation.
Fortunately, we have a touchstone: it is our statutory mission to protect market users and the public from fraud, manipulation, and abusive trade practices and to foster open, competitive, and financially sound futures and option markets. As a functional regulator we look to the nature and the purpose of a transaction in order to determine the nature of our regulatory interest. Accordingly, whatever new contracts or trading platforms may be devised, we can, and are attempting to, formulate an approach that encourages innovation and maintains standards that will continue to instill confidence in our markets.
Thanks again for inviting me and for your kind attention. I will be happy to answer any questions you might have at this point.