COMMISSIONER THOMAS J. ERICKSON
Commodity Futures Trading Commission
Silver Users Association
October 18, 2000
I was pleased to accept Walter Frankland’s invitation to speak with members of the Silver Users Association. This is an exciting time for the CFTC, both because of the new directions the derivatives markets are taking and the attempts of legislators and regulators to adapt to these evolving trends.
Today I would like to share with you my personal observations on the derivatives markets and their regulation. The good news for you as end-users is unprecedented access to information, intermediaries and, increasingly, the market itself. Derivatives market participants are part of a dynamic market whose financial and technological innovation continues to expand expectations – and test regulatory boundaries. This raises the question: What are your expectations as end-users of federal financial regulators, whose job it is to promote the integrity of markets?
The markets are wired, global, and restless. Exchanges are reaching beyond traditional trading floors and across national boundaries. The traditional derivatives marketplace, the open-outcry, member-owned futures exchange, is responding to market demand by developing new technology, new business plans, or both. U.S. exchanges are using electronic trading platforms and finding ways to harness technology for open-outcry trading. The three largest domestic futures exchanges have taken the first steps toward revised business models based upon a demutualized, for-profit corporate structure. Smaller futures exchanges are searching for partnerships that will enable them to trade electronically, and financial intermediaries themselves are contemplating becoming exchanges. Moreover, firms in other, unrelated sectors of the economy are constructing platforms and forming new alliances for business-to-business and business-to-consumer commerce. Once B2B and B2C platforms are in place, such ventures will compete head-to-head with existing exchanges.
As you know, the CFTC and the Congress have spent much of the last year wrestling with the appropriate response to these profound shifts in the marketplace. On the legislative side, both the Senate and the House have taken advantage of the Commission’s reauthorization process to attempt to fix some especially nettlesome problems, most notably the issue of "legal certainty" for over-the-counter derivatives transactions. Closer to home, the CFTC has released its own proposal for a new regulatory approach. The Commission’s proposal attempts to address these changes by balancing discrete private interests with the public interest in open, competitive, and sound markets.
I would like to say that the best thing about this legislation is that it is dead, but it still appears to be drawing breath. Throughout this process and, even now, in the closing days of the 106th Congress, the legislation has been a moving target, with important provisions appearing, disappearing, and reappearing in subsequent drafts. This is probably due, in no small part, to the fact that the House and Senate Agriculture Committees, the House Banking Committee, and the House Commerce Committee all, at various stages, either have taken the lead or have contributed significantly to the drafting. Despite the numerous interests at play, the multiple drafts by the various committees share a common theme: They all envision largely unregulated marketplaces in most derivative products. I think it is important to understand how these bills might work – despite the fact that they probably will not be passed in this session – because I believe they represent the current thinking of many legislators.
Each of the bills essentially defined the CFTC’s jurisdiction with a negative – by telling the agency where it would not have jurisdiction. For example, most derivative products in financial instruments – if traded among sophisticated parties – were excluded from the CFTC’s jurisdiction in the proposed legislation. This was based on the mere assertion that these markets are so big, and so liquid, that they simply are not susceptible to manipulation. Physical commodities, with the exception of a handful of agricultural products, would have been exempted from the Commission’s jurisdiction. These exemptions would have applied to metals markets. As a result, the agency would have had limited abilities to monitor these markets and to address problems when they did occur.
Interestingly, early versions of the legislation did not include metals and energy markets among those exempted from regulation – apparently recognizing both the history of manipulation in these markets and the heightened public interest in their vitality and integrity. Later versions, however, exempted metals and energy from Commission jurisdiction. And the bills did not simply focus on types of products; they also excluded and exempted markets based on types of trading platforms. For example, in one of the last versions of the House bill, electronic exchanges in energy and metal markets were exempted from Commission jurisdiction, leaving even those exchange markets subject only to the anti-fraud and anti-manipulation provisions of the Commodity Exchange Act. In effect, they would have been allowed to operate without oversight by the CFTC or any other federal agency.
More generally, this legislation would have left significant portions of the $100 trillion over-the-counter derivatives market subject to no direct regulation or oversight. In fact, no federal financial regulator or supervisor would have had the legal authority to investigate or bring actions for fraud or manipulation in large portions of the derivatives marketplace.
As many of you know, the CFTC released its own proposal for regulatory reform in June of this year. Final rules have not yet been published, but it seems clear that, absent legislation, the Commission will move to final rules in the near future. In very general terms, the proposed rules would create three tiers of regulation in which the level of regulatory interest is based on the nature of the product traded and the relative sophistication of the market participant.
Recognized Futures Exchanges
Under the new scheme, recognized futures exchanges, or RFEs, would correlate most closely to today’s designated contract markets, or exchanges, and would be subject to the highest level of regulation based on 15 broad "core principles." RFEs would be open to all types of participants and products and would be subject to the most extensive customer protection.
Derivatives Transaction Facilities
Derivatives transaction facilities, or DTFs, would be subject to an intermediate level of regulation based on seven "core principles" and would be designed for products that, in theory, are less susceptible to manipulation. DTFs would operate as primarily institutional or commercial markets, and participation would be limited accordingly. Institutional DTF markets could choose to accept otherwise non-eligible participants, such as individuals, by subscribing to several additional requirements. However, individuals only could access these markets through a registered, sufficiently capitalized intermediary. DTFs would be "recognized" by the Commission as adhering to an acceptable, if greatly reduced, level of regulatory oversight.
Exempt Multilateral Transaction Execution Facilities
The third tier would provide a self-effectuating exemption from regulation for exempt multilateral transaction execution facilities, or exempt MTEFs. Transactions on exempt MTEFs would be limited to those between institutional traders in contracts for commodities that are "highly unlikely to be susceptible" to manipulation. Exempt MTEFs would not be "recognized" by the Commission. In short, this structure would allow the existing swap market to become more standardized and trade as an exchange does, but without regulation.
Silver markets could operate as RFEs and DTFs and, if approved by the Commission through a case-by-case review process, even could operate as exempt MTEFs.
Questions and Conclusion
Obviously, the legislative and regulatory approaches I have talked about above represent some fairly bold departures from the status quo and, accordingly, raise some fairly significant questions. For example, how is liquidity affected when markets are segregated by types of users and/or types of platforms? Has the case been made that some commodities are less susceptible to manipulation than others? What role should federal regulators have in these markets?
As market users, the way the questions are answered may have profound effects on the way you do business. I have read the Silver Users Association’s letter commenting on the Commission’s regulatory proposal, so I know you are both concerned and engaged, and commend you for your interest. And I know that with all the activity that has taken place in Washington, it may seem difficult to keep your eye on the ball. But perhaps I can lend you my perspective.
I think that much "regulatory reform" can be reduced to the following. The risk and responsibility of participating in derivatives markets is being laid squarely on the shoulders of end-users. This will mean that you, as end-users, will have to understand that all markets are not created equal. It will fall to you to evaluate the integrity, merit, and utility of each market in which you choose to participate. Will the market serve your liquidity and price discovery needs? Does the market accurately reflect commercial activity in the underlying commodities? What rights, obligations, and remedies will you have on a particular market? These questions are not new. The range of possible answers, however, is unprecedented.
Thank you for your kind attention. I am happy to answer any questions.