Remarks of William J. Rainer
Commodity Futures Trading Commission
BOCA 2000: 25th Annual International
Futures Industry Conference
Boca Raton, Florida
March 16, 2000
Today I will comment on our progress in bringing to fruition a new regulatory framework for U.S. derivatives markets governed by the Commodity Exchange Act. Any solutions adopted will not be tailored to the desires of any special interest or driven by jurisdictional concerns. We want to find solutions that meet the public interest.
I have mentioned before that there are three public policy goals we should concentrate on: first, creating a comfortable climate for competition in all sectors of the industry; second, removing any regulatory barriers that hamper these markets from exploiting fully innovations in technology; and third, decreasing the level of systemic risk in domestic and international derivatives trading. To achieve these goals, we find it imperative to modernize the way we regulate futures markets.
Late last year, I formed a staff task force to create a new regulatory framework, which would have as its underpinnings our public policy goals. To assist in this effort, the Commission held two public roundtables and one Agriculture Advisory Committee meeting in December. Moreover, to assure that the task force considered an array of perspectives, the staff met frequently with participants in the derivatives markets, who represented a range of industry views.
In response to a request from the leadership of our Congressional oversight committees for a status report on CFTC regulatory reform initiatives, we submitted on February 22, 2000 a staff proposal for regulatory reform. Many of you may be familiar with this proposal.
I want to underscore several points:
The new framework is a work in progress on which there has been no Commission action. Although I believe the framework goes a long way toward resolving difficult regulatory issues posed by changing market conditions, there nonetheless will be plenty of opportunity for comment, debate, and where necessary, alteration. The CFTC will hold at least one public hearing on this framework. The stakes are high and we will air these issues fully.
I also believe it important to emphasize and re-emphasize a point I made in testimony before the Senate Agriculture Committee last month: time is not our ally. In spite of the difficulty of developing answers to questions of regulatory architecture, we must work together expeditiously to reach conclusions suitable for these markets and the public interest. The benefits of technology stand immediately before us: faster and better execution; significantly lower transaction costs; cross-market clearing, netting and offsetting systems; and increased liquidity. The U.S. futures markets must embrace technology without reservation to build stronger markets if they expect to remain competitive.
Before recent advances in electronic trading, futures exchanges were shielded from competition by the prohibitive cost of establishing a physical trading facility. That business model is changing quickly, as Eurex’s capture of the Bund contract from LIFFE attests. Existing, successful contracts face a competitive threat different from historically unsuccessful "me too" attempts, because competitors may build a less expensive, less cumbersome electronic platform.
Competition provides a strong incentive for market participants to perform at the lowest cost and with the highest degree of integrity by giving market users the ability to choose the products and providers that best serve their individual needs. This is true for execution facilities, intermediaries and clearinghouses. Competition imposes a discipline on the markets that reduces the need for regulation. The greater the level of competition in the marketplace, the lower the level of direct regulation required to ensure that key public policy goals are met.
In this newly competitive environment, the CFTC's mandate to serve the public interest means that we both recognize and encourage greater competition and technological innovation. The public interest also demands that we acknowledge the differences among futures contracts and adjust our regulatory burden to a level commensurate with the nature of the product traded and the type of entity trading it.
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Flexibility is the hallmark of the new framework. The plan replaces the concept of a designated contract market with two new kinds of trading facilities: recognized futures exchanges (RFEs) and derivative transaction facilities (DTFs), each of which would be subject to a different level of Commission oversight. The framework also contemplates a category of exempt multilateral trade execution facilities—exempt MTEFs—which would operate on an unregulated basis.
Keep in mind that while the framework invites change, it does not impose it on established futures exchanges. While existing exchanges operating as contract markets may reorganize under the terms of the framework, they are not compelled to do so.
The multi-tiered design takes into account important differences among underlying commodities and the different levels of financial sophistication among traders.
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Of the new trading facilities described in the framework, recognized futures exchanges--RFEs--will be subject to the greatest degree of CFTC oversight. Recognized futures exchanges may list any commodity and offer open access to all trading participants.
Unlike designated contract markets, which operate under a number of detailed, prescriptive rules, recognized futures exchanges will be subject to 15 core principles that can be adapted to the needs and practices of individual market participants. For example, the position monitoring and reporting standard for RFEs requires only that these entities monitor markets "as necessary" to prevent manipulation, price distortion and delivery disruption; and trading systems must "have the appearance of providing, and provide, a competitive, open and efficient market."
Upon adoption of the framework, the RFE model could be used immediately by existing exchanges. Moreover, this regulatory structure inherently removes barriers to entry faced by start-up, electronic trading platforms that may want to attract a broad-based market. Such a platform could seek recognition as an RFE and avoid the process of filing an application under rules designed for a traditional board of trade. The 15 core principles applicable to RFEs nevertheless capture all essential elements of an effective regulatory structure, and meet generally applicable international standards, including requirements for transparency, fair trading standards, financial integrity and customer protection.
An early version of the framework included another tier, known as the "recognized institutional futures exchange," or RIFE, that fell between the RFE and the DTF categories on the regulatory bandwidth. Industry comments led to the conclusion that the RIFE category should be scrapped.
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The second new trading facility proposed in the framework, the recognized DTF, may be of great benefit to both existing exchanges and to startups. The DTF category establishes a facility subject to seven core principles. It represents the Commission’s recognition that not all commodities are alike, and that as a consequence, the nature of the product that underlies a derivative transaction affects the level of regulation that ought to govern that market.
Fewer core principles apply because generally, a DTF may offer (i) contracts only on underlying commodities that have a nearly inexhaustible deliverable supply, (ii) contracts that have no underlying cash market, or (iii) contracts that have been determined on a case-by-case basis to be appropriate for listing on a DTF.
Because these classes of commodities do not raise concerns about market manipulation, it is unnecessary to require them to operate under a restrictive regulatory regime. Thus, DTFs are not subject to core principles governing position monitoring and position limits, among others, that do apply to RFEs. Also, while DTFs may allow access to noninstitutional traders, these facilities are intended primarily for institutional users and may be organized and operated as such. DTFs accordingly are not subject to core principles pertaining to customer protection, dispute resolution, and governance, principles which are applicable to RFEs.
The task force originally suggested that noninstitutional customers should be prohibited from trading on DTFs. After reviewing this idea with industry members, the task force was persuaded that denying such traders access to derivatives transaction facilities was not necessary, because adequate customer protection could be provided by intermediaries. Because such a denial of access was unnecessary, we concluded that it would be unfair, and would deprive certain markets of liquidity and noninstitutional customers of better execution opportunities.
To provide additional flexibility, the framework allows commercial users to establish DTFs for their exclusive use, irrespective of the nature of the commodity involved. The framework contemplates that commercials all will have the capacity to make and take delivery, and thus do not raise issues of market manipulation or disruption in the settlement and delivery process. Electronic DTFs could be established to serve commercial financing and risk management functions in a number of industries.
The framework describes a third class of trading facility, exempt MTEFs, which will not bear the imprimatur of Commission recognition. These will be limited to institutional traders, and to markets with no underlying cash market, or virtually inexhaustible deliverable supplies. Consequently, they will be exempt from all provisions of the Act except prohibitions against fraud and manipulation. In addition, if any instrument now traded on a designated contract market is eligible to be traded on an MTEF, and if the sponsoring exchange decides to establish an MTEF and trade it there, the MTEF would have to continue to provide pricing information to the public. The public interest in price transparency is served, while the instrument is traded in an environment free of unnecessary constraints.
The reforms we are proposing through the framework and other initiatives have generated debate. I have mentioned some of the ways in which the framework has been modified pursuant to industry views. I want to share with you some of the remaining issues raised by our reform efforts.
The first speed bump we have encountered does not involve the framework itself; it concerns one of our earlier regulatory reform measures--the proposed Rule 1.41(z), that would permit futures exchanges to adopt new rules without seeking prior approval from the Commission. That proposed rule has engendered opposition from several agricultural producer groups.
My initial thought was that agricultural markets will benefit from a less restrictive regulatory environment. Nevertheless, for reasons specific to these markets, it may be necessary to treat some agricultural contracts differently from contracts on other commodities. This aspect of the debate has not been resolved and we will continue to work with all interested parties to reach an acceptable outcome.
The thorniest issues before the task force and the Commission involve definitions of key concepts. What should be the contours of an MTEF for purposes of the new exemption? What is an institutional customer? What criteria should be used to determine whether contracts are readily susceptible to manipulation? We are eager to hear your views on these engrossing matters. These are difficult questions. And while we are confident that we will be able to devise appropriate answers, we know that the process entails consultation with the industry and that well-intentioned efforts may result in occasional false starts. If a particular feature of our proposal creates more problems than it solves, we will reject it.
The message I would like to leave you with is this: these markets serve a vital public interest best served when they function most efficiently. We at the CFTC are committed to finding competent solutions to enable these markets to prosper and the U.S. to maintain its customary leadership role in world finance.