REMARKS OF WILLIAM J. RAINER
Commodity Futures Trading Commission
The Bond Market Association’s
Sixth Annual Legal and Compliance Conference
October 25, 2000
I want to thank The Bond Market Association, especially Micah Green and Paul Saltzman, for inviting me to participate in your Legal and Compliance Conference. It is a privilege to address the members of this industry.
The same powerful forces shaping the fixed-income industry--new technology, consolidation, and global competition--also are affecting the futures industry and its regulation. The futures industry also faces competition from over-the-counter products. Neither the members of these industries, nor the regulators that oversee them, can stand still in the face of these changes.
Last year, shortly after joining the CFTC, I asked the question: should the CFTC change the way it regulates US futures markets? I concluded the answer is yes. One year later, the Commission, working with Congress, is on the verge of (1) significantly deregulating futures markets; (2) enhancing legal certainty for over-the-counter financial derivatives; (3) clarifying the ambiguities contained in the Treasury Amendment; and (4) with the collaboration of the Securities and Exchange Commission, repealing the Shad-Johnson prohibition on trading single-stock futures.
These and other reforms are contained in legislation currently pending before the Senate after overwhelming approval last week by the House of Representatives. If Congress adjourns without passing the bill, the Commission can issue regulations that approximate many of its principal amendments to the Commodity Exchange Act (CEA), but not Shad-Johnson repeal or Treasury Amendment reform. The Commission will meet next week to vote on a comprehensive regulatory reform package if the legislation is not enacted.
These pending initiatives addressing deregulation, legal certainty, Shad- Johnson, and the Treasury Amendment in fact follow a host of other completed improvements to our regulatory structure. We began by permitting exchanges to list new contracts without first submitting them to the Commission for review and approval.
We also have created a lighter regulatory environment for intermediaries. Among other matters, the Commission has:
* increased access to foreign exchanges through US-based electronic terminals;
* amended its net capital rules to ease the restrictions on the withdrawal of capital from a futures commission merchant;
* dropped the requirement that FCMs accepting funds from US customers trading in foreign futures and options maintain a separately capitalized "mirror account" to cover those customer funds; and
* broadened the definition of what constitutes a "qualified eligible participant" exempt from certain regulations governing commodity pools and commodity trading advisors.
The reforms instituted by the CFTC during the past 12 months rest on the premise that a financial regulator needs to pursue its public interest mission--as defined by law, rule and custom--in a manner that promotes innovation, enhances efficiency, maintains competitiveness and reduces systemic risk. The CFTC’s regulatory regime needed to change to allow these things to happen. While those goals seem self-evident now, they represent a significant departure from an approach to market regulation that placed "prevention" – with a commensurately detailed and prescriptive structure to accomplish that – as the top regulatory objective. I am pleased to say that we have taken the first important steps to make those changes.
With respect to legal certainty for OTC derivatives, the Commission has concluded that there is no compelling evidence of problems involving bilateral swap agreements that would warrant their regulation under the CEA. If Congress acts, financial swaps will obtain legal certainty through an exclusion from the CEA. If not, the Commission intends to provide greater legal certainty by amending its swaps exemption for the first time since it was issued in 1993.
Currently, a bilateral transaction cannot be standardized or cleared mutually and still qualify for the exemption. We propose to allow such transactions to be both standardized and cleared through a clearinghouse. Legal certainty for swaps would be buttressed further through a non-repudiation clause, long sought by the industry, which addresses the threat that contracting parties may avoid legitimate obligations by claiming their contracts are illegal. The non-repudiation clause states that transactions are enforceable between counterparties even if all of the conditions of the exemption have not been fully satisfied.
The Commission also has concluded that in most instances, its regulatory mission does not reach multilateral financial transactions executed among institutional accounts, irrespective of whether the transaction takes place on a trading floor or on a screen, and without regard to what the transaction is called. The pending bill and our proposed rules leave these markets to function essentially without oversight.
The President's Working Group on Financial Markets--consisting of the Secretary of the Treasury, the Chairman of the Board of Governors of the Federal Reserve, the Chairman of the Securities and Exchange Commission, and the Chairman of the CFTC--concluded that clearing systems for OTC derivatives have the potential to mitigate systemic risk. The Commission agrees. The sheer size of the OTC market is an argument for prompt action to ameliorate this risk: its outstanding volume, as measured by notional value, increased from $5 trillion in 1992 to approximately $100 trillion today. The Working Group urged that jurisdictional obstacles to clearing be removed. Accordingly, both the pending legislation and the Commission’s proposed rules allow swaps to be submitted for clearing.
Because clearinghouses tend to concentrate risk in a central facility, the effectiveness of the clearingsystem's operations becomes critical for stability. Therefore, under both the bill and our proposed regulatory framework, swaps clearinghouses will be overseen by a domestic financial regulator, which may be either the CFTC, the Securities and Exchange Commission, the Federal Reserve, the Comptroller of the Currency, or an appropriate foreign regulator.
Futures clearing systems traditionally have operated as adjuncts to regulated exchanges, and the Commission verified the financial integrity of a clearinghouse in the course of overseeing the related exchange. For a number of reasons, including encouraging competition, we propose to unbundle clearing and execution functions. Futures clearinghouses may operate independently from execution facilities and may clear both Commission-regulated transactions and unregulated swaps.
By lessening its oversight of certain financial futures markets restricted to institutional participants, the Commission is giving effect to its belief that a "one-size-fits-all" approach is inappropriate for today’s markets, and that the degree of regulation should be governed by the nature of the product traded and the participants trading it.
Disparities in size, sophistication and market power among market participants demand a flexible regulatory approach; differences in the risk of manipulation in commodities as diverse as the Eurodollar and rough rice also demand a flexible approach. Thus, our regulatory reform proposal provides for three tiers of trading facilities. The most regulated tier, Recognized Futures Exchanges or "RFEs," would be open to any trader and any futures product.
The middle tier, Derivative Transaction Facilities, or "DTFs," would be subject to a lighter regulatory touch. DTFs generally would operate either as institutional markets offering products such as financial instruments that raise few manipulation concerns; or as commercial markets in any commodity, physical or financial, limited to users able to make or take delivery.
Finally, exempt multilateral trading facilities, or exempt MTEFs, would not be regulated by the Commission. These markets would be limited primarily to transactions among institutions involving certain financial instruments and other non-manipulable commodities, such as weather.
While these structural regulatory reforms should improve the competitive position of established futures markets, they will simultaneously lower the formerly very high barriers to new market entrants.
In response to the pressures from new technologies, consolidation and competition, the three leading US exchanges have taken various steps to improve their business models. The CFTC has approved demutualization plans submitted by the Chicago Mercantile Exchange and the New York Mercantile Exchange. The CFTC also has approved the first phase of a multi-step demutualization plan submitted by the Chicago Board of Trade.
Thus far, our three largest exchanges have not elected to convert fully to electronic trading, as have Eurex and LIFFE. US exchanges are moving incrementally to increase their involvement in electronic trading, although the seeds for more rapid transformation are there. The CBOT recently launched its a/c/e electronic trading platform (alliance/CBOT®/Eurex), which replaced its six-year old Project A system. The new platform, which began trading on August 27, concurrently with open outcry, traded two million contracts in its first full month, about 12 percent of the total September volume of 16.6 million contracts. Since a/c/e's inception, almost 18 percent of financial instruments traded at the exchange have been executed electronically. By contrast, volume in financial contracts on the exchange's discontinued Project A averaged less than 1 million contracts per month in its best year.
Recently, the New York Mercantile Exchange announced that it was preparing to launch e-NYMEX to compete with new electronic systems trading energy and other products.
The CME has listed several "e-mini" versions of popular contracts that trade electronically. In a separate move to exploit technology, it is exploring joint ventures with B2B markets, including CheMatch.com, Inc., a B2B exchange serving the wholesale chemical market.
While no new domestic electronic futures platform has emerged yet as a serious threat to established open-outcry exchanges, the growth of volume at international electronic exchanges has been breathtaking.
The success of Eurex suggests that migration to electronic trading in our markets may be inevitable. Eurex became the world leader in volume last year (trading approximately 300 million futures and options contracts, excluding options on individual securities), compared with volume of 254 million at the CBOT and 200 million at the CME.
Eurex continues to hold a comfortable lead again this year. Its volume through August 2000 was 235 million futures and options (excluding individual security options), compared with 163 million at the CBOT and 151 million at the CME. It should be noted, that these numbers represent a ten percent decrease at the CBOT, but a ten percent increase for the CME, which itself appears to be headed for a record year.
An important development, important because of implications related to greater competition and greater user choice, occurring in this country is that there will be an increase in the number of electronic exchanges. In the past nine months, the CFTC has approved two new electronic exchanges, Future.com and the Merchants Exchange of St. Louis; has granted no-action relief to two electronic trading facilities for energy products, Intercontinental and BrentBrokers; is in the process of reviewing applications from two proposed electronic exchanges, BrokerTec and OnEx; and has received serious inquiries from at least six other startup electronic trading platforms. I mention these developments because they represent a major shift from the past: between 1986 and 1997, the CFTC designated only two new exchanges – neither of which ever began trading.
This trend is comparable to the growth of electronic trading in the bond industry. As surveyed by this Association, fixed-income products can be traded on more than 60 electronic systems based in the US and at least 5 more in Europe. The Association's first survey, conducted in 1997, identified only 11 such systems.
Discrete events are helping to drive changes in the types of hedging instruments offered in the marketplace, namely, innovations in technology, the advent of the era of budget surpluses and the explosive growth of the equities markets.
The spectacular performance of the US economy, particularly its technology sector, has spurred new futures products, and electronic trading platforms. On the other hand, that same growth has led to large surpluses, which in turn have been used, in part, to reduce the size of Treasury auctions and the level of outstanding public debt. In addition to the impact of these changes felt by bond market participants, the financial futures markets have also been influenced dramatically.
For example, bond futures traded 112 million contracts in 1998, 90 million in 1999, and are annualized at approximately 65 million in 2000. Five-year and 10-year futures volumes have increased, but not nearly enough to offset fully this magnitude of decline.
The CME, however, appears to have benefited somewhat from the change in bond market dynamics. Traders seeking a substitute for Treasury securities have turned to, among other instruments, interest rate swaps, which in turn may be hedged with Eurodollar futures. Eurodollar futures volumes are up this year by about nine percent.
It is possible that US futures markets may be able to offer a broad new line of products through Congressional action. The reauthorization process proved to be the catalyst for an historic agreement between the CFTC and the Securities and Exchange Commission on single-stock futures. That agreement proposes to abolish the existing prohibition on these instruments and to institute joint jurisdiction.
The agreement to repeal Shad-Johnson requires action by Congress. In other words, neither the CFTC nor the SEC may permit single stock futures trading through agency rulings. The need for further action, however, does not diminish the importance of this joint agency agreement in resolving what heretofore had been presumed to be an impasse between two regulatory agencies, the CFTC and SEC, incapable of any resolution other than one imposed by Congress.
One word about the Treasury Amendment. Legislation is needed to clarify this provision of the CEA. The problem is that if the term "board of trade" as used in the Treasury Amendment is defined too broadly, then legitimate dealer markets in foreign currency and government securities may fall outside the scope of the Treasury Amendment's exclusion. If "board of trade" is defined too narrowly," the CFTC becomes compromised in its ability to take enforcement action against the foreign currency bucket shops that prey so heavily on retail customers. Only Congress, through a legislative fix, can clear up this ambiguity and we support the language in the bill passed by the House.
The important highlights of the past year--a new regulatory framework for the futures industry, greater legal certainty for OTC markets, and the agreement between the CFTC and SEC with respect to single-stock futures--have been both satisfying and, in my view, necessary. The CFTC’s sense of achievement is tempered, however, by the recognition that these initiatives cannot mark the end of our efforts. We have set the process of regulatory reform in motion, but much work lies ahead.