The CFTC’s Regulatory Reinvention
David D. Spears, Commissioner
Commodity Futures Trading Commission
National Grain Trade Council
September 21, 2000
I’d like to thank the National Grain Trade Council for giving me the opportunity to participate in today’s program and to compare notes with some of the leading figures in agribusiness and the futures industry. My remarks today will cover some of the profound changes that are reshaping the world of financial and agricultural risk management, the CFTC’s response to those changes, as set out in the agency’s June 22 regulatory reinvention proposal, and some speculation about what the future may hold for agricultural risk management.
The New World of Risk Management
My official topic today is the CFTC’s regulatory reinvention proposal. However, to really understand that proposal we must put it in context. The Commission is seeking comment on a series of reforms that will fundamentally reshape the regulatory system for futures trading. Those reforms constitute the agency’s response to a series of even more profound changes in the financial marketplace.
Financial markets – including America’s futures and option markets -- are becoming increasingly integrated into a huge, fiercely competitive, global financial marketplace. Capital moves from market to market, crossing borders and time zones with the click of a computer key, as international financial conglomerates seek the best return on their money. Assets are allocated, managed and transferred through a constantly expanding, ever mutating variety of transactions – futures, swaps, forwards, options, swaptions, securities, hybrid instruments. Some of these instruments are traded on organized exchanges and others over-the-counter. At the same time, the lines between these various types of instruments become increasingly blurred as OTC products become more standardized, while exchanges explore ways to offer more individualized/customized products.
In this new global marketplace, traditional open-outcry futures exchanges are experiencing tremendous competitive pressure. OTC derivatives markets have seen a huge increase in volume. For example, according to the Bank for International Settlements, the face value of outstanding OTC derivatives on June 30, 2000 was $105 trillion, up 50 percent from $70 trillion on June 30, 1998. Meanwhile, from January through August of this year, total trading volume on U.S. futures exchanges was down 3% from the same period last year. Every exchange but one showed a decline in volume. Internationally, in July of 1998 Eurex, the European electronic futures exchange, surpassed the Chicago Board of Trade in volume to become the world’s largest futures exchange.
As electronic trading systems become more sophisticated and reliable the very future of open outcry may be in doubt. In April of 1998, the MATIF, the French futures exchange, offered an electronic trading platform operating side-by-side with its existing open outcry system. Within 21 days, 90% of the volume migrated to the electronic system and by the end of June MATIF dropped pit trading altogether. Other overseas futures exchanges have followed a similar pattern. The Sydney Futures Exchange dropped open outcry in favor of electronic trading in November of 1999 and LIFFE in London followed suit in May of 2000.
In addition to reshaping trading on existing open outcry exchanges, electronic trading is paving the way for the creation of new exchanges. If you go back and look at old copies of the CFTC annual Report, the list of designated exchanges remains pretty much unchanged from 1976 through 1997. Beginning two years ago, however, we started seeing applications for new electronic exchanges. In September 1998, the Commission designated the Cantor Financial Futures Exchange to trade various financial futures contracts. In March of this year, we designated Futurecom, the first internet-based futures exchange, as a contract market in live cattle futures. Four months later, we designated the Merchants Exchange of St. Louis to trade two different barge freight futures contracts. Neither of these exchanges has started trading yet, but with the designations approved, the ball is in their respective courts. In addition, the Commission staff is currently reviewing designation applications from two more new electronic exchanges. BrokerTec, a proposed electronic market for bond futures, is backed by several large institutional financial market participants. OnExchange, is an internet-based electronic exchange described by its CEO as a "next generation derivatives enabler" intended to allow both regulated and unregulated derivatives to be traded and cleared through online eMarketplaces. Even more significantly, the staff informs me that we have had inquiries from at least a dozen other potential electronic exchanges in various stages of development.
Of course, U.S. futures exchanges are not sitting idly by as the storm clouds gather. They are working feverishly to meet these competitive challenges on all fronts. Their responses include structural changes. For example, five years ago there were five futures exchanges in New York. Today, due to mergers and consolidations, there are only two, with corresponding increases in economy and efficiency. A much more profound change is the movement to "demutualize" – to revise the very structure of exchanges from their current status as membership organizations to a leaner, meaner corporate structure that can respond more quickly and efficiently to competitive challenges. Other than the Kansas City Board of Trade (which has always had a corporate structure), every U.S. futures exchange is in one stage or another of the demutualization process.
U.S. exchanges are also embracing the benefits of electronic technology. They have added various enhancements, such as electronic order routing systems, to make pit trading more efficient. Development continues on hand-held electronic trading terminals. Most recently, NYBOT announced it is preparing to introduce an "automated trading card" that will provide real-time order and trade processing. U.S. exchanges have also implemented after-hours electronic trading systems, such as the CME’s Globex System and NYMEX’s ACCESS. And they have entered cross-exchange access agreements with various offshore exchanges to broaden markets and extend the trading day. Most recently, the Chicago Board of Trade has taken a very significant step through its alliance with Eurex, giving its members access to new customers, new markets and new technology. I’m sure you will be hearing more about this new system, which recently announced its millionth trade, from your next speaker, Chairman Brennan. So I won’t steal his thunder by going into any more detail on this major CBT initiative.
That is a brief overview of the competitive challenges facing U.S. futures markets and some of the steps they are taking to meet those challenges. However, there is another aspect to the competitive picture and that is the regulatory side – the primary topic of my remarks here today.
Steps Leading to the CFTC’s Regulatory Reinvention Proposal
All financial markets, whether domestic or international, exchange-traded or OTC, are subject to legal restrictions of varying degrees. U.S. futures markets have been around the longest – over 150 years in the case of the CBT. Not surprisingly, they are subject to the oldest and, some would argue, most elaborate set of restrictions – the Commodity Exchange Act and CFTC regulations. In applying the Act and crafting regulations, the Commission must perform a very difficult balancing act. We are charged by law with preserving the integrity of the marketplace and protecting customers from fraud and abuse. At the same time, we must maintain a regulatory system that is flexible enough to allow exchanges to create and innovate as they respond to competitive challenges. We can’t put ourselves in the position of the aeronautical engineer who designs an airplane loaded with so many safety features it can’t get off the ground.
Over the years, the Commission has done a commendable job of striking the right balance and providing appropriate regulatory relief -- from simplifying registration requirements, to streamlining reporting and recordkeeping rules, to allowing brokers to use electronic media to submit information to the Commission, and furnish disclosure documents and account statements to customers. However, the recent changes in the marketplace that I have described are fundamentally reshaping the competitive landscape. This new marketplace demands a more far-reaching approach to regulatory reform.
Therefore, last year, with the encouragement of our Congressional authorizing committees, Chairman Rainer appointed a staff task force to examine the CFTC’s entire regulatory structure, from top to bottom, and come up with a broad-based plan for regulatory reform. The general goals were to come up with recommendations to remove unnecessary regulatory burdens and to move the Commission from direct regulation to oversight regulation, from prescriptive rules to performance standards, and from merit to disclosure-based regulation.
In February of this year, the task force report, entitled "A New Regulatory Framework," was furnished to Congress and made public. Over the following months, with input from industry leaders, market users and other experts, the staff worked to flesh out the task force recommendations into a comprehensive regulatory reinvention proposal. That proposal was published on June 22, 2000, with a comment deadline that was later extended to August 21st. We followed up with a two-day public hearing on June 27 and 28, providing testimony from a cross-section of derivatives industry leaders and experts. On July 19th, I chaired a meeting of the Commission’s Agricultural Advisory Committee, which gave the agriculture community a separate forum to air its views on the proposal. In addition to the statements and transcripts from those meetings, the record now before the Commission includes 67 comment letters, many with quite lengthy and detailed comments. The staff is currently in the process of reviewing all these materials and formulating recommendations to the Commission for a final regulatory reinvention package.
I can’t tell you exactly what the final rules will look like. They are still being drafted. I can however, give you an overview of the general outlines of the June 22 proposed rules. While there will undoubtedly be a number of changes in the final rules, I would expect them to follow the general outlines laid out in the June 22 proposal.
Overview of the Regulatory Reinvention Proposal
The proposed regulatory reinvention rules were drafted with three basic objectives in mind: (1) to rationalize our regulations to match the goals of the Commodity Exchange Act to the products and participants trading in today’s derivatives markets; (2) to reinforce legal certainty for OTC derivatives; and (3) to modernize CFTC regulation. The intent was to design a more flexible regulatory system that would still meet the Act’s basic objectives of protecting market and price integrity, protecting against market manipulation, protecting financial integrity and protecting customers.
Flexibility is achieved by replacing one-size-fits-all rules with core principles tailored to particular market characteristics. The performance standards embodied in these core principles are broad enough to encompass different technologies and different organizational structures. The proposal includes separate rulemakings to address the functions of trade execution, services by market intermediaries, and clearing. The centerpiece of the proposal, however, is a system establishing three varying levels of regulation for derivatives facilities based upon the nature of the commodity being traded and the sophistication of the trader.
The top tier, subject to a comparatively higher level of regulation, is known as a Recognized Futures Exchange or RFE. Any commodity, including those that may be subject to the threat of manipulation, may be traded on an RFE. Traders on an RFE can include both institutional and non-institutional customers. RFEs would be subject to 15 core principles. Existing futures exchanges would be "grandfathered" as RFEs, but with the ability to opt into a less-regulated tier for qualifying contracts.
However, that option would not be generally available for contracts on the enumerated agricultural commodities. Those basic agricultural commodities tend to rely on futures markets as their primary, if not their only, price discovery mechanism. To protect that vital price discovery function, the enumerated ag commodities would generally be allowed to trade only on an RFE. Within the RFE context, agricultural commodities would be subject to special treatment in other respects as well. While an RFE could amend the rules for its other contracts simply by certifying that the rule changes didn’t violate the CEA, amending the terms and conditions of agricultural contracts would still require CFTC prior approval. An RFE could, however, list new contracts, including new agricultural contracts, by self-certification.
The middle tier of regulation is the recognized derivatives transaction facility, or DTF. There are two types of markets in this category. One type of DTF would be limited to eligible commercial participants trading for their own accounts, often referred to as B-to-B markets. Because the definition of eligible commercial participants is limited to large commercial and institutional traders, most farmers would not qualify. Thus, under the proposed rules, the enumerated agricultural commodities would not be eligible for trading on a commercial DTF. Those agricultural commodities not on the "enumerated" list, such as coffee, sugar and cocoa, could however trade on a commercial DTF.
The second type of DTF would be open to all eligible participants, both commercial and non-commercial. Certain financial commodities listed in the proposed rules could be freely traded in such markets. Other commodities – including enumerated agricultural commodities and other physicals, such as energy contracts, -- could also be traded. They would, however, have to et certain conditions on a case-by-case basis. Those conditions include demonstrating that the commodity has a sufficiently liquid and deep cash market and a surveillance history showing that it would not be subject to manipulation. Non-commercial traders, including most farmers, could trade on a case-by-case DTF, but only if they traded through a large, well-capitalized FCM – one that maintains net capital of at least $20 million. Both types of DTF would be subject to the same seven core principles.
The lowest tier of regulation – essentially an unregulated market -- would be the exempt multilateral trade execution facility, or Exempt MTEF. An exempt MTEF would be limited to institutional traders. It would be subject only to anti-fraud and anti-manipulation requirements. If serving a price discovery function it would also have a transparency requirement. An exempt MTEF would not be allowed to hold itself out to the public as a "regulated" market. Agricultural commodities would not be allowed to trade on an Exempt MTEF.
A separate section of the regulatory reinvention proposal includes relief for intermediaries – FCMs and Introducing Brokers – when intermediating on an RFE. This proposal expands the eligible instruments for investing segregated funds, scales back CFTC registration rules, and relaxes disclosure and competency requirements.
The regulatory reinvention proposal also includes standards for clearing organizations. If there is a clearing function on either an RFE or a DTF, the clearing organization must be recognized by the CFTC. Clearing organizations may be independent of execution facilities, but to be recognized by the Commission they must abide by a set of 14 core principles.
The primary issues for agriculture in the regulatory reinvention proposal include: (1) the requirement that rule changes in an agricultural contract on an RFE will still be subject to CFTC prior approval; (2) the conditions and circumstances under which enumerated agricultural commodities could trade on a DTF; and (3) the net capital requirement for FCMs handling non-institutional customers on a DTF. We have received comments in these areas from a variety of agricultural interests.
For example, the National Grain Trade Council argues in its comment letter that enumerated agricultural commodities must be allowed to trade on DTFs under less restrictive criteria than the Commission has proposed. NGTC also argues that the $20 million net capital threshold for FCMs handling customer trades on eligible participant DTFs is unnecessary and unsound.
A coalition of eight national farm and commodity organizations commented in favor of the proposed standards for enumerated agricultural commodities to trade on a DTF. However, they urged the Commission to make sure producers have an opportunity to comment on any petition to move an agricultural commodity from an RFE to a DTF. They also ask that any such trading
should retain safeguards, such as large trader reporting and appropriate audit trails. With respect to FCMs handling trades on DTFs, the ag groups urge the Commission to "further clarify the responsibilities and obligations of intermediaries representing non-institutional traders."
The National Grain and Feed Association would support greater flexibility in allowing enumerated ag commodities onto a DTF. However, they propose "limit [ing] the ability of exchanges to split markets on the basis of type of trader." NGFA is concerned that separate institutional and non-institutional markets could harm volume and liquidity. NGFA also argues hat the proposed definition of "eligible participants" who could trade on less regulated exchanges is too restrictive. They urge the Commission to "consider other methods of qualifying individuals or companies to trade as eligible participants."
The staff is hard at work drafting final rules, but I can’t predict when they will be issued, especially since Congress could change the equation. If Congress passes a reauthorization bill before it adjourns, we would have to delay the final rules to make sure they were completely consistent with the terms of the legislation.
The Future of Agricultural Risk Management
Let me conclude with a few thoughts on the future of agricultural risk management. Clearly derivatives markets, including agricultural markets, are changing and evolving. The CFTC’s regulatory reinvention proposal is intended to allow that process to continue without unnecessary regulatory barriers. Our goal is to fashion a regulatory system that preserves basic market and customer protections, but is sufficiently flexible and accommodating so that market evolution is determined by the forces of supply and demand, and the needs of market participants, rather than the whims of bureaucrats.
Exactly where those marketplace needs will lead is hard to predict. Perhaps the afternoon’s other speakers, Chairman Brennan and the panel on E-commerce, will provide further enlightenment. I will go out on a limb and make a couple of general predictions, however. I believe the farmers of tomorrow will be more computer literate than today’s farmers. I believe they will use those computers, the internet and other learning tools to become more sophisticated at marketing than today’s farmers. Those are both pretty safe predictions because I’m convinced the farmers that don’t become computer literate and don’t learn to be better marketers won’t be around to be counted.
Another equally safe prediction, based on existing trends, is that the range of marketing options available to farmers will continue to increase – new types of contracts, new methods of trading, new linkages with those who supply farmers’ inputs and those who buy their outputs. The real challenge for farmers will be to find a path through the blizzard of information and to home in on the right marketing plan for their particular situation.
The challenge for the grain industry is the other side of that coin. You must take a leading role in making meaningful marketing information accessible to farmers. It is vital that the right information, describing the right marketing program for any given operation, gets into the hands of the farmer who needs it. I hope the industry is up to that challenge.
Thank you for your kind attention. I will be happy to take any questions you might have.