Remarks of Commissioner Thomas J. Erickson
National Introducing Brokers
10th Annual Conference
June 23, 2001
Good morning. I'd like to thank Melinda Schramm for extending the invitation for me to join you today. I've gotten to know Melinda through her representation of the NIBA on the CFTC's Agricultural Advisory Committee, where she has been a forceful advocate for the IB community. Through Melinda's work on that Committee, I've become fairly familiar with the membership of your group and its concerns. Of course, there's no substitute for being able to speak with you personally and to become better acquainted with the issues you face, and, more broadly, to discuss some of the issues the Commission and the industry face. In that regard, I thought it might be helpful to start off with a quick overview of how the recently enacted Commodity Futures Modernization Act works and what it might mean to this industry.
The Commodity Futures Modernization Act of 2000, or CFMA, was part of the congressional reauthorization process the CFTC periodically goes through. Reauthorization basically means that, every five years or so, Congress takes a hard look at the agency's mission and its effectiveness in achieving that mission. To the extent the Commodity Exchange Act needs a tune-up, Congress does that at the same time it reauthorizes the agency. As many of you may know, this year's reauthorization was closer to a complete overhaul than a tune-up.
Passage of the CFMA has altered the very nature of the CFTC's mission. In short, we have moved from being a “front-line” regulator to an “oversight” regulator. In general terms, this means that the Commission must take a much more flexible approach to regulation – one which allows industry participants more latitude in deciding how best to comply with regulatory requirements. Commensurate with this approach, the industry has been given much more responsibility to police itself. This means that for the sake of your business, it's imperative that you understand the legal framework within which you now operate.
As far as markets go, the CFMA establishes a multi-tiered approach to
regulation based on the notion that certain instruments, certain
commodities, certain types of trading platforms,
and certain market participants require less regulation than others. Under the new law, designated contract markets are subject to the highest level of regulatory scrutiny. These markets are closely analogous to traditional exchanges both in terms of permitted participants, commodities allowed to trade, and the level of regulatory scrutiny applied. All existing exchange markets overseen by the CFTC automatically became designated contract markets when the CFMA was signed into law on December 21st of last year. Designated contract markets must comply with a set of 18 “core principles” that are designed to provide exchanges with more flexibility in their approaches to compliance through self-regulation.
One step down from designated contract markets are derivatives transaction execution facilities, or DTEFs, which cater to primarily non-retail participants. DTEFs must comply with nine core principles. In return, they are allowed to represent that they are regulated by the CFTC; this is an important factor for trading facilities seeking to do business abroad. Finally, the CFMA creates two categories of exempt markets that generally are free from Commission oversight, subject only to the Commission's anti-fraud and anti-manipulation authorities.
Who, and what, can trade on these various markets depends upon a number of variables. A series of exemptions and exclusions throughout the CFMA define on which tier particular commodities, contracts, or participants may or must trade. For example, most derivative products in financial instruments – if traded among sophisticated parties – are excluded from the CFTC's jurisdiction. Thus, they can trade over-the-counter or on proprietary trading platforms with no regulation by the CFTC. If the market chooses, such instruments can also trade on exempt markets, on DTEFs, or on designated contract markets, depending upon the level of regulatory oversight desired. All other commodities, with the exception of agricultural products, are exempted from the Commission's jurisdiction. These products may trade on designated contract markets, DTEFs, or even on exempt markets. A handful of agricultural products, commonly referred to as the “enumerated agricultural commodities,” must trade on designated contract markets, unless, by rule, the Commission decides to permit trading by DTEFs.
Just to add yet another layer of complexity, electronic platforms enabling sophisticated customers to enter bilateral transactions – presumably trading any product except agricultural products – are excluded from Commission jurisdiction. In fact, those excluded systems are arguably outside the “trading facility” definition in the Act and could never seek to be regulated.
From this brief description, you can see that one of the top priorities of the drafters of this legislation appears to have been an attempt to loosen requirements for markets with sophisticated customers. In addition, this legislation not only acknowledges, but also embraces, the increasing role technology is playing in the derivatives industry. Certainly, one cannot ignore the profound changes technology brings to our industry, or the warp speed at which these changes can take place.
As Chairman of the CFTC's Technology Advisory Committee, I have a
chance to discuss the application of new technologies with a broad
spectrum of industry participants. The more I hear about these issues
from industry participants, the more clear it becomes that when we refer
to “technology” we are not simply talking about the face-off
between traditional open outcry exchanges and emerging electronic trading
platforms. Rather, we are talking about a force that
touches and inalterably changes every aspect of our industry. Yesterday's buzzwords are overtaken by tomorrow's, and phrases like “automated order routing systems” begin to sound quaint when industry participants begin talking in terms of “straight-through processing.” I know many of you have integrated technology into your businesses, and I hope we'll have time in the question-and-answer session to discuss some of the issues you see on the horizon.
So what do the CFMA and the changes it enables mean to introducing brokers? I suppose there is the potential for both good news and bad news in all this innovation. Whether it's good or bad news may depend to a great extent on how willing IBs are to embrace change and think creatively about where they fit in this shifting landscape. As an initial matter, it appears as though open outcry trading will remain a vital part of our industry, at least in the near term. We have not seen our domestic exchanges migrate to electronic trading with nearly the same speed and decisiveness as the European bourses. Nevertheless, electronic trading is plainly here to stay. It's also a safe bet that electronic trading technology will increasingly enable customers to access markets more directly – probably not a comforting thought to the intermediary community.
But just as surely, technology will present potential customers with multiple domestic markets offering similar products. In an environment with so many more options for the derivatives customer, IBs may end up providing a vital link between the customer and the exchange to which that individual's business is best suited. On which market a customer chooses to trade may well depend upon the quality of information he or she has about the way the market works.
By way of example, last Monday, the Commission approved the BrokerTec Futures Exchange's application for designation as a contract market. One of the more significant components of the BrokerTec application is a rule that permits block trading with a reporting timeframe of up to four trading session hours. Block trading permits certain exchange participants to negotiate and execute large trades away from the exchange pit or trading facility for a single price. The block and price are subsequently reported to the floor. By negotiating the trades off the floor, the parties to the trade are not forced to unbundle a large transaction through piecemeal execution over time. The theory of block trades and how they interact with traditional notions of price discovery is something that can be debated, but the CFMA explicitly permits such trades.
Prior to BrokerTec, the Commission had considered block trading petitions from other exchanges and had approved rules for several exchanges, but in no event was the reporting timeframe that was ultimately approved greater than 5 minutes. BrokerTec, at 240 minutes, represents an enormous expansion of the time between when a trade is agreed to and when it must be reported to the exchange and, subsequently, to its participants. As I said in my concurrence to BrokerTec's exchange designation, I can't help but believe that this significant reporting delay will result in a less transparent, more volatile marketplace, and one that might disadvantage retail and modest commercial market participants.
Why do I tell you all this? Because I think this represents both the opportunity and the risk inherent in the new regulatory scheme under which we all operate. I believe the new law and changing marketplace will require you, as IBs, to consider how to provide new value to potential customers. For example, the distinctions between the operating procedures – such as block trading rules – of various exchanges may become significant factors in a customer's decision regarding on which exchange to trade. The IB who introduces that customer's trade may serve a key role in helping the customer identify what type of exchange best suits his or her objectives and risk tolerance.
In addition, the increased and more direct accessibility to markets by retail customers may make some of you consider the advantages of providing more direct trading advice. I am pleased to see that you will have the chance later in your program to learn more about registration as commodity trading advisors. Certainly, in the context of securities futures products that will be traded on both futures and securities exchanges, it's worth considering how you might add value to your services, because you will be competing directly with securities broker dealers.
It's my hope, and expectation, that as the character of our markets changes, new avenues of opportunity will open for industry participants. In keeping with the thrust of the CFMA, these new opportunities will also mean increased responsibility for industry participants as the Commission takes a step back, into an oversight role. The Commission is in the process of implementing the new law. Among the many priorities in this regard is a study of the regulation of intermediaries. I believe the Commission's request for comment was published in the Federal Register yesterday. This will be an opportunity for you to weigh-in on those issues that affect you most directly.
In a similar vein, I'd also like to say a few words about a topic that I know concerns a great many of you: the NFA's recent increase in its membership dues and registration fees. I know there is significant concern among you based of the stack of mail in my in-box. First, a bit of background.
The NFA's decision to raise membership dues and registration fees for all classes of registrants was based on its desire to stabilize operating capital by reducing its dependency on transaction fees. The NFA informed the Commission's staff that the proposed increases were reviewed and supported by its Advisory Committees – including the IB Advisory Committee.
As I said, I understand your concerns. But I must stress that the decision with regard to fees is, in effect, a business decision of the NFA. The Commission would only intervene in such a decision in the most extraordinary of circumstances.
I think there are a couple of lessons for all of us embedded in the fee debate. First, both the industry and the agency are operating under new rules. Under these rules, SROs such as the NFA will be the industry's “front-line” regulators and first point of contact for industry participants on many more issues. As an oversight regulator, the Commission will not intervene when an SRO has made a business decision that can be rationally explained and meets the limited standards established in law. Second, under this new regime, more responsibility is placed on both industry participants and their SROs. Accordingly, it is incumbent upon industry participants to take a proactive role and to work closely with their SROs to achieve results that are in their mutual business interests. I believe these are important lessons for us all because, in the end, public confidence in our markets will depend on how the industry adapts to and carries out its new responsibilities under the law. This will only occur with the energetic participation of all of industry participants in the self-regulatory process.
Thank you again for the invitation. I'd be happy to answer a few questions if we have time.