Speech to the New York City Bar Association Committee on Futures Regulation
Sharon Brown-Hruska, Commissioner
Commodity Futures Trading Commission
November 22, 2002
I am delighted to have an opportunity to share my thoughts with you this morning regarding futures regulation and related issues. The thoughts and views I express do not necessarily represent those of the Commodity Futures Trading Commission, but rather are those of one Commissioner, from a perspective unique to my particular background. This perspective is really the product of an education in economics with a strong public policy orientation, experience as a researcher in the microstructure of derivatives markets, and employment as a finance professor in the business schools at Tulane University and George Mason University.
As an undergrad, I was introduced to law and economics by Dr. Gordon Tullock. He and Dr. James Buchanan founded the Center for the Study of Public Choice at Virginia Tech (now, conveniently, at George Mason University). Their passion really inspired me to think about economic incentives and how individuals in a market environment respond to laws, regulation, and the government. Not surprisingly - and I hope to have a chance to talk a little about this later - this experience has proven to be quite rich, and especially useful, when weighing decisions regarding enforcement, adjudication, litigation, and appellate issues facing the Commission.
When I was an economist at the Commission in the early 1990s - it was rather fortuitous timing - since there were a number of pressing issues facing the futures and derivatives industry. I was able to contribute to the analysis of a number of those issues – including market volatility, margins, fragmentation, and innovation in the over-the-counter market.
I learned during my first tour at the CFTC that there is a tendency to blame derivative instruments, and the markets in which they trade, for perceived negative conditions and events in the underlying markets, or in the economy as a whole. Back then, it was the market declines of 1987 and 1989 that raised the question of whether stock index futures - the way they trade, their margin levels, or applicable regulation - caused the extreme volatility and declines experienced by the stock market. Today, questions surround the public demise of corporations such as Enron and WorldCom, and the contemporaneous decline of the stock market, in particular the technology sector, coupled with the downturn of the economy at large.
In numerous quarters, especially in Congress and in the press, derivatives have been fingered as a contributing factor in recent corporate and market declines. Some have even suggested that the failure of these companies and the market losses were due to a lack of regulation. If we accept the implication that inadequate regulation caused the blowouts, then the expected reaction is that we need to do something to ensure that these do not happen again. Let me share with you my take on these views, in turn: first, that derivatives instruments and markets caused the problems; second, that the markets in question were not regulated; and third, that more regulation will solve, and help avoid, similar problems in the future.
From my perspective, nothing I have seen validates the supposition that derivatives, whether traded by exchange or over-the-counter, were to blame for the market declines experienced by specific companies or the markets, in general. Putting on my finance professor hat, it was and is clear that the valuations of many companies were simply unsupportable.
At the time, I was teaching two courses, Investments and Venture Capital, in which valuation methods and techniques were important topics for analysis. In both those courses, my students were required to use valuation models, which rely on the use of financial ratios that require such inputs as earnings and cash flows, to predict stock prices for the companies we studied. Time after time, we found that the market prices derived by these models were far below the prices at which the markets were actually trading, suggesting either a sell signal or, alternatively, a seriously flawed discounted cash flow model. While I was trying to defend the validity of these models to my classes, the markets kept rising and many of my colleagues set out to develop new valuation techniques for the “new economy” based on “clicks” instead of “bricks”, and “eyeballs” instead of cash flow.
In a number of highly publicized cases, it appears that management, and their agents, had significant incentives to propagate and perpetuate valuations that were neither supported by market fundamentals nor their company’s balance sheets. In corporate finance, and in the industrial organization, we spend a significant amount of time talking about principal-agent problems with regards to the treatment of shareholders, corporate boards, and their agents - the managers of the firm. Poorly aligned incentives, which fueled the use of “fuzzy” valuation techniques and inadequate disclosures, resulted in a precipitous slide of the stock market and downturn of the business cycle. Eventually, however, the market did function as expected and brought discipline to those individuals that sought to “game” the system.
Interestingly, Federal Reserve Chairman Alan Greenspan gave his now famous “irrational exuberance” speech on December 5, 1996. Those who would hope to gain by politicizing the national economy, or otherwise suggest that the Bush Administration is weak or somehow vulnerable on the economy, should take note: the seeds of the economic downturn were sown well before this President took office. President Bush is directing us towards a return to rationality - where earnings matter, the integrity of the markets matters, and those who skirt the laws and act without integrity are held accountable. And while there are those out there whose strategy for finding solutions is simply more finger pointing, the recent elections validate that Americans reject the blame game when it comes to the markets and economic security. Americans want rational solutions, responsible actions, and strong, decisive leadership.
From my perspective, it is not clear that embracing legislation requiring additional layers of regulation is a rational solution, unless we can establish that existing regulation failed in the first place. We have seen several proposals in the 107th Congress, including an amendment offered by Senator Feinstein, and sponsored by Senator Fitzgerald - a version of which was later revived by Senator Harkin and Senator Lugar - proposing additional regulation of the over-the-counter derivatives market; in particular the energy and metals sectors. In the House, Representative DeFazio drafted legislation to merge the Commodity Futures Trading Commission with the Securities and Exchange Commission.
With regards to the Senate proposal, I am heartened that premature action was not taken to rollback the provisions of the Commodity Futures Modernization Act. This historic legislation opened the door for single stock futures markets by resolving a jurisdictional battle between the SEC and the CFTC, and provided regulatory certainty by clarifying the CFTC’s authority in the over-the-counter derivatives market.
With respect to both Senate and House proposals, I would note that the CFTC should be recognized for its expertise and understanding of the vital functions of these markets; more specifically, adequate price discovery and risk management. Since these products are used to hedge both upward and downward price movements, a derivatives regulator cannot afford to have the biased mindset that the only good way for prices to go is up. In fact, derivatives have helped businesses weather the downturn in the economy, allowing them to hedge interest rate risk, energy price risk, currency risk, etc. Far from causing economic turmoil, derivatives have helped “steady the ship” through uncertain and difficult economic cycles.
Perhaps because he knew I had drafted this speech, and to lend credibility to my views, Chairman Greenspan, in a speech on Tuesday, also extolled the benefits of a healthy derivatives market. Mr. Greenspan noted that such instruments allow the breaking down of various types of risks that may then be sold to parties better capable of efficiently managing these risks. Furthermore, the use of such complex financial instruments “have significantly lowered the costs of, and expanded the opportunities for, hedging risks that were not readily deflected in earlier decades.”
While many have erroneously suggested that the energy markets are unregulated, I would note that the Commission has authority to police against fraud and manipulation in these markets. Our current Chairman, James Newsome, has implemented a vigorous enforcement effort of our rules and statutes in these and other markets, using every tool at our disposal to root out and prosecute wrongdoing. I am confident in our ability at the Commission to ensure that the financial and economic integrity of the markets are preserved and enhanced in the future.
We saw in the market breaks of 1987 and 1989 a tendency to over-react when the capital markets experienced decline – to look towards regulatory solutions to curb market volatility and avenge investor losses. Speaking generally, I expect that in many high profile cases, existing laws were broken, ethical standards of business practice were egregiously breached, and regulations were violated. I have no specific cases in mind, nor will I comment on ongoing CFTC investigations, but I am not convinced we need to pass new regulations or “rewrite the book” if we can determine that certain existing laws were violated.
The prescription to help avoid these problems in the future is smarter oversight, better enforcement of our laws, and tougher penalties for violators. To that end, as financial market regulators, we cannot eschew the use of finance and economics in our supervision of the markets. In the glare of headlines relating to big issues, such as those I have just mentioned, it is often easy to lose sight of what is going on below the surface - activities that often have as profound of an impact on the financial markets as do new laws and new rules. While it is customary among those who follow the activities of the Commission to focus their attention on our regulatory role and related legislation, I also intend to focus on the adjudicatory and litigation roles of the Commission.
In accepting my appointment to be a Commissioner at the CFTC, my commitment was and is
to ensure that the policies of the Commission are reflected as much in enforcement,
adjudication and litigation as they are in the formal regulatory rule-making process.
While the temptation is to delegate this function to the CFTC’s professional
staff - that is, to “rubber stamp” opinions to save time and to focus on
bigger issues - I am committed to being actively involved in adjudicatory issues. As
an economist, my approach to adjudicatory issues, as I have hinted previously, is
based on a “law and economics” perspective.
A law and economics approach entails “the application of economic theory and econometric methods to examine the formation, structure, processes and impact of law and legal institutions” (Rowley, 1989b, p. 125). The idea is to bring the same level of scientific rigor used in economics to an analysis of the law. And the idea that economic theory can serve as the basis for bringing this rigor to specific areas of the law is quite natural, as both sciences ultimately deal with individual behaviors, which are guided by individual preference sets in light of outside constraints.
In economics, for example, we consider how consumers make choices regarding purchases, given their personal incomes and wealth, and the prices for various products, including competing and complementary products. Such analysis can also be brought to bear in the legal arena. For example, we might consider the deterrent effect that a given scheme of civil penalties could be expected to have on potential lawbreakers; an issue of great importance and relevance to the Commission.
As a Commissioner, I have a responsibility to uphold the laws passed by Congress and to ensure the integrity of the futures and options markets. Of course, the laws that Congress writes, and the rules enacted by the Commission, establish the broad outline under which the futures and options industry operates. However, the legal opinions of the Commission, and the litigation we undertake, can have just as profound of an effect on the industry, its participants and, more broadly, on the overall economy, as those laws that Congress writes and the Commission enforces.
I firmly believe the integration of economic and traditional legal analysis is critical to ensuring the continued effectiveness of the CFTC’s regulatory, enforcement, and adjudicatory missions. As an economist, and a Commissioner, one of my goals is to meld economic theory with the principles of law, and to “force my mind” upon such matters.
And while on the topic of forcing the mind, I would like to take this opportunity to acknowledge the efforts of one of my colleagues, Commissioner Tom Erickson, who has never had to “force” his mind on such matters. Commissioner Erickson will be leaving the Commission at the end of the month, and although his views on many matters are different from my own, he has approached this area of the Commission’s business with as much enthusiasm as he has toward other areas that are more commonly associated with the headlines. No one could legitimately accuse Commissioner Erickson of being a “rubber stamp”. Indeed, he has raised important questions and has left an indelible mark on our body of case law.
In my short tenure at the Commission, Commissioner Erickson has engaged me on a number of adjudicatory issues that were and are before the Commission. His departure is a loss to the robust exchange of ideas, which is so vital to an organization such as the CFTC. I hope to perpetuate the spirit of Commissioner Erickson’s enthusiasm and approach during my tenure at the Commission.