Testimony of James E. Newsome before
the Subcommittee on Agriculture, Rural Development and Related Agencies
Committee on Appropriations
United States Senate
March 20, 2002
Thank you, Chairman Kohl, and members of the Subcommittee. I am pleased to be here to testify before you on behalf of the Commodity Futures Trading Commission and I appreciate the opportunity to discuss issues related to the Commission’s budget. I would like also to briefly review the important role of the futures markets in our economy and the role of the CFTC in overseeing those markets – and how that role has changed under the Commodity Futures Modernization Act of 2000.
Futures based on agricultural products, non-agricultural physicals, and financial items have come to serve the risk management needs of businesses in virtually every sector of the U.S. economy. While farmers and ranchers continue to use futures contracts to safely lock in the prices for their crops and herds months before they come to market, manufacturers now also use futures contracts to plan their raw material costs. Exporters reduce uncertainty over the prices they receive for finished products sold overseas. Mutual fund managers and individual investors use stock index futures to protect against market volatility. And electricity generators use futures contracts to secure stable pricing for their coal and natural gas needs.
Although the primary purpose of futures markets is risk management, it should be noted that many futures markets play another important role in the economy, that of price discovery. Many investors and businesses that are not direct participants in the futures markets nonetheless refer to the quoted prices of futures market transactions as reference points or benchmarks for other types of transactions and decisions. This is particularly important in many agricultural markets where no other means of price discovery exists outside of the quoted futures prices, but it is also true in other sectors, including many energy markets.
Congress created the Commission in 1974 as an independent agency and charged it with deterring and preventing price manipulation and other disruptions to market integrity, ensuring the financial integrity of transactions to avoid systemic risk, promoting responsible innovation and fair competition in these markets, and protecting all market participants against fraudulent or other abusive sales practices and from misuse of customer assets. The CFTC has traditionally had three operational divisions: Economic Analysis (DEA), Trading and Markets (T&M), and Enforcement (DOE). DEA has helped the Commission -- through market surveillance, market analysis, and market research -- to fulfill its responsibility to promote competitive markets free of manipulation or congestion. T&M has developed, implemented, and interpreted regulations that protect customers, prevent trading and sales practice abuses, and assure the financial integrity of firms that hold customer funds. DOE has investigated and prosecuted alleged violations of the Commodity Exchange Act and the Commission’s rules.
Recently, to ensure its ability to properly oversee trading in single stock futures and the many other innovative products and platforms that I believe will flourish under the CFMA, we restructured our staff to make the agency more responsive, more effective, and more efficient. The main thrust of the new structure will be that functions previously performed by T&M and DEA will now be performed by two new divisions and one new office: the Division of Market Oversight, the Division of Clearing and Intermediary Oversight, and the Office of Chief Economist. Additionally, the Offices of Public Affairs and of Legislative and Intergovernmental Affairs were combined to form the new Office of External Affairs.
How the CFTC Performs Its Mission:
In seeking to fulfill its mission, the Commission focuses on issues of integrity. We seek to protect the economic integrity of the futures markets so that they may operate free from manipulation or congestion. We seek to protect the financial integrity of the futures markets so that the insolvency of a single market participant does not become a systemic problem affecting other market participants or financial institutions. We seek to protect the operational integrity of the futures markets so that transactions are executed fairly, so that proper disclosures are made to customers, and so that fraudulent sales practices are not tolerated.
The Commission pursues these goals through a multi-pronged approach to market oversight. We seek to protect the economic integrity of the markets against manipulation and congestion through direct market surveillance and through oversight of the surveillance efforts of the exchanges themselves. The heart of the Commission’s direct market surveillance is a large-trader reporting system, under which clearing members of exchanges, futures commission merchants (FCMs), and foreign brokers electronically file daily reports with the Commission. These reports show all trader positions above specific reporting levels set by CFTC regulations. Because a trader may carry futures positions through more than one FCM and because a customer may control more than one account, the Commission routinely collects information that enables its surveillance staff to aggregate information across FCMs and for related accounts.
Using these reports, the Commission’s surveillance staff closely monitors the futures and option market activity of all traders whose positions are large enough to potentially impact the orderly operation of a market. For contracts which at expiration are settled through physical delivery, such as contracts in the energy complex, staff carefully analyzes the adequacy of potential deliverable supply. In addition, staff monitors futures and cash markets for unusual movements in price relationships, such as cash/futures basis relationships and inter-temporal futures spread relationships, which often provide early indications of a potential problem.
The Commissioners and senior staff are kept apprised of market events and potential problems at weekly surveillance meetings and more frequently when needed. At these meetings, surveillance staff briefs the Commission on broad economic and financial developments and on specific market developments in futures and option markets of particular concern.
If indications of attempted manipulation are found, DOE investigates and prosecutes alleged violations of the Act or regulations. Subject to such actions are all individuals who are or should be registered with the Commission, those who engage in trading on any domestic exchange, and those who improperly market commodity futures or option contracts. The Commission has available to it a variety of administrative sanctions against wrongdoers, including revocation or suspension of registration, prohibitions on futures trading, cease and desist orders, civil monetary penalties, and restitution orders. The Commission may seek federal court injunctions, restraining orders, asset freezes, receiver appointments, and disgorgement orders. If evidence of criminal activity is found, matters may be referred to state authorities or the Justice Department for prosecution of violations not only of the Commodity Exchange Act but also of state or federal criminal statutes, such as mail fraud, wire fraud, and conspiracy. Over the years, the Commission has brought numerous enforcement actions and imposed sanctions against firms and individual traders for attempting to manipulate prices, including the well-publicized cases against Sumitomo for alleged manipulation of copper prices and against the Hunt brothers for manipulation of the silver markets.
In protecting the financial integrity of the futures markets, the Commission’s two main priorities are to avoid disruptions to the system for clearing and settling contract obligations and to protect the funds that customers entrust to FCMs. Clearinghouses and FCMs are the backbone of the exchange system: together, they protect against the financial difficulties of one trader becoming a systemic problem for other traders. Several aspects of the oversight framework help the Commission achieve these goals with respect to traders: (1) requiring that market participants post margin to secure their ability to fulfill obligations; (2) requiring participants on the losing side of trades to meet their obligations, in cash, through daily (sometimes intraday) margin calls; and (3) requiring FCMs to segregate customer funds from their own funds.
The Commission also works with the exchanges and the National Futures Association (NFA) to closely monitor the financial condition of the FCMs themselves, who must provide the Commission, exchanges, and NFA with various monthly, quarterly, and annual financial reports. The exchanges and NFA also conduct annual audits and daily financial surveillance of their respective member FCMs. Part of this financial surveillance involves looking at each FCM’s exposure to losses from large customer positions that it carries. As an oversight regulator, the Commission reviews the audit and financial surveillance work of the exchanges and NFA but also monitors the health of FCMs directly, as appropriate. We also periodically review clearinghouse procedures for monitoring risks and protecting customer funds.
As with attempts at manipulation, DOE investigates and prosecutes FCMs alleged to have violated financial and capitalization requirements or to have committed other supervisory or compliance failures in connection with the handling of customer business. Such cases can result in substantial remedial changes in the supervisory structures and systems of FCMs and can influence the way particular firms conduct business. This is an important part of fulfilling the Commission’s responsibility for ensuring that sound practices are followed by FCMs.
Protecting the operational integrity of the futures markets is also accomplished through the efforts of several divisions. T&M has promulgated requirements that mandate appropriate disclosure and customer account reporting, as well as fair sales and trading practices by registrants. T&M has sought to maintain appropriate sales practices by screening the fitness of industry professionals and by requiring proficiency testing, continuing education, and supervision of these persons. Extensive recordkeeping of all futures transactions is also required. T&M has also monitored compliance with those requirements and supervised the work of the exchanges and NFA in enforcing the requirements.
As with the Commission’s efforts to protect the economic and financial integrity of the futures markets, DOE also plays an important role in deterring behavior that could compromise the operational integrity of the markets by investigating a variety of trade and sales practice abuses that affect customers. For example, the Commission brings actions alleging unlawful trade allocations, trading ahead of customer orders, misappropriating customer trades, and non-competitive trading. We also take action against unscrupulous commodity professionals who engage in a wide variety of fraudulent sales practices against the public.
September 11th and Enron:
The Commission began last year with a full plate of tasks relating to implementation of the Commodity Futures Modernization Act, but two unforeseen events would increase its workload even more: the World Trade Center attacks and the Enron bankruptcy. The New York Regional Office of the Commission was located on the 37th floor of 1 World Trade Center. Thankfully, all of our employees escaped without major physical injury. Using backup systems and with help from staff of the Chicago Regional Office and D.C. headquarters, we provided ongoing surveillance of futures markets in the hours and days immediately following the tragedy.
Two of the four largest commodity futures exchanges regulated by the CFTC were based in Lower Manhattan: the New York Board of Trade and the New York Mercantile Exchange. Both were drastically impacted on September 11th and trading did not resume on either exchange for several days. Other futures exchanges, in Chicago and elsewhere, were also impacted by events in New York, particularly by the closing of the stock markets, and experienced temporary interruptions in trading. However, in its preparedness and by its responses to this unprecedented disaster, the futures industry demonstrated foresight, resilience, and determination. Steady leadership, thoughtful contingency plans, prudent investments in redundant facilities and backup systems, the ingenuity of technical staffs, and the courage and tenacity of everyone in the industry, made possible a remarkably fast and effective resumption of trading, restoring for the U.S. economy rapid access to risk-management and price-discovery tools uniquely provided by the futures industry. The Commission, in coordination with local authorities, other federal financial regulators in the President’s Working Group on Financial Markets, the Congress, and the White House, strove to assist the industry in restoring operation of these important markets.
The Commission has been working steadily for the last six months to fully reestablish its permanent presence in New York City. At the end of April, the Commission will move into permanent space in Lower Manhattan from our temporary quarters in Jersey City, New Jersey. The Commission and its staff are particularly appreciative and grateful for the assistance of this Subcommittee in securing the supplemental funding we needed to recover and to prepare adequately for the future. The Commission has completed a detailed report on both its own and the industry’s efforts to recover from the attacks and to prepare, as we all must, for future disasters we hope never to face. A copy of that report is attached hereto.
The Commission also found itself with new challenges following initial disclosures of Enron’s financial difficulties last autumn. Because Enron was a large trader of energy-based contracts traded on NYMEX, its on-exchange activity had been monitored by our market surveillance staff for some time. However, the rapid financial deterioration of Enron last year presented an additional concern for the Commission: Could Enron’s on-exchange futures positions be closed out without causing sudden price volatility or unduly reducing liquidity? In fact, Enron was but one of many significant participants in these large and liquid markets and the markets proved to be quite resilient. When its financial difficulties became known and Enron voluntarily closed out its positions, the futures markets reacted well, with little or no adverse impact on price volatility or liquidity.
As would the financial difficulties of any large futures customer, Enron’s difficulties also raised concerns about the ability of the FCMs that carried Enron’s on-exchange futures positions to successfully close out those positions if Enron were to fail to meet margin calls. When Enron’s financial troubles became known last fall, T&M staff worked closely with the NYMEX clearinghouse and the affected FCMs to monitor and manage the closing out of these positions. By appropriately adjusting margin requirements, the clearinghouse was able to ensure that adequate Enron funds remained on deposit at the FCMs. By the time of Enron’s bankruptcy filing, the risks to which FCMs were exposed, as measured by standard margin requirements, had dropped by 80% from only a week earlier. By mid-December, all of Enron’s positions on the regulated exchanges had been liquidated. I believe this episode was a success for the system of financial controls in on-exchange futures markets. There were no disruptions to clearance and settlement system. Enron met all its obligations. No customer lost funds entrusted to any FCM. Obviously, as an oversight regulator, we will continue to look at how and why markets respond the way they do, whether well or poorly, to a situation such as this one.
As the facts surrounding Enron's collapse have unfolded over the last several months, the Commission has made a variety of inquiries both to Enron and other federal agencies investigating Enron to determine whether Enron's conduct may have violated the Commodity Exchange Act. We are obtaining information from Enron and other sources to determine how it conducted its trading business and whether it functioned within the bounds of applicable exclusions and exemptions under the Act. The Commission is also working with the SEC, FERC, and the Justice Department to ensure that we keep each other apprised of relevant information developed in our respective investigations.
Separately, as a member of the President's Working Group on Financial Markets, I have worked with Secretary O'Neill, Chairman Greenspan, and Chairman Pitt to review for the President potential improvements in accounting, auditing, and disclosure practices by publicly-held companies.
Implementation of the Commodity Futures Modernization Act:
Certainly events last year caused many of us to pull attention away from previous plans and intended courses of action. But implementation of the CFMA remains the most important task before this Commission. And notwithstanding the unexpected challenges, solid progress was made last year on security futures products. We are continuing to move toward permitting trading of these new products at the earliest possible date.
As many of you know, we have issued final rules on notice registration, listing standards, self-certification of rules and rule amendments, data reporting, speculative position limits, and dual trading of single-stock futures. Together with the SEC, we have also issued final rules on determining if an index is a narrow-based index subject to joint regulation or a broad-based index subject only to our rules. With the SEC, we have published proposed rules on margin, customer funds protection issues, cash settlements, and trading halts. The NFA has developed numerous rules required by its new capacity as a limited-purpose national securities association.
Chairman Pitt and I agreed generally last year on how to best address the issues that remain before us and we issued a joint statement on December 21st, 2001, the first anniversary of the CFMA’s enactment, expressing our commitment to promulgation of final rules on margin and customer funds protection at the earliest possible date, with a goal of permitting actual trading by early in the second quarter of this year. I remain committed to meeting that objective but I believe that in the long term issuing the right rules is as important as issuing rules quickly.
We are also looking forward to completing the intermediary study called for by the CFMA and are considering proposals for rule modernization. We have finalized our timeline for the phases of this important project, including individual interviews which we hope to conduct in late March and early April, public hearings planned for late April, circulation of a final report prior to June 21st, and promulgation of rule amendments as appropriate.
Budget Request for FY 2003:
The President’s FY 2003 budget request for the CFTC is $82.8 million. That sum represents an increase of $9.1 million (or 12 %) over the FY 2002 regular appropriation. Of that $9.1 million, approximately $5.9 million is required to maintain the current level of services and operations. The remaining $3.2 million is being requested for an additional 27 staff years over the current base of 510 FTEs, which is the lowest staffing level since FY 1988.
Overview of Funding Levels and Operational Effects:
The Commission’s top budget priorities are to dedicate resources to fully implement the CFMA and to invest in the technology improvements needed to increase the Commission’s ability to continue fulfilling its mission in the face of the rapid technological change that is sweeping the futures industry.
Our request for 27 additional positions should improve our ability to keep pace with the rapid growth in volume, innovative products and transactions, new trading systems, evolving market practices, technological advances, and market globalization. The largest staff increase – an increase of ten – will go to information technology because the effective use of information technology is critical to our ability to fulfill our mission. It is critical that our information technology capacity stay on par with industry practices so that we can provide the timely and accurate information in a relevant format to our investigators, analysts, and attorneys.
The budget also calls for an increase in two staff years for the Enforcement program. This staff growth will be augmented by supplemental anti-terrorism funds intended to allow us to significantly upgrade our litigation, case, and document imaging and management systems through implementation of the “E-law” project. This system will enable staff to image all documents received or created during investigations and litigation. Those imaged documents -- as well as all on-line annotations, notes, work products, and case information relevant to each matter (such as names and phone numbers for witnesses, counsel, and staff at other agencies involved in the matter, etc.) -- will be available to Commission staff despite any destruction of the paper documents, as happened in New York. We expect this system to increase productivity in DOE as well as to assist the Office of General Counsel and the Office of Proceedings.
In FY 2003, the Market Surveillance, Analysis, and Research program will gain five positions. This 7% increase should allow us to keep pace with the growth in new types of exchanges and products, such as single-stock futures, as well as provide the proper level of surveillance, exchange oversight, contract design review, and market and product studies. However, it is difficult to be sure that resource levels are adequate because so much is not known at this time about the direction of the markets. If, for example, growth in the industry outpaces the resources available to oversee the industry, several risks are introduced, including the increased possibility of undetected price manipulations and abusive trading practices. A key goal of the Commission is to ensure that its regulatory policies reflect industry developments and do not to impede beneficial market innovation. But because these markets and the products traded on them are increasingly complex, it will be difficult to meet this goal without the proper level of staff resources.
The T&M programs which will become part of our new Market Oversight and Clearing and Intermediary Oversight will together gain four positions, or 4 % of staff, in FY 2003. These functions play important roles in developing regulatory reform initiatives are key to full implementation of the CFMA. In FY 2003, in addition to providing guidance to the public and industry professionals concerning compliance with the CEA, the programs will continue to review Commission rules to determine if they should be streamlined further in light of technological and market developments, to provide guidance to foster innovative transactions and electronic trading systems, and to monitor the risks to regulated industry participants by unregulated derivatives activities as well as the risks posed to registrants by their unregistered affiliates. In addition, these programs help maintain U.S. leadership in setting internationally acceptable standards for the regulation of markets and trading. Again, however, we cannot say with certainly that this increase will be sufficient because the pace of industry transition is uncertain. It is the Commission’s objective to be equipped to respond as quickly as desired to these critical challenges and their associated interested parties.
Finally, the Office of the General Counsel is slated for an increase of one FTE to ensure it is able to provide for the timely review of contract market designation applications, rule changes, and proposed enforcement actions; to provide for thorough and timely review and analysis of legislation and proposed legislation affecting the Commission and in defending the Commission in appellate and other litigation; and to assist the Commission in the performance of its adjudicatory functions.
Employee Attrition and Pay Parity:
The Commission continues to face a serious challenge in attracting and retaining the type of highly skilled and experienced staff that is needed to operate effectively with our new responsibilities under the CFMA. The Commission must move from the role of a front-line regulator to a more flexible oversight role. Some might believe that, in this new capacity, the agency will need fewer resources than in the past. In the near term, anyway, just the opposite is true. The CFMA liberated markets and allowed innovation to flourish, creating new financial products and new trading platforms and permitting clearinghouses to respond in kind. I believe we have seen only the beginning of this exciting process.
This growth and innovation in the marketplace will provide real benefits to participants, customers, and the economy as a whole. However, because our fundamental duties have not changed, this growth and innovation will place increasingly greater demands on our resources. With new exchanges and alternate trading platforms, there is no longer a “template” to follow; rather, oversight must now be tailored to fit a variety of markets along a spectrum of regulatory classifications from basic fraud and manipulation protections to full oversight. To continue to fulfill our mission to promote markets free from congestion and manipulation and to protect market participants from fraud and abusive practices, we must have staff with the proper training and with solid experience in the markets we oversee.
All too often, however, we lose good people just as they are coming into their own as economists, commodity lawyers, and trading specialists. Our overall turnover rate is twice the federal average. Among attorneys it is almost 20% annually and we have seen the average tenure of a new attorney decrease from five years to three years. In most, if not all, cases our ability to compensate skilled people lags not only far behind that of the private sector, but also well behind that of the other federal financial regulators, where turnover rates are significantly lower. We are now the only federal financial regulator still subject to the pay restrictions of Title V. The SEC recently was exempted from Title V but their recruitment and retention problems, according to the statistics, are less serious than our own. It is difficult enough to accept the loss of a productive employee to a higher-paying job in the private-sector but it is downright frustrating to lose such an employee to another federal agency because of disparate pay scales. Therefore, Mr. Chairman, I respectfully request this Committee’s support for removing the Commission from Title V pay restrictions so we may successfully hire and retain the dedicated staff we need to accomplish the important mission that we have in front of us.
Thank you for the opportunity to present our mission, responsibilities, and resource needs. I would be happy to provide answers to any questions you may have.