Remarks of Dr. James E. Newsome, Chairman of
the Commodity Futures Trading Commission before
the Friends of Finance Executive Speaker Series at
The University of Tulsa on October 10, 2002
Thank you, Mr. Hobbs, for that introduction. I could not be more pleased to have been invited here today. These are both challenging and exciting times in the derivatives industry and I am honored to be at the Commodity Futures Trading Commission at this point in the history of the financial markets. I would like to visit with you today about some of the things happening in these dynamic markets as well the role I see for the Commission.
Let me begin by confessing that I first accepted a position as a CFTC Commissioner in 1998 with more than a little trepidation. My own educational background is in animal science and agricultural economics and much of my experience before coming to the Commission was in the cattle industry. While futures and options on agricultural commodities were then, and still are, being traded as actively as ever, their volume has been dwarfed in comparison to the huge trading volumes in interest rates, stock indices, and currencies. When I was confirmed at the Commission, financial instruments comprised almost two-thirds of contracts traded, while ag contracts made up 15%. Last year, the financials increased to 70% of volume, ag volume was 12%, and energy and metals contracts primarily made up the remainder.
None of which is to say that ag markets do not continue to play a critically important role in the U.S. economy. Instead, other sectors of the economy are now benefiting from many of the strategies and techniques pioneered by producers, distributors, and users of agricultural commodities. While the stock markets provide an effective means of capital formation, the commodity futures and option markets provide investors and firms in virtually every sector of the economy with the means to manage exposure to price risks. Manufacturers can use futures contracts to fix their raw material costs. Exporters can reduce uncertainty over the price they’ll receive for finished goods overseas and investors can hedge against market volatility. This year futures and option volume has increased over 30% and is on pace to exceed one billion contracts. This increase in demand indicates the need for risk management tools, and, I believe, a greater understanding and comfort with the use of futures and option contracts as those tools.
However, the importance of the price discovery role played by many futures markets should not be understated. This is particularly true in many agricultural markets but also holds in other sectors, including many energy markets and can have great significance. For example, I believe the fact that the New York Mercantile Exchange was able to get its benchmark crude oil markets back on line very quickly and demonstrate stability in the energy markets following the terrorist attacks contributed significantly to the relative stability of the stock markets when they subsequently resumed trading.
As I came to the Commission, it wasn’t just new types of underlying commodities that I saw coming rapidly to the futures markets, but also new platforms and trading technologies. While open outcry trading in Chicago and New York continues to be an important component of trading activity, I could see that electronic trading was growing at a tremendous pace. This and other market changes were beginning to bring new participants to the marketplace, increase efficiency and liquidity, enhance customer service, and even lower many economic barriers to effective cross-border activity.
Yet it also quickly became apparent to me that certain aspects of the regulatory regime were not facilitating this process, were even stifling innovation and progress. Fortunately, help was soon to be on the way in the form of the Commodity Futures Modernization Act that was signed into law in December 2000.
I should say at this point that I have a relatively simple regulatory philosophy that can really be boiled down to two principles: For the legitimate efforts of market participants who through innovation and fair competition bring to the marketplace greater liquidity, more useful risk management tools, better use of technology, more efficient pricing, and enhanced customer service, I believe in providing the most flexible and responsive regulatory regime possible. For those who attempt fraud or manipulation in our marketplaces, however, I can promise prompt investigations and aggressive exercise of our broad authority under the Commodity Exchange Act.
As to rules, I do not subscribe to the idea of regulation for regulation's sake alone. The temptation to resort to prescriptive regulations that take a static view of markets and technology has traditionally been hard to resist for some regulators. But I believe the key to success for an oversight agency such as ours that is witnessing great change in the marketplace is to pursue the same innovativeness and creativity that successful market participants rely upon in conducting their businesses. Fortunately, the CFMA afforded the Commission the opportunity to do so, with principles-based rules that provide for varying levels of sophistication among market participants and differences in the nature of the contracts being traded, that take into consideration the costs as well as benefits of compliance, that allow business to be conducted without unnecessary restrictions, that reflect a common sense approach to regulation, and are they type of rules that are most often best able to achieve public policy goals.
I believe that Congress exhibited vision and determination in passing the CFMA, a landmark piece of legislation that is responsive to market changes. Its passage represented tremendous progress. The alternative to prescriptive regulations is a rational set of principles and I believe that the CFMA’s principles-based approach could not have come at a better time. The new oversight approach called for by the CFMA empowers the Commission to accomplish important public policy goals without imposing unnecessary costs on market participants, without stifling innovation driven by new technologies and the evolving needs of customers, and without implementing inflexible regulations that quickly become obsolete or ineffective. Market innovations that provide real value for participants and customers are now free to develop as quickly as technology permits and customer demand requires.
The CFTC has worked hard to implement the new Act. In the twenty months since passage of the CFMA, the Commission has succeeded in modernizing the rules governing exchanges and other trading platforms. We have also succeeded in developing joint rules with the Securities and Exchange Commission to permit the trading of futures on single stocks and narrow-based stock indices, contracts that were denied to market participants for almost twenty years prior to the CFMA. I am excited about the upcoming launch of trading in these important new risk management tools and curious to see how and by whom they will be utilized.
The CFMA provided for far more than just single-stock futures and rule modernization for exchanges. The Act’s full implementation remains my highest priority as we continue working on such things as rule modernization for intermediaries and foreign as well as domestic security futures.
With respect to the situation in the energy markets, let me begin by giving you an overview of the Commission’s mission and how we pursue it. The Commission perceives its mission to be twofold: to foster competitive and financially sound markets, and, to protect market users and the public from fraud, manipulation, and abusive practices. In seeking to fulfill that mission, the Commission focuses on issues of market integrity. We seek to protect the economic integrity of the markets so that they may operate free from manipulation. We seek to protect the financial integrity of the markets so that the insolvency of a single participant does not become a systemic problem affecting other market participants. We seek to protect the operational integrity of the markets so that transactions are executed fairly, proper disclosures are made to existing and prospective customers.
The CFTC is an enforcement agency with almost half our staff working in the Enforcement Division. If any indication of fraud or manipulation is found, the Commission will investigate and prosecute violations of the Commodity Exchange Act or our regulations. We have available a variety of administrative sanctions, such as bans on future trading, civil monetary penalties, and restitution orders. The Commission may seek federal court injunctions, asset freezes, and disgorgement orders. If evidence of criminal activity is found, matters can and will be referred to state authorities or the Justice Department for violations of criminal statutes, such as mail fraud, wire fraud, and conspiracy. Typically, the Commission has over a hundred investigations open at any particular time. Over the years, the Commission has brought numerous enforcement actions and imposed sanctions for attempts to manipulate prices. The Sumitomo copper case and Hunt brothers silver case are well-known examples.
The Commission oversees the on-exchange trading of energy-related futures and option contracts based on such things as crude oil, natural gas, heating oil, propane, gasoline, and coal. Several U.S. exchanges are designated to trade energy product futures and options, but the overwhelming majority of on-exchange energy transactions are executed on New York Mercantile Exchange. The CFTC does not regulate the trading of energy products on the cash or forward markets, which are excluded from our jurisdiction under the Commodity Exchange Act. Additionally, while the Commission does not have regulatory oversight responsibility for over-the-counter energy markets, we do have anti-fraud and anti-manipulation authority.
The rapid financial deterioration of Enron last year presented a concern about the markets: Could on-exchange futures markets be protected from price volatility or reduced liquidity if large positions were suddenly unwound? Enron was but one of many participants in what are very large and liquid markets and when its financial difficulties became known, energy futures price showed remarkably little reaction: The markets for energy-related futures were not roiled and prices did not spike nor did liquidity dry up. The difficulties of any large market participant also raise concerns about the ability of intermediaries carrying that trader’s positions to successfully manage those positions if the trader fails to meet margin calls. The Commission worked closely with the NYMEX clearinghouse last fall to ensure that the winding down of certain large positions was accomplished quickly and smoothly. I believe that this episode was a success for the system of financial controls at the exchanges. There were no disruptions to the system of clearance and settlement. Each trader met its obligations. No customer lost funds entrusted to any intermediary.
In 1999, the President’s Working Group on Financial Markets released a report entitled “Over-the-Counter Derivatives and the Commodity Exchange Act.” This report recommended changes to the CEA to, among other things, create legal certainty for off-exchange derivatives transactions, such as swaps. Congress considered these recommendations and ultimately codified many of them, together with substantial reforms of the regulatory regime for domestic exchange-trading of futures and options, in the CFMA.
I have testified before Congress several times on the Enron situation. The Commission has opened investigations into certain alleged events in the energy markets and these investigations are ongoing. We have worked closely during this process with the Federal Energy Regulatory Commission, the SEC, and the Justice Department. In addition to leading to formal action against wrongdoers, these investigations may reveal facts that cause us to revisit our rules or even to suggest legislative changes. Until such time, however, I believe that the prudent and proper course is to focus on the investigations and work to determine the factual evidence. Only then can I make responsible recommendations to Congress regarding potential changes in regulations for OTC energy markets. In the meantime, we have recently approved the clearing of OTC energy contracts to facilitate credit stability. You will hear more with regard to our investigations in the weeks to come.
The last twelve months have been quite eventful, however, for everyone in the financial sector. More than at perhaps any other time in its history, the Commission has been involved in joint efforts with other financial regulators. Recently, I was asked to participate on the President’s Corporate Fraud Task Force, which is an effort among independent agencies, U.S. Attorney offices, and the Justice Department to coordinate investigations and enforcement activities. Earlier this year, as one of the four members of the President’s Working Group on Financial Markets, I had the opportunity to work with Secretary O’Neill, Chairman Greenspan, and Chairman Pitt to review for the President possible improvements in accounting, auditing, and disclosure practices with respect to publicly-held companies. I applaud the President for issuing his “Ten-Point Plan to Improve Corporate Responsibility and Protect America’s Shareholders.” The President’s important recommendations on enhancing disclosures by publicly-held companies and strengthening auditor independence should provide valuable protections for investors, creditors, and counterparties.
The Commission has also been actively involved in cooperative efforts, particularly with the Treasury Department, to implement the anti-money laundering provisions of the Patriot Act, and in doing so have strived to put into place practical, workable, and effective measures. In an era where financial regulators must now be concerned not only with marketplace misbehavior by domestic participants but also with attempts by external enemies to use our markets to fund or conceal their activities, and where we must watch not only for wrongdoing in the trading pit but also in the boardroom, such joint efforts in law enforcement are regrettably very necessary and the CFTC will cooperate fully in them.
In conclusion, as you can see, the Commission has been very busy. As we move forward to address problem areas from a policy perspective, we must do so in a well reasoned, methodical fashion using only factual information. Markets have been damaged and investors and customers injured. As regulators, we must address real market deficiencies and not perceived problems, we must avoid overly broad regulations that could potentially do more harm than good.