Remarks of Chairman James E. Newsome to
the Electric Power Supply Association
Washington, D.C. - October 23, 2002
Thank you, Mike, for that introduction. I was pleased to be invited here today. These are both challenging and exciting times for the derivatives markets and I am honored to be at the Commodity Futures Trading Commission at this point in history. I would like to share with you today some of the things I have noted about the marketplace and the role I see for the CFTC.
Derivatives generally continue to grow in their contributions and importance to the U.S. and global economy. Futures and option volume has increased over 30% this year 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. Swaps volume has also grown tremendously, up a hundred-fold since 1987, with gross notional values of over $100 trillion. I agree with Chairman Greenspan’s observations that growth in the derivatives markets has contributed to a more flexible and efficient financial system and that derivatives can propel growth, increase resilience, and maintain stability.
When I came to the Commission four years ago, I saw new platforms and trading technologies coming rapidly to the futures markets and I could see that electronic trading was growing at a tremendous pace. These 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, and were even stifling innovation and progress. Fortunately, help was soon to be on the way in the form of the Commodity Futures Modernization Act.
I should say at this point that I have a relatively simple regulatory philosophy that can 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, believe in providing the most flexible and responsive regulatory regime possible. For those who choose not to play by the rules and who attempt fraud or manipulation, however, I can promise prompt investigations and aggressive exercise of our authority under the Commodity Exchange Act. The derivatives markets are too important to the countless investors, producers, distributors, and users of commodities that rely upon these markets for their risk management needs -- certainly, too important for the growth and stability of the economy as a whole -- to tolerate misbehavior that threatens the efficiency and reliability of these markets or that undermines trust in their integrity.
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 through its targeted flexibility.
Specifically, the Act instituted principles-based rules that allow rules to be tailored to the sophistication of market participants, the nature of the contracts being traded, and the manner in which they are traded. This framework appropriately takes into consideration the costs and benefits of compliance, allows business to be conducted without unnecessary restrictions, and reflects a common sense approach to regulatory oversight. 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, progress that was both necessary and timely.
The new oversight approach called for by the CFMA empowers the Commission to accomplish important public policy goals, without stifling innovation driven by new technologies and the evolving needs of market participants. Innovations that provide real value for participants can now develop as quickly as technology permits.
The CFTC has worked hard to implement the new Act. Since passage of the CFMA, the Commission has successfully modernized the rules for exchanges and other trading platforms. We have also succeeded in developing joint rules with the SEC to permit the trading of futures on single stocks and narrow-based stock indices, contracts that were prohibited for almost twenty years prior to the CFMA. I am excited about the upcoming launch of trading in these new risk management tools and curious to see how and by whom they will be utilized.
However, 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.
Events in the energy markets have presented the Commission with a number of challenges. First, as the financial condition of Enron rapidly deteriorated last year, there was immediate concern over whether the futures exchanges could be protected from price volatility or reduced liquidity if large positions had to be suddenly unwound. Although Enron was a large participant, it turned out that these large and liquid markets were able to cope well with the situation. 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 clearinghouse 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 in place. There were no disruptions to the system of clearance and settlement. Each trader met its obligations. No customer lost funds entrusted to any intermediary.
Once the winding down of on-exchange positions had been successfully accomplished, the focus of many commentators turned to the issue of off-exchange oversight. 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 Commodity Exchange Act to, among other things, create legal certainty for off-exchange derivatives transactions. Congress codified many of these recommendations in the CFMA, which was signed into law in December 2000, but certain provisions of the new law drew new attention as the problems at Enron emerged.
I have been called to testify before the Congress several times on the Enron situation. We have also monitored -- and been asked to provide technical expertise on -- proposed legislative changes. However, because the Commission has opened investigations into certain alleged events in the energy markets which may reveal facts that cause us to revisit our rules or suggest legislative changes, I believe the proper course is to focus on those investigations. Only when the facts are determined can I responsibly consider offering any recommendations to Congress regarding potential changes in regulations for OTC energy markets.
Although I am keenly aware of the challenges facing users of OTC risk management tools, I would like to note some of the positive changes I have seen in the energy derivatives markets. Earlier this year, the Commission approved the clearing of a number of OTC energy contracts by a regulated clearinghouse, which may help to mitigate credit and counterparty risk concerns, and even enhance the credibility of these markets. I have also noted EPSA’s initiative in adopting a new code of ethics. I understand compliance with this code, along with annual certifications, is now a condition of membership. You are to be commended for this effort.
There are other indications of movement toward incorporating codes of conduct in transaction documents, improving systems to better detect wash trades, and establishing dedicated compliance functions. I applaud such initiatives and encourage all market participants, especially system providers, to continue to pursue these and other efforts to restore confidence in the use of risk management mechanisms in the energy sector. I believe that market responses, coupled with appropriate regulatory responses arrived at only after careful consideration of the facts, are critical to restore confidence in the marketplace.
The last twelve months have been quite eventful 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 regulators. 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 President Bush 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.” These 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 to implement the anti-money laundering provisions of the Patriot Act, and in doing so have strived to put in place practical, workable, and effective measures. Recently, I was asked to participate on the President’s Corporate Fraud Task Force. In an era where regulators must now be concerned not only with misbehavior by domestic market 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 is cooperating fully in them.
As we move forward to address policy concerns, we must do so in a well reasoned, methodical fashion and rely on verified facts, not conjecture or speculation. Markets have been damaged and market participants injured or disadvantaged. As regulators, we must address real market deficiencies and not perceived problems and we must avoid overly broad regulations that could potentially do more harm than good.