Remarks by Commissioner Sharon Brown-Hruska
Commodity Futures Trading Commission
On the Regulation of Commodity Futures, Options and Derivatives Markets
Conference on Corporate Behavior and Financial Markets
April 11, 2003
Good morning. It’s a pleasure to be invited to participate in this conference on corporate behavior and financial markets. Last year I attended this conference as a George Mason University finance faculty member. Appointed by the President, and confirmed by the U.S. Senate in August of 2002, as a Commissioner at the Commodity Futures Trading Commission (CFTC), I hope to reassure you that my perspective is still intact. Hence, the views I express are my own and, therefore, do not necessarily reflect those of the Commission’s staff or other Commissioners.
An economist by training, I find it gratifying to bring an economics-based approach to this level of regulatory decision-making. The Commission is immersed in unprecedented, historic efforts to restructure the regulatory landscape of the futures and derivatives markets. The rapid pace of innovation, and the entry of new competitors, both electronic and foreign, have made this regulatory modernization even more significant and timely.
This restructuring is being undertaken in accordance with the Commodity Futures Modernization Act of 2000, commonly referred to as the “CFMA.” Many of you here may remember former CFTC Chairman Phillip McBride Johnson’s remarks last year suggesting that the CFMA was overly deregulatory, representing a significant loss of authority for the agency. He especially questioned the exemption status conferred on certain over-the-counter markets. Naturally, having just been nominated by the President, and facing confirmation by a U.S. Senate that was generally opposed to anything deregulatory, I was a little concerned. I was also concerned that so many experts were declaring the eminent death of single stock futures before they had even started trading.
Contrary to conventional wisdom, the CFMA is not deregulatory. It is a smart piece of legislation that in the bravest fashion seeks to provide legal and regulatory certainty to markets that had been in regulatory limbo going back to the mid-seventies. The CFMA provides a template for adopting a more flexible regulatory structure under which the Commission is able to better match regulation to the characteristics of the marketplace. In addition, by clarifying our jurisdiction, and establishing core principles to guide our efforts, the CFMA allows us to provide much needed legal certainty to over-the-counter markets, and finally permits futures on individual stocks and narrow-based stock indices.
While there are still aspects of regulatory innovation that we are hammering out with our staff and other agencies, we have accomplished a great deal. I would like to share some of these achievements with you today. While some have suggested that various markets under our jurisdiction are unregulated, they are simply mistaken. For example, in the exempt energy markets, our exercise of fraud and manipulation authority allowed us to charge Enron with wrong doing, and we have entered settlements with El Paso and Dynegy for 20 million and 5 million, respectively, for false price reporting.
Our approach is a more targeted, principle-based form of regulation. This approach allows us to more effectively and efficiently use our regulatory resources to police and maintain the credibility of the markets, while also allowing us to reduce costs for market participants, consumers, and the taxpayers who pay our salaries.
The appeal of the CFMA is that the Commission can focus resources on areas that require close regulatory scrutiny, including markets that involve retail customers or commodities that are more susceptible to price manipulation. Simultaneously, a less prescriptive form of regulation is appropriate for markets that primarily involve sophisticated customers, or otherwise regulated individuals and firms that require fewer protections.
As anyone who has heard me speak, or read my articles, can attest to, my guiding philosophy with respect to the regulation of financial markets is economic in nature. First, we must avoid, when possible, reliance on overly prescriptive rules and regulations. Otherwise, as regulators we might cause more harm to markets and consumers, even as we strive to provide benefits to those the rules and regulations are intended to protect. Second, where rules and regulations are necessary, they should be targeted to achieve specific purposes, and the inevitable costs that they impose on the industry and customers must be justified by actual benefits. Third, rules and regulations must be complemented by aggressive enforcement designed to deter further abuses. A well-implemented system of enforcement and penalties will provide the economic incentives necessary to curb market abuses, without resorting to prescriptive measures that impose costs across all participants.
Experience demonstrates that regulators, in their zeal to protect a segment of a market or industry, often establish rules and regulations that haphazardly impose costs across all participants in the market, without fully assessing the benefits. Regulators must understand that when a rule affects trading activity, such as position or price limits do, and even when a rule indirectly affects the market, such as reporting and disclosure requirements, compliance with the rules raises the costs of trading and may adversely affect market quality.
For instance, in the past, both the CFTC and the U.S. Securities and Exchange Commission (SEC) have relied on regulations requiring that disclosure documents, which are often quite lengthy and detailed, be given to a potential customer before an account to trade futures, stocks, or options may be opened. Initially, this seems like a reasonable requirement. After all, a disclosure document educates customers on the investments in which they are about to embark. Everyone here today would probably agree that education is positive. After all, it is the core of your business.
In looking at the history of disclosure document rules, it is clear that this requirement, like “Pinocchio’s nose”, grew and grew. As the requirements expanded, the length, detail and complexity of disclosure documents have increased. The result is that fewer customers are willing to read them. As one example, Rule 9b-1 under the Securities and Exchange Act of 1934 requires brokers and dealers to provide customers a copy of an options disclosure document prior to accepting an order to purchase or sell an option contract. The disclosure most often used is a fifty-five page document, which is more suitable as text for an introductory options-trading course.
This raises a number of questions. First, should it be the role of a regulator to require firms to provide general information to customers that is already widely available? Second, how many potential investors actually need this type of detailed disclosure? Third, for those investors who need parts of the information being disclosed, how many actually read the entire document? Finally, is there a more logical, sensible approach?
A step in the right direction is the disclosure document given to potential investors in security futures contracts. While still a rather lengthy twenty-six pages, the document is half the length of the options disclosure document on which it is based. However, I would argue that we could go further than simply cutting the length of these disclosure documents. It is important to focus on delivering the information that is needed and ensure that those who need it not only get it, but also truly “get it.”
To further illustrate my views, I would like to highlight three initiatives that the Commission has recently proposed to eliminate unnecessary and costly rules, which I might add, in the past, have accomplished little in protecting customers. These proposed rule changes were the subject of a March 30th “Market Watch” column in the New York Times. The column criticized the Commission for proposing the changes, and for not recognizing that investors increasingly view deregulation as the best way to “propel the fox into the henhouse”. Unfortunately, like Chicken Little, the Times article seems to advocate running from the henhouse without careful consideration of whether the rules, as currently written, actually protect the public in an effective way. I would like to outline the proposed rules in hopes that those who better understand them will provide constructive comments.
The first request for comment proposes changes to the way in which the Commission requires commodity trading advisors (CTAs) to calculate and report their performance to managed account customers. Typically, an advisor will manage and trade a number of accounts in accordance with a proprietary trading program. Currently, advisors are required to perform calculations based on the actual amount of funds customers provide to their advisors. To the uninitiated, this appears to be a reasonable requirement. The problem, however, is that customers trading through the same trading advisor and program often have deposited different amounts, and calculating a meaningful and comparable number with actual funds becomes impossible.
A trading advisor will often designate a particular trading program as trading at a nominal account size—say $100,000. That $100,000, which is often referred to as the “fully-funded” or “notional” amount, is the amount the customer would be required to deposit with the advisor. As time has progressed, trading advisors have generally reduced the amount customers are required to deposit—these accounts are referred to as “partially-funded” accounts—and frequently few customers deposit the full amount.
Accordingly, to calculate returns for futures trading, what number do we use as the denominator? Many of you are probably thinking, this is a trick question; it is not possible to calculate a return on a futures position because these positions have no value when they are entered. While that is true, potential customers want to compare the performance of various trading advisors and programs, and a percentage return is something they are familiar with. In light of this problem, the Commission is requesting comment on whether to allow CTAs to calculate returns based on the notional account size.
A number of vocal commentators have argued that CTAs will be able to arbitrarily raise the notional amount to high levels in order to dampen the volatility of returns, and thereby make futures trading look no more risky than buying a money market account. However, this argument fails to consider that such a strategy would also reduce the size of returns, thereby making them no more attractive than a money market account. The important point is that once the decision is made to calculate returns on a futures position, we enter into a world where the numbers cannot be reconciled with reality, since the concept of a return is not well defined.
So, is it inherently wrong to allow return calculations using a notional amount? Very simply, no. What is important is that customers relying on these figures know how they are calculated, which happens to be the same whether notional amounts or actual amounts are used. In the end, there should not be a significant impact, if any, on customers and their ability to inform and protect themselves in these markets. On the other hand, a rule that requires advisors to calculate returns based on actual funds deposited by customers complicates the task for advisors, and increases costs that must be passed on to customers. The notional method increases the uniformity and comparability of the performance numbers. Far from “letting the fox in”, this method allows the chickens and farmers to better identify the fox.
A second proposal would allow trading advisers, when authorized by the customer, to bunch orders for execution and allocate them to individual accounts at the end of the trading session. The change is designed to provide flexibility to account managers to quickly bundle orders into larger sizes, resulting in more homogeneous prices for their customers. Under current rules, it is possible that similarly situated customers in an advisor’s portfolio of clients might receive different fills. If approved, the changes will allow advisors to treat customers more equitably through bundling of orders into a single order that receives one price, or through an allocation scheme that treats all customers the same.
Although the rule would treat customers more equally, there has been considerable criticism that it would allow a trading advisor to pick and choose how customers are treated. However, the National Futures Association, which oversees these particular compliance rules, has indicated that they have never uncovered, in the course of their audits, instances of abuse under current post-allocation rules. How can this be? Because we know exactly who is allocating under the rules.
Additional safeguards have been designed to protect customers so that they can elect whether their orders are bunched and can verify that the account manager does so fairly, without prejudice. In addition, the advisor will be required to maintain records demonstrating the fairness of the allocation scheme and make this information available to the Commission, the U.S. Department of Justice or other appropriate regulatory agencies, upon request. Hence, the Commission retains the right and ability to go after bad actors, while allowing those individuals and entities that follow the rules—the overwhelming majority of market participants—to more efficiently operate their business to the benefit of customers.
The third initiative I would like to mention is a proposal to exempt certain commodity pool operators (CPOs) and commodity trading advisors (CTAs) from registration. The change is aimed at reducing redundant regulation and removing regulatory burdens where sophisticated investors or otherwise regulated investors are involved.
Under the proposal, certain persons and qualifying entities, such as investment companies, insurance companies, banks, and other regulated entities, that include futures and options contracts in their trading strategies would not be required to register as a commodity pool. Because these entities are already subject to regulation by the SEC, insurance, pension fund or bank regulators, as well as state regulatory bodies, registration under the CFTC’s rules is an unnecessary and redundant burden. The caveat is that entities taking advantage of the exemption would not be able to market themselves as a commodity pool or a vehicle to trade commodity interests. Further, the Commission would retain special call authority to obtain information necessary to ensure compliance with the terms of our markets.
Consistent with the CFMA, where participation in a market, or in this case, an investment pool, is limited to sophisticated individuals or entities, as opposed to “retail customers”, there is less of a need to provide detailed disclosure documents or impose trading restrictions. Acknowledging this distinction enables regulators to open more markets to traders and investors, reduce costs associated with operating in these markets, and ultimately provide benefits to customers.
While on the subject of commodity pools and sophisticated investors, I would note that another allegedly unregulated asset class falls to some extent under the jurisdiction of the CFTC. A significant number of the hedge funds listed on Institutional Investor’s Platinum 2002 Hedge Fund 100 are registered with the CFTC. Of these top 100 hedge funds, 55 are registered as CPOs and 44 are registered as CTAs. Approximately 62.7% of the $260 billion in capital managed by Institutional Investor’s Platinum 2002 Hedge Fund 100 are controlled by firms registered with the CFTC as CPOs. As registered CPOs, they are subject to periodic examinations, review of required disclosure documents and financial statements pursuant to our delegated authority to the National Futures Association.
In regulation of hedge funds, energy, and single stock futures, the CFTC has and continues to work with financial market regulatory authorities through the President’s Working Group on Financial Markets. The goal of this group is to ensure the level and type of regulatory oversight is appropriate to protect investors while also ensuring that duplicative and costly regulations are not applied without justification.
In closing, I believe the Commission has made important strides over the past couple of years in implementing the Commodity Futures Modernization Act of 2000. The primary goal of the Act is to balance the costs and benefits of regulation by eliminating unnecessary, duplicative or questionable regulatory practices, while also continuing regulatory protections for markets and individuals, as appropriate. As I have discussed, the Commission has and continues to accomplish this balancing through the reduction of regulatory burdens in markets, or in circumstances where sophisticated or otherwise regulated investors are involved. The Commission has eliminated or revised rules that provide no, or limited, benefits and protections to customers. Finally, the Commission has adopted a vigorous enforcement program designed to catch lawbreakers and assess significant penalties as a deterrent to those who might be tempted to violate provisions of the Act and Commission regulations. Through these combined efforts, as regulators, we can establish a balance between cost effective rules, and a safe marketplace.