Speech to the Bond Market Association
New Domestic Landscape for Financial Futures Seminar
Sharon Brown-Hruska, Commissioner
Commodity Futures Trading Commission
September 9, 2003
It is a great pleasure to address you today on the topic of the “New Domestic Landscape for Financial Futures”. It is clear that we are experiencing a tremendous surge in innovation and change in the industry. The modernization of our laws via the Commodity Futures Modernization Act helped solidify an environment where the introduction of new products, including single security futures and various hybrid products, could go forward without the legal uncertainty that had prevailed in the past. This is a very exciting time to be at the Commission, where under Jim Newsome’s leadership we have pressed forward with rulemakings and updated processes to further implement the regulatory model that enables such progress. Yet there is still much to be accomplished to ensure that innovation and value creation continues, not just in the space of a particular market or one agency, but throughout the entire financial sector.
Before I get too far along, I must note that the views I express do not necessarily represent the official position of the Commodity Futures Trading Commission (CFTC), but rather are those of one Commissioner. My research has focused on how changes in regulatory policy and market structure affect aspects of market quality, and the public policy implications of those effects, and that perspective will be evident in my comments today.
I would like to share with you my thoughts about innovation. Not just innovation in products and markets, but what I call “regulatory innovation.” Regulatory innovation is actually the toughest kind, since there are many forces against change in the regulatory arena, often including regulators themselves. Achieving regulatory innovation requires proactive participation by government: including not only regulators, but also legislators, the administration, and industry interests like traders, firms and exchanges. This kind of innovation requires a full court press. But the payoff is huge, with markets that are more efficient and agile, igniting innovation in products and services that can lower risks and increase wealth for individuals, business, and the economy.
The Commodity Futures Trading Commission, created in 1974 and given exclusive jurisdiction over futures markets, has had the unique challenge of regulating derivatives, perhaps the most innovative markets of our time. In our case, regulatory innovation was propelled by market innovation, since the derivatives industry has seen tremendous change and concomitant uncertainty. Part of the uncertainty, as many of you know, derived from ambiguity over what kind of regulation was appropriate for these products, as well as what regulatory agency had jurisdiction over the variety of derivatives that were being developed.
Since its inception, the CFTC has been at the center of a jurisdictional storm, since derivatives, by definition, are contracts whose value is based on prices and rates associated with commodities and assets that are also regulated by various other agencies within the federal government, as well as by state and foreign regulators. For example, the CFTC regulates US futures and options markets on agricultural commodities, while the Department of Agriculture oversees the cash commodities themselves. The CFTC regulates exchanges that trade US treasury futures and stock index futures, while the Department of the Treasury, the banking authorities, and the Securities and Exchange Commission (SEC) regulate the underlying securities markets.
As a professor teaching courses on derivatives, in particular their risk and pricing structure, I had always felt that product-specific regulation was a logical approach that allowed for a kind of regulatory specialization that was necessary and effective, and this seemed particularly true when I was at the CFTC in the early 90s. However, over the years the CFTC has had to contend with numerous challenges to its jurisdiction, both in the courts and from other agencies, and this has created significant legal uncertainty for the developers and users of derivative products. Indeed, legal uncertainty was so acute in the territory of derivatives on equities, it took an act of Congress to help resolve the jurisdictional impasse between the CFTC and the SEC to finally allow the introduction of security futures products.
That act was the Commodity Futures Modernization Act (CFMA) of 2000 and it not only sought to resolve the legal uncertainty experienced by users of financial derivatives, but it also laid out a blueprint for regulatory innovation. Following the guidance of the President’s Working Group on Financial Markets outlined in the report on Over the Counter Derivatives Markets and the Commodity Exchange Act, the CFMA codified changes that were necessary to allow the CFTC to cope with innovation, including that of the rapidly expanding over-the-counter (OTC) markets and the increasingly electronic and global marketplace.
The CFMA was the culmination of a ongoing effort, going back even before the Swaps Exemption of 1992, to recognize that banks and other financial institutions that market over-the-counter transactions were often already under the purview of other regulatory agencies. Further, given that OTC transactions were typically customized transactions done on a principal to principal basis between professional market participants and sophisticated counterparties, it was recognized that the prescriptive regulatory approach and invasive disclosure requirements typical of exchange-style regulation were not meaningful nor practicable.
Replacing the model of day-to-day review and approval is a mechanism that allows markets to self-certify new rules and rule changes, proposed contracts, or operational changes that are consistent with core principles. The core principles are complemented by a system that no longer relies on checking the figures on financial statements or checking off boxes in our audit and compliance function, but instead moves us in the direction of a risk-based model of compliance. Again, this is a road that many of our markets and firms have been paving for the last 20 years, using techniques like Monte Carlo simulation and variance at risk (VAR) type models to determine everything from prudent margin levels to minimum capital requirements.
The regulatory model of oversight, rather than one of rules-based day-to-day regulatory intervention, is not untested. In fact, those of you more familiar with the fixed income market will recognize that this model is more close to that of the banking sector than that of the equities market model. The banking regulatory model is not one-size-fits-all, but instead employs different levels of regulatory involvement based on the quality of one’s assets and liabilities. Regulators apply risk weighting to the assets held, with the understanding that not all assets are created equal.
Similarly, our regulatory model recognizes that not all markets are created equal. The statutory framework adopted in the CFMA allows different levels of regulatory involvement depending on the type of market one is operating and the sophistication of the market participants using them. For example, institutional market participants not needing the same protections as retail market participants are subject to a less intrusive regulatory framework than traditional markets like exchanges, which are increasingly available to retail customers.
Many critics have chimed that this model leaves holes in our regulatory coverage that could allow train wrecks to occur that, they say, could otherwise be prevented. I believe, however, that the government cannot be the engineer on every train, and that a hold-every-hand model is costly and not any more effective than an oversight model. Even in the exempt markets, we retain and have exercised our authority to police against fraud and manipulation. In the OTC energy markets, for example, we have vigorously pursued those who engaged in false price reporting and manipulation. In the retail foreign exchange markets, we have been equally effective in prosecuting fraudulent activity that takes place outside the confines of our contract markets. Rather than limiting our authority or our jurisdictional reach, the tiered oversight model has increased our strength and effectiveness as a regulatory agency.
In my view, the most important feature of the principles-based orientation is a movement away from regulatory micromanagement of business decision-making. Many of you who know me and my work know that I have long been critical of actions by regulators to dictate specific terms or conditions related to contract design and market structure. In these areas, I believe that the economic incentives of those who operate exchanges and firms who enter this market are aligned such that they will make the choices that are not inconsistent with our regulatory goals.
Economic incentives are a driving force not only to market operation, but also to effective market self-regulation. Regardless of their organizational structure, self regulatory organizations (SROs) dedicate substantial investment to ensuring that individual misdeeds and isolated implosions cannot and will not jeopardize the integrity of the whole market. The incentives of industry to build reputational capital to attract investors make self-regulation work.
Marshalling the expertise of the industry, drawing on its self-knowledge of costs and benefits, allows the CFTC to more efficiently use our 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. Concerns that there may be embedded conflicts in the self-regulatory model are worthy of consideration, and the CFTC will investigate that potential in our forthcoming study of SROs. In this regard, I am looking forward to the comments of Dan Roth, Chief of the National Futures Association, who will discuss his assessment of concerns about conflicts and the merits of the self-regulatory model.
Experience demonstrates that regulators, in a desire to protect a segment of a market or industry, often establish rules and regulations that 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, 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.
In my view, requirements for mandatory disclosure of information are one of the most common, and potentially, most costly forms of prescriptive regulatory policy. In recent years, we have seen a number of proposals and rules requiring greater disclosure of transaction information, particularly in equities, bonds, and over-the-counter markets.
Requirements for public dissemination of information are often seen as the safe solution to all manner of ill that comes with very little cost. This is considered true regardless of whether the information may be proprietary; regardless of whether it may provide a free ride to competitors; regardless of whether it compromises one’s ability to lay off the risks of open positions; regardless of whether we as regulators have the resources or the skills to evaluate the information; and regardless of how investors value the information.
For instance, in the past, both the CFTC and the 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. On its face, 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 agree that education is positive.
In looking at the history of disclosure document rules, however, 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 a 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?
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 ‘get it.’
Clearly, joint regulation of security futures products by two regulatory agencies has involved some compromise. In addition to disclosure documents, such compromise has occurred in margin levels and the methodology for setting them, in the determination of position limits, and more recently, in negotiating whether and how notice registered exchanges are to be examined and inspected by a secondary regulator when they are already subject to the same level of scrutiny by their primary regulator. In my reading of it, the CFMA was clear when it instructed that the agencies should endeavor to avoid duplicative and costly regulatory requirements.
Congressional intent in the CFMA that the CFTC avoid prescriptive regulatory mandates and that we respect an exchange’s ability to make decisions and adopt rules without regulatory micromanagement remains relevant, as well. Security futures products have incurred their developer’s substantial investment and exchange incentives are aligned to ensure that their rules comply with our core principles requiring that their markets are fair and transparent, free from fraud and not susceptible to manipulation, and that investors are protected.
Security futures products hold tremendous promise, as a potentially low cost method to take a position without the supply constraints of short selling or up-tick rules in the stock market, as a decisive way for retail investors who hold diversified or sector funds to make adjustments to hedge their short term risks and get to their optimal portfolios, and various other uses to numerous to mention. As a result, I think both our agencies must be willing to put aside our egos and be committed to work together to give these products a real chance, and to make or revisit decisions where we could improve the regulatory environment. It should never be said that regulation by either of our agencies was an impediment to this product’s success and implied benefits that can be realized by investors, the financial industry, and the economy.
Hedge fund regulation is another area where the SEC and the CFTC share a joint interest in protecting investors and ensuring market integrity, while encouraging innovation, economic growth, and efficiency. The number of Institutional Investor’s Platinum 100 largest hedge funds that were registered as Commodity Pool Operators (CPOs) under the CFTC’s delegated authority grew from 55 in 2002, to 65 of the top 100 funds in 2003. In addition, 50 out of the 100 largest hedge funds were also registered with the CFTC as Commodity Trading Advisors (CTAs).
Many predict that the regulatory relief we have granted to CPOs and CTAs under the CFMA to rationalize regulation for sophisticated or otherwise regulated entities will lesson the proportion of hedge funds on our radar screen. Jane Thorpe, Director of our Division of Clearing and Intermediary Oversight, will provide more specifics on our exemptions from registration for those funds engaging in de minimus futures investments or otherwise regulated entities, and discuss our plans for further relief for intermediaries later in the afternoon. While we recognize that regulatory relief may change the landscape of firms over which we survey, a few factors come to mind that may lead to an increase in those funds registered as CPOs and CTAs.
First, the USA Patriot Act requires that all financial entities, including hedge funds, select and submit to an approved regulatory agency for identification of fund sources and fund flows. The expertise of the CFTC in the derivatives markets, its demonstrated comfort with the complexities of the global market, and the significant use of futures products by hedge funds makes the CFTC the agency most likely to be selected by these funds, given that they must demonstrate their compliance with the anti-money laundering requirements (AML).
In addition, pursuant to our delegated authority to the NFA, elective registration with the CFTC will get those firms an independent and expert review that includes periodic examinations, evaluation of internal controls, and review of required disclosure documents and financial statements. Again, the incentives of firms to build reputational capital by submitting to regulation that I believe is appropriate, is not only good business, but good public policy.
In order to bring the benefits of credit mitigation to the broader market and to reduce systemic risk in the financial markets, the CFMA gave the CFTC more explicit authority to regulate the clearing function and to facilitate greater capital efficiency through portfolio margining. This has created opportunities for the clearing of over-the-counter products at the New York Mercantile Exchange (NYMEX) and the Intercontinental Exchange (ICE).
Our separate authority in clearing has also been tested by the Chicago Board of Trade’s (CBOT) decision to use the Chicago Mercantile Exchange (CME) as their clearinghouse. This clearing link offers great opportunities for cross margining in the interest rate complex offered by the two exchanges, especially when hedging swaps exposures, implementing credit spreads, and Treasury-Eurodollar spread positions. For a long time, putting these positions on in the exchange-traded market has been expensive, both in terms of “slippage” in the pit environment and capital commitment.
As many of you know, both exchanges have increasingly embraced electronic mechanisms for order delivery, execution, and to a lesser extent, processing. In the last few months, the percentage of trades done electronically at the CBOT has exceeded those done in the pit, and this percentage has been lead by the 10 year Treasury Note Contract. As electronic trading helps to reduce slippage costs, the CBOT/CME Clearing Link promises to deliver a significant reduction in the capital required to assume futures positions.
As the markets are becoming increasingly global, the CFTC cannot just focus on domestic markets. The expected application of Eurex to enter the U.S. market demonstrates this point. One innovation that Eurex envisions is the ability to clear on a global basis. This could create even greater potential savings to firms operating internationally. In this regard, the CFMA affords the CFTC the ability to facilitate global markets and help US investors expand beyond our borders.
In closing, I would simply say that we are already starting to see the fruits of regulatory innovation. As I have mentioned, we have seen innovation in the introduction of security futures products, in the clearing of OTC products, linking of clearing between exchanges, and the pending entry of an international exchange into the U.S. market. In these and in other potential innovations that may arise, we as regulators need to move quickly and effectively to ensure that we do not create artificial barriers to entry and that we remove impediments to legitimate business activity where they exist. Granted, regulatory innovation is difficult, but I believe that because of it, we will be more effective in our primary mission to protect investors and ensure the financial and economic integrity of our markets.