Address by Chairman James E. Newsome of the
U.S. Commodity Futures Trading Commission before the
Bond Market Association
New York, New York - April 11, 2003
It is an honor to address the Bond Market Association this morning. Since some of you may not be very familiar with the Commodity Futures Trading Commission, I’d like to use my time here this morning to tell you generally how we do business. Specifically, I want to describe my philosophy of effective market oversight. I’d also like to describe some of our current efforts, including some of our rule modernization proposals and enforcement cases.
The CFTC oversees the trading of futures and options on commodities, including those based on tangible physical commodities, such as agricultural commodities, energy products, and metals, as well as contracts based on financial measures such as stock indices, foreign exchange rates, and government securities. Within our jurisdiction are not only the organized futures exchanges in New York, Chicago, and elsewhere but also the clearinghouses and futures commission merchants who process transactions, the commodity pool operators and commodity trading advisors that direct much of the trading activity, and a variety of newer trading platforms, such as all-electronic commercial derivatives markets that have developed up since passage of the Commodity Futures Modernization Act two-and-a-half years ago.
Today, roughly 80% of the volume in futures trading is made up of contracts based on financial measures. About 8% of the volume is in agricultural contracts, and the remainder in contracts on precious metals and energy products, such as crude oil and natural gas. I should note that ag contracts, which only a few decades ago constituted the entire futures market, are being traded just as actively today as they have ever been. It’s simply that financial contracts have grown astronomically since their initial introductions in the mid-1970s. And it is for this reason that the CFTC today is considered a financial regulator. I believe that the incredible growth in the trading of these contracts demonstrates that the derivatives markets are providing important risk management tools to an ever growing number of investors and businesses in virtually every sector of the U.S. economy.
The Commission is currently composed of four commissioners, including myself, but may have as many as five. Typically, there are two Democratic commissioners, two Republicans, and a Chairman that represents the party of the Presidency. However, as an independent regulatory agency, we have operated relatively free of partisanship, which is a point that makes us very proud. Recently, we reorganized and modernized the structure of the CFTC to make better use of our resources in overseeing these important and dynamic markets. Our Division of Market Oversight, which includes primarily economists, conducts ongoing market surveillance and other key functions, including reviews of contracts and exchange rules. Our other major regulatory unit is the Division of Clearing and Intermediary Oversight, which includes auditors and other staff who monitor the financial and operational integrity of the clearinghouses and their clearing members to ensure that customer funds are protected and that safeguards are in place to prevent individualized financial problems from being transmitted through the system. This division also handles the registration of FCMs, pools operators, and trading advisors. Supplementing the expertise of these two divisions is our Chief Economist’s Office, which provides key analysis to the other divisions and to the Commission, as well as our General Counsel’s Office, which provides legal expertise to the Commission and handles such matters as our appellate cases.
We have a very effective Division of Enforcement to investigate and bring cases against those who attempt to defraud customers, manipulate prices or supplies, or otherwise violate the Commodity Exchange Act and the Commission’s rules. We have also formed an External Affairs Office to respond to inquiries from the public, the press, and the Congress and to communicate our position on issues pending before the Congress or other agencies, including legislative matters that could affect the markets we oversee.
In addition to our individual efforts, the CFTC also works cooperatively with other financial regulators. As Chairman of the CFTC, I sit on the President’s Corporate Fraud Taskforce. I am also honored to be a member of the President’s Working Group on Financial Markets with Secretary Snow, Chairman Greenspan, and Chairman Donaldson. The members of the PWG were in immediate and constant contact following the September 11th attacks. I believe that coordination helped effect the smooth reopenings of the financial markets. In fact, I believe that this sort of coordinated decision-making, at the highest levels of government, should be brought to bear in the event of any major market crisis, a topic which I discussed with Bond Market Association representatives just last week. My experience has been that this coordinated approach has advantages, especially in markets that reach across regulatory jurisdictions or that can affect other markets in the financial system.
As I’ll discuss in a moment, the CFTC works cooperatively with other agencies in a variety of formal and informal ways to address circumstances in the derivatives markets. When I came to the Commission in 1998, I could see that new technologies promised rapid and meaningful improvements in the marketplace and that these changes could bring new participants, greater liquidity, and increased efficiency to the markets while also enhancing customer service, lowering barriers to effective cross-border business, and generally improving the availability and usefulness of risk management tools. Yet it also quickly became apparent to me that the regulatory structure did not always facilitate such progress. In fact, the regulatory structure in some cases stifled innovation and efficiency.
Fortunately, help soon arrived in the form of the Commodity Futures Modernization Act, a much-needed law that I consistently supported. The CFMA embodied three key objectives: rule modernization for both the trading platforms and the market users, legal certainty for the over-the-counter derivatives markets, and legalization of futures based on single stocks and narrow stock indices. The CFMA has also provided the Commission with the flexibility to modernize its oversight of these markets, something that I have greatly appreciated because it has allowed us to make key changes in how we approach the important task of protecting market participants and ensuring the integrity of the market mechanisms.
I have a straightforward market oversight philosophy that reflects two basic principles. First, for the legitimate business activities of those 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 we should provide the most flexible and responsive oversight structure possible.
But, for those who attempt fraud or manipulation, I believe in the most prompt and aggressive exercise of our enforcement authority under the Commodity Exchange Act. More specifically, my view is that the proper deterrent to wrongdoing should not be more prescriptive or burdensome regulations that adversely affect legitimate activities but, instead, tough enforcement actions against those who would try to operate outside the established rules.
I have noticed that the temptation to resort to prescriptive regulations, which often take a very static view of markets or technology, has sometimes been hard to resist for regulators. I believe that successful market oversight requires an agency such as ours, one that is witnessing great change in the markets, to be innovative and to adapt to changing market realities. The CFMA affords the CFTC the opportunity to do so through its targeted flexibility; through principles-based rules, it allows oversight to be tailored to the nature of the particular contracts being traded, the sophistication of the market participants involved, and the manner in which those contracts are traded. Overall, the framework reflects a common sense approach to market oversight and empowers the Commission to fulfill its important public policy mission without stifling the innovation driven by new technologies or the evolving needs of market participants.
A good example is the first major set of rule modernizations that the Commission was able to implement very quickly after passage of the CFMA. These rule modernizations affected exchanges and other trading platforms. Congress also allowed the CFTC to review the rules affecting market intermediaries, such as futures commission merchants, pool operators, and trading advisors. After soliciting input from market participants through hearings and roundtables, we recently published a number of proposals for public comment, some of which address issues that have challenged the Commission for years. The proposed changes include rule modernizations affecting not only our traditional registrants but also changes to improve access to risk management tools for mutual funds, insurance companies, and banks. I would encourage each of you who may be interested to comment on these proposals because the insights and concerns of market participants are invaluable to the Commission as we seek to improve the way we oversee these markets.
My desire to pursue this continuous improvement in our oversight is due to my belief that one-size-fits-all regulations and inflexible prohibitions that ignore unique risk management needs are effective neither in maximizing the efficiency of our various markets nor in minimizing the risks to participants. Rather, I believe an oversight structure which permits innovation in risk management while maintaining and enhancing workable safeguards is not only the best protection against systemic problems, but also a good provider of legal and regulatory certainty for business decision-makers.
The increasingly more widespread use of derivatives to manage risk not only benefits direct users but also contributes to greater flexibility, resiliency, and efficiency in the economy. The importance of these markets only strengthens my determination to protect them from attempts at fraud, abuse, or manipulation. Our efforts to modernize CFTC rules to allow greater flexibility and innovation for legitimate business activities must be accompanied by our continuing determination to use strong enforcement actions to deter illegal activities. Accordingly, it has been my consistent policy to bring the Commission’s enforcement capabilities fully to bear on anyone who attempts to compromise their integrity, efficiency, or reliability.
In the short time since passage of the CFMA, which clarified our authority over illegal off-exchange forex bucket shops, the Commission has used that authority to bring almost two dozen cases. At the end of last year, the Commission imposed a $5 million civil monetary penalty against two firms in connection with false reporting and attempted manipulation. Last month, we filed a complaint in federal court in Houston against a former major energy trading company, alleging manipulation of natural gas prices and the online operation an illegal futures exchange. Also last month, another large energy trading firm entered into a consent order with the CFTC penalizing it $20 million for the reporting of false information to energy price reporting services. Our Enforcement Division is actively engaged in other energy sector investigations, which may result in further charges being filed.
During these investigations, the CFTC has cooperated closely with other regulators. The cases are complex and require substantial time and resources to develop, but it is my goal to identify the wrongdoers, and, just as importantly, to exonerate those not involved, as expeditiously as possible so that the energy and energy derivatives markets can work toward restoring the confidence of market participants and the public.
Investigations and enforcement cases are not the only ways in which we are cooperating with other oversight agencies. For example, earlier this year, we jointly hosted with the Federal Energy Regulatory Commission a conference on possible solutions to credit risk problems in the energy sector, at which I was made even more keenly aware of the challenges facing those who very much need the risk management tools offered by OTC energy derivatives. The CFMA made possible one potential solution, the clearing of OTC derivatives by futures market clearinghouses. The Commission has been working since early last year with the New York Mercantile Exchange, the Intercontinental Exchange, and EnergyClear on initial efforts in this area because we recognize that centralized clearing can do much to address counterparty credit concerns, which appear to be a key concern among potential market users.
As a follow-up to discussion at that conference, FERC Chairman Pat Wood and I wrote jointly to Congress to express our strong support for certain previously proposed amendments to the bankruptcy code that could help to alleviate counterparty credit risk concerns by ensuring the enforceability of acceleration and termination provisions, netting clauses, and other contractual safeguards in the event of one counterparty’s insolvency. I know that the Bond Market Association is very familiar with these particular legislative initiatives.
A key reason that I have expressed my support for those amendments -- most recently with Chairman Wood but also previously as a member of the President’s Working Group on Financial Markets -- is that they would provide market participants with a greater degree of certainty that the key protections which they carefully negotiate into their transaction agreements will be honored and enforceable should a problem ever arise. I believe that certainty for counterparties is critically important to the smooth and efficient operation of markets. If laws, regulations, or even enforcement policies are unclear, then market participants must factor that uncertainty into their decisions and this, in turn, can often result in missed opportunities, inefficient results, or misallocated resources.
In closing, let me express my high regard for the staff and leadership of the Bond Market Association. They do a good job of representing your interests in Washington. I have enjoyed our meetings and find their input and insights educational. Thank you again for the invitation to be here this morning and for allowing me to update you on our efforts at the CFTC.