James E. Newsome, Chairman
Commodity Futures Trading Commission
Subcommittee on General Farm Commodities and Risk Management
Committee on Agriculture
U.S. House of Representatives
June 5, 2003
Chairman Newsome speaks with
Subcommittee Chairman Moran before testifying
Thank you, Chairman Moran, and members of the Subcommittee. I appreciate your giving me the opportunity to testify on behalf of myself and my fellow Commissioners at the Commodity Futures Trading Commission: Commissioner Barbara Holum, who has served impressively at the Commission, taking on numerous responsibilities such as chairing our Global Markets Advisory Committee; Commissioner Walt Lukken, who brought to the Commission a wealth of experience gained on Capitol Hill, including active involvement in the development of the Commodity Futures Modernization Act of 2000 (the “CFMA”); and Commissioner Sharon Brown-Hruska, who brings the valuable skills of a Ph.D. economist to the Commission. The commodity futures and options markets play a critically important role in the U.S. economy. Today, I would like to describe the CFTC’s role in overseeing those markets and how both the markets and our oversight have developed in the two-and-a-half years since passage of the CFMA.
As you know, the Commission was created by Congress in 1974 to oversee the nation’s commodity futures and options markets. The Commission’s mission is twofold: to foster transparent, competitive, and financially sound commodity futures markets that operate free from manipulation or distortion, and to protect users of those markets from fraud and other abusive practices. There are important differences between the futures markets and the stock markets. While the stock markets provide a means of capital formation, a way for new and existing businesses to raise funds, the futures markets provide producers, distributors, and users of commodities throughout the economy with the means to manage their exposures to price risk.
Historically, commodity futures were traded primarily on agricultural products. These contracts gave farmers, ranchers, distributors, and users of everything from corn to cattle an efficient and effective set of tools to handle the price volatility often experienced in agricultural markets. Indeed, risk management efforts were seen as so successful in the agricultural sector that this model was eventually adapted for use in other sectors of the economy when, more than two decades ago, contracts were introduced to manage volatility in interest rates, stock market indices, and foreign currency exchange rates. Subsequently, new contracts were developed to provide risk management tools to producers, distributors, and users of energy and metal commodities.
These non-agricultural contracts, following the tradition of success seen in the agricultural futures markets, enjoyed rapid growth as their benefits were quickly recognized by a wide variety of market participants. And while the agricultural contracts continue to enjoy volume growth and are traded as actively today as ever before, the financial contracts based on interest rates, foreign currencies, and stock market indices have actually outgrown them in trading volume because they are useful to market participants in so many sectors of the economy. Because they have come to serve the risk management needs of businesses in virtually every sector of the economy over the last two decades, the volume of trading in the financial contracts is now almost nine times that in agricultural contracts. While farmers and ranchers continue to use futures contracts to effectively lock in the prices for their crops and livestock months before they come to market, manufacturers now can also use foreign currency contracts to reduce uncertainty over the prices they receive for finished products sold overseas. Mutual fund managers can use stock index contracts to protect against market volatility and effectively put a floor on portfolio losses. And corporations in every sector can use contracts on U.S. Treasury instruments to manage their exposure to interest rate volatility.
Although I have described the primary purpose of futures markets as mechanisms for risk management, it should be noted that many futures markets play another important role in the economy, that of price discovery. That is, businesses and investors that may not be direct participants in a particular futures market may nonetheless refer to the quoted prices of certain futures market transactions as reference points or benchmarks for other types of transactions and decisions. This is particularly important in many agricultural markets where no other means of price discovery exist outside of the quoted futures prices but it is also true in other sectors, including many energy markets.
How the CFTC Performs Its Mission:
In seeking to fulfill its mission, the Commission has traditionally focused on issues of integrity. We seek to protect the economic integrity of the futures markets so that they may operate efficiently, free from distortions or price manipulations. We seek to protect the financial integrity of the futures markets so that the insolvency of a single market participant does not become a systemic problem affecting other market participants or financial institutions. We seek to protect the operational integrity of the futures markets so that transactions are executed fairly, so that proper disclosures are made to existing and prospective customers, and so that fraudulent sales practices are not tolerated.
The Commission pursues these goals through a multi-pronged approach to market oversight. We seek to protect the economic integrity of the markets against attempts at distortion and manipulation through direct market surveillance and through oversight of the surveillance efforts of the exchanges themselves. The heart of the Commission’s direct market surveillance is a large-trader reporting system, under which clearing members of exchanges, commodity brokers (called “futures commission merchants” or “FCMs”), and foreign brokers electronically file daily reports with the Commission. These reports contain the futures and option positions of traders that hold positions above specific reporting levels set by CFTC regulations. Because a trader may carry futures positions through more than one FCM and because a customer may control more than one account, the Commission routinely collects information that enables its surveillance staff to aggregate information across FCMs and for related accounts.
Using these reports, the Commission’s surveillance staff closely monitors the futures and options market activity of all traders whose positions are large enough to potentially impact the orderly operation of a market. For contracts that settle through physical delivery, such as those in the agricultural futures complex, staff carefully analyze the potential adequacy of deliverable supplies. In addition, staff monitor futures and cash markets for unusual price relationships among contracts that can provide early indications of a potential problem.
The Commissioners and senior staff are kept apprised of significant market events and potential problems at weekly market surveillance meetings, and on a more frequent basis when needed. (For example, market surveillance staff have continuously monitored conditions in the cattle markets since the recent reports of the Canadian BSE diagnosis, just as they did last year with respect to the rumors of foot-and-mouth disease, which led to a Commission report on the event.) At the weekly market surveillance meetings, surveillance staff brief the Commission on broad economic and financial developments and on specific market developments in futures and options markets of particular concern. If indications of attempted manipulation are found, the Enforcement Division investigates and prosecutes alleged violations of the Commodity Exchange Act (the “Act” or “CEA”) or the Commission’s regulations. Subject to such actions are all individuals that are (or should be) registered with the Commission, those who engage in trading on any domestic exchange, and those who improperly market commodity futures or option contracts. The Commission has available to it a variety of administrative sanctions against wrongdoers, including revocation or suspension of registration, prohibitions on futures trading, cease and desist orders, civil monetary penalties, and restitution orders. The Commission may seek federal court injunctions, restraining orders, asset freezes, receiver appointments, and disgorgement orders. If evidence of criminal activity is found, matters may be referred to state authorities or the Justice Department for prosecution of violations of the Commodity Exchange Act (the “CEA”) and of state and federal criminal statutes, such as mail fraud, wire fraud, and conspiracy.
Over the years, the Commission has brought numerous enforcement actions and imposed sanctions against firms and individual traders for attempting to manipulate or distort market prices, including the well-publicized cases against those who attempted to manipulate prices in the copper and silver markets some years ago. More recently, the most prominent cases have involved problems in certain energy markets. Last year, we ordered a $5 million civil monetary penalty against two energy companies for false reporting and attempted manipulation. In March, we filed a three-count complaint against a major energy trading company charging manipulation of natural gas prices, operation of an unregistered futures exchange, and the offering of off-exchange agricultural futures. Also in March, the Commission finalized a consent order under which another energy company was penalized $20 million for the reporting of false information to certain energy price reporting indices.
Our Enforcement Division is engaged in other investigations in the energy sector, which may result in further charges being filed. However, I want to make clear that when the Commission brings charges against an entity with regard to illegal futures contracts, as in our Enron case, we approach the issues of whether the CEA applies to, and whether we have jurisdiction over, any particular transaction solely on the basis of the economic substance of the transaction. Thus, where we have brought charges alleging operation of an unregistered futures exchange that involved the trading of contracts that may have been labeled or referred to as, quote, “swaps,” it is because the economic substance of those transactions was that of a futures contract. Let me assure you, Mr. Chairman, that we are not seeking to expand the scope of our jurisdiction over other transactions, such as the true swaps and forwards that Congress has determined -- appropriately so, in my opinion -- to exclude under the CEA. In the case of over-the-counter (“OTC”) swaps, for example, such an exclusion was expressly provided by the CFMA following recommendations from the President’s Working Group on Financial Markets, and I believe that this brought much-needed legal certainty for counterparties in this important sector of the risk management market.
I wanted to emphasize that point because the Commission believes that legal certainty and regulatory clarity are critically important for the efficient and reliable operation of markets generally, but perhaps particularly important for many derivatives markets. If the enforceability of contracts is in doubt among counterparties or if regulations or regulatory enforcement policies are unclear, then rational market participants must factor that uncertainty into their decisions and this, in turn, can result in unnecessary added costs, missed opportunities, inefficient results, and misallocated resources. The CFMA provided much-needed legal certainty in a variety of areas, including the OTC markets. The importance of OTC risk management markets should not be overlooked nor should the fact that effective control mechanisms already at work within those markets themselves have made defaults and other problems there very rare.
The Commission’s aggressive enforcement actions in the energy sector reflect an approach to market oversight that emphasizes, as the proper deterrent to wrongdoing, tough enforcement actions against those who would try to operate outside the established rules. Simply issuing more numerous or more prescriptive regulations that could adversely affect legitimate activities is not the correct, or even an effective, deterrent. The established rules should lay out a basic legal framework without being overly prescriptive or unnecessarily burdensome and they should permit sufficient flexibility for market participants to innovate and compete in legitimate business endeavors, a process that can bring to the marketplace greater liquidity, more useful risk management tools, more efficient pricing, and enhanced customer service. But once established, the rules must be enforced, and enforced firmly.
The Commission has been successful in its recent enforcement efforts. For example, one of the many helpful clarifications provided by Congress through the CFMA was legal certainty for the Commission in the area of retail foreign exchange fraud. Our Enforcement Division has risen to the challenge and in just over two years has conducted numerous investigations and initiated almost three dozen formal actions, making a big dent in this type of abuse against futures market participants, particularly individuals.
In protecting the financial integrity of the futures markets, the Commission’s two main priorities are to avoid disruptions to the system for clearing and settling contractual obligations and to protect the funds that customers entrust to FCMs. Clearinghouses and FCMs are the backbone of the exchange system: together, they protect against the financial difficulties of one trader from becoming a systemic problem for other traders or the market as a whole. The Commission works with the exchanges and the National Futures Association (the “NFA”) to closely monitor the financial condition of FCMs. The Commission, the exchanges, and the NFA receive various monthly, quarterly, and annual financial reports from FCMs. The exchanges and the NFA also conduct annual audits and daily financial surveillance of their respective member FCMs. Part of this financial surveillance involves looking at each FCM’s exposure to potential losses from large customer positions that it may be carrying. One of the ways in which such positions are tracked is through the large trader reporting system. As an oversight regulator, the Commission primarily reviews the audit and financial surveillance work of the exchanges and the NFA but it also monitors the health of FCMs directly, as necessary and appropriate. The Commission also reviews clearinghouse procedures for monitoring risks, ensuring the adequacy of margin and capital requirements, and protecting customer funds.
As with attempts at manipulation, the Commission’s Enforcement Division investigates and prosecutes FCMs that are alleged to have violated financial and capitalization requirements or to have committed other supervisory or compliance failures in connection with the handling of customer business. Such cases can result in substantial remedial changes in the supervisory structures and systems of FCMs and can influence the way particular firms conduct business. This is an important part of the responsibility of the Commission to ensure that sound practices are followed by FCMs.
Protecting the operational integrity of the futures markets is also accomplished through various efforts by Commission staff. Commission rules provide for appropriate disclosure and customer account reporting, as well as fair sales and trading practices by registrants. The Commission also seeks to encourage appropriate sales practices by screening the fitness of industry professionals and by requiring proper supervision of such persons, and ensuring that adequate proficiency testing and continuing education take place. Extensive recordkeeping of all futures transactions is also required. To ensure compliance with these various requirements, the Commission directly monitors compliance but also supervises the work of exchanges and the NFA in enforcing the relevant requirements.
Just as with the Commission’s efforts to protect the economic and financial integrity of the futures markets, the Division of Enforcement also plays an important role in deterring behavior that could compromise the operational integrity of the markets. Enforcement investigates a variety of trade and sales practice abuses that affect customers. For example, the Commission brings actions alleging unlawful trade allocations, trading ahead of customer orders, misappropriating customer trades, and certain non-competitive trading. The Commission also takes actions against unscrupulous commodity professionals who engage in a wide variety of fraudulent sales practices against the public.
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 Task Force. I am also a member of the President’s Working Group on Financial Markets with Secretary Snow, Chairman Greenspan, and Chairman Donaldson. My experience has been that the coordinated approach has many advantages, especially in markets that cross regulatory jurisdictions and with respect to issues that can affect multiple markets in the financial system.
Changes at the CFTC since the CFMA:
After passage of the CFMA, we reorganized and modernized the structure of the CFTC to make the most effective 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 is responsible for 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 Office of General Counsel, which provides legal expertise to the Commission and handles such matters as our appellate cases. As noted above, a very effective Division of Enforcement investigates and brings cases against those who attempt to defraud customers, distort or manipulate prices, or otherwise violate the CEA and the Commission’s rules.
The Commission is looking at how we approach all of our oversight responsibilities with an eye toward making changes wherever we can increase our effectiveness and make better use of taxpayer resources, including such things as risk-based audits and developing, pursuant to Congressional direction through the CFMA, an oversight framework for futures clearinghouses. With the audits, the move from a strictly compliance-based approach to a risk-based approach can better focus the resources of both the Commission and the self-regulatory organizations for maximum effectiveness. We recently initiated the first such examinations and the process appears to be on the right track.
Passage of the CFMA two-and-a-half years ago initiated a period of intense effort at the Commission. Our first task, guided by schedules established within the legislation, was to modernize the rules affecting trading facilities, both traditional and the new electronic commercial markets now permitted by the CFMA. Despite the unexpected challenges the industry and the Commission faced following the September 11th attacks, those rule modernizations have been successfully accomplished. Working with the Securities and Exchange Commission (the “SEC”), the CFTC was also able to put into place the rules and other mechanisms to allow the launch of trading in domestic security futures.
Now the Commission is well underway with efforts to modernize the rules affecting clearinghouses, futures commission merchants, pooled investment managers, and other intermediaries in the futures markets. Through hearings, studies, and roundtables, the Commission has, as directed by Congress, undertaken a concerted examination of the rules currently imposed on intermediaries and we have identified a number of areas where key improvements can be made. These range from providing financial institutions that are primarily overseen by another regulator (such as banks, insurance companies, and mutual funds) with an opportunity to use the risk management tools offered in the futures markets without subjecting themselves to unnecessary duplicative regulation, to providing appropriate registration relief to pooled investment vehicles that restrict participation to sufficiently well sophisticated persons, to affording FCMs with greater operational flexibility so that they can provide their customers with more efficient trade executions. We have proposed a great number of rule modernizations in the Federal Register, received largely supportive and always insightful comments on these proposals, and implemented final rules in a number of areas. We are also well underway with efforts to design an effective oversight framework for clearinghouses which, as discussed below, occupy a new place in the regulatory landscape since passage of the CFMA.
Changes in the Marketplace since the CFMA:
The CFMA opened the door for great change in the markets as well as at the CFTC. The U.S. commodity futures and options markets continue to grow rapidly. Total volume rose by more than 33% from 2000 to 2001, and again by more than a third from 2001 to 2002, as increasing numbers of companies and investors avail themselves of the risk management tools offered by these markets. Financial contracts represent the largest portion of the market and continue to grow in volume. Of the ten most widely traded contracts, which together represent more than 80% of U.S. futures volume, seven are financial contracts (based on Eurodollars, Treasury instruments, the S&P 500, and the Nasdaq 100). The other three top-ten contracts are crude oil, natural gas, and corn. (Soybeans are close behind corn in the eleventh spot.) While the traditional U.S. futures exchanges are enjoying record volumes, not all the growth is taking place there. Newly designated contract markets (“DCMs”) that have been approved by the Commission since passage of the CFMA are achieving significant trading volumes with new products and platforms.
Perhaps one of the most visible categories of new products is, of course, the security futures category. Futures based on individual stocks or on narrow stock indices were prohibited from trading for almost twenty years prior to the CFMA. Three brand new exchanges have been created to host trading in these new contracts, offering equity investors and portfolio managers of all kinds access to useful new risk management tools. Security futures are treated as both futures and securities under the CFMA and, accordingly, both the CFTC and the SEC share oversight responsibility for their trading under a primary regulator and notice regulator regime intended to avoid duplicative or overly burdensome requirements on market participants. Some work still remains to be done, but we are optimistic that the two agencies can continue to cooperate to fully accomplish the purposes of the CFMA in this area.
I have been asked for my views on the growth thus far in trading of security futures. Prior to last year’s launch, I refrained from making forecasts of how popular these products would be because I felt that it was my role as a regulator to make sure that success would not be decided by regulators but by market participants in a marketplace made as free as possible from unnecessary, duplicative, or unduly restrictive regulations. Having said that, I would point out that other products in our markets have faced some initial skepticism and yet turned out to be quite successful. While I recognize that it may not be exactly an apples-to-apples comparison, I would note, for example, that average monthly volumes in the security futures offered thus far on Microsoft common stock have exceeded the volumes in the now hugely successful Treasury bond, Eurodollar, and crude oil contracts during corresponding periods after their introduction.
Strong trading growth and security futures are not the only changes that have been occurring recently. Other key trends in the futures markets include the continued migration of trading activity from open-outcry trading on the exchange floors to all-electronic trading from widely dispersed geographic locations, the transition from purely member-owned exchanges to publicly-held trading facilities, continued globalization of all financial markets, and, of particular note since passage of the CFMA, the decoupling of the trading activities hosted by exchanges from the clearance and settlement functions performed by clearinghouses. The CFMA made express provision for this last transformation and we are already starting to see activity in this area, with recent press announcements of new relationships among exchanges and clearinghouses that would have been hard to imagine only several years ago.
In fact, while the Commission has designated four new contract markets since passage of the CFMA, it is has accepted the registration of five additional derivatives clearing organizations, several of which were existing clearinghouses serving other financial market sectors outside of futures but several of which are new organizations not previously affiliated with any particular trading facility. The Commission has received expressions of interest or applications from numerous other trading facilities and clearing organizations and foresees that its oversight responsibilities in both areas will only increase as time goes on.
Not only does the Commission foresee more work ahead as volumes increase and as market participants are presented with greater choice in risk management products and trading platforms, and as clearing and settlement functions evolve, but the work is changing in ways that present new and exciting challenges for the Commissioners and the staff. Under the CFMA’s principles-based approach, which we have commended the Congress for adopting to replace an outdated regime of prescriptive and often obsolete regulations, the Commission works with exchanges, clearinghouses, and others who now have the flexibility to satisfy the fundamental objectives of the CEA in alternative ways, some traditional but some very new and unique. Gone is the era of cookie-cutter applications and Commission approvals that dictate the same approach for every institution. While I believe the new era will be one in which market users benefit greatly from innovative uses of technology, better customer service, greater liquidity, and more efficient transactions, I also believe that the Commission and its staff will have to work harder than ever to fulfill its important public mission.
I am excited by the remarkable changes we have seen in just the short time since enactment of the Commodity Futures Modernization Act. I firmly believe that it was the right legislation to pass at the right time and that its principles-based approach has already proven to be a workable and effective means of overseeing markets that play a crucial role in the U.S. economy. The Commission stands ready to work with this Subcommittee, the Congress, other regulators, and market participants to ensure that our regulatory structure keeps up with developments in the marketplace and continues to make good sense. Thank you for the invitation to appear before your Subcommittee. I will be happy to answer any questions you may have.