Address by Chairman James E. Newsome of the
U.S. Commodity Futures Trading Commission at the
Futures Industry Association (FIA)/Futures Option Association (FOA)
International Derivatives Conference
London - June 10, 2003
Thank you, John. And thanks to Roy Leighton and Anthony Belchambers, as well. It is an honor to be with you again today. There are several issues I’d like to discuss this morning that I believe will be of interest to you. As the Commission continues to implement the Commodity Futures Modernization Act, we have initiated a number of rule modernizations and other efforts that will affect futures commission merchants. On the managed futures side, we have also undertaken some significant rule modernizations that will affect commodity pool operators and commodity trading advisors, as well as other pooled investment vehicles and institutional investors with an interest in the futures markets. With regards to derivatives markets generally, there are some things going on at the CFTC that I want to mention. For those who know me, you know that I believe strongly in my regulatory philosophy. It is this philosophy that guides how I hope to address the issues that come before the Commission, including those I will discuss this morning.
This philosophy led me to become an early and strong supporter of the CFMA and its three key objectives: modernizing rules affecting trading platforms and market intermediaries, providing legal certainty for over-the-counter derivatives, and permitting futures based on single stocks or narrow-based indices. As we have pursued implementation of those objectives, my relatively straightforward philosophy has guided our efforts: for the legitimate business activities of those who through innovation and vigorous competition bring to the marketplace greater liquidity, more useful risk management tools, and more efficient pricing, I want to provide the most flexible and responsive oversight structure possible.
But, for those who would threaten the integrity of these important markets through attempts at fraud or manipulation, I believe in promptly and aggressively exercising our enforcement authority. In my opinion, the proper deterrent to wrongdoing should not be more prescriptive regulations that can unduly burden legitimate business activity but, rather, tough enforcement actions against those who would try to operate outside the established rules. Those rules should lay out a basic legal framework and they should permit sufficient flexibility for market participants to innovate and compete in legitimate business endeavors. But once established, the rules must be enforced, and enforced firmly.
That is why, at the same time that our Divisions of Market Oversight and Clearing and Intermediary Oversight have been hard at work on numerous rule modernizations, our Division of Enforcement has been aggressively conducting investigations and initiating cases. For example, one of the many areas in which the CFMA provided legal clarity was with respect to our authority to go after unscrupulous people who engage in various forms of fraud and abusive sales practices against small investors, especially individuals, in the off-exchange foreign currency area. A particular court decision in the United States had created some uncertainty about our jurisdiction and a legislative remedy was needed. After Congress provided that clarification, our Enforcement teams reactivated in this area and in barely two years have conducted numerous investigations and initiated almost three dozen formal actions, making a huge dent in this type of abuse. This is the kind of effort I am certain that legitimate market participants appreciate because they want and need a marketplace free from fraud and manipulation just as much as we.
The Enforcement Division has also been active in the energy trading area. Many of you are familiar with the multi-million dollar civil monetary penalties and other sanctions we have imposed within the last six months or so. We remain actively engaged in other energy sector investigations, which may result in further charges being filed, but let me take a moment here to provide some perspective on our energy cases. We continue to conduct these complex and resource-intensive investigations and to bring the necessary cases as quickly as we possible so that, in addition to identifying the wrongdoers, we can also exonerate those not involved and allow these important risk management markets to work toward restoring the confidence of market participants and the public.
Also, I want there to be no confusion over our intentions when we bring charges against an entity with regard to illegal futures contracts. We approach the issues of whether the Commodity Exchange Act applies to, and whether we have jurisdiction over, any particular transaction 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 that we are not seeking to expand the scope of our jurisdiction over other transactions, such as the true swaps and forwards that the Congress has determined -- appropriately so, in my opinion -- to exclude under the Commodity Exchange Act.
I wanted to provide that perspective because I believe that legal certainty and regulatory clarity are critically important for the efficient and reliable operation of markets generally, but particularly important for many derivatives markets. If the enforceability of contracts is in doubt among counterparties or if laws, regulations, or even a regulator’s enforcement stance 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.
Therefore, the three principles that I believe should guide our efforts as we face the many new issues that arise in these dynamic markets are: regulatory flexibility, tough enforcement, and legal certainty. I’d like to take a moment to share with you a few of the CFTC’s current efforts and mention some issues on which our attention is focused. The public comment period that is an important part of our rulemaking process recently closed on a number of proposed changes to modernize our oversight in the managed futures area and provide increased operational flexibility for FCMs. My fellow commissioners and I are always grateful for the time and attention that market participants devote to providing us with invaluable feedback and suggestions when we solicit public comment on pending matters. As we hoped and expected, we received a number of thoughtful comments, some from people and organizations represented here today.
The proposals would provide operational flexibility for commodity pool operators, through such changes as reducing duplicative reporting requirements and permitting electronic distribution of statements. For pools that limit participation to sophisticated persons, the CFTC has for some time provided a more flexible set of requirements but we recently proposed a new exemption from registration for those that limit participation to certain highly sophisticated persons and those that restrict futures activity to certain de minimus levels. I am hopeful that, in addition to easing the regulatory burden on entities that currently use the futures markets, the final rules in this area may increase interest in the futures market by entities that have not used them before, which can ultimately benefit all market participants with greater market liquidity. We also proposed modernizing the exemption for certain otherwise-regulated entities -- such as banks, mutual funds, and insurance companies -- that wish to use the futures markets. These changes should benefit not only traditional futures contracts, but also our new security futures market by broadening the scope of potential users. The numerous comments we received were overwhelmingly in favor of both proposals and also contained helpful technical suggestions that our staff are reviewing. It is my hope that we will be able to finalize our rule modernizations in this area very soon.
Last year, the Commission held very productive public discussions on the need for rule changes for other intermediaries, including FCMs. Accordingly, our recent rule proposals also included things that I believe are responsive to those needs. A good example is what we proposed to simplify the bunched order process and clarify respective responsibilities so that this mechanism’s promise of better executions and better pricing will be more accessible and greater numbers of customers can benefit. The comments we received were overwhelmingly in favor of the proposal and I am happy to report that the Commission approved final rules in this area last week. We are currently at work examining other areas of potential rule modernization for FCMs, including further refinements to the rules governing the investment of customer funds and moving forward with margin-based or risk-based capital requirements.
But rule modernizations are not the only changes we are making. We are also well underway with various other efforts, including moving toward a risk-based approach to conducting audits and developing an appropriate oversight framework for futures clearinghouses. I believe that moving from a strictly compliance-based approach to a risk-based approach can better focus the resources of the Commission and the self-regulatory organizations for maximum effectiveness. We recently initiated the first such examinations and while the process still needs work, it appears to be on the right track.
The CFMA anticipated a decoupling of trading activities hosted by exchanges from clearance and settlement functions performed by clearinghouses and made express provision for such a transformation. We have developed a plan for an oversight framework that is appropriate for an environment in which the traditional one-to-one exchange and clearinghouse relationship is not necessarily the only structure in the marketplace. In fact, CFTC staff will be meeting with clearinghouses in New York later this week and in Chicago next week to discuss specifics. This is a timely issue because of recent press announcements of new relationships among exchanges and clearinghouses that would have been hard to imagine only several years ago.
Let me now take a moment to update you on our latest efforts to fully implement the CFMA’s provisions regarding security futures. As you know, the CFTC worked hard along with the SEC to adopt the rules that allowed security futures to begin trading on a domestic basis last year. But the Act also directed the two agencies to jointly develop rules to give foreign access. To date, we have not been able to reach agreement on the rules necessary to allow this activity. This may be due in part to the fact that the two agencies have developed very different oversight frameworks and philosophies to suit the different markets for which each has responsibility. As you well know, there are fundamental differences in both the economics and the public policy concerns of the equity capital markets and the risk management markets.
The CFTC has successfully tackled the foreign access issue on the futures side by allowing U.S. customers access to foreign terminals as long as they are overseen by a comparable foreign regulator. Our own experience at the CFTC with foreign access has been a positive one, which I believe is a testament to the wisdom of giving investors choices and to the robustness that results from allowing competition to flourish in these markets. While this is an issue that has perhaps far broader implications for the SEC, I am confident that under Chairman Donaldson’s leadership, we will make positive strides in this area. A resolution to this important issue is necessary so that our two agencies can comply fully with the Congressional intent of allowing U.S. market users to engage in global risk management activities. Toward that end, I asked Commissioner Walt Lukken to take a lead role for the CFTC in working with the SEC to finalize a full implementation of the CFMA. Commissioner Lukken has met with SEC Commissioner Paul Atkins over the past several weeks to discuss such matters, and I am looking forward to those efforts bearing fruit in the near future. My confidence is bolstered by the success of the two agencies last week in finalizing a draft agreement on the coordination of the oversight responsibilities of the primary and notice regulators regarding exchanges and firms handling domestic security futures. As you know, the Congress expressly directed through the CFMA that market participants not be subjected to duplicative or redundant oversight due to the Act’s treatment of security futures as both securities and futures and this clarification will help to avoid that problem.
My desire to pursue ongoing improvement in our approach to oversight is based in part on my recognition that the Commission faces a continuing increase in its workload as trading volumes increase, as market participants are presented with ever greater choices in risk management products and trading platforms, and as clearing and settlement functions evolve. Not only is there more work ahead, but the work is changing in ways that present new and exciting challenges for the Commissioners and the staff. In fact, while the Commission has designated four new contract markets since passage of the CFMA, it has also accepted the registration of five additional derivatives clearing organizations, including the London Clearing House, whom we were happy to welcome. We have also acknowledged four notices from markets of their intent to operate exempt electronic commercial markets. 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.
Because the Congress introduced a principles-based approach to oversight with the CFMA, the Commission now works more closely than ever with the exchanges, clearinghouses, and firms, who now have great flexibility in how they choose to satisfy the fundamental objectives of the Commodity Exchange Act. Some are choosing to pursue very new and unique approaches. Gone, as it should be, 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 to foster transparent, competitive, and financially sound markets that operate free from manipulation or distortion, and to protect users of those markets from fraud and other abusive practices.
The Commission could not realistically hope to serve that mission fully if we had not been able to work so productively and cooperatively with the this industry’s self-regulatory organizations and to confidently rely upon each other, something which I believe has been integral to the success of the futures markets. Even as the structure of the industry changes with developments such as demutualization and increasing competition, I am confident that this productive relationship will continue and that the principles of objectivity, confidentiality, and consistency can continue to be adhered to as well as they have always been in this business. In this regard, however, just as I think it’s important for the CFTC to review its own regulatory structure, I also believe it is equally necessary for SROs, in consultation with us, to do the same. This is especially important, given the CFMA’s emphasis on self-regulation and the changing structure of the business. Accordingly, I announced recently that we are beginning a review of the roles, responsibilities, and capabilities of SROs in the context of various market changes. Hopefully, this review should provide all market participants with the reassurance that we, like the exchanges, consider market integrity to be of paramount importance. I have spoken with several in the SRO community about this initiative, who have expressed their unqualified support for the effort.
Let me conclude today by noting the exciting changes that are occurring in the business structure of the futures industry, particularly new relationships and arrangements that have been recently announced or proposed. I believe these developments reflect the strong competitive forces that underlie these markets. I also believe that this is just one more demonstration that the CFMA was the right law at the right time, one which allows exchanges, clearinghouses, and firms to compete more vigorously both domestically and in an increasingly global environment, which helps to remove artificial barriers to competition for all competitors, and, ultimately, which benefits users of the risk management markets. The continuing and strong growth in futures trading across the board certainly seems to confirm that. I see ever more widespread recognition of the benefits of futures-based risk management by businesses and investors that today represent virtually every sector of the economy. True economic competition is a dynamic process, one that produces an ever-changing landscape as new entrants bring new products to market and devise new ways of transacting business while existing competitors respond with innovations of their own. I must point out, however, that I do not equate fair market access with guaranteed market success. It is my goal to ensure a level regulatory playing field so that all competitors, new and existing alike, have the opportunity to compete. But then, the market process must and will sort out the winners and losers. I am confident that it will be the end users, the futures customers, who benefit most by this process.
I see the Commission’s role as one of working closely with all sectors of the industry as they cooperate, ideally through business decisions made among business people, to work out mutually beneficial solutions to the challenges that lie ahead. I am greatly encouraged by efforts to improve capital efficiency such as those being made through the Clearing Link Committee hosted by the FIA which, I understand plans to hold weekly meetings among representatives of the exchanges and the FCMs. My door is always open if I can assist such endeavors and I hope that you will continue to provide us with the insights, wisdom, and suggestions that you have generously shared in the past. Thank you for inviting me here today.