Address by Chairman James E. Newsome
of the U.S. Commodity Futures Trading Commission
at the Seminar on the International Practice of Derivatives Market Regulation
Sponsored by the Center for Strategic Research and the FRI Fund
November 17, 2003
Institution Building and the U.S. Regulatory Experience
Good morning to all of you. It is an honor and a pleasure to address you during this critical time in the development of your model for regulating the financial derivatives markets within the Russian Federation. I understand and commend your interest in enhancing the efficiency of your markets, as well as of the judicial system and laws that support their operation. In particular, I am happy to describe the experience of the United States, and to relate our framework for regulation to the immense success of our markets to date. In today’s rapidly evolving and increasingly integrated markets, regulators and market participants from different jurisdictions have much to share about effective institution building.
Of course, I must begin by stating that each jurisdiction must design its regulatory framework in the context of its own situation, taking into account international standards. And, although there are various models to follow, at the end of the day, the question you must answer is how to develop a regulatory structure that works best within your own system to provide fair, efficient and transparent markets; customer protection; and the reduction of systemic risk.
In structuring a regulatory system, it is important to keep in mind the three component parts of any futures market. The first component is a product, which is a contract based on a reference price (usually made in a cash market) and which, because it is a contract, requires that the law ensure its enforceability. The second component is a trading venue, which, whether floor-based or electronic, operates according to rules of trading and an auction-type pricing model. The third component is a credit enhancement mechanism, which can be a clearinghouse or other form of guarantee arrangement, which assures the financial completion and settlement of the contracts. These three components can be assembled within a single institution, or they can be segmented and provided by different parties, and even from different jurisdictions.
In every case, the success of the market depends upon the legal and operational reliability of these three component parts. The basic objective of the regulatory system is to assure their reliability, most importantly from my perspective, without unduly or unnecessarily restricting how the market operates, or the products that it develops. Success also depends upon a reliable relationship between the cash market and the futures market, and the existence of a two-way demand for the type of risk management being provided—that is, there must be interest in both transferring and assuming the risk that is traded in a marketplace.
To understand how we arrived at our current system of regulation in the U.S., which meets the foregoing objectives through a framework calibrated to the type of market being regulated, some historical background is helpful. Although the futures markets in the U.S. date from the mid-1800s, when a new method for discovering the prices of corn, wheat and soybeans in a centralized marketplace was developed in Chicago, the first comprehensive futures law was not enacted until 1936. At that time, the risk management and price discovery functions of the markets related solely to agricultural commodities, and it was clear that policing the markets for manipulation required the expertise of agricultural economists. Not surprisingly, therefore, regulatory oversight was placed within the Department of Agriculture.
As time passed, however, it became apparent that ensuring market integrity and customer protection depended upon more effective tools for monitoring a marketplace, the importance of which had extended beyond purely agricultural interests. With the deregulation of foreign exchange and interest rates in the U.S., and the expansion of the types of interests in which collective investment vehicles could participate, futures exchanges sought to apply the mechanics of futures trading to new products, including currencies and sovereign debt. In addition, futures markets were flourishing in metals, coffee, sugar and cocoa—and beginning in energy—all of which were outside the contours of the existing federal legislation. The international nature of the cash products on which these contracts were traded, coupled with the international makeup of the market participants, called for ways to effectively cooperate across borders.
In response to these developments, in 1974 Congress created the U.S. Commodity Futures Trading Commission (“CFTC”) as an independent agency of the federal government, structured along the same lines as the Securities and Exchange Commission. It gave the agency jurisdiction over contracts for future delivery in “all services, rights and interests” in which contracts for future delivery were traded, or could be traded in the future, as well as powers to regulate intermediaries and enhanced powers to deal in an international arena. Congress also vested the agency with emergency authority, subject to limited judicial review, to address conditions that could prevent the markets from reflecting supply and demand, which in turn created a strong incentive for the markets to police themselves. Unlike securities regulation, which focused on disclosure necessary to capital formation, futures regulation focused on the market integrity necessary for effective risk transfer.
The law that was developed in 1974, and later expanded, served the markets well for more than ten years, and the volume of trading and types of participants and products grew. By the early 1990s, however, signs were emerging that the law, which required that all contracts with futurity be traded on registered exchanges, no longer made sense in a world where counterparties wanted to shift more tailored risks over-the-counter, through swaps and structured debt. Uncertainty arose as to whether such over-the-counter transactions might be viewed as illegal off-exchange futures contracts. This uncertainty was exacerbated as over-the-counter activity moved to electronic trading platforms that were difficult to distinguish from the centralized trading pits of traditional exchanges. It was clear that the regulatory structure, which consisted of very prescriptive rules originally designed for contracts based on domestic agricultural products, traded in a floor-based environment, had become outmoded.
By the late 1990s, a consensus developed that the law needed a complete overhaul. The result was the Commodity Futures Modernization Act of 2000 (“CFMA”). This legislation replaced the prescriptive rules with broad core principles, which gave the CFTC the flexibility it needed to tailor regulation to the type of market, product and participant, and to keep better pace with change. It also permitted a framework that could be more readily harmonized across multiple markets and jurisdictions than very specific rules.
Although regulators around the globe were consolidating the regulation of multiple types of financial institutions (banking, insurance, and securities, including derivatives) within a single regulatory authority, or slicing and dicing regulation so that one regulator addressed financial integrity and another customer protection, in 2000 the U.S. preserved its model of oversight by an independent expert agency devoted solely to derivatives trading. No changes were made to the overall structure of expert financial services regulators. This was partly a product of history, but it was also a way to ensure that the implementation of the CFMA receive the priority that it deserved. In a larger vehicle addressing financial regulation as a whole, those needs could have been overwhelmed by other more pressing priorities. The decision may also have reflected the size of the U.S. market. For example, it is important to note that even after long awaited reforms that removed the Glass-Steagall Act prohibitions on combining the banking and investment banking functions, there remain three federal banking authorities (the Federal Reserve Board, the Comptroller of the Currency, and the Federal Deposit Insurance Corporation), and the multiple state banking commissions.
You have asked that I discuss the value of a particular regulatory structure in the context of what you are planning within Russia. The international consensus is that an effective regulatory structure should be built upon the following fundamental principles:
Importantly, regulators must also be able to cooperate in an increasingly global marketplace to combat fraud and market abuse. I am happy to say that we have preliminary arrangements in place to share certain information with our Russian regulatory colleagues and that our experience with cooperative enforcement efforts in Russia has been excellent. On two separate occasions your regulated entities have responded on an urgent basis, within the parameters of your existing law, to requests to assist us in combating fraud.
As I’ve noted, because the regulation of futures markets in the U.S. has concentrated largely on the integrity of the markets rather than on disclosure principles common to securities markets, it relies on the expertise of economists, who can address whether pricing disparities are caused by malfeasance or are just anomalies, and futures trading specialists, who understand the mechanics of trading, just as much as it relies on the skills of lawyers. The CFTC, as a unitary regulatory authority, not only can target its regulation precisely to the types of products traded, but also to the types of users of the markets. It can take account of the fact that, unlike the securities markets—which have 170 million customers, thousands of issuers, and where 50 % of families participate in mutual funds—the principle users of the futures markets continue to be professional traders, sophisticated individuals, and commercial interests.
That being said, futures are big business. More than one billion contracts traded hands in 2002, and more than one billion in funds and many trillions in risk pass through the U.S. system daily. This means that, whatever the design or regulatory model, the U.S. watchdog should not be diverted by too many conflicting demands. Recent history demonstrates that, though the costs and benefits of public confidence in the markets are difficult to measure, the costs of its potential loss are painfully apparent.
Of course, in a vibrant system changes can be expected to occur and one cannot predict with certainty that the design and structure governing who actually regulates what within the U.S. system will remain as unchanged for the next 60 years as it has for the past 60 years. I believe, however, that the existence of multiple expert agencies has contributed to a regulatory structure that is more tailored to the differences among markets, and that such agencies are continually challenged to change with the markets rather than to languish in bureaucratic fiefdoms, or solely to respond to disaster.
Therefore, although I commend to you a review of a good sampling of different approaches—the twin peaks approach of the Netherlands, Australia and France, and the single regulatory authority approach of the U.K., Mexico and Brazil, and perhaps some of those that are in between—it is important to keep in mind that what matters is not so much the structure of regulation, as its result.