Market and Regulatory Innovation in a Global Environment
Keynote Address by Commissioner Sharon Brown-Hruska
U.S. Commodity Futures Trading Commission
Futures Industry Association (FIA)/Futures Option Association (FOA)
International Derivatives Conference
London, June 29, 2004
It is a pleasure to have been invited here to address you today and I would especially like to thank Chairman James Newsome for asking me to do the honors this year. As this is an international conference, I would like to take some time to talk about some of the issues and initiatives that the Commission has taken over the past year that have had an effect on the global nature of the derivatives markets—and quite frankly, issues that lie before us going forward. As I proceed, I would like to share my philosophy on the role of regulation in ensuring that the markets flourish in a manner that embodies financial integrity and increases economic growth and opportunity.
As a college professor and economist who spent most of my career studying, writing, and teaching about derivatives markets, I have developed a deep understanding and appreciation for the markets I now am charged with regulating. For those of you who know me, you know that I am committed to promoting and protecting free and competitive markets. It seems only fitting that this conference is held here in London, just south of the home of Scottish economist and philosopher Adam Smith, who recognized the working of a market to allocate scarce resources when he mused about its invisible hand. It is also fitting that the newest members of the European Union have had such recent experience showing that central planners and government controls cannot successfully determine prices or allocate resources as efficiently or fairly as the market itself. While regulation is vitally important to protect market users and to ensure economic and financial integrity, it cannot take the place of the markets and market users themselves.
Probably more than at any other time in history, markets are thriving. And they are doing so, I believe, because there is less undue interference by government regulators and because internationally there has been greater communications and coordination between governments to foster business and trade between countries.
As I look back on the development of financial derivatives markets, let me go to 1990 when I began my first tour as an economist at the Commission. At that time, the agency was struggling with what some perceived as a threat to its regulatory jurisdiction—the burgeoning swaps market. To many, the neophyte swap market was a doomsday scenario. To the exchanges, the swaps market was viewed as an unregulated competitor that would eventually steal away their business. To regulators, swaps, hybrids, and their dealers were of a speculative and unregulated territory where innocents should dare not tread. And while it is true that there were some bumps in the road—the Bankers Trust/Proctor Gamble/Gibson Greeting Card incident; the Orange County meltdown; and the State of Wisconsin Investment Board misfortune are some that come to mind—a true doomsday scenario never materialized.
In fact, the opposite is true. Market abuses in the over-the-counter (OTC) markets have been few and far between. Today the OTC markets for financial derivatives are thriving and exchange-traded contract volumes are also at all-time highs. Many have come to realize that, far from being competitors, the OTC and exchange-traded derivatives markets are complements to each other. Although this seems to have come as a surprise to some, it shouldn’t. For more than a century and a half, the trading of agricultural futures in Chicago has supported the cash forward market for grains and vice versa. The complementary relationship between OTC and exchange-traded contracts is demonstrated by the growth of the interest rate and currency swaps markets and the unparalleled success of the Eurodollar and government debt futures markets.
To get a perspective on just how much the derivatives industry, both OTC and on-exchange, have grown recently, let me share some figures with you. At year-end in 1990 there was a total outstanding notional value of interest rate and currency swaps of about three and a half trillion dollars. By 2003, outstandings stood at 142 trillion dollars. Over the same period the volume of futures trading increased from 272 million contracts to 986 million contracts. Moreover, the volume of trading on futures exchanges since 2000 has more than doubled.
It is my view that the legal certainty that we attained for OTC derivatives and the modernization of the US statutes governing derivatives trading in the Commodity Futures Modernization Act of 2000 provided a necessary foundation for the explosive growth we have seen recently. As global market regulators and policy makers move forward to coordinate and unify the development and oversight of markets, duplicative and complicated regulatory hurdles that have existed to competition and cross-border business are starting to be lowered, and as global competition and business expand, so does economic opportunity. Instead of the pie being sliced thinner, the pie has grown larger.
And why is all the growth in the derivatives markets good? It is good for business and the economy because it expands businesses’ and consumers’ ability to manage their risks and diversify their portfolios. But it goes even beyond that. One of the unique byproducts of derivatives, particularly those traded on organized markets, is price discovery. Price discovery is really the lifeblood of a free market system. It is how the free market system is able efficiently to allocate scarce resources. It is what induces people to exchange goods and services. In essence, price discovery is the transparency of markets that participants seek to assure themselves that they are getting fair prices in their transactions. And as regulators, it is this price discovery process that we endeavor to encourage and protect.
As I look forward to what we might expect to see in the future for derivatives, in general I anticipate that we will continue to see innovative products being offered and a concomitant growth in both OTC and on-exchange products. In the financial and currency markets there is already a great deal of activity and variety of products available in the OTC and exchange markets, but I believe that there are still large numbers of potential users that do not use derivatives products to manage risks.
I believe this particularly to be the case when we look at physical commodities, such as those for energy products. A recent article in the New York Times highlighted the uneven use of hedging in the energy markets. For example, the article noted that Waste Management Inc. of Houston Texas chooses not to hedge its fuel purchases for its fleet of 20,000 garbage trucks that it employs. Instead Waste Management chooses to pass on its fuel costs to its customers through fuel surcharges. By contrast, Southwest Airlines has hedged 80 percent of its fuel needs for this year and 2005. While each of these approaches is able to deal with high fuel prices, in the currently competitive US airline industry, Southwest’s strategy surely puts them at an advantage over Delta Airlines and Northwest Airlines, neither of which has hedged their fuel purchases for this year.
Now certainly derivatives are not the answer for all companies since there are techniques like exposure netting and natural hedging that work extremely well at managing economic risk. However, I would note that there is a fundamental misunderstanding about the particular function of derivatives in a hedge. The article notes that PanOcean Energy Corporation, a company that produces oil in West Africa, is obligated to sell oil for $30 a barrel at a time when oil is selling at much higher prices. The article, wrongly I believe, states that the company has lost $1.4 million. In fact, what I would argue is that PanOcean, Southwest, Alaska Air and the other companies cited for hedging in the article have brought stability and certainty to their energy revenues, costs, and asset value that provides a great benefit to planning. Those non-hedging companies may be able to bring stability to their cost and revenue streams in other ways, but likely without the certainty that a consistent and careful hedging strategy can afford. In my view, those producers in the energy sector who are getting beat up for the losses on the derivatives side of their hedge should not abandon their hedging programs either, for as surely as prices rise, they will also fall.
Now of course there are those critics out there who would maintain that it is in fact derivatives markets that have caused or at least exacerbated high prices in the energy markets. Some market commentators have alluded to the trading of funds, a term these days used to refer to speculators, as a source for high prices. While it is true that currently the funds are more actively involved in trading energy commodities, I challenge the assertion that these funds are somehow artificially inflating prices. Hedge funds, like any other participant, bring information and liquidity to markets whenever they trade. When they are speculating, they seek to make money for their clients by making predictions of market trends and movements, and trading on that basis. If funds do a bad job of predicting the markets, then they will inevitably lose money and find themselves out of the market. If they do a good job of predicting the markets, they inherently make the markets more efficient by their trading. But in addition to bringing information into the markets, which is a crucial part of the price discovery process, funds bring vital liquidity to the markets. Thus, I believe that the funds represent an important and fundamental part of the futures markets.
While I am on the topic of funds, it behooves me to speak more generally on the regulation of hedge funds. As many of you know, the US Securities and Exchange Commission has pressed for registration of advisors and managers of hedge funds. It is almost surreal to me that the staff at the SEC have continually failed to acknowledge that most hedge funds are already registered with the CFTC. Based on data collected by the CFTC with help from the NFA, 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, and we have continued to see growth in 2004. In addition, 50 out of the 100 largest hedge funds were also registered with the CFTC as Commodity Trading Advisors (CTAs) in 2003 and this has also grown in 2004. Among the 25 largest hedge funds, the proportions get even higher, with 68% registered as CPOs in 2003. Thus, a significant proportion of the hedge fund industry is duly registered with the CFTC and this number is growing.
In addition, and perhaps more importantly, any hedge fund that uses the markets under CFTC’s jurisdiction, even if their advisors qualify for an exemption from registration, continue to fall under the legal definition of a CPO or CTA, meaning that certain of the CFTC’s rules and provision of the Commodity Exchange Act—such as those proscribing fraud or manipulation –continue to apply. In short, the operators and advisers to hedge funds, as collective investment vehicles, are not distinct from CPOs and CTAs, but rather are an important, and apparently increasing, subset of the population we oversee as a whole.
Many had predicted that the regulatory relief we have granted to CPOs and CTAs under the 2000 Modernization Act to rationalize regulation for sophisticated or otherwise regulated entities would lessen the proportion of hedge funds on our radar screen. Specifically, the CFTC has adopted exemptions from registration for those funds engaging in de minimus futures investments and whose investors can claim accredited investor status; otherwise regulated entities such as mutual funds, insurance companies, and banks; and funds that cater to highly sophisticated investors, or “qualified purchasers.”
Filing for an exemption from registration does not release any of these persons from complying with our statutes, including the prohibitions against fraud and manipulation. All CPOs and CTAs, regardless of their registration status, are subject to prescribed disclaimer requirements for hypothetical performance, the antifraud and anti-manipulation provisions of the Commodity Exchange Act and the CFTC’s rules, and all trader reporting requirements. In addition to large trader reporting, we have an active, real time surveillance program, and continuously monitor the activities of large hedge funds in our markets, from commodities to precious metals, to stock and interest rate products. In fact, the activity of hedge funds in the various markets is a routine part of the weekly surveillance briefings that I receive at the Commission.
The exemptions from registration are also noteworthy because they derive from the instructions given by Congress to the CFTC in the Modernization Act, which endorse some important concepts that I think we should take to heart. Specifically, Congress instructed the CFTC to identify and adopt core principles and acceptable business practices to replace prescriptive rules and regulations; and, where prudent, use our exemptive authority to provide relief from such prescriptive rules. Moreover, the Modernization Act enabled a principles based, multi-tiered approach based on the sophistication of investors, consistent with the private versus public markets in securities regulation. Finally, in the context of jointly regulated single security futures, the Modernization Act instructed the CFTC and the SEC to avoid duplicative and inconsistent regulatory structures.
With regard to our implementation of the provisions of the CFMA with regards to the SEC and the CFTC, certainly I have had particular concerns with respect to implementing portfolio margining, avoiding double audit and review of notice registered exchanges and brokers, and the setting of the levels of contract position limits. However, it is my view that we can accomplish a great deal if the CFTC rolls up its sleeves and brings its significant experience and knowledge of financial markets, derivatives products, and managed funds to bear in our ongoing discussions. It is my hope that in both the hedge funds area, as well as the jointly regulated single stock futures markets, we will work with the SEC to find a regulatory approach that avoids burdening these important markets. In my view, we are playing on the same team and share a common goal of protecting customers and promoting healthy markets.
In support of my and the Commission’s commitment to the development of healthy markets I would like to talk about some of the global developments in which we have been involved over the past year. Clearly the two events that have most captured our attention have been the approval of the US Futures Exchange and the proposed global clearing link between The Clearing Corporation and EUREX Clearing Frankfurt.
Let me speak first about the USFE application and bring some perspective to the approval process. I know personally that the staff at the Commission worked extraordinarily hard to conduct an expeditious, but thorough review of the USFE application. And while I think all of us would like to have accomplished a more timely approval of the application, certainly our due diligence was made more extensive due to an unprecedented number of comments and interest that was generated by the application. This interest came from potentially competing exchanges and their members; other industry participants, US congressmen and senators; and from the general public. As a regulator, it is our duty to carefully and fully consider these opinions and concerns, and that is what the Commission did. It is also noteworthy that the Commission sought and received the input of other financial regulators, including the Fed and Treasury, who endorsed the Commission’s assessment that competition, regardless of the source, should be enabled, not deterred by unnecessary regulatory barriers. Ultimately satisfied that the application was sound, the Commission gave its approval to USFE on February 4th, 2004, approximately a month-and-a-half prior to the March 15th deadline required by our statutes.
With respect to the entry of USFE in the U.S. marketplace, while volumes remain scant, the challenge that the USFE has mounted has had a dramatic effect on the industry. Even before their formal application arrived at the Commission, the announced plan of USFE to use the former Board of Trade Clearing Corporation as their clearinghouse prompted a realignment of clearing arrangements between the Chicago Board of Trade and the Chicago Mercantile Exchange. This merging of clearing operations between these two exchanges has had a profound effect on the ability of FCMs to consolidate their clearing activities in a single entity, resulting in overall efficiency gains in capital management that I think will lead to a further streamlining of clearing in futures markets. In addition, we have seen a dramatic reduction in exchange fees as the Board of Trade has reacted to the potential competition from the USFE for its contracts, and the USFE has moved to lower its fees, in turn. Ultimately, customers benefit from the lower costs and innovations that have followed from the increased global competition in our markets.
Another competing product that has been introduced to the U.S. markets this year is the Liffe Eurodollar contract that trades on the LIFFE CONNECT platform. While volume on this contract also remains at a low level, the fact that it exists and provides customers greater choice in the global market is a positive. That Liffe was able to offer this contract for trading in the U.S. without additional regulatory action by the Commission is due to the efforts of the Commission to establish a level playing field between foreign exchanges that have received no-action relief to offer contracts in the U.S. and domestic U.S. exchanges with respect to offering certain new futures and options contracts in the U.S. Under the Commission’s statement of policy adopted in 2000, these foreign exchanges may list new contracts, other than those based upon a stock index, without having to return to the Commission to acquire supplemental relief under their no-action letters. In effect, foreign exchanges are able to list new contracts on an expedited basis in much the same way that domestic U.S. exchanges are able to certify new contracts.
And it is not only with respect to competition for contract execution that is occurring, but also with respect to clearing. USFE has made its presence felt, with the proposal by The Clearing Corporation, which serves as the clearinghouse for the USFE, to establish a clearing link between itself and Eurex Clearing, which serves as the clearinghouse for Eurex. In its fully developed form, this link would allow customers to clear on a global basis, choosing whether to consolidate their clearing activities in the U.S. or in Europe. And not to be outdone, I am pleased that the Chicago Board of Trade is offering their combination of execution quality, transparency, and clearing by entering the market for the German bund, bobl, and the schatz. Innovations by exchanges in the US and worldwide are truly exciting and will continue to build on the evolution of the derivatives marketplace into a truly global one.
I think that as we look back on the past decade or so it is heartening to see how the futures and derivatives markets have expanded into an international marketplace. Through international exchange linkages, like the CME-Singapore Exchange mutual offset arrangement and the recent overtures by the CME and CBOT to assist and potentially forge partnerships with Chinese and Japanese exchanges, the market is becoming more global in reach.
At the Commission I am proud to report that we have also taken a role in helping to forge links and broaden the markets for derivatives. In addition to the USFE application and pending global clearing link, the Commission has taken a number of other actions to foster the development of global markets. Over the year, the Commission has issued no-action letters allowing the offer and sale in the U.S. of several futures contracts based on foreign stock indices. These include contracts on the Taiwan Stock Exchange Capitalization Weighted Stock Index, the FTSEurofirst 80 and 100 Indexes, the S&P CNX Nifty contract traded at the Singapore Exchange and the National Stock Exchange of India.
The Commission has also expanded its clearing designation to the London Clearing House. In October of 2001, the Commission issued an order allowing LCH.Clearnet to clear over-the-counter interest rate swaps and commercial energy contracts. Early last month the Commission amended that order to allow LCH to clear financial futures and options traded on U.S. designated contract markets, derivatives transaction execution facilities, and exempt boards of trade. I think both the introduction of futures contracts traded overseas to the U.S. markets as well as the entry of a non-U.S. clearinghouse to the U.S. markets are significant developments in the effort to establish truly global derivatives markets. And I hope that these developments will ultimately encourage a greater opening of markets in countries around the globe to products and services from non-domestic sources.
In this regard, the Commission has been active in setting up relationships with other countries to establish information sharing, technical assistance, and enforcement agreements with the intention of opening each other’s markets to the derivatives industry. In October of 2003, the Commission entered into an IOSCO multilateral enforcement memorandum of understanding with 24 other countries. This MOU enables regulators to exchange essential information to investigate cross-border securities and derivative violations, including the most serious offenses, such as manipulation, insider trading, and customer fraud. Such an ability to efficiently investigate violations is important not only to regulators but to the political bodies in these countries who can now be given assurances that the derivatives industry and domestic customers can be protected when dealing with foreign entities. I think that our close relationships with German regulators certainly were a factor in our being comfortable with the USFE application. In addition to the enforcement MOU, the Commission in March signed a Statement of Intent with the Irish Financial Services Regulatory Authority concerning consultation and cooperation in the administration and enforcement of futures laws. In April of this year we signed a cooperation arrangement with the Securities Exchange Board of India, which establishes a mutually acceptable basis for cooperation, consultation and provision of technical assistance.
So it has been a busy year for the Commission, dominated as it were by a number of initiatives and events on the part of the industry and government. As a result, the global market for derivatives is more open and richer in the diversity of products than at any time in history. That is not to say, however, that we do not have some work ahead of us or that we can rest on our laurels. The application for the global clearing link remains outstanding and there remain a number of complicated and challenging hurdles ahead before that is a reality. With the cross-pollination of the global markets with derivative contracts, brokerage and clearing services can be streamlined. To this end, the Commission has recently proposed amendments to its requirements for foreign futures firms to clarify when such firms would need to register with the Commission or seek an exemption from registration under the Commodity Exchange Act.
As a regulatory agency, I believe we have moved expeditiously and judiciously to shepherd the growth and development of the global derivatives markets. The Commodity Futures Modernization Act, which passed in the year 2000 with our periodic reauthorization by the US Congress, has enabled us to contend with the rapid expansion and change in this dynamic industry. I know you have heard our Chairman Jim Newsome trumpet the value of the flexible, core principles based model, and I would second that strong endorsement. That said, we need to be vigilant not to allow those who would turn back elements of this smart and progressive regulatory approach to accommodate their own competitive interests or to accomplish their own political agendas. This is particularly true of the OTC energy markets, where a variety of proposals have been made and unsupportable revisions have been circulated to modify CFTC jurisdiction to a more prescriptive regulatory model and to expand CFTC jurisdiction in such a way that might jeopardize the legal certainty afforded to the principal-to-principal swaps markets.
As we approach Congressional reauthorization for the Commission next year, I am committed to standing firm to ensure that we are not put in a position in which the intent of Congress and many of the accomplishments of the Modernization Act are put in jeopardy. Yet even as we have much more work to do, I think the future is bright for the industry and I look forward to my role in bringing positive change to the industry. Thank you for inviting me here today. I look forward to participating in remainder of the conference and having the opportunity of meeting with some of you during the next two days.