Ensuring Financial Integrity in a Changing Market Environment
Acting Chairman Sharon Brown-Hruska
U.S. Commodity Futures Trading Commission
Futures Industry Association (FIA)
New York, September 21, 2004
It is a pleasure to have been invited here to address you today and I would especially like to thank John Damgard, President of the Futures Industry Association. I have known John for a long time and I can tell you that his commitment to the competitive markets; his standup, no-nonsense approach; and his advocacy of those who make markets are traits that, while threatening to some, serve this industry well. Having said that, we all know that Barbara Wierzenski is the brains behind the organization and without whom, John would get it done, but folks might walk away from the deal wondering whether they got the worse end. I have enjoyed getting to know the FIA Board and the Law and Compliance Committee and look forward to working with you in the future.
I would like to take the 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 competitive and 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 that I am now charged with regulating. For those of you who know me, you know that I am committed to promoting and protecting free and competitive markets. 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 have been greater communications and coordination between governments to foster business and trade between countries. Certainly, regulation is an important and necessary function of government. However, I firmly believe that as regulators we have become more efficient and targeted in our interface with markets to ensure customer protection and market integrity with less duplication and less involvement in the decisions and operational choices that markets themselves must make.
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 swaps 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 should not. 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 was attained for OTC derivatives and the modernization of the US legal framework governing derivatives trading in the Commodity Futures Modernization Act of 2000 provided a necessary foundation for the explosive growth that we have seen recently. As domestic and global market regulators and policy makers move forward to coordinate and unify the development and oversight of markets, duplicative and complicated regulatory hurdles that stifle competition and cross-border business are being lowered. 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, expands their asset allocation strategies, and diversifies 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 aids participants as they 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 still do not use derivatives products to manage risks. Rather than close the door on these potential users, I believe that regulation can help open the door by giving users comfort that the markets are fair and free from fraud and manipulation.
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 with 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 statute.
With respect to the entry of USFE in the U.S. marketplace, while still a small percentage of total volume, 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, it provides customers with greater choice in the global marketplace. 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.
The concept of a global clearing link is compelling to participants in our markets who seek more efficient global market access and increased foreign investor participation in the US futures markets. Advantages of clearing foreign executed transactions in the US include greater segregated funds protections, more efficient use of end-user collateral, and greater flexibility and ultimate reduction in margin requirements without degradation of customer or firm protections. Even more appealing from a regulatory perspective, we get better information on the risks US investors and firms are exposed to in their foreign activities. As we adopt more risk-based methodologies to assess the financial condition of firms, we look forward to working with firms to develop useful reporting metrics and better capabilities to preempt financial problems before they occur.
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. Earlier this year 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 the relationships that we have developed with German regulators certainly have been a factor in our being comfortable with the USFE market application. Following a fruitful visit a few months back by German regulators to our DC offices in Washington, we have just this week sent a delegation of the Market and Clearing and Intermediary Oversight Divisions to Germany to learn what mechanisms and policies they employ to ensure financial and market integrity.
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 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. In 2005, the CFTC will go back to Congress to report on the progress we have made in implementing the Act, how well the Modernization Act is performing, and whether changes are necessary to better protect customers, contend with innovation, and promote competition. Anticipating that process, let me share with you my interpretation of the Act and how I will approach this challenging and important time for our agency and the industry.
In the Modernization Act, Congress instructed the CFTC to identify and adopt core principles and acceptable business practices to replace prescriptive rules and regulations; and, where prudent, to use our exemptive authority to provide relief from prescriptive rules. Moreover, the Modernization Act enabled a principles-based, multi-tiered approach based on the sophistication of investors and the type of market being regulated. 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.
In our implementation of the provisions of the CFMA with regards to the joint regulation of single security futures by the SEC and the CFTC, I have had particular concerns with respect to the lack of progress in implementing portfolio margining, the double auditing and review of notice registered exchanges and brokers, and the manner in which contract position limits have been determined. I am also concerned that we have yet to make progress on the offering of narrow-based indices and single securities on foreign stocks. 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 and derivatives products to bear in our ongoing discussions with the SEC. It is also my hope that we will work with the SEC in the hedge funds area, where the CFTC also has significant experience, to find a regulatory approach that avoids duplicative regulation of these important markets. Ultimately, the CFTC and the SEC are playing on the same team and share a common goal of protecting customers and promoting healthy markets.
I know many of you have heard former Chairman Jim Newsome trumpet the value of a flexible, core principles-based model that abandons a one-size-fits-all regulatory approach, and I would second that strong endorsement. Chairman Newsome knew, as do I, that actions speak louder than words. So while some would like to stop the process of regulatory innovation in its tracks, either by tying our deliberations up in knots through decoy issues and through politics, we must, however, not allow ourselves to become distracted, delayed, or thrown off course by such tactics.
As Acting Chairman of the CFTC, I am committed to upholding the goals and principles espoused in the CFMA and moving forward with rule modernizations that better conform to the changing technologies and increasingly global nature of the marketplace.
Let me define for you my expectations regarding the challenges that will come my way as I seek to do my job and fulfill the congressional mandate of the CFMA. First, many will resist regulatory innovation for fear it may change their competitive position. Others will resist because a different approach, regardless of its potential improvement, is not the way they have always done things. I call this the “can’t do” attitude and its expression seems universal. Frankly, this view is expressed by firms, existing exchanges, new entrants into the marketplace, and even by we regulators ourselves from time to time. But as much as we might like to remain static, the marketplace is evolving and the industry is growing, and we must strive to keep pace with that change. In my interpretation of it, the CFMA dictates that we should be flexible in our approach, but inflexible with regard to the principles we must uphold to ensure financial and economic integrity.
On this score, I would note that regulatory flexibility applies with equal force to incumbent entities and new entities. We are no more willing to throw out the rulebook for new entrants than we are to use that rulebook as a weapon to keep them out. As regulators, we will do what we believe is the right thing to protect customers and ensure market integrity regardless of who we are dealing with.
It is also my job to ensure that we do not maintain or propagate regulatory barriers to entry, whether they be in the form of outdated rules or practices, or new prescriptions that impose uncalled for burdens on those who would seek to compete on the open and competitive market. I will not allow the laws of the CFTC to be controverted by rules or interpretations thereof that could create regulatory hash of our precedent and convert legal conduct into illegal conduct.
On the other hand, I would be hesitant to circumvent decisions made by firms and exchanges that are fully within the scope of their domain as business entities. The desire of regulatory agencies to financially engineer markets to perfect them through prescriptive approaches is not our model. Business decisions regarding contract design or market structure belong with those who bear the cost and enjoy the benefits of making those choices. As long as those decisions are non-discriminatory and do not violate our core principles, firms should be able to manage their accounts as they think best serves their customers and exchanges should be able to determine what kinds of trades they allow or how they organize their marketplace.
While I have a substantial knowledge of the derivatives industry and good understanding of the workings of the agency, I will admit to you now that I do not intend to go it alone. In addition to the good counsel of my colleague Commissioner Walt Lukken, I will be looking to you, the experts, the firms, the exchanges, and others who have worked through this process for guidance and support. As the one responsible for leading the CFTC through this challenging process, I will adhere to my own principles and seek above all else to be judicious and fair. I will keep my eyes open and try to ensure that those who would take advantage of this process for their own purposes are alive to the potential costs of such a strategy.
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 working with you in the coming year and hearing your concerns, questions, and views on how best to promote and protect these important markets.