Address by Chairman James E. Newsome
at the Winter Meeting of the American Bar Association
Committee on Futures and Derivatives Instruments
Key West, Florida
February 13, 2004
It is good to be back in Key West for this annual winter meeting. As always, I am impressed by the quality of the panel discussions at this meeting and look forward to the rest of the conference.
There have been a number of developments in the futures industry over the past year that I would like to comment on today—developments that I believe were possible due to the flexibility afforded by the Commodity Futures Modernization Act of 2000 (“CFMA”), and the resulting competitive forces that it was designed to foster. I would also like to review some of the things we have accomplished at the Commission, and describe a few of the initiatives that we have underway.
The event that has taken up the majority of our time is the designation as a contract market of the U.S. Futures Exchange, LLC (“USFE”), also known as Eurex US. Although USFE is not the first US contract market with a predominantly foreign ownership structure, it was the first one to announce an intent to establish a transatlantic clearing link for transactions entered into on a designated contract market. This announcement raised a lot of consternation in certain quarters, primarily because plans for a clearing link were not included in the application. However, after considering all of the issues arising out of the application, which were debated and discussed in a Congressional hearing, two public comment periods, and through follow-up questions from Congress, the Commission determined that approval of the link was not necessary in order to approve the application for designation.
As I stated in my remarks last week when voting on the application, the flexibility inherent in the CFMA—while bringing great benefits to the marketplace—can be challenging because the statute lends itself to varying interpretations, even concerning the Commission’s authority. This was illustrated by the strongly held views of the commenters on the USFE application and the applicant itself, both of which were at times contrary to the views of the Commission. In the end though, it is the Commission’s responsibility to interpret the Act as intended by Congress and to assure that all activity in the US marketplace is subject to appropriate oversight.
The undertakings incorporated in the order approving USFE reflect these objectives by making it clear that neither USFE nor The Clearing Corporation (“CCorp”), USFE’s current clearing services provider, can implement any part of a global clearing link without prior Commission approval or permission. Furthermore, they ensure that if CCorp believes that some aspect of a link is appropriate for certification, it must consult with the Commission to determine whether we agree. The new regulatory structure of the CFMA depends on solid working relationships between the Commission and its registrants. I am confident that USFE and CCorp understand our regulatory expectations and will abide by them. I am also confident that the Commission has done its job to ensure that as USFE establishes itself in the US marketplace, it does so on a level regulatory playing field.
USFE, which opened for business on Sunday night trading US Treasury futures and options, is now poised to compete head-to-head with the CBOT, which in turn has signaled its intent to list and trade futures contracts based on debt instruments issued by the German Federal Government—the bund, the bobl and the schatz. It is my hope that the competition provided by this new entrant in the US marketplace will promote responsible innovation and serve the public interest in the manner intended by the CFMA. And, as a strong believer in the benefits of both domestic and global competition, I look forward to working through the regulatory issues that would permit Eurex and CCorp to forge the clearing link that they envision.
An equally important and groundbreaking clearing link was forged in 2003 between the CBOT and the CME. The phased transition of CBOT positions to the CME clearinghouse went smoothly and the link became fully operational on January 2. I expect that significant capital efficiencies will result from the portfolio margining made possible by the link, to the benefit of many market participants.
I would like to turn now to some of the other issues that have been keeping us fully engaged at the Commission. When I was here last year I told you that we were well underway with efforts to modernize regulations governing intermediaries, and I am happy to report progress in this area. We have completed a number of rule amendments pertaining to commodity pool operators (“CPOs”) and commodity trading advisors (“CTAs”). For example, otherwise-regulated entities such as banks, insurance companies, and mutual funds seeking to use the futures markets for their risk management needs now no longer have artificial constraints on their trading activities. In addition, an exemption now available allows a number of other pooled investment vehicles to pursue their risk management goals in the futures markets without being subjected to additional regulation. Under this new rule, almost a thousand “newcomers” have notified us of their interest in using the futures markets, while only several dozen former registrants have sought to “deregister” under the rule. Because those who utilize the exemption remain subject to the Commission’s special call, anti-fraud, and anti-manipulation authority, I am confident that this revision will in no way impair the Commission’s ability to accomplish all aspects of its mission.
The Commission also adopted a core principle for the presentation of partially funded client accounts by CTAs. This permits CTAs to present the performance of partially funded accounts in a manner that is balanced and not in violation of the Commission's antifraud provisions, which provides the flexibility needed to respond to evolving industry developments and practices, while continuing to ensure customer protection. The National Futures Association (“NFA”) has submitted rules on the presentation of partially funded accounts that it intends to make effective on May 1, 2004.
Most recently, we announced rule amendments allowing futures commission merchants (“FCMs”) and derivatives clearing organizations to enter into repurchase agreements and collateral management programs using customer-deposited securities, which should allow for more efficient use of capital. We will also continue to review our requirements in this area and consider suggestions for further refinements.
As the Commission continues moving forward with regulatory initiatives that further the spirit and purpose of the CFMA, to replace obsolete prescriptive requirements with principles-based oversight that allows for innovation and new competition, let me assure you that we are also evolving our supervisory methods to keep pace with the change we anticipate. Risk-based examination cycles and risk-focused reviews provide good examples of this. Similar to the approach of other federal financial regulators and certain overseas financial supervisors, the Commission has begun to enhance its oversight of exchanges, clearinghouses, and other self-regulatory organizations (“SROs”) with risk-based examination cycles and risk-focused reviews. Both the scheduling and scope of the CFTC’s supervisory reviews will now be based on careful analysis of the underlying risks to which an institution is exposed and the controls which it has in place to address those risks. This approach promises to better utilize staff resources and to help ensure even greater financial integrity and risk management within the firms and clearinghouses that are the backbone of the futures clearing system.
As I have stated before, in my opinion, the creativity afforded by the CFMA must be accompanied by strong enforcement as a deterrent to misconduct, and our Division of Enforcement had an exceptionally busy year, bringing 50 % more enforcement matters in fiscal year 2003 as it brought in the previous fiscal year (64 vs. 41). During 2003, an enormous amount of the Division's staff time and other resources were devoted to investigating energy matters and charging wrongdoers in that area. Over the thirteen-month period beginning December 2002, that work resulted in the filing of two litigation matters against Enron and American Electric Power, and 13 settlements with an aggregate 17 companies involving the payment of civil monetary penalties totaling $180 million. All in all, the Division has wrapped up nearly all the energy investigations of companies it began in 2002, and is looking now at a few remaining companies, as well as the employees at all the companies who were responsible for the wrongful conduct.
The Division also continues to be pro-active in the forex area. Since the CFMA confirmed the Commission's jurisdiction over foreign currency operators selling off-exchange futures and options to retail customers, the Commission has brought 56 forex actions, nearly 40% of them in fiscal 2003. Through the Division's efforts to date, the Commission has obtained awards of nearly $96 million in civil penalties and $60 million in restitution.
One group of forex cases deserves special mention. Last year, the New York Regional Office worked closely with criminal authorities conducting an undercover investigation of complex, interconnected forex activities. Dubbed "Operation Wooden Nickel," the investigation resulted in the Commission filing six cases simultaneously against a total of 31 entities and individuals in November 2003, all involving fraud in the solicitation and sale of foreign currency contracts. At the same time, criminal prosecutors charged 47 individuals with various crimes related to their participation in the forex trading. The Securities and Exchange Commission also filed a case arising from this effort. I want to highlight this investigation as a model of civil and criminal cooperative enforcement and commend everyone involved.
Finally, I would like to talk about self-regulation, an issue that is critical to market integrity. Last May I announced that, given the CFMA’s added emphasis on self-regulation and the changes taking place in the market brought about by demutualization and increased competition, it was time for the Commission to review the roles, responsibilities and capabilities of the industry’s SROs. This was not because of any perceived existing problems, but simply because I believe it is prudent for an oversight agency to periodically ask whether the policies, practices and systems that are in place to ensure market integrity continue to serve their purposes as well as they can. Over the summer and fall, a team comprised of staff from our Divisions of Market Oversight and Clearing and Intermediary Oversight solicited a wide variety of views through interviews with participants in all areas of the marketplace, including FCMs, CPOs, and key exchange, clearinghouse, and NFA personnel responsible for their respective SRO functions. Although our review is ongoing, we made two recommendations last week.
First, the staff learned that one area of concern was the extent to which SROs protect the confidentiality of information gathered during audits and investigations of market participants. The staff concluded that SROs take this obligation seriously, and found SRO staff to be professional, ethical and well respected. The staff also found, however, that some SROs are better than others at making this obligation clear through training manuals, written procedures and ethics guidelines. The first recommendation, therefore, is to encourage every SRO to review its policies and procedures, employee training efforts, and day-to-day practices to ensure that adequate safeguards are in place to prevent the inappropriate use of confidential information obtained during self-regulatory activities. SROs are also encouraged to publicize these safeguards so that market participants continue to have full faith in the integrity of the self-regulatory process.
An integral part of the SRO system is the cooperative arrangement among SROs, operated under the auspices of the Joint Audit Committee, through which each FCM is assigned to a designated SRO (“DSRO”) for purposes of monitoring compliance with financial integrity, financial reporting, sales practice, recordkeeping, and anti-money laundering requirements. Commission Rule 1.52 expressly provides for such cooperation among SROs, recognizing that such a system of assigning each FCM to a single DSRO for examination purposes helps to avoid redundant burdens on FCMs, makes more effective use of SRO resources, and fosters important information sharing across markets. The rule reserves for the Commission a role in approving and monitoring this system to ensure that it remains appropriate to the public interest and that it works to strengthen customer protections. In accordance with the staff’s second recommendation, therefore, the Commission will begin a review of the DSRO system, including its cooperative agreements and programs.
Finally, in view of the fact that an SRO’s governing body can significantly influence key aspects of self-regulation, the Commission’s continuing review will include consideration of governance issues at SROs. In furtherance of this effort, the Commission will solicit written comments on the topic of SRO governance from members of the public. We will also listen with interest to the views of a number of our foreign counterparts at the International Regulators’ Meeting to be held on March 17 in Boca Raton, which will focus on a discussion of these issues from an international perspective.
In closing, I would like to publicly thank the staff of the CFTC for their tireless efforts since the passage of the CFMA, in particular, my personal staff as well as the current leadership team we have assembled at the Commission, many of whom are here today. Their dedication to public service and the oversight of the futures industry has been outstanding, and has led to a complete restructuring of rules, regulations, and even the Commission itself.
Additionally, I would like to thank each of you for being the most active participants with the Commission in discussing issues. I can assure you that your valuable insights and suggestions are key to keeping the Commission fully informed. Thank you again for the invitation to be here with you.