ABA Committee on Regulation of Futures and Derivative Instruments
Winter Meeting, Key West, Florida

Keynote Address

Sharon Brown-Hruska
Acting Chairman, U.S. Commodity Futures Trading Commission
February 4, 2005

It’s a pleasure to address this conference on the regulation of futures and derivative instruments.

As I look around I see a number of familiar faces, many of whom were involved in helping to design the innovative regulatory model that has enabled the futures and derivatives industry to grow and thrive. I am therefore delighted to have an opportunity to share with you my thoughts with respect to the issues that we face going forward as another reauthorization approaches. As I proceed, I would like to share my philosophy on the role regulation should play in ensuring that the markets flourish in a manner that embodies financial integrity and increases economic growth and opportunity.

Since some of you may not be familiar with my background, let me tell you a little about myself, but let me start by noting that the opinions and views I express here today are my own and do not necessarily represent those of the Commission or its staff. As for myself, prior to joining the Commodity Futures Trading Commission in 2002 as a Commissioner, I was a finance professor at the business schools of Virginia Tech, Tulane University, and George Mason University, where I taught courses on derivatives, risk management and financial market innovation, investments, venture capital and private finance, and international financial management. Prior to that, I was a research economist at the CFTC, where I worked for five years while finishing my PhD. Last summer, upon the departure of Chairman James Newsome, President Bush designated me as Acting Chairman, and I have enjoyed serving in that role since July of last year.

As I have 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. My academic research has instilled in me an appreciation for how well these markets function, how vital they are to business and the economy, and how regulation can and has contributed to ensuring that these markets continue to perform their important functions of price discovery and risk management.

For those who know me as an economist, you know that I am unapologetic in my support for open and competitive markets. Being an economist, my first instinct is to let the markets work. But as a regulator and law enforcement official, I am equally committed to ensuring the financial integrity of our markets. So how do I reconcile these seemingly competing goals? How do I fulfill my role as both a protector and promoter of our markets? The answer may be found in my adherence to an approach based on “law and economics” principles. As an undergrad, Dr. Gordon Tullock introduced me to law and economics. He and Dr. James Buchanan founded the Center for the Study of Public Choice at Virginia Tech (now, conveniently, at George Mason University). Their passion really inspired me to think about economic incentives and how individuals in a market environment respond to laws, regulation, and the government.

Law and economics, as the name implies, entails the application of economic reasoning and evidence to traditional legal analysis. The idea is to bring the same level of scientific rigor used in economics to an analysis of the law. And that approach has transformed the way that courts look at a whole array of legal issues, most notably in antitrust and market regulation. That is, many in the legal profession have come to the realization that, as Judge Richard Posner puts it, “economics is a powerful tool for analyzing a broad range of questions of legal interpretation and policy.”[1]

Take market regulation, for example. Economic theory recognizes that regulators have a role to play in instilling credibility in the markets while minimizing legal uncertainty. But economic theory also tells us that when regulators intervene in the market, it should be to ensure integrity and not to affect prices. The markets will take care of prices as long as we take care of the markets.

The rub occurs when the promotion of market solutions comes up against the regulator’s role of protecting markets. There is often a temptation to overprotect markets and market participants, usually through extensive licensing, registration, and reporting requirements, and even by government approval over what can be offered to whom and how. The problem is that an overly restrictive regulatory environment that uses these prescriptive approaches can sometimes slow down the development and availability of innovative products or put up barriers to entry into the market. When innovation is stifled, everyone suffers because of the missed opportunity to lower costs or effectively manage risks through the use of innovative products.

Modern finance has become a complex science. Over the past few decades there have been numerous advances in pricing, financial engineering, risk management, and fund management. In addition, the opening and development of foreign markets have given investors more global opportunities to pursue their investment and risk management needs. In such an environment regulatory agencies simply cannot, and should not attempt, to define and then develop rules for every type of trading strategy or activity or trading mechanism. Economic studies routinely find that prescriptive regulation of markets chills innovation, raises costs and often results in market participants migrating to less regulated settings.

I therefore firmly believe that in order to carry out our mission, financial regulators cannot eschew the use of the principles of finance and economics in our supervision of the markets. When these tools are used properly, regulators are forced to take into account the economic policy implications—the costs and benefits, if you will—of their actions. And being aware of this allows us to be better regulators.

We often hear, for example, that the solution for every wrongdoing is to pass new laws, new regulations, or to “rewrite the book.” But the prescription for dealing with perceived problems in our markets is often simply smarter oversight, better enforcement of our laws, and the imposition of penalties appropriately tailored according to principles of deterrence. Let me illustrate by discussing a natural phenomenon that perennially spooks both markets and those on Capital Hill.

It seems that whenever prices behave in a volatile manner—energy comes to mind as the commodity du jour—there are immediate calls to “do something” to rectify the situation. This usually involves pleas for more laws and more regulation. The fact that prices may move in a way that we don’t anticipate does not mean, however, that the markets are not fulfilling their role. We may not like the prices we see, but we must accept that markets at times act as the messenger of bad news. Indeed, markets in their price discovery role synthesize information to tell us something we need to know about the fundamental state of supply and demand. So as a regulator I know that I must be vigilant not to equate unpopular price movements with manipulative behavior and overreact with prescriptive regulatory or legislative solutions. Otherwise, I risk throttling the market’s ability to serve its vital role as a means for managing and assuming price risks, discovering prices, and disseminating price information.

To emphasize this point, suppose that I was the all-powerful Oz, who could slip behind the curtain and set prices. If I were to set out to please to energy consumers, I would lower prices. And in fact we saw this done during the Nixon Administration. So what happens? Well, energy consumers consume more energy because prices are cheap, and energy producers produce less because there is no financial incentive to produce more. Eventually we end up with dwindling supplies of energy and resort to unpopular and inefficient rationing programs. So with respect to calls to take regulatory actions to effect prices, I think that it’s time to get our heads out of Oz and return to the reality of Kansas. It may be black and white in Kansas, but at least we aren’t looking at the world through rose-colored glasses.

Another example of a call for increased regulation involves manipulation of reported price indexes in the energy markets. Many have raised concerns that the Commission does not have sufficient authority to address this illicit behavior and numerous remedies have been proposed to address it ranging from extensive rulemakings imposing requirements or limits on market participants, to wholesale legislative solutions designed to discourage market “strategies” that are alleged to be manipulative. In particular, critics see mandates for increased transparency and disclosure as a “quick-fix” for these problems.

Putting on my economist’s hat for a moment, it is not clear that such proposals constitute the right prescription. For one thing, such prescriptive approaches are generally operationally difficult to implement and can do significant harm to the markets if they are done without regard to market structure. In the energy sector, moreover, the market is usually bilateral, proprietary, and over-the-counter. It is not clear that forcing exchange-style transparency or requiring the details of private, individually negotiated transactions to be made public is appropriate or even that it will work in such a setting. I believe that the Commission’s enforcement actions in this area demonstrate not only that we have significant authority to bring cases of manipulation, but also that we are prepared to exercise that authority. In my view, calls for additional authority for the CFTC in the OTC energy markets based on the premise that they are unregulated does not square with the strong action the CFTC has taken in these markets. As I said earlier, sometimes we simply need to make better use of the tools we have, rather than running out to get a new tool.

It is my view that a program of prescriptive regulation would likely not address the problems experienced in the energy sector, and in fact could exacerbate a liquidity shortage in the energy complex by unnecessarily imposing costs on industry participants, and creating regulatory and legal uncertainty. We must be careful that in our effort to squelch manipulative behavior, we do not end up unwittingly nurturing it by encouraging noncompetitive, illiquid markets. Remember, the true enemy of manipulation is competition and liquid markets.

Economic analysis can even help us to analyze more generic reform proposals. For example, it seems that no session of Congress ever passes us by without some form of legislation proposing to merge the Commodity Futures Trading Commission with the Securities and Exchange Commission. With respect to such proposals, the literature reveals that competition may be as beneficial in the regulatory arena as it is in a market setting. On that score, let me just say that the CFTC should be recognized for its expertise and understanding of the vital functions of these markets; more specifically, effective price discovery and risk management. In addition, we must keep in mind that derivative products are used to hedge both upward and downward price movements, and as such the regulator cannot afford to have the mindset that the only good way for prices to go is up—or for that matter only down.

I would also add that derivatives contracts for price discovery and risk management were developed by the agriculture markets, which are overseen by the agriculture committees of Congress. And though less than 10% of futures trading now occurs in agricultural commodities, the Ag Committees had the foresight to craft the Commodity Futures Modernization Act, demonstrating their fundamental understanding of these markets and their ability to craft legislation that encourages innovation while preserving market integrity.

Economic analysis can also advance our enforcement mission by helping us to determine where to direct our limited resources. Take the problem of manipulation again, for example. Economic analysis suggests that markets characterized by a high degree of liquidity and sophisticated counterparties are less susceptible to manipulation than markets where this is not the case. This is something, for example, that the Hunt brothers learned the hard way back in the 1980s when they tried to corner the market in silver. Therefore, focusing on regulatory programs on less liquid markets, or markets where counterparties are less sophisticated or retail market participants has been a high priority.

And when it is the case that the Commission needs to act against wrongdoers, economics can help us do a better job of policing the markets. We know there are times when the markets or participants in the markets do not function as we would like. There will always be bad guys out there. Usually the markets themselves will discipline the would-be wrongdoers. But at other times regulators must step in to ensure market integrity, when, for example, traders attempt to manipulate prices in their favor, or unscrupulous dealers attempt to take advantage of unsophisticated users of our markets. When that happens, the CFTC has an important role to play to foster market integrity, financial integrity, and customer protection. In this role we must make it clear to all that criminal and fraudulent behavior by market participants will not be tolerated. And we accomplish this by assessing rational penalties that deter others from engaging in manipulative and fraudulent behavior.

There is a large body of economic literature, for example, that deals with the relationship between penalties and deterrence.[2] A central idea of this literature, according to Professor Mitchell Polinsky, “is that enforcement costs can be reduced, without sacrificing optimal deterrence, by lowering the probability of detection and raising the fine accordingly.” [3]

This literature on optimal penalties, which draws upon the work of Nobel laureates George Stigler and Gary Becker,[4] suggests that the goal of deterrence is best attained when a penalty reflects a multiple of the revenues that a wrongdoer expects to obtain from his wrongdoing, not on the accounting profit that he actually realizes. That is, a monetary sanction should be set such that the expected cost of the penalty—which takes into consideration not only the size of the penalty, but the probability of being caught—to the respondent exceeds the expected gain from the offense. In plain English, this means that penalties should be set at a level that ensures that one does not expect crime to pay.

At the same time, economic theory recognizes that in our efforts to rid markets of illegal behavior, we must not become so overzealous that we severely stifle legitimate activity to achieve political purposes. While the literature suggests that sanctions for violations in regulated industries be based primarily upon the goal of deterrence, it also makes clear that regulators should avoid the twin evils of over and underdeterrence. If we make the first error, we only encourage further wrongdoing; if we make the second error, we discourage legitimate and useful activity.

So to sum up my philosophy: As a market regulator, I will not hesitate to act, to protect investors and ensure the financial and economic integrity of our markets. That is the most important part of my job. But in carrying out that mission, I believe that our actions must be grounded on sound legal as well as economic principles. Only in this way can we more effectively and efficiently protect our markets from wrongdoing. Moreover, in pursuing enforcement actions against wrongdoers, it is incumbent upon us to employ sound, empirically defensible means not only to prove up our cases, but to determine penalties and to carry out our mission. As Judge Easterbrook cautions us, “[a]n agency must act like an expert if it expects the judiciary to treat it as one.”[5]

Now let me give you my perspective on where we are today and where we appear to be heading as we approach another reauthorization. Happily, more than at any other time in history, derivatives markets are thriving. Both domestically and globally, a tremendous surge in innovation and change has taken place. A host of new products and trading systems and clearing arrangements have been introduced to the markets. And with them we have seen a concomitant increase in the use of derivatives by a broader spectrum of customers. Our markets are thriving, I believe, because of the action that Congress took in conjunction with the last reauthorization when it enacted the Commodity Futures Modernization Act of 2000.

This historic legislation provided a blueprint for regulation in a market characterized by rapid growth and change and diversity. The thrust of the CFMA was, first, to provide legal certainty for innovative products in the OTC markets. It accomplished this through specific exclusions and exemptions that enabled new entrants and new products to be traded without the deliberate imprimatur of the Commission. Second, the CFMA enabled the Commission to move from a prescriptive regulatory model to a core principles-based model. This model set out fundamental principles for product offering and market operation while ensuring that the CFTC’s mandates for customer protection, financial soundness, and economic integrity are fulfilled.

The CFMA also recognized that not all markets and not all participants are created equal. During the late 1980’s and throughout the 1990’s there was significant movement, particularly among commercial participants in the financial and energy markets, to develop over-the-counter derivatives such as swaps and forward rate agreements. Congress recognized that such markets did not require the level of supervision traditionally applied to the exchange-traded markets due to the sophistication or commercial expertise of the participants in these markets.

The CFMA also gave traditional futures exchanges greater autonomy in operating and regulating their business. To this end, Congress choose to regulate the futures and options industry through core principles, where general regulatory guidelines and goals are set forth to govern market activity—but the industry itself determines exactly how to meet those goals. Gone then were the paternalistic and prescriptive regulations of the past. So too was the requirement that exchanges have their contracts approved prior to being able to list them for trading. Exchanges are now able to certify that proposed contracts meet the Act’s core principles and begin trading them immediately.

It is my view that the legal certainty that we attained for OTC derivatives and the modernization of the US statutes governing derivatives trading and clearing in the Commodity Futures Modernization Act of 2000 provided a necessary foundation for the explosive growth that we have seen recently. Moreover, these changes and growth in the markets more and more cross international boundaries. As global market regulators and policy makers move forward to coordinate and unify the development and oversight of markets, duplicative and complicated regulatory hurdles to cross-border business are being lowered. In fact, next week I will be co-hosting a joint roundtable with the Committee of European Securities Regulators to focus on what regulators can do to further bring down the frictions to international trade. In the end, it is my hope that instead of the derivatives pie being sliced thinner, the pie will grow larger.

Only four years have elapsed since the enactment of the CFMA, but already we have seen that the fruits of this innovative regulatory approach are huge. That said, we should not rest on our laurels. Going forward, we must make sure that our regulatory policies are similarly innovative. We must ensure that the results Congress intended regarding competition and innovation are realized. And in that regard, we still have much that we can do as a regulatory agency, working with industry, other domestic and foreign regulators, and Congress, to move the ball forward without a single statutory change.

So as we enter the reauthorization process, I believe that it is prudent to take stock and ensure that we consider the costs and benefits of making changes to the Act. With that in mind, let me highlight two areas of concern that I have—avoiding duplicative regulatory burdens on markets and ensuring the CFTC has clear and adequate authority to police retail fraud, particularly in the forex area.

With regard to our implementation of the provisions of the Modernization Act as it relates to joint regulation by the SEC and the CFTC, I have particular concerns that we have not made sufficient progress with respect to implementing portfolio margining, avoiding double audit and review of notice registered exchanges and brokers, and determining the appropriate treatment of foreign security indices and foreign security futures products. 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.

As many of you know, the CFTC is in discussion with the SEC to hammer out an exemption from registration with the SEC as Investment Advisors for those Commodity Pool Operators who are already registered with the CFTC. 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. I believe that Congressional instructions to avoid duplicative registration and regulatory requirements is clear in the CFMA, yet in our evaluation of how well the CFMA is performing, additional guidance from Congress would not be unwelcome.

With respect to the setback the CFTC received in the Zelener decision, I am concerned that there remains a legal cloud over our jurisdiction. Here it is 2005, and after decades of interpretation and litigation, we still do not have clarity for something as fundamental and basic as what is a futures contract. Recall, that a major objective of the CFMA was to provide legal certainty for our markets. Yet, that objective continues to elude us, for reasons that have nothing to do with the CFMA.

The current state of affairs characterized by legal ambiguity regarding our jurisdiction is unacceptable. As mentioned, the thrust of the CFMA was to provide legal clarity for innovative products in the OTC markets while ensuring customer protection is not compromised. How is it, then, that we still see forex bucket shops flaunting our authority and offering products that look and act like futures, but are able to escape our law enforcement efforts? I very much appreciate the rigorous discussions that are occurring in this conference on the Zelener matter, and I want to encourage this Committee of the ABA in particular to help the CFTC in its efforts to address the retail forex problem to ensure market integrity and customer protection without impinging on legitimate cash market activity that is outside our jurisdiction. I believe that without greater clarity, either via regulatory or, if necessary, legislative action, innovation will be stifled and market integrity impaired.

On a final note, let me say that as we look back on the past decade or so it is heartening to see how the futures and derivatives markets have blossomed, expanding both domestically and internationally. As a result of the regulatory innovation made possible by the Modernization Act, the global market for derivatives is more open and richer in the diversity of products than at any time in history.

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 the remainder of the conference and having the opportunity to meet with you and discuss your insights and views.

[1] Richard A. Posner, Economic Analysis of Law (2d. ed. 1977) at 3.

[2] See, e.g., A. Mitchell Polinsky & Steven Shavell, The Optimal Tradeoff Between The Probability and Magnitude of Fines, 69 Am. Econ. Rev. 880 (1979).

[3] A. Mitchell, Polinsky, An Introduction to Law and Economics (1983) at 83.

[4] See George J. Stigler, The Optimum Enforcement of the Laws, 78 J. Pol. Econ. 526, 531, 533 (1970) (arguing that gains must be multiplied by probability of detection such that “[e]xpected penalties [must] increase with expected gains”); Gary S. Becker, Crime and Punishment: An Economic Approach, 76 J. Pol. Econ. 169 (1968) (applying economic analysis to develop optimal penalty policies to combat illegal behavior).

[5] Peabody Coal Co. v. McCandless, 255 F.3d 465, 469 (7th Cir. 2001).