Sound Regulation in a Competitive Global Environment
Address by Acting Chairman Sharon Brown-Hruska
U.S. Commodity Futures Trading Commission
Futures Industry Association International Derivatives Conference
Boca Raton, Florida, March 17, 2005
Thank you John, for that warm introduction. It is a pleasure to address this audience and participate in FIA’s International Conference. I have always viewed this conference as the most significant industry event during the year because of the opportunity it presents for all of the participants of the futures industry to come together to share issues, problems, suggestions, solutions, and, of course, complaints, in an effort to build a stronger futures industry. What a fine opportunity to bring together the firms, exchanges, and regulators—both domestic and international, and members of Congress and their staffs to consider the issues of the day.
This year is especially important for a number of reasons, not the least of which is that it marks the 50th year of the founding of FIA. I congratulate the organization for all the good work it has accomplished over those years. As you will note, the program this year is the best ever, with former first lady Barbara Bush, columnist William Safire, and investor Jim Rogers.
This is an important year for the industry for several reasons. Unlike other segments of the financial industry, the futures industry operates under the oversight of a regulator that must go through a periodic reauthorization. As a result, the industry, the CFTC and Congress get the opportunity to assess what’s working in the regulatory structure and what’s not working, and if necessary, improve the structure.
Over the past two weeks, I, as well as a number of you gathered here today, have had the chance to testify before Congress to share our assessments of where we are and where we would like to go. With respect to where we are, I do not think there is much disagreement among us. We all agree that the CFMA has been a phenomenal success. The exchanges are now able to implement their business plans with less undue interference from their regulator. Core principles complemented by sound self-regulatory structures have allowed us to replace the more interventionist regulatory model wrought with prescriptive rules and approval processes. Now, contracts can be introduced without delay and most rules can be instituted or updated with a simple notification to the Commission.
The CFMA has also sped up the processes by which new exchanges can come on line—and eight have done so since the passage of the Act in 2000. The competition sparked by these new exchanges introduced new types of contracts and has driven down trading costs and helped forge new clearing alliances. In short, the state of the industry is strong.
As we move forward in reauthorization, there are three areas that I highlighted for Congress where it should focus its attention as it deliberates. And let me be clear on a point here. As the regulator of the futures industry, I believe that our role is to carry out the mission that Congress has defined for us. At last week’s hearing before the House, Congressman Marshall of Georgia asked whether I was prepared to propose concrete legislative changes to the Act. As I said in my response, I am prepared and will propose specific legislative language for reauthorization. But in proposing that language, my intention is gather the opinions of those in the industry as well as the counsel of other U.S. regulators in crafting that language. We must always be cognizant of the fact that when we go about changing the language of the statute, we can at times cause far reaching consequences to not only those in the futures industry, but to other industry sectors as well as to the economy as a whole.
Although the CFMA clarified that the CFTC has jurisdiction over retail foreign currency futures and option contracts, whether transacted on exchanges or over-the-counter as long as they are not otherwise regulated by another agency, legal uncertainty has bedeviled our law enforcement efforts to stamp out fraud in this area. The problem that we face with respect to retail forex is two-fold: First, some courts, most notably the Seventh Circuit in the Zelener case, have taken the view that the products offered by these firms, which allow retail customers to speculate on price fluctuations in foreign currency, are not futures contracts, but are spot contracts not subject to our authority. Second, the language of the statute allows some firms who are committing fraud in this area to escape our jurisdiction.
In my view, the prospect of letting forex boiler room operators off the hook because of the way their transactions are viewed is unacceptable. The thrust of the CFMA, after all, 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 would caution, however, that before acting in haste and changing our statute in a way that inadvertently impedes legitimate market activity, we must take stock in whether our current approach needs some sharpening. For while developments like Zelener represent a set-back to our enforcement authority, I do not believe that they preclude us from bringing these kinds of cases in the future. Nor should they preclude us from prevailing in these cases, even in the Seventh Circuit. A more focused litigation strategy, one that relies upon extrinsic evidence surrounding the formation of the contract should, in our view, allow us to prevail in the future, even in the Seventh Circuit. Our enforcement staff has been thinking about how to win these cases in the aftermath of Zelener, and I for one am confident that we are on to a good strategy.
If it turns out that the judicial approach falls short, then a regulatory or, if necessary, legislative solution will be in order. However, while we are in the process of reauthorization, and we embrace this chance to consider the CFMA’s performance, it is important to remember that the window for necessary changes to our statute does not close once the CFTC is reauthorized. If we cannot prevail in these fraud cases, I will not hesitate to bring language to Congress that does the job.
In my view, any legislative solution must satisfy three criteria. First, we must be careful to avoid a fix that is overbroad in scope. We should eschew any remedy that interferes with the legitimate risk management function of the OTC derivatives marketplace where transactions are entered into by commercial parties.
Second, any standard that we develop should allow for legitimate parties to operate in a legal fashion without having to fear that the Commission is looking over their shoulder ready to pounce. On the other hand, it should not permit unscrupulous dealers with a “roadmap” for how to evade our jurisdictional boundaries.
Third, we should be wary of any attempt to impose a definition that gives competitive advantage to one segment of the industry over another. I am unwilling to allow or facilitate opportunistic behavior that could discourage innovation or stifle legitimate market activity in an attempt to solve what is fundamentally a law enforcement problem. The effort to clarify the scope of the Commission’s jurisdiction has engaged the CFTC, the courts, and Congress for more than three decades. Given what’s at stake, we will undertake this task in a measured and prudent manner, in consultation with industry and the members of the President’s Working Group on Financial Markets.
In the forex and energy areas, I am unwilling to return to a regulatory model that was characterized by legal uncertainty and inflexibility. Under the old model we had a one-size-fits-all model that required everything to be traded on an exchange under a prescriptive regulatory regime. Recent legislative proposals in the energy area would revise the tiered oversight model and unwisely apply many of the regulations designed for the exchange-traded market to the over-the-counter market. In the wake of the Enron collapse, and in response to recent run-ups in prices of natural gas and crude oil, there have been calls to increase the CFTC’s regulatory authority in the energy sector. Some have called for retrenchment and a return to prescriptive forms of regulation like the adoptions of federally determined price limits and position limits. Others have called for more sweeping legislative changes that would give the Commission greater reach into proprietary and bilateral markets.
As I mentioned in my testimony, last year’s energy bill contained several provisions that would directly affect the CFTC’s oversight responsibilities. The proposed changes sought to make it clear that the Commission has the authority to bring anti-fraud actions in off-exchange principal-to-principal transactions, such as those that occurred in the Enron Online-type of environment. While the CFMA provided for the Commission’s anti-fraud authority over exempt markets, some have questioned whether its application to bilateral and multilateral transactions would hold up given that our fundamental anti-fraud authority appears to pertain only to intermediated transactions.
Make no mistake, determination of what Congress intended in this area is vital to our implementation of the Act and it continues to be an important factor going forward if any changes are contemplated. I appreciated the remarks of Senator Harkin as he considered his own views with regard to interjection of the Commission into principal-to-principal transactions, wondering whether it was the right approach or not. I think this is what reauthorization is all about – providing Congress with the information and tools so that they can make reasoned decisions.
And again, while I am pleased to provide recommendations for changes to the Act, my job is to assess and report without bias what the likely effect of those changes would be. My greatest concern has been, and continues to be, that we not stifle innovation or create competitive disincentives via our regulatory model. Developing OTC markets in energy are far more transparent and liquid than the brokered markets of the past. Markets like Intercontinental Exchange have made numerous improvements in their rules and platform that improve our confidence in their integrity and has enhanced the quality of information about energy transactions available to both regulators and to the marketplace. When you see these markets take off, and the positive effect they have on the competitive landscape and expansion of risk management products to the energy market users, you must recognize how mandates may impact them. In my view, some proposals in the energy area, most notably Senator Feinstein’s proposal, many of Representative Barton’s amendments on price reporting and transparency, and the Industrial Energy Consumers of America proposals, could potentially harm these developing markets, possibly forcing those markets back into the closet and/or offshore.
The third area that I believe may warrant Congressional action is with respect to security futures. As you know, the CFMA was landmark legislation for its decision to permit the trading of futures on single securities under the joint jurisdiction of the CFTC and the SEC. However, more than four years after its passage, the growth of single-stock futures trading continues to be modest at best. Moreover, in December, 2004, the NQLX exchange, one of two exchanges that had been offering single stock futures, suspended trading.
In my response to Congressional queries, I specifically raised the issue of margins, which I continue to believe are too high to permit this segment of the futures industry to thrive. Curiously, however, the margins themselves are not set within the Commodity Exchange Act, but in the Securities Exchange Act. The Securities Exchange Act language basically says that margins on SFPs can be no lower than those found on stock options. While it is not clear to me that margins on futures and security options need necessarily be the same, it occurs to me that margins on stock options are not set in a reasonable way. My message to Congress in this regard is that the SEC must realize that futures and options are risk management instruments whose margins are designed to ensure performance. Thus, a risk-based approach should be used to set margins for futures and options as opposed to the lending-based approach common to the securities industry.
In sum, I remain concerned that we have not made sufficient progress with respect to implementing portfolio margining; have not avoided the double audit and review of notice registered exchanges and brokers; and have not determined the appropriate treatment of foreign security indices and foreign security futures products. Just as with our discussions with the SEC regarding an exemption for our registrants from their hedge fund registration proposal, we will faithfully seek to resolve these issues with the SEC, both directly and through the President’s Working Group on Financial Markets. I do believe, however, that a better approach would be to make clear the intent of the Congress that there be a primary regulator, and that the notice regulator should have very limited involvement to avoid duplication and inefficiencies inherent in a dual regulation approach.
Another area in which we wish to avoid duplicative regulation is in the international arena. And while this was not a topic in the reauthorization hearings, it is certainly a topic that has garnered our attention here at these internationally focused meetings. Today, more than ever, U.S. businesses and investors sell their products and services overseas, rely upon foreign resources, and access international capital markets. To properly manage the price, market, currency, and interest rate risks they face in doing so, U.S. businesses and investors need to be able to effectively access the risk management tools provided by derivatives markets both here and abroad. Outdated, duplicative, or overly burdensome regulatory barriers can impede that access and should be avoided. This is the message of the CFMA, and in this area, we are committed to encouraging competition and market access while ensuring customers are protected and market integrity is preserved.
Cooperation among financial regulators in different jurisdictions can help us to do just that. Indeed, improving access for market participants can actually improve the markets themselves, as increased trading activity creates greater liquidity and more reliable price discovery.
In addition to supporting cooperative regulatory initiatives, I am also a strong supporter of common enforcement efforts. The Commission has been active in setting up relationships with other countries to establish information sharing, technical assistance, and enforcement agreements. For example, in October 2003, we entered into an IOSCO memorandum of understanding with two dozen other nations that enables regulators to exchange essential information to investigate cross-border securities and derivative violations. This ability to effectively investigate violations is important not only to regulators but to the political bodies in these countries who can now be given assurances that both markets and customers can be protected in their dealings with foreign entities.
I believe there is a kind of optimal regulation that recognizes a “mapping” from the regulatory structure to the market, its products and its participants --- a calibration of regulation to fit the particular risk characteristics of different markets and market participants. The CFMA certainly incorporated this “mapping” concept by instituting a principles-based approach that allows the Commission to tailor rules to the sophistication of market participants, the risk characteristics of the products being traded, and the manner in which they are traded. In doing so, I believe that consulting with market participants affected by regulation is important to “getting it right.”
That’s why I believe the public comment process is so valuable to Commission decision-making. For example, there’s a lot of interest this week in Monday’s requests by The Clearing Corporation and Eurex US that the Commission permit expansion of their Global Clearing Link. These requests can be viewed on the CFTC website. This is not the first cross-border or inter-market clearing arrangement that the Commission has considered, of course. There have been many before and the markets have benefited tremendously.
For example, the Clearing Link between CBOT and CME has permitted enormous efficiency gains in operations and capital management for market participants. Internationally, the Commission has approved a number of clearing arrangements, including CME-Simex, CBT-Liffe, and CME-Meff. I would note here that, without the many important innovations that the CME and CBT have brought to the futures industry, it is unlikely that we would have seen the growth of futures markets across Europe and Asia to the extent that we have.
Each of the clearing links approved by the CFTC was structured differently to suit the business needs of the exchanges, clearinghouses, and market participants involved and the markets in which they operate. I expect that sort of healthy customization to continue as other clearing links and cross-border arrangements are proposed. Trying to force one-size-fits-all requirements on these important business ventures would, in my opinion, be the worst thing any regulator could do.
It’s important to remember that, just as overseas institutions are seeking to access the U.S. marketplace, either alone or in partnership with U.S. institutions, so too are U.S. institutions trying to access and compete in foreign markets. If regulators take a protectionist stance and stifle this competition, it will be U.S. businesses and investors that are hurt the most. We all can think of instances in the past, and unfortunately even today, when regulatory obstinacy has stifled innovation and denied market participants of important benefits. I am therefore greatly encouraged by the current spirit of cooperation and mutual recognition among jurisdictions and hope that reciprocity and respect will carry it further.
So I would conclude by noting that the state of the markets is good. The regulatory model in the CFMA has encouraged global market access, innovation, and competition. The CFTC has diligently and effectively policed the markets and we will continue to do so. Customer protection and market integrity are not and will never be a casualty of a successful market under my watch. I look forward to working with this industry and Congress to ensure that markets continue to flourish for the benefit of us all.