Speech by Acting Chairman Sharon Brown-Hruska
Center for European Policy Studies
Brussels, Belgium, 24th May 2005
“Market Competition and Regulatory Cooperation:
A New Dynamic in US-EU Financial Relations”
It is a pleasure to appear before the Center for European Policy Studies to discuss US-EU financial market developments that might impact our close ties.
The CFTC welcomes the opportunity to come to Brussels to meet with European regulatory leaders and to learn more about the European process for achieving market integration. I believe it is a good moment for our discussions here, since both the U.S. Congress, as I will discuss in my remarks today, as well as the EU Parliament, have taken fundamental steps to liberalize the financial regulatory structure in order to make our respective systems accommodate more open, competitive, and integrated markets.
After meeting Commissioner Charlie McCreevy for dinner last month during his Washington visit, it has become clear to me that the CFTC, which oversees a U.S. market, that is increasingly global, can work with your multi-lateral institutions and national leaders in a very productive fashion. While in the U.S., Charlie McCreevy said that although we need regulation, we must also “ensure that we get the balance right, that the solution doesn’t become the problem,” and that we must be certain that our regulatory environment “does not smother innovation, enterprise or growth.” I could not agree more. So we are taking note of your new focus, on implementing the existing directives in a way that maximizes the benefit for your internal market, rather than just imposing new statutory mandates. This is a regulatory philosophy that I share.
Regulation should have a recognized benefit and not just be a burden to the bottom line—which means that the focus must be on consistent application of basic regulatory objectives over central markets--customer protection and removal of systemic risk--not regulation for the sake of regulation—or worse, regulation for the purpose of protecting a domestic market. In our specific area of expertise at the CFTC we note that commodity markets, and the users of such markets, are increasingly international in scope. For example, where in 2001, the CFTC reported secured amounts with respect to foreign trades in the aggregate amount of 7.7 billion dollars, or 12 percent of total secured funds, by 2004, secured amounts with respect to foreign trades had more than doubled to 17.8 billion dollars, about 19 percent of total secured funds.
Today, market participants and the intermediaries who service them can use technology to perform portions of their business activities in different jurisdictions. It is time for regulators to catch up to the marketplace by removing undue barriers that limit the ability of a market participant or intermediary to conduct business based solely on the particular jurisdiction in which that person or firm finds themselves. Our task as regulators should be to foster the conditions that allow markets to perform seamlessly, and individuals and firms to execute their preferences globally and maintain their preferred relationships with service providers. If we do so, markets can compete with one another and innovate in order to provide the highest possible level of service to their customers at the lowest possible cost.
It is perhaps an irony that the seamless market that permits unbridled competition requires at its core that regulators cooperate. This is, because to the extent that global access to markets and products can be achieved, there must be some measure of reliance on our regulatory counterparts. I will outline today the steps we have already taken at the CFTC to rely on our foreign counterparts, and what further areas we wish to explore.
Role of the CFTC
However, before I launch into these issues, I thought I might tell you a bit about the CFTC. The CFTC is an independent U.S. Federal agency that oversees futures and options markets and professionals. As an independent agency, its powers are provided directly by the U.S. Congress and therefore, the CFTC is not part of any Executive Department, such as the U.S. Treasury Department.
We often tell our foreign colleagues that if we were to design the U.S. financial regulatory system from scratch, the system might look different today. The United States uses a relatively unique system of functional regulation. Therefore, my agency regulates commodity futures and options products, while other agencies, such as the Securities and Exchange Commission, banking regulators and insurance regulators regulate securities, banks and insurance companies, respectively. While this approach may seem unduly complex to outsiders, our system recognizes real differences between the sectors and a legitimate need for each regulator to possess a keen knowledge and understanding of the financial sector that they are assigned to regulate. This type of regulation has permitted many different types of financial products to develop and flourish and has permitted agencies to focus on the development of new markets that could be overwhelmed if they were part of a broader remit within a single agency. As our system explicitly permits “open season” on fraudsters and persons operating outside the regulatory framework, it also maximizes enforcement resources and permits state regulators to address matters directly that affect their constituencies.
Our system also places a premium on cooperation among the domestic financial regulatory agencies. Since 1987, following the market crash, this has been accomplished through a group known as the Presidents Working Group on Financial Markets, which is chaired by the Secretary of the Treasury and whose core members are the Chairmen of the Federal Reserve, the SEC and the CFTC and is also attended by the Office of Thrift Supervision, the Comptroller of the Currency, the Federal Deposit Insurance Corporation and the Council of Economic Advisors.
While there is a great deal of cooperation among the regulators, it is also the case that functional regulation introduces a bit of healthy competition amongst the U.S. regulatory agencies. I believe that this has fostered innovation and cost efficiencies in our respective approaches. At the same time, functional regulation requires accountability amongst the regulatory agencies. In the few instances in which a U.S. financial regulatory agency has failed to properly perform its mission, as was the case in the late 1980s with the savings and loan industry, Congress has taken the initiative to re-structure the regulatory system in a responsive manner.
Growth of Derivatives Markets
While there may be differences in the way our respective jurisdictions approach regulation, even a cursory review of statistical information nonetheless suggests that our regulatory environments have permitted healthy market growth. Probably more than at any other time in history, markets are thriving, both in the United States and in Europe. And while there are many reasons that this growth is occurring now, I believe that part of the reasons relates to the fact that regulators and the industry are working together to achieve common objectives, and striving to reduce unneeded interference by government regulators. In addition, internationally there has been greater communication and coordination between governments to foster business and trade between countries.
To give you some perspective on the growing state of our industry, let me go back to the year 1990, which happens to be the year I first began to work at the CFTC. The volume of futures trading on exchanges regulated by the CFTC has increased from 272 million contracts to over 1.3 billion contracts by 2004, with most of this growth occurring during the past four years. Growth rates of the European futures markets are expanding at an equal pace. During the first half of 2005, the Chicago Mercantile Exchange clearing house daily settlement exceeded 1.5 billion dollars, more than the record-breaking settlement that occurred during the market break of 1987 on the U.S. futures exchanges. The adoption of the Commodity Futures Modernization Act, which I will discuss in more detail in a moment, clarified the status of over-the-counter products between eligible participants and set up a tiered approach to different types of markets, has driven market expansion. With the new legal certainty created by the CFMA, the outstanding notional value of interest rate and currency swaps increased from about 3.5 trillion dollars in 1990 to over 180 trillion dollars by 2004.
III. Both the U.S. and the EU have undertaken regulatory reforms in recent years
Developments in the United States
I stated at the outset that one reason markets are thriving is because there is less undue interference by government regulators and greater communication and coordination amongst governments. Let me discuss for a few minutes the concrete steps that we have taken to foster this climate of competition and cooperation.
In the United States, the critical event that fostered competition was passage of the Commodity Futures Modernization Act. The CFMA provided a new flexible regulatory structure for the futures exchange. The law laid out differing tiers of regulation for exchanges, depending on the types of products traded and the level of sophistication of the participants trading them. Futures on commodities that might be more susceptible to manipulation and are offered to the retail public, such as agricultural futures contracts, are more heavily regulated. Those instruments that are less vulnerable to manipulation and are offered only to sophisticated investors and institutions would benefit from less regulation. The intent behind the tiered structure was to allow exchanges to innovate more rapidly to meet competitive challenges while enabling the CFTC to tailor its regulatory focus to those areas requiring greater government scrutiny.
Further, the CFMA transitioned the regulatory structure of the CFTC from prescriptive rules and regulations to one using a principles-based approach. Instead of prescribing the means for achieving a specific mandate, the CFMA set forth core principles that are meant to allow participants to use different approaches to achieve statutory requirements. Finally, the CFMA provided legal certainty for products such as OTC swap contracts and single stock futures, which my agency was struggling with when I first started at the CFTC in 1990.
Now, with four years of hindsight since passage of the CFMA, I think we all agree that the CFMA has been a success. Our exchanges are now able to implement their business plans under a more disclosure-based, less merit-based system. Core principles, complemented by sound self-regulatory structures have allowed us to replace the more interventionist regulatory model that included prescriptive rules and approval processes. New contracts can be introduced without delay and most rules can be instituted or updated with a simple certification to the CFTC that they are compliant with the Act and rules. This places more accountability on the market than a system that requires the CFTC to make that determination in the first instance. The CFTC is now attempting to be certain that there is sufficient airing of new proposals from the self-regulatory organizations and notice to the markets to reinforce this accountability effect.
Developments in Europe
At almost the same time as the U.S. reformed its regulatory system in 2000, Europe, likewise, overhauled its regulatory structure in order to permit greater market competition and efficiencies. In 1999, the EU conceived the Financial Services Action Plan in order to better integrate the European capital and financial services markets. I know that that many of you in this room today were part of this process. The progress you have made since then is most remarkable, with the European Commission having issued directives in all of the areas set forth in the 1999 Plan.
As a result of the timely adoption of the FSAP, your markets are beginning to integrate, with striking increases in the number of foreign market participants in EU markets. Not surprisingly, with these increased efficiencies and enhanced competition, the costs of trading for investors, and the cost of capital for industry, is falling, and capital is being allocated more efficiently than at any other time in Europe’s history. As is the case in the United States, there is a clear trend to lower cost and greater efficiencies.
IV. Access to Competing Markets
The efforts by both the U.S. and the EU to liberalize our financial markets are clearly a positive development. But these are just initial measures. Let me turn now to the changing global marketplace for derivatives products, and the implications this is having for regulators such as me.
It is heartening to see how the futures and derivatives markets have grown to become an international marketplace. In 2004, the CFTC approved the application of Eurex’s U.S. affiliate, the U.S. Futures Exchange, to enter the U.S. markets as a registered exchange. Subsequently, we approved the first phase of the clearing link between Eurex Clearing Frankfurt and The Clearing Corporation to permit the clearing of Euro-denominated products traded in Europe and approved for trading by U.S. persons.
At this time, my staff is working extraordinarily hard in reviewing further proposals to expand on the initial clearing linkage. We are reviewing the proposal to ensure that the combined market will be monitored appropriately and that there will be no gaps in supervision and are consulting with German authorities in this review.
It is clear that the entrance of the USFE to the U.S. marketplace has already had a dramatic impact. Even before we approved USFE’s application, a realignment of clearing arrangements between the two existing Chicago exchanges occurred. This merging of clearing operations between the CBOT and the CME has had a profound effect on the ability of brokerage firms to consolidate their clearing activities in a single entity, resulting in overall efficiency gains. In addition, we have seen a dramatic reduction in exchange fees as the Board of Trade has reacted to the competition from 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. I believe that our approach to these applications argues for similar treatment going in the opposite direction across the Atlantic for U.S. based proposals so that further efficiencies might be realized in these important markets.
The emergence of USFE and proposals to construct global clearing linkages demonstrates that on a day-to-day basis we must cope with an international market from our perspective as a national regulator. The CFTC, while ceding no jurisdiction over cross-border transactions and arrangements, has concluded, therefore, that to be effective, oversight arrangements must be founded on cooperation with other regulatory authorities.
To promote thinking about this type of regulatory cooperation, the CFTC has actively supported efforts in IOSCO and in some cases has led its own initiatives, like the Boca Declaration with other interested regulators to clarify what types of practical arrangements between regulators are useful in overseeing cross-border business. The CFTC has also worked on its own and with others to promote the movement toward common standards, both in IOSCO, with respect to screen-based trading systems, and in the Windsor Declaration and the Tokyo Communiqué.
But these are only the most recent developments. Over the past 20 years or so, the CFTC has developed a cooperative regulatory arrangements with our counterparts in the EU and elsewhere to support cross-border industry ventures, such as permitting reliance for some purposes on foreign regulators’ authorization processes to admit brokers selling off-shore products to U.S. customers and to permit foreign terminals to be accessed from the US; clearing through a mutual offset system and mutual access to linked markets, and to strengthen the capacity of regulators to oversee linked markets by specifying in advance information that would be immediately available under bilateral information sharing agreements for surveillance purposes, information that could be passed to markets for oversight of market integrity, and information that would support the more rigorous oversight of members operating in related markets located in different jurisdictions.
V. What do we still need to accomplish?
I want to end with a look ahead, and what we hope to accomplish both during our discussions with you this week, and more generally, our goals for the near to intermediate term. I believe that as commodities contracts are offered the benefits of a passport within Europe, it is time for us to discuss how the European and the U.S. markets can maximize expected synergies between them. The future is to move to markets with much broader reach, through proprietary trading electronic models and other mechanisms. Therefore, we need to be cognizant of how structural changes that are the result of legislative and technology changes will affect the role of regulators and how regulators can continue to effectively perform their jobs without impeding the development of a broader marketplace. In this respect, we are happy to bring some of what we see as possible new issues to the table. We also welcome the opportunity to know more about the European process and institutions. It is a perhaps mistaken view in the U.S. industry community that Europe operates in a very opaque way. Therefore the mere fact of opening the doors to U.S. regulators sends a good message across the sea.
It goes without saying however, that there would be no point in making the trip to Brussels if everything was absolutely perfect. Our interest is to foster conditions that permit markets to function seamlessly, so that market participants can execute their investment preferences globally and markets themselves can innovate and deliver the range of products and services demanded by their customers.
We therefore want to seek to ensure, to the maximum extent possible, that the transposition and implementation of various European Directives that comprise the FSAP will assist and not hinder the movement towards free and open markets. And in that regard, it is my desire that U.S. firms, even those that do not necessarily have existing operations in one or more European countries, will be able to participate in the vibrant and expanding European financial sector.
The ability to ascertain the components of a jurisdiction’s regulatory and market requirements is critical to the conduct of transatlantic business. Therefore, I look forward to the discussions that I will be having this week with my European colleagues regarding such Directives as the Markets in Financial Instruments Directive (MiFID), and particularly, how the pan-European “passport” system for markets and firms that are based in the EU will operate for firms that are not EU-based. And as a regulator of commodity derivative products, I am naturally keen to understand better the MiFID’s proposed definition of a commodity derivative product.
Similarly, I will be interested to learn more concerning the Financial Conglomerates Directive. We are already working closely with the SEC, as they have recently revised their capital requirements in a way that permits firms to qualify for consolidated supervision. We would like to expand our discussions with the EU, as any changes made to the definition of a commodity derivative under the MiFID could have implications under the FCD.
One way for regulators to foster seamless global markets is to be good listeners. It was with this goal in mind that I recently visited Paris to meet with CESR in order to commence a dialogue with CESR on operational and technical issues that could be impeding expansion of cross-border business opportunity or preventing comprehensive market oversight. At the conclusion of my meetings, my staff and the CESR Secretariat worked to draft a formal work plan to implement these objectives. We already believe that it is important for us to work through CESR as well as to maintain robust bilateral contacts with national regulators in the European member States. CESR is a means of getting operational and technical issues on the table that affect 25 different jurisdictions and this means it is an efficient way for us to identify issues to a broad group of national regulators as well.
In late March, we released a Communiqué requesting comment on a proposed work program. The work plan has three components: first, enhancing transparency and the clarity of regulatory requirements to that market professionals and end-users located outside a national jurisdiction understand the types of conduct that may require registration, licensing or authorization; second, simplifying access and recognition procedures, which may involve the development of practical arrangements for substituted compliance or recognition-like procedures to address access requirements for EU and U.S. financial institutions, and third, targeted consultation on cross-border issues as narrow as the protection of customer funds and as broad as overall market responsibilities in such areas as proprietary trading.
So I believe we are on the right track. It is not an accident that the derivatives markets are thriving on both sides of the Atlantic. Initiatives such as the CESR-CFTC dialogue and my visit here today, followed in quick succession by the EU-US summit in Washington this summer, is manifest proof of the renewed willingness to foster greater communications and coordination between governments to promote business and trade between countries. These efforts by regulators, combined with the actions of our respective legislative bodies to lessen interference by government regulators and open up markets to cross-border competition, are fostering a new era of competition in the derivatives markets. I am greatly encouraged by the current spirit of cooperation and mutual recognition among jurisdictions and hope that reciprocity and respect will carry it further.