Striking a Balance in the Regulation of Global Markets
Acting Chairman and Commissioner
US Commodity Futures Trading Commission
May 26, 2005, Brussels, Belgium
It is a pleasure for me to appear here today before the Federation of European Securities Exchanges (FESE). I am honored to appear before an organization that has such a distinguished tradition of adding value to the debates and policy decisions that have shaped Europe’s securities and derivatives markets and of promoting cooperation both within the European Union and internationally.
I am also particularly pleased to learn that FESE, in cooperation with the Capital Markets Institute, has been awarding young academics the very generous Joseph de la Vega Prize for papers examining the application of economics to the functioning and regulation of markets. As an economist and academic myself, it is heartening to see programs such as this. Also, I am a confirmed believer in the immense value that economic thought can bring to the development of optimal regulation.
After talking with Charlie McCreavy, it is clear that the EU’s single market initiative is one that recognizes the strength of market-based approaches. Accordingly, today I would like to share with you my own regulatory philosophy that emphasizes the importance of incorporating sound economic theory and applications in the regulatory process. The foundation of that philosophy is the promotion of competition. I believe we as regulators and industry can work together in a principled manner to create conditions that promote a seamless global regulatory structure, taking into account that a reliable, consistently applied regulatory scheme is a pre-requisite for vital, open markets. At the end of my remarks I would be happy to answer any questions.
But first I am obliged to give the official disclaimer that my remarks today are my own and do not necessarily represent the views or positions of the Commodity Futures Trading Commission or its staff. Also my remarks, while having some generic import, are primarily directed at the exchange-traded derivatives markets and professionals that the CFTC oversees.
While treated as securities in many jurisdictions, futures markets in physical commodities for example, can pose different issues from traditional equity products. And, although risk management products support and complement capital formation, there are regulatory issues relative to public companies that are not within my specific remit.
I’d like to begin by telling you a little about myself and the Commodity Futures Trading Commission. 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 while finishing my PhD. Last year, 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 as an economics researcher and professor 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 demonstrated how well these markets function, how vital they are to business and the economy, and how regulation can and does contribute to ensuring that these markets continue to perform their important functions of price discovery and risk management. Economics, and the underlying costs and benefits that drive economic choices, form the core set of beliefs that I bring to the regulatory process.
As an economist, I am unapologetic in my support for open and competitive markets. As such, 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 and efficiency of our markets. The rub occurs when the promotion of market comes up against the regulator’s role of protecting markets. There is often a temptation to overprotect markets and market participants, even to the extent of government determining the merit of specific offerings. An example of this in the U.S. was a requirement that exchanges have futures contracts approved before they could be traded. Unfortunately, this often meant that the introduction of contracts was delayed while the CFTC reviewed contracts for potential flaws. In essence, perfection became the enemy of the good for well-intentioned regulators. I would argue, however, that markets can move quickly to determine whether a contract is flawed and send clear signals to an exchange as to how to fix them.
The problem is that an overly restrictive regulatory environment that uses too prescriptive an approach or which tries to decide what products or approaches will succeed in the marketplace can slow down the development or even suppress innovative products. Even worse, they can erect unwarranted barriers to entry into the market. When competition is stifled, everyone suffers because of the missed opportunity to lower costs or effectively manage risks.
Modern finance has become a complex science, but has also increased our ability to be creative. 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 diversify 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 overly prescriptive regulation of markets chills innovation, raises costs and often results in market participants migrating to less regulated settings.
We must also avoid the temptation to adopt politically motivated quick fixes. There are often outcries, for example, to quickly react to each new instance of wrongdoing with broad new laws and regulations. There is the temptation to “rewrite the book.” But the solutions for dealing with perceived problems in our markets should be simply to first, employ smarter oversight, which in the United States has been facilitated by the principled-based approach of the Commodity Exchange Act, second, pursue more targeted enforcement of our laws with the imposition of penalties appropriately tailored according to principles of deterrence. In effect, instead of rewriting the book, let's throw the book at wrongdoers, and third, in the international arena, pursue global cooperation that includes a dialogue between regulator and regulatee. I would like to explore these three concepts more fully.
Having proposed bringing economics to bear on regulation, the first requirement is to implement regulation in practice that achieves the goals of unifying and opening markets, accommodates different regulatory approaches, and fosters effective enforcement.
I believe that the Commodity Futures Modernization Act of 2000 serves as a model of a legislative framework intended to do precisely that for those products within CFTC’s regulatory competence. This historic legislation provided a blueprint for regulation in a market characterized by rapid growth and change, and diversity of participants and products.
The CFMA enabled the Commission to move from a prescriptive regulatory model to a core principles-based, risks-based model. One way to quickly explain this approach is by reference to the economic understanding that there is an optimal regulation that recognizes a “mapping” from the regulatory structure to the market, its products and its participants --- or in other words, a calibration of regulation to fit the particular risk characteristics of the market and market participants.
The CFMA approach permits the CFTC 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. The CFMA freed the CFTC to regulate the derivatives industry in
a more flexible and targeted fashion, as opposed to being bound by prescriptive and
overly micro-managing legislation. However, in order to calibrate rules correctly, a
regulator needs to understand fully its regulatory target and be mindful of the need
to still meet the regulatory objectives of customer protection, fair and efficient
markets, and reduction of systemic risk. In this regard, the CFMA encourages the
clearing of over-the-counter products, and eliminates possible interference with
institutional regulators’ approaches to counterparty risk.
In addition to providing legal certainty as to enforceability of over-the-counter derivatives, and permitting the development of markets restricted primarily to commercial participants under a framework that recognizes their differences from retail markets, the Act 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, most importantly, the industry itself determines exactly how to meet those goals. Gone then are 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. That does not mean that we do not review and monitor these contracts, but it does mean that the markets get the first crack at exposing flawed contracts.
It is my view that the Act provided a necessary foundation for the growth in competition among markets that we have seen recently and the flexibility to be responsive and creative in addressing the challenges of accommodating cross border business.
But while the CFMA establishes a flexible regulatory system, that does not mean that there are no laws to be broken or shortage of those who will try to break them. I believe that the use of principles encourages accountability as it fosters compliance with the spirit as well as the precise letter of the law. I also believe that strong and equitable national enforcement also fosters open markets. But in economics, we have also observed that integrity is part of a market's brand. Good compliance and the expectation that rules will be honored fosters confidence and liquidity, and thus enhance the bottom line. Businessmen know that fraudsters can adversely affect the reputation of a market as a whole. To be effective in achieving the benefits of a robust enforcement program—that is discouraging and punishing abusive conduct without harming legitimate commerce,--we have endeavored to bring economic discipline to the enforcement arena.
There is a large body of economic literature, for example, that deals with the relationship between penalties and deterrence. This literature on optimal penalties, which draws upon the work of Nobel laureates George Stigler and Gary Becker, 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 wrongdoer 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.
Ultimately, as markets become linked globally and participants reside in scattered locales, regulation and enforcement become issues of global cooperation. Less prescriptive rules encourage global commerce and make it easier to address our regulatory objectives without unduly constraining the relationships or transactions which cross borders in a global marketplace.
The problem raised by international trading arrangements of course is that although markets and clearing organizations may reside under the jurisdiction of separate regulatory authorities, transactions on one market can raise important market and customer protection concerns on others. However, no one market authority will necessarily have the supervisory power over all aspects of an international trading arrangement nor will it have access to all of the information that may be needed to obtain a comprehensive view of the market in question.
In the absence of a common, harmonized legislative structure such as you have in the European Union, what are world regulators to do? If one believes as I do that we as regulators should strive to construct a sound regulatory environment that enables the markets to function seamlessly, it follows that we must both cooperate with other regulators to provide effective supervision and enforcement and engage our fellow global regulators in a dialogue to determine where we can appropriately rely on each other and coordinate our efforts.
I am proud of the Commission’s long history of cooperation with foreign regulators. A good example is our approach, under Part 30 of the CFTC's Rules, of assessing the comparability of supervision over foreign markets. The less attractive alternative is insisting upon identical, homogenized regulation of intermediaries, which could render cross border business prohibitive. Similarly, the Commission has approved rules permitting innovative clearing linkages and direct screen access to US customers, each of which rely on meticulous attention to ensuring customer and market protections within an environment of cooperation among market authorities. I have heard a lot about European exchanges’ desire to permit the placement of trading screens in the U.S. for trading European equities, but perhaps what many do not realize is that the CFTC has permitted the trading of European stock index products under the CFTC’s jurisdiction since 1996. Moreover, in the proposed legislative language that we sent to Congress in conjunction with the CFTC’s reauthorization, we proposed a definition of broad-based foreign stock and debt indexes, which would further increase the access of U.S. commercial interests and investors to European markets for risk management and diversification.
Our approach has allowed U.S. businesses and investors to safely access derivatives markets in a growing number of jurisdictions, without incident, for more than fifteen years. In each case, our confidence in foreign supervision has been based upon a knowing inquiry into its foundations and the negotiation of necessary cooperative arrangements. Rather than insist on a rigid approach to doing things one way, we have been able to focus upon common regulatory objectives and core standards. We also have worked together to combat financial crime and to protect the reputation and integrity of the world’s marketplaces.
Today's markets, intermediaries, and market users not only encounter the legal and commercial risks common to doing business in any domestic market, but also must navigate complex combinations of legal, operational, market, credit and liquidity risks associated with doing business in multiple jurisdictions. Often, the lack of transparency and clarity of relevant rules or lack of awareness by regulators of how regulatory differences can impact the marketplace can, and do, inhibit the smooth transaction of business.
One way regulators can improve the efficiency, credibility, and effectiveness of our regulatory services is by being responsive to the practical problems and risks faced by market participants in the day-to-day conduct of their businesses.
In order to address these problems, last year the CFTC and Committee of European Securities Regulators (CESR) launched a Trans-Atlantic Cooperation Initiative to foster a dialogue among US and European derivatives regulators. The goals of this dialogue are to institute regular communication on matters of regulatory developments of common concern; heighten each respective region’s attentiveness to the need for early and effective consultation; and explore where areas of convergence and of common interest permit the development of practical EU-wide mechanisms to enhance the existing bilateral relationships between the CFTC and individual CESR members.
Of course, regulators cannot just talk among themselves. In today’s complex world of financial sector opportunities, one way for regulators to foster a seamless global marketplace that is both safe and efficient is to be good listeners – not just to each other but also to those who use and operate the markets. In this way we can understand better the risks and practical concerns each other face in cross-border transactions, and to thoughtfully consider these things in developing our cooperative agreements and setting our regulatory modernization agendas. In other words, we as regulators must increasingly pay close attention to the marketplace to ensure that regulatory requirements are clear and transparent and that oversight takes account of how business really gets done so that our supervision remains efficient and effective.
Accordingly, the CFTC and CESR quickly followed up our announcement of the Initiative with a very productive Round-Table earlier this year, which was attended by 60 market participants and senior regulators. The purpose of the Round-Table was to allow the United States and European derivatives industry to inform our regulatory thinking by identifying the very practical issues they confront in transacting transatlantic business. We as regulators also discussed the feasibility of conducting further work to explore the development of cooperative strategies to foster a more compatible business and regulatory framework.
Following these discussions, in March of this year the CFTC and CESR published a communiqué requesting comment on a proposed work program and several comments have been received. Under the proposed work program a combined CFTC-CESR task force will be established to review issues relating to enhanced transparency and clarity of regulatory developments, simplified access and recognition procedures and targeted consultation on cross-border issues.
As we proceed in this work, we believe strongly that you can assist us in prioritizing issues and in framing solution-oriented regulatory strategies to make it easier to assess the requirements and risks of specific cross-border transactions and in facilitating cross-border transactions as appropriate. In this I believe that we share your vision of a thriving transatlantic marketplace.