Keynote Address by Sharon Brown-Hruska
Acting Chairman, Commodity Futures Trading Commission
Managed Funds Association Annual Forum 2005
June 7, 2005
Thank you very much for the kind introduction. I would especially like to thank Jack Gaine, President of the Managed Funds Association. I have known Jack for some time, and I can tell you that his intelligence, commitment, and his dogged advocacy of best practices and integrity in the business serve this industry well. Perhaps the most interesting complement for Jack Gaine I ever heard came from Chairman Bill Donaldson of the SEC, who, responding to Jack’s efforts in the regulatory area, told me, “That guy is good.” The only plausible explanation for where we are today is that Jack is too good!
Since this panel is entitled “Washington Regulatory Update,” it is a good time to mention how much I enjoyed working with Bill Donaldson, even as we were frequently on different sides of the issues, most prominently regarding the registration of hedge fund advisors. In those and other matters, his determination and desire to fix things he thought were wrong are traits that explain why even the good guys like Jack Gaine could not convince him otherwise. But I also appreciated Chairman Donaldson’s willingness to seek compromise in areas of mutual concern to our agencies, such as in the area of avoiding duplicative registration of funds and in the area of single stock futures, and for that I wish to commend him publicly and wholeheartedly.
I am also pleased to precede Senator John Breaux today and congratulate him and the MFA for putting him on the Board of Directors of the MFA. I have the pleasure of getting to know John through his excellent former Chief of Staff, Fred Hatfield, who has jointed the CFTC as a Commissioner. Fred is a wonderful addition to the Commission, bringing the same common sense and integrity that his former boss displays to the regulatory arena.
One of the things that I enjoy about addressing this group and having the opportunity to meet and chat with you, is that you put into practice what I have spent my life researching and teaching about: risk taking and risk management. It is as fundamental to business as water is to life, since without risk taking, there would be little entrepreneurship and innovation would likely move at the pace of the Stone Age. But with risk and its expeditious management, individuals and businesses can dare to specialize and innovate in order to maximize their opportunities, expand their wealth and that of investors, and expand the limits of the economy to achieve greater employment and higher welfare.
Relatedly, however, of increasing concern to me are efforts by regulators to more vigorously regulate risk taking. Some discussion seems positive, like utilizing risk-based methods to determine exposure and set collateral requirements, but other efforts are more prescriptive – like endowing overly simplistic and sometimes biased valuation models to define leverage or to divine the purpose of derivatives in a portfolio. While I agree that the monitoring and regulation of risk taking is appropriate for banks, as a regulator, I am leery of efforts to regulate risk taking by firms. As a regulator of markets that specialize in risk shifting, I believe the model we have has proven particularly effective, without unnecessarily constraining the markets and the firms that use them.
Before I get started, let me begin by telling you a little about myself and the Commodity Futures Trading Commission, but also let me state 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 Commission, I was an assistant professor of finance at George Mason University, and before that, Tulane University. In 2002, President Bush asked me to serve as a Commissioner at the CFTC, and I was confirmed by the Senate and began work in August 2002. Upon the departure of Chairman James Newsome last summer, the President designated me as Acting Chairman, and I have served in that role since July of last year.
When I first started looking at hedge funds as a professor in risk management, I saw that in addition to their lack of homogeneity and their thirst for exploiting inefficiency, they were really on the cutting edge in terms of their use of asset selection, leverage, and pricing techniques that are commonly employed by users of the derivatives markets. Hedge fund managers recognize the appeal of uncorrelated assets as tools for diversification, as well as the natural appeal of derivatives to build uncorrelated portfolios. In derivatives, going short is as legitimate as going long, and to the extent that hedge funds trade in commodity interests, they are closely akin to the funds I have seen in the futures business. In fact, recent data show that 65% of the largest hedge funds have managers that are registered with the CFTC as Commodity Pool Operators. Over half are also registered with the CFTC as Commodity Trading Advisors and the proportions get even higher as the funds get larger.
In the last 30 years under the CFTC, the commodity pool industry has become quite large. Today there are approximately 1800 CFTC Registered CPOs who sponsor, operate or advise 3500 commodity pools. These commodity pools hold over $600 billion in net assets. While this is small in comparison to the almost $9 trillion in mutual funds, it is a significant amount of money – even in Washington. Many of the large commodity pools are “hedge funds” which are run by the biggest names in the industry – Soros, Tudor, Citadel, Moore, Caxton, Renaissance, etc. In addition, there are many new and growing CPOs and CTAs that provide important asset diversification and non-correlated returns for pension funds, endowments, institutions and high net worth individuals.
Over the past few years, hedge funds, or in the vernacular of the futures industry, commodity pools, have generated an increasing amount of interest and fascination on the part of the investing public and regulators. To read the press, at times it seems that this industry operates under more secrecy than the National Security Agency, but with the abandon of a bull (or just as often a bear) in a china shop. Certainly much of the industry has operated outside of the investment sphere of the average investor because of net worth and income restrictions. As is the case with most private asset markets, most funds do not engage in widespread public dissemination of information to their own participants in order to protect investment strategies. This has lead to the mistaken view that there is not enough information about the hedge funds and their activities and, as a result, the view that funds pose significant unquantifiable risk to the financial system.
As the regulator of commodity pools and futures markets, it is actually the case that we know a great deal about this industry. We know a great deal about who is operating in this industry; when trading in the futures markets we know a great deal about the positions they take; through registration and auditing by the National Futures Association, we know a great deal about how these funds invest their money, value their assets and deal with their customers.
In addition, and perhaps more importantly, any hedge fund manager that includes investments in the markets under CFTC’s jurisdiction, even if they qualify for an exemption from registration, continue to fall under the legal definition of a CPO or CTA, meaning that certain of the CFTC’s rules and provisions of the Commodity Exchange Act—such as those proscribing fraud or manipulation –continue to apply. In short, the operators and advisers to hedge funds, as collective investment vehicles, are an important and increasing subset of the population we oversee as a whole.
As many of you know, up until some recent rule modernizations, holding any futures in your portfolio meant you had to register via the CFTC’s delegated authority to the National Futures Association. Today I want to bring you up to date on the CFTC’s regulatory program and what it implies for fund management. I also hope to provide some context, much of which emanates from an approach endorsed by Congress in the Commodity Futures Modernization Act of 2000, which provides a blueprint for regulatory innovation that is both effective and appropriate for derivatives and the managed funds that use them.
Many had predicted that the regulatory relief we have granted to CPOs and CTAs under the Commodity Futures Modernization Act to rationalize regulation for sophisticated or otherwise regulated entities would lessen the proportion of hedge funds on our radar screen. Specifically, the CFTC has adopted exemptions from registration for those funds engaging in de minimus futures investments and whose investors can claim accredited investor status; otherwise regulated entities such as mutual funds, insurance companies, and banks; and funds that cater to highly sophisticated investors, or “qualified purchasers.”
Filing for an exemption from registration does not release any of these persons from complying with our statutes, including the prohibitions against fraud and manipulation. All CPOs and CTAs, regardless of their registration status, are subject to prescribed disclaimer requirements for hypothetical performance, the antifraud and anti-manipulation provisions of the Commodity Exchange Act and the CFTC’s rules, and all trader reporting requirements. In addition to large trader reporting, we have an active, real time surveillance program, and continuously monitor the activities of large hedge funds in our markets, from energy to precious metals, to stock index and interest rate products. In fact, the activity of hedge funds is a routine part of our ongoing surveillance of markets that is an integral part of our regulatory program at the Commission.
It has been our experience that when prices or price volatility increases, such as has recently occurred with energy prices, there are often calls for the government to “do something.” And by doing something that usually means interfering with the markets. We hear this today as some politicians and market commentators call for the government to do something about speculation in energy markets. Fortunately, cooler heads have prevailed thus far and we have avoided the disastrous economic experiment of price controls that we saw in the 1970’s. But even so, the mere fact that we hear these continual calls to “do something” tells me that we need to be vigilant to ensure that wrongheaded policies do not creep into legislation or regulation that impede market users and prevent markets from doing their job.
Alternatively, if we must to “do something,” the most effective thing we can do is to promote markets and innovations that allow them to operate more efficiently. As a proponent of competitive markets, I feel strongly that the role of government is to promote competition by ensuring the integrity of markets, but to stay neutral with respect to prices and the risks assumed by willing, informed investors. The danger is that when government steps in to regulate prices or risk taking, the government, as opposed to legitimate market forces, ends up picking winners and losers.
As an example, I have been asked a number of times in the last year or so to comment on hedge fund activity in the energy markets. Often the line of questioning goes something like this. “Chairman Hruska, many have observed that hedge funds and speculators have been building up long positions in oil futures and some economists estimate that these speculators are adding $5 to $10 to the price of a barrel of oil. What is the CFTC’s doing to reign in these speculators and powerful interests like hedge funds who are driving up prices?”
Well, first, let me say that the CFTC actually does monitor these traders very closely. The Commission has a Market Surveillance staff of about 45 that monitors activity on the futures exchanges and the participants in those markets. Every week the other Commissioners and I receive a briefing on the markets. Part of the briefing typically includes a summary of activity by various participant categories, including hedge funds. In addition, when markets go through periods of high volatility or significant price movement, we focus additional attention on the markets involved.
With respect to the energy markets, the Enforcement Division, the Division of Market Oversight and the Office of the Chief Economist have each taken a close look at hedge fund activity in the markets. Shortly after I became Chair, economists at the Commission began a study of the role of managed funds, particularly hedge funds, in our markets. This study and its results have received a lot of attention for good reasons. First, it is an independent analysis done by scholarly economists who follow the highest standards of scientific research to ensure that the analyses are objective and free from bias. It uses data that are uniquely available from the CFTC’s Large Trader Reporting System. The time frame covered by the data is the most recent available and not selected in a manner that would predetermine the results. This unique database allows an in-depth study based on testable hypotheses of well-founded precepts about the role of hedger and speculator in the markets.
In the end, the results confirm what I have been observing continuously and routinely in the weekly briefings by Market Surveillance. Managed money traders do not change positions as frequently as other traders in the markets – they do not create volatility by frequently getting in and out of positions. Managed funds are not driving prices, but rather the higher prices and their associated volatility are attracting those traders. Rather than increasing volatility, funds are found to be dampening market volatility by providing liquidity to the commercial hedging community. The study contradicts with force the anecdotal observations and conventional wisdom regarding hedge funds and speculators, in general.
So do hedge fund managers require increased regulatory scrutiny? I have long agreed with Federal Reserve Board Chairman Alan Greenspan that imposing a regulatory regime that would constrain risk-taking and leverage by these funds could do significant harm in that it may deprive the markets of the efficiency enhancing liquidity that funds provide. Thus, I have repeatedly argued against additional regulation of hedge funds since I believe that the current regime in which our regulatory energies are focused on markets to ensure their efficiency and integrity has proven effective.
Overall, the Commodity Futures Modernization Act, which erected our regulatory approach, has worked well for the derivatives industry as the Commission has stepped up to stress its surveillance and enforcement functions. In the almost 5 years that the Act has been in effect, we have seen a substantial increase in trading volume and a proliferation of new types of contracts, an expansion of clearing to OTC contracts, and new electronic markets. But even more significantly, we have not observed an increase in the number of trading abuses or violations of the Act. More than anything, the Act validates the concept that government can take a more oversight role in regulation, complemented by an unbending focus on deterrence in enforcement, and direct its attention on real problems in the markets rather than attempting to engineer or constrain markets or prices. By not interfering in the natural business activity of risk taking, we also can enable the markets to perform their vital functions of price discovery, risk management, and efficient resource allocation.
As in other securities market regulatory settings, the regulatory model prescribed in the Modernization Act recognizes that not all markets are created equal. The statutory framework adopted allows different levels of regulatory involvement depending on the type of market one is operating and the sophistication of the market participants using them. For example, institutional market participants, not needing the same protections as retail market participants, are subject to a less intrusive regulatory framework; and markets that primarily involve principal to principal transactions are less a concern than traditional markets like exchanges, which are more easily accessible to retail customers.
Rather than limiting our authority or our jurisdictional reach, the tiered oversight model has increased our strength and effectiveness as a regulatory agency. Even in the exempt markets, the CFTC retains and has exercised its authority to police against fraud and manipulation. In the OTC energy markets, for example, we have vigorously pursued those who engaged in false price reporting and manipulation. In the retail foreign exchange markets, we have been equally effective in prosecuting fraudulent activity that takes place outside the confines of our contract markets.
Pursuant to our delegated authority to the NFA, elective registration with the CFTC results in an independent and expert review that includes periodic examinations, evaluation of internal controls, and review of required disclosure documents and financial statements. In our review of the NFA’s audit and compliance program, the NFA has demonstrated the necessary understanding of the complexities of the firms they examine, and a willingness to be tough when problems are uncovered.
This and the fact that fund managers are such significant users of futures markets led us, in October of last year, to formally request that the SEC provide a broad exemption for CPOs and CTAs who are already registered with the CFTC. While the SEC did not provide the requested exemption at the time, the senior staff of the SEC and the CFTC have met to discuss a test that would allow those entities that are already registered with the CFTC and not “primarily engaged in” securities transactions to avoid double registration with our two agencies.
I firmly believe that CFTC registrants who sponsor, operate or advise identified commodity pools should be exempted from the SEC’s new rule. Avoiding duplicative and unnecessary regulation is a priority of the administration and Congress -- it is just common sense that two agencies should not spend taxpayer money doing the same thing.
I appreciate the opportunity to address you today and I look forward to future opportunities to provide my thinking on the important role of markets and market users like hedge funds to our economy. Thank you.