Building a More Transparent and Flexible Regulatory
Environment for Derivatives
Commissioner, Commodity Futures Trading Commission
Seoul International Derivatives Conference
Seoul, Korea, August 30, 2005
Thank you for that kind introduction. I would especially like to thank our hosts of The Financial News for holding this important conference and providing a forum for the views of such distinguished scholars and leaders in the international derivatives field. I would also like to congratulate Sam Chung for his good work in the derivatives area and putting together such a fine program.
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. Three years ago, President Bush nominated me to serve as a Commissioner at the CFTC, and I was confirmed by the Senate and began work in August 2002. Until recently, I was honored to serve as Acting Chairman of the agency at the request of President Bush. With a new Chairman, Rueben Jeffery III, at the helm, I look forward to continuing in my term as Commissioner until 2009.
I am pleased to speak on the topic of risk management through derivatives, since this has been my primary area of interest, first as an academic, but more recently, as a regulator of US derivatives markets. The activities of risk taking and risk management are 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 global economy to achieve greater employment and higher welfare.
Of increasing concern to me, however, 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 may be appropriate for banking institutions, as a regulator, I am leery of efforts to regulate risk taking by individuals and firms. Overseeing markets that specialize in risk shifting, I believe the regulatory model we have has proven particularly effective, without unnecessarily constraining the markets and the firms that use them.
Derivatives markets, both those that are exchange centered, and over-the-counter markets, are designed to help business and individuals to take and manage their risks. Risk management creates certainty of cash flows and helps facilitate sound planning for the future. Managers are thus better able to focus on their specific business, to innovate and specialize, without being thrown off track by unexpected price and interest rate changes. And while risk management helps mitigate risks at the microeconomic level, it also translates into greater stability at the macroeconomic level. Researchers have found that increased derivative use has been accompanied by greater growth and more robust economic development.
But we all know that risk entails there will be winners and losers. Regulators of these markets cannot protect businesses or individuals from losses arising from the risks they assume. The challenge for regulators in derivatives markets has primarily been to ensure that the markets represent a “fair game.” We must do that while seeking to avoid unnecessarily constraining firms and consumers from assuming the risks they desire. My view is that, as regulators, we must constantly seek to remove prescriptive programs that interfere in pricing or employ economic constraints that could harm markets in functionality and efficiency. This can ultimately harm the firms and consumers that depend upon the risk shifting markets to properly price the assets and commodities that underlie them.
In order to ensure that the markets represent a fair game, the CFTC regulatory model focuses on market and financial integrity. This means that we require brokers and intermediaries to provide adequate and truthful disclosure of risks. We guard against fraud and manipulation by a real time market surveillance system, complemented by vigorous enforcement of our laws to ensure deterrence from wrongdoing. Increasingly, we have increased our financial surveillance of markets as well, monitoring the structures such as margin levels and collateral to ensure performance under the most volatile conditions.
Critical to the CFTC regulatory program is its targeted approach that provides different levels of supervision and regulatory involvement based on the type of customer served and the types of products offered. Over-the-counter (OTC) markets that offer financial swaps are excluded from our jurisdiction. This exclusion is based on the recognition that swaps are uniformly offered by financial entities that are otherwise regulated appropriately by banking and securities regulators. Energy and metals markets that cater to commercial or sophisticated entities are subject to our anti-fraud and manipulation protections, but are subject to somewhat lower disclosure and monitoring requirements than the exchange-traded markets that are more likely to be used by retail market participants.
The development of over-the-counter (OTC) derivatives markets has at times been slowed by government authorities, sometimes because of our lack of understanding of the uses of products in these markets or the complexity inherent in market processes, but other times due to the fact that they are perceived as a competitive threat to organized exchanges. This has been true in both commodity derivatives markets and has been no less true of securities markets. To put it into perspective, consider that 30 years ago the US law that governs derivatives markets, the Commodity Exchange Act, required that all futures contracts and most option contracts be traded on an exchange. Because many OTC derivative contracts share some of the same basic economic features of futures and options contracts, there was great uncertainty over the legality of OTC derivatives.
The Futures Trading Practices Act of 1992 and the Commodity Futures Modernization Act of 2000, sought to remove the legal uncertainty over the OTC derivatives market. From a regulatory perspective, however, it would be premature to suggest that OTC derivatives are completely immune to the kinds of disclosure and registration requirements that are characteristic of the exchange-traded markets. Since exchanges have historically regarded OTC markets as competitors, pressure is often put on regulators and legislators to create the proverbial “level playing field” where regulatory requirements are equivalent across the instruments whether they are exchange-traded or OTC. In my view, this equivalence approach that relies on such terms as “comparable” or “consistent” can often result in rules and regulations that are backwards and even anticompetitive.
Clearly there has been some convergence of the OTC and exchange markets over time. It is only natural that this occurs as innovators in each market seek to replicate the perceived advantages that are seen to exist in other markets. One can think of it as the neighborhood contest between the Smiths and the Joneses to attain the best lawn. While Mr. Smith sees lushness on Mr. Jones’ side of the fence, Mr. Jones sees emerald green on Mr. Smith’s side.
In the matter of exchange trading versus OTC trading, the characteristics that drive the competition are liquidity and credit enhancement in the exchange-traded lawn, versus customization in the OTC lawn. As to whether the two markets could ever converge enough to become perfect substitutes while retaining their distinctness, I believe the answer is no. That is because the liquidity and high level of credit enhancement that exchanges offer come as a result of standardization. The most efficient way to standardize is to create an exchange or a central trading platform. Likewise, if exchanges chase customization, markets fragment and liquidity is surrendered.
Given that there is an incentive for the markets to seek to fill niches without sacrificing economies of scale, how do they live with each other? And perhaps the more important question from my vantage point is, how can regulators ensure that the regulations do not stunt the growth of either marketplace?
If we look back at the history of derivatives markets, what we observe is that exchange markets and OTC markets have lived side-by-side as complementary for a long time. The difference today is that there has been an explosion in financial derivatives that are still viewed by many as being novel or threatening by many in the public. Although futures contracts on euro-dollars, U.S. Treasury bonds, German bunds, and stock indices are now commonplace, and we treat credit derivatives, interest rate and total returns swaps with routine indifference; the fact is, these instruments are relatively new creations of finance and are indicative of the explosive growth that has taken place over the last thirty five years in financial risk management.
In 1970, none of these products existed. In 1970, price risk management through the use of derivatives contracts was the domain of agriculture, and its epicenter was Chicago, and specifically, the Chicago Board of Trade. The dominant futures contracts were in corn, soybeans and wheat. The Chicago Mercantile Exchange was a small cross-town exchange primarily offering contracts in livestock. And in New York City, the world capital of finance, the New York Mercantile Exchange was where you went to trade potato futures, not energy.
It wasn’t until 1972 that Leo Melamed and the Chicago Mercantile Exchange introduced the first financial futures on currencies. It would not be until 1977 that the Chicago Board of Trade would introduce futures on U.S. Treasury Bonds; 1981 before the CME introduced Eurodollar futures; and in 1982, the first stock index futures were introduced at the Kansas City Board of Trade on the Value Line Average Stock Index. Later, options on stock indices were introduced and they, too, have had resounding success as market risk management, diversification and investment tools. The Kospi 200 Option contract, traded on the Korea Exchange, is the most actively traded derivatives contract in the world. Moreover, NYMEX has grown to become the leading energy market in the world, in large part due to its innovative offerings of clearing services to OTC markets.
The growth of the OTC markets in financial derivatives has been equally if not more impressive in its growth and innovation. The swaps and OTC financial derivatives markets were a growth phenomenon of the 1980’s and 90’s. While the precursor to swaps, in the form of parallel loans, existed prior to 1980, it was a transaction between IBM and the World Bank to swap obligations involving U.S. dollars, Swiss francs and Deutsche marks that has come to be recognized as the first swap transaction.
Since that transaction, the swaps and OTC financial derivatives industry has grown into a multi-trillion dollar market. The Bank for International Settlements, estimated the notional amount outstanding in OTC derivatives at the end of 2004 at $248 trillion. And if we could possibly catalogue all the variations that exist in these transactions we would observe a dizzying array of products intended to manage all types of financial risks and contingencies. Literally, in thirty five years we have gone from a world where hedging through derivatives products was primarily the domain of farmers in middle-America and a few minor outposts in other parts of the world, to an industry dominated by financial corporations and measured in the trillions of dollars, and I am sure within the next few years the quadrillions of dollars.
But as we watch these markets in derivatives grow in terms of the size of the markets and the variety of products being offered, we must be cognizant that we are only seeing the tip of the iceberg. We sometimes forget that underlying these products there is a whole underlying structure and network that supports and links these products. Additionally, these products, either directly or indirectly, fall within a regulatory purview that increasingly crosses international borders.
The links that we see both between markets and across different jurisdictions creates regulatory challenges. I believe that we too often make the mistake of viewing various markets or jurisdictions as different or separate, and a better understanding the nature of the links between them would lead to a more rational regulatory program.
For example, in the late 1980’s and early 90’s many in the exchange-based futures industry viewed the growth of the swaps and the OTC derivatives industry as a threat to their survival. Since both swaps and futures were financial risk management tools, many believed they were competitors. And in the history of futures markets, the self-perpetuating power of liquidity, what we academics like to call “network externalities,” have dictated that only one competing market survives. This fed the fear that the “unregulated” OTC swaps markets would win out over the “regulated” futures markets. If we all agree that regulation imposes costs, then the simple analysis would suggest that the market that faced lower costs would prevail.
But regulated or not, both marketplaces have not only survived, but flourished. In our current regulatory model, exclusions and exemptions for OTC markets provided flexibility for market growth, while intermediaries maintained linkages by using both exchanges and OTC products. In this way, intermediation is the lynchpin that has ensured that the markets have continued to grow and maintain their value to the public. Intermediaries in the OTC markets excel in their ability to offer customized products and risk management solutions.
Intermediaries have also strengthened the marketplace by exploiting arbitrage opportunities across global and related marketplaces, thereby ensuring the efficiencies of the linked markets. For example, swaps dealers are able to offer their customers products that suit their needs and their appetite for risk. Customers’ needs may vary by duration; by unique characteristics of the investments or commodities being hedged; by transaction size; by credit risk; or by a host of other risk characteristics. Often the swaps dealer steps in to offer a specialized product, and then offsets some or all of the residual risks through a standardized exchange-traded futures contract.
That this relationship—this symbiosis—between related but different instruments or transactions in different markets, exists should not surprise us. For more than a century, farmers and grain elevators have taken advantage of this relationship. Modern futures contracts began as forward contracts that grain handlers, middlemen, and ultimately, speculators began to trade around. Eventually they found their way onto organized exchanges where liquidity could be concentrated and credit risk assumed by the clearinghouses.
But the explosion in the variety of derivative contracts is just one aspect of the growth of this industry. Underlying these instruments is a support structure of intermediaries that brings participants together and provides financial support for the transactions. As with the variety of contracts, we see a variety of systems that have been developed out of either necessity or convenience to support the markets. And these systems have evolved and become more complex, as well, challenging the regulatory models that had developed to ensure performance and accountability.
As I have noted, the futures industry has primarily relied on exchanges and clearinghouses to support their contracts. Because the contracts are standardized, they are conducive to trading in a pit or through an electronic trading algorithm. Since the only negotiation required to trade such contracts is price, the contracts can be offered by a large number of anonymous participants to many other anonymous participants. Of course, this model aggregates a large amount of credit risk. The solution has been to create clearinghouses that remove the counterparty risk. Over the years, clearing houses and their member clearing firms have developed a number of mechanisms to manage the default risk of customers in an efficient way, the first line of defense being margin deposits.
Because of the importance of the clearinghouse and the financial risk they assume, the integrity of the clearinghouses is a very important concern for regulators like the CFTC. Clearinghouses have taken on a larger role in the exchange-traded and OTC environment as they expand their horizons. With respect to OTC markets, clearinghouses have begun to clear OTC contracts, though this activity remains small and is primarily focused in the energy space. These new arrangements create challenges for regulators, since they represent a convergence in the lightly regulated OTC markets and the more heavily monitored exchanges,
It is also the case that clearinghouses have begun to seek clearing arrangements across borders in an effort to give international traders easier access and more efficient clearing arrangements across markets. While oftentimes these clearing arrangements are viewed as risky, I believe that ultimately they serve the best interests of the customers and that as regulators we have an obligation to foster these arrangements while assuring that the public interest is protected.
As a commitment to these efforts, during the past year I have endeavored to foster a more seamless global regulatory structure. Beginning this spring, the CFTC entered into a dialogue with the Committee of European Securities Regulators (CESR) and industry participants to look for ways to ease access to the markets for international customers. I felt that as commodities contracts are offered the benefits of a passport within Europe, it was time for us to discuss how the European and the U.S. markets can maximize synergies between them. It was with this goal in mind that we sought a dialogue with CESR on operational and technical issues that could be impeding expansion of cross-border business opportunity or preventing comprehensive market oversight.
In late March, the CFTC and CESR 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 so 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 that with respect to the European markets we are on the right track. It is my hope that similar accommodations can be attained for regulatory cooperation across the Asian markets. Initiatives such as the CESR-CFTC dialogue and by the EU-US summit in Washington this summer, are manifest proof of the renewed willingness to foster greater communications and coordination between governments to promote business and trade between countries. 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.
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 global and technological 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.
But regulatory differences between political jurisdictions are only one aspect of the regulatory structure that needs to be addressed if we are to attain a truly seamless regulatory structure. The other is based on regulatory differences related to product classes, such as those between the futures markets and other product classes. Here too, we need to focus on initiatives to create seamless links between markets. As I have said, clearinghouses under the CFTC’s jurisdiction have begun to offer their services to OTC markets. Likewise the CFTC has made a proposal as part of its reauthorization process to establish a pilot program to coordinate and rationalize margin requirements for security futures products that would use a risk-based portfolio approach. If we as regulators can implement these market specific improvements and recognize that funds flow and are managed globally, substantial efficiencies can be attained with no sacrifice of market or financial integrity.
Marketplaces will do what they always do best—expand, contract and fill niches as customers demand. The relevant question is, as regulators, how do we react? My hope is that when derivative products cross jurisdictional boundaries, whether international or domestic, we, as regulators, can coordinate our efforts to assure that the markets remain open and accessible. Our regulatory programs need to be transparent and almost imperceptible, in the sense that they should not be duplicative across jurisdictions, nor so different as to create unnecessary costs to market operation. If we continue to pursue these goals, the markets will continue to grow and flourish to the benefit of market users and the economy at large.