Commodity Futures Trading Commission
Office of External Affairs
Three Lafayette Centre
1155 21st Street, NW
Washington, DC 20581
Regulatory Challenges in a Global Market Environment
Address by Sharon Brown-Hruska, Commissioner
U.S. Commodity Futures Trading Commission
International Regulator’s Meeting at Bürgenstock
September 8, 2005
Thank you, Jean-Baptiste, for organizing and developing this very timely program. It is a pleasure to address this audience and participate in the International Regulator’s Meeting at the 26th Bürgenstock Meetings. I have always viewed this conference as a significant international event for the derivatives industry since it presents an opportunity for international regulators and participants of the derivatives industry to come together to share issues, problems, suggestions, and solutions in an effort to build a stronger and healthier marketplace.
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 George 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 act as Chairman of the CFTC 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 market structure topics, since this is an area that has been of considerable interest to me, first as an academic, but more recently, as a regulator of U.S. derivatives markets. As a result of technological advances and competitive pressure, the markets are undergoing significant evolution in market structure, and this challenges us to keep pace in both our knowledge of market practices and in the implementation and adaptation of our regulatory programs.
In matters of market structure, regulators must be both dexterous and deft. 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 markets--customer protection and removal of systemic risk. We must constantly update and adapt our programs so that we do not perform regulation for the sake of regulation—or worse, regulation for the purpose of protecting a particular market or preserving an outmoded, but familiar and thus easily supervised, method of transacting.
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, derivatives markets are thriving around the world. And while there are many reasons that this growth is occurring now, I believe that part of the reason relates to the fact that regulators and the industry are working together to achieve common objectives, and striving to reduce barriers to competition. In addition, internationally there has been greater communication and coordination between governments to foster business and trade between countries.
Many jurisdictions have undertaken regulatory reforms in recent years, with what I believe are great strides in the U.S. and the EU to foster a 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 more flexible regulatory structure to accommodate change in the derivatives markets. 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. In addition, core principles were adopted that set out regulatory objectives that replaced prescriptive rules and requirements. The intent behind the new regulatory structure was to allow exchanges to innovate more rapidly to meet competitive challenges that were arising from technological innovations that were beginning to change the face of derivatives markets.
Derivatives markets are risk shifting markets that are designed to help firms and individuals manage risk. But we all know that risk entails that 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 employ economic constraints that interfere in pricing or could harm markets in functionality and efficiency. Many market structure questions can be evaluated according to how they affect pricing and efficiency, with an eye toward ensuring that markets, not regulators, are determining the winners and losers.
Most importantly, we must endeavor to avoid erecting or perpetuating regulatory barriers to entry. I believe that a direct corollary to that is an obligation to encourage competition at every level of our regulatory responsibility.
Our experience in the development of the U.S. derivatives markets illustrates how regulation can impede market development. Specifically, 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 exchanges. To put it into perspective, consider that 30 years ago the U.S. 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.
As a result of that uncertainty regarding the enforcement of swaps contracts executed during the late 1980s and early 1990s, much of the OTC swaps market moved off shore, to such places as London, which offered a more conducive regulatory environment. Indeed, we should acknowledge that the theme of the Burgenstock meetings this year—London, A Global Market Place—can be partly credited to the history of U.S. regulatory treatment contrasted with the more open and less regulatory posture of the UK toward OTC markets during this period.
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, an equivalence approach that relies on such terms as “comparable” or “consistent” can sometimes result in rules and regulations that are backwards and even anticompetitive.
If we look back at the history of derivatives markets, we observe that exchange markets have often regarded OTC markets as competitors. 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 with similar pricing characteristics, 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 often resulted in one dominant market. This fed the fear that the “unregulated” OTC swaps markets would win out over the “regulated” futures markets.
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 my view, intermediation is the bridge that has ensured that both OTC and exchange-traded 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. They 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, then offsets some or all of the residual risks through a standardized exchange-traded futures contract.
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, I believe the answer is no. That is because the liquidity and high level of credit enhancement that exchanges offer derive from standardization. And in execution, evidence suggests that if exchanges chase customization, markets fragment and liquidity is surrendered.
And while standardization delivers liquidity in the trade execution function, it also has yielded significant efficiencies in the clearing function, as well. In the area of clearing, we have seen promising evolution across assets and borders. With ground breaking strides in asset pricing, risk modeling, and financial engineering, it is a logical progression for clearing entities to seek to span multiple asset classes and markets. Basic economic relationships like interest rate parity and covered interest arbitrage would suggest that integrated or linked clearing model could realize significant efficiencies and potential risk reduction on a global basis, as well. And many exchanges have come to realize that, far from being a competitor, these markets represent significant opportunities.
Therefore, it is not surprising that exchanges and clearinghouses are seeking to create clearing links and partnerships to expand the scope of products they clear across markets and jurisdictions. Because of the importance of the clearinghouse and the financial risk they assume, the integrity of clearinghouses is a very important concern for regulators like the CFTC. Today, numerous OTC markets have sought to expand the risk novation function of clearing to OTC products. A variety of OTC clearing systems have developed, including Swapclear, ICAP’s clearing of repos, and the recent clearing mechanism in the European bank sector through TriOptima.
For my part, I have been advocating for clearing arrangements in the OTC energy markets since I joined the Commission. Firms in the energy space experienced quite a credit crunch in the post-Enron environment, and this was having a serious effect on liquidity. When you talk about systemic risk and our responsibility to have a handle on it, we must recognize that a sudden loss of liquidity can have as devastating an effect on the market and the firms involved as a default (witness Long Term Capital Management was largely a liquidity crisis). So I believe that clearing in the OTC market environment is a very good development from a regulatory perspective.
Similarly, I believe that proposals to enable clearing across international jurisdictions can result in capital efficiencies while also lowering market and systemic risk. And as many are aware, the CFTC has been considering the application of the Clearing Corporation and Eurex US that the Commission permit expansion of their Global Clearing Link. 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. Internationally, the Commission has approved a number of clearing arrangements, including CME-Simex, CBT-Liffe, and CME-Meff. 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.
The challenges to regulators of the affected jurisdictions are enormous, however, ranging from tedious differences in how we regulate markets operationally and structurally to broad political and institutional factors over which we have limited control. These new arrangements represent a convergence of different markets with different risks and different regulatory jurisdictions. At times, there are concerns that the risks from one market can bleed over into another with dire consequences. 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.
To do this effectively, we must endeavor to understand how various markets and jurisdictions are regulated and be willing to accept alternative regulatory practices where they provide acceptable levels of protection for the markets and market participants. Clearly, different jurisdictions have developed different ways of supervising and monitoring their markets. That is not to say that one jurisdiction has a better model of regulation than another—it may simply mean that it is different. I would note, for example, that while the CFTC relies heavily on large trader surveillance of its markets to guard against manipulation, certain European jurisdictions rely more on position limits and what we at the CFTC call “trade practice surveillance“ to monitor markets. I would argue that each of these approaches has its strengths and weaknesses. While the large trader surveillance approach places a heavy reporting burden on market participants, particularly the clearing firms who in the U.S. do the reporting, the use of position limits can negatively impact market liquidity, constrain trading and hedging strategies, and impede convergence.
The area of clearing also demonstrates differences between how European regulators oversee clearinghouses and brokers versus that in the U.S. As examples, brokers in Europe operate under universal banking requirements, whereas in the U.S., we have specific capital requirements and other regulations that govern brokers. Rules differ in the U.S. and Europe on who holds customer funds and how they are held—for instance clearinghouses in Europe do not hold customer funds, whereas in the U.S., such funds are held by the clearinghouse in segregated accounts. And certainly, the differences in the bankruptcy treatment of customers in Europe versus the U.S. are both complex and weighty.
Our approach to these issues is to reach out to our regulatory counterparts and try to find areas where we can rely upon each other to share supervisory responsibilities. The concept of mutual recognition of market regulatory regimes is not a new one for the CFTC. Over the past 20 years or so, the CFTC, under Part 30 of its rules, has developed cooperative regulatory arrangements with our counterparts in the EU and elsewhere to support cross-border industry ventures, such a 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 U.S. Similarly, the Commission has approved rules permitting innovative clearing linkages which rely on meticulous attention to ensuring customer and market protections within an environment of cooperation among market authorities.
Our goal has been to foster a recognition approach that goes beyond today’s agreements and would leverage the combined efforts of U.S. and European authorities. And this concept of reliance is embedded in U.S. statutes governing derivatives, banking, and derivatives, as well, where exclusions and exemptions from requirements are often provided for “otherwise regulated” entities within our national sphere. It has recently been my vision to expand the forward looking model contained in the CFMA to the international context. Yet, again, there are challenges that I must acknowledge have been difficult to overcome.
As sovereign regulators, we know quite well that there are limits to mutual recognition of comparable regulatory programs. For example, we may be willing to relax some requirements for foreign entities when they are clearing U.S. traded products for their European customers, but the challenges become more difficult when it comes to the mechanisms used to clear for U.S. customers. Domestic exchanges and domestic firms have raised concerns that this could be at a disadvantage since they would be subject to U.S. regulatory requirements while foreign entities are not. Again, recall that I said that we look to have a fair game and we must be sensitive to tipping of the balance, we also must recognize that clinging to our regulatory model can create barriers to competition.
As in the OTC markets experience, we observe that incumbent exchanges will use every tool at their disposal to maintain their dominance and we have learned that that includes the political process, as well. I expect no less of foreign entrants who are not above seeking specialized passes from regulatory treatment to attain their own competitive advantages. Thus, a regulatory challenge for us has been: what requirements are necessary to ensure protection of our domestic customer funds from unscrupulous brokers in foreign jurisdictions? Can we rely on the regulatory programs of foreign jurisdictions to provide appropriate oversight?
Beginning this spring, the CFTC entered into a dialogue with the Committee of European Securities Regulators (CESR) and industry participants to help learn from each other how we could encourage competition while retaining the integrity of our respective market places. As we were seeing new entrants into our markets, U.S. exchanges were seeking to enter clearing arrangements for foreign markets. It was time for us to discuss how the European and the U.S. market regulators could 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. 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.
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.