Commodity Futures Trading Commission
Office of External Affairs
Three Lafayette Centre
1155 21st Street, NW
Washington, DC 20581
Targeted Regulation of Derivatives Markets
Keynote Address by Commissioner Sharon Brown-Hruska
U.S. Commodity Futures Trading Commission
New York City Bar Center
December 9, 2005
Thank you for the opportunity to join the faculty of so many experts on the legal and statutory framework governing exchange-traded and over-the-counter derivatives. As I look around I see a number of familiar faces, some of whom were involved in helping to design the innovative regulatory model that has enabled the futures and derivatives industry to grow and thrive. I am therefore pleased to have an opportunity to share with you my thoughts with respect to the issues that we face going forward, particularly as we consider matters related to the CFTC’s pending reauthorization. As I proceed, I will also share my philosophy on the role of regulation in ensuring that the markets flourish in a manner that embodies financial integrity and increases economic growth and opportunity.
Let me start by noting that the opinions and observations I relate to you today do not necessarily represent those of the Commission or its staff, but rather are those of one Commissioner whose background and interest in the law and economics of derivatives markets reaches throughout my professional career as a scholar and regulator. I would like to take a moment to recognize Bob Zwirb, who as my attorney advisor, has helped me to parse through Commission law and articulate an approach to these challenging matters that is consistent with this perspective.
Unlike other segments of the financial industry, the futures industry operates under the oversight of a regulator that must go through a periodic reauthorization. During this exercise, the CFTC and Congress get the opportunity to assess what’s working in the regulatory structure and what’s not working, and if necessary, make changes to ensure that the Commission can perform its mission. This occurs every five years, and we are now in the waning weeks, perhaps the waning days, of the legislative session. While both chambers have passed language, the House did so just this week, there still remain hurdles if it is to be accomplished this session. While we at the CFTC certainly would like to see the agency reauthorized for another 5 years, I believe that we must be concerned about the substance of legislative language that accompanies that reauthorization.
Earlier in the year, I had the honor to testify before Congress to share my assessments of where the derivatives industry is and provide guidance on proposed changes. My message was that the Act, as amended by the CFMA, functions exceptionally well. The CFMA provided flexibility to the derivatives industry and legal certainty to much of the over-the-counter derivatives market. This flexibility has allowed the industry to innovate with respect to the design of contracts, the formation of trading platforms, and the clearing of both on-exchange and off-exchange products. The industry is no longer overburdened with prescriptive legal requirements and is able to operate using its best business judgment, rather than that of its regulator. At the same time, economic and financial integrity have been safeguarded and the Commission has been able to maintain its ability to take action against fraud and abuse in the markets it oversees. It struck me then, and I am even more convinced now, that the performance of the Act suggests that changes to it, if any, should be narrowly focused and approached with a great deal of precision.
As I stated then and have reiterated, any changes to the Act must be carefully weighed so as to avoid any unintended consequences on legitimate business activity. We must always be cognizant of the fact that when we go about changing the language of the statute, we can at times cause far reaching consequences to not only those in the futures industry, but to other industry sectors as well as to the economy as a whole. In this regard, I have been particularly vigilant in following the various changes that have been proposed and included in legislative language that has emerged in the energy and forex areas. I will discuss each of these areas in turn. Nothing I will say here is new and should not come a surprise to those who have heard me speak on these matters before. But I feel it is important to reiterate these points as Congress contemplates the changes before them.
We often hear that the solution for every wrongdoing is to pass new laws, new regulations, or to “rewrite the book.” But the prescription for dealing with perceived problems in our markets is often simply smarter oversight, better enforcement of our laws, and tougher penalties that achieve the goal of deterrence. Let me illustrate by discussing a natural phenomenon that perennially spooks both markets and those on Capital hill, but has special significance this reauthorization year.
It seems that whenever prices behave in a volatile manner, there are immediate calls to “do something” to rectify the situation. This usually involves pleas for more laws and more regulation. The fact that prices may move in a way that we do not like or do not anticipate does not mean that the markets are not fulfilling their role. Indeed, markets in their price discovery role may be telling us something we need to know about fundamental changes in supply and demand. What they tell me as a regulator is that we need to be careful not to equate unpopular price movements with manipulative behavior. Otherwise, we risk throttling the market’s ability to serve its vital role as a means for managing and assuming price risks, discovering prices, and disseminating price information.
An example involves manipulation of reported price indexes in the natural gas markets. Many have raised concerns that the Commission does not have sufficient authority even though we have brought over 32 enforcement cases for attempted manipulation and false reporting and have assessed over $300 million in civil monetary penalties. To additionally address this illicit behavior, numerous remedies have been proposed to address it ranging from extensive rulemakings imposing transparency requirements or limits on market participants, to wholesale legislative solutions designed to discourage market “strategies” that are alleged to be manipulative. In particular, critics see mandates for increased disclosure and more transparency as “quick-fixes” for the high prices and volatility they perceive must be caused by manipulation.
Just this week, the House Committee on Agriculture passed an amendment to the CFTC’s reauthorization bill that seeks to increase transparency in the pricing of natural gas by requiring the CFTC to conduct surveillance of trading in “contracts for natural gas.” The bill, which was introduced by Congressmen Goodlatte, Graves, Barrow, King, Rogers, and Marshall, would require the Commission to conduct a review to determine whether manipulative activity has taken place whenever there exists a “highly unusual change in the settlement price of any physically delivered natural gas futures contract.” The legislation would also impose surveillance and large trader reporting requirements in connection with such transactions. Under this legislation, the Commission would be required to consider “any related contract, agreement, or transaction in natural gas” as part of its review of price spikes in natural gas. We are still trying to assess the implications of this amendment for our regulated markets, but my general impression is that we already monitor markets and investigate unusual price movements to determine whether they are consistent with the underlying economics of the marketplace. My overriding concern and the one that leads me to oppose the language in general is that this expanded surveillance authority appears to apply to cash market transactions broadly and to OTC market transactions that are exempt from certain parts of our jurisdiction by Section 2h(3) or excluded from our jurisdiction by Section 2(g).
Putting on my economist’s hat for a moment, it is not clear that such proposals constitute the right prescription. For one thing, such approaches are generally operationally difficult to implement and can do significant harm to the markets if they are done without regard to market structure. In the energy sector, the cash market is often bilateral, proprietary, and over-the-counter. It is not clear that forcing exchange-style transparency or requiring the details of private, individually negotiated transactions to be disclosed to the Commission is appropriate or even that it will work in such a setting. I believe that our cases in this area demonstrate not only that we have significant authority to bring action against manipulation in the energy sector, but also that we are prepared to exercise that authority. In my view, calls for additional authority for the CFTC in the natural gas markets based on the premise that they insufficiently regulated does not square with the strong action the CFTC has taken in these markets.
Requiring the CFTC to prescribe rules that would apply to electronic as well as dealer markets, or the persons holding or controlling positions, to report information regarding their holdings, may seem reasonable, but it could be highly detrimental to the developing exempt commercial markets. Where the contracts are principal-to-principal, proprietary, or done on a one-off basis, it is also not clear how this information would deter manipulation, but it certainly might deter participation in the markets. Markets like the Intercontinental Exchange, which is an exempt commercial market that is all electronic between commercial entities and eligible participants, have greatly enhanced the quality of the market for energy, bringing much needed liquidity and transparency that result in lower costs for businesses seeking to hedge their energy costs and the consumers that rely upon them. While I wholeheartedly support a regulatory program for the exchange-traded markets like NYMEX that act as a source of significant price discovery and which is often therefore referenced by commercial entities and the public for pricing, I do not see the necessity of a prescriptive model for the bilateral cash and OTC markets. Unfortunately, language that has been proposed by Congressman Graves and his colleagues appears to be overly broad, expanding the CFTC’s authority to conduct surveillance on natural gas transactions that are not clearly within our jurisdiction. I am concerned that the effort to increase our surveillance authority over natural gas transactions generally could result in pressure to require large trader position reports that could chill market participation in exempt markets and move business back to the more opaque brokered markets where information would be difficult, if not impossible, to come by.
It is my view that a program of prescriptive regulation cannot address the problems experienced in the energy sector, but may unnecessarily impose costs on industry participants, and create regulatory and legal uncertainty. In our effort to squelch manipulative behavior, we may end up unwittingly nurturing it by encouraging noncompetitive, illiquid markets. As I have said before and I will say it again, the true enemy of manipulation is competition and liquid markets.
Although the CFMA clarified that the CFTC has jurisdiction over retail foreign currency futures and option contracts, whether transacted on exchanges or over-the-counter as long as they are not otherwise regulated by another agency, legal uncertainty has bedeviled our law enforcement efforts to stamp out fraud in this area. The problem that we face with respect to retail forex is that some courts, most notably the Seventh Circuit in the Zelener case, have taken the view that the products offered by these firms, which allow retail customers to speculate on price fluctuations in foreign currency, are not futures contracts, but are spot contracts not subject to our authority.
To those of us at the Commission, this development was regrettable for several reasons. First, the contracts at issue looked and acted exactly like the kind of contracts that were normally subject to our regulatory jurisdiction. After all, these contracts allowed investors to maintain an open position indefinitely without ever having to take delivery, as a result of a clause allowing them to automatically rollover their position every two days. And the fact that we couldn’t get our regulatory hands on them, even in the opinion of the trial judge, was “unfortunate” since the evidence clearly showed that the respondents engaged in “systematic fraud” against their customers.
Many were caught off guard by the Zelener decision. Indeed, after passage of the CFMA, it was taken for granted that we had adequate authority to regulate these kinds of futures. The CFMA, after all, was intended “to clarify the jurisdiction over certain retail foreign exchange transactions and bucket shops that may not be otherwise regulated.”
For the legal eagles out in the audience, I should note that Zelener did not arise out of a vacuum. Rather, it was derived from a flawed legal standard and a litigation strategy that parlayed with the courts regarding what are the essential features of a futures contract and that sought to differentiate such contracts from forwards and spots primarily based upon a feature shared by all of them alike. Let me explain.
The Commodity Exchange Act tells us that we have jurisdiction over futures contracts, specifically, that we have jurisdiction over “transactions involving contracts of sale of a commodity for future delivery.” The problem with this is that at least two types of contracts that clearly fall outside the jurisdiction of the Commodity Exchange Act are also transactions where delivery occurs sometime in the future. Forwards, for example, involve the “sale of any cash commodity for deferred shipment or delivery,” while even spots have an element of futurity given that they involve “agreements for purchase and sale of commodities that anticipate near-term delivery.”
No doubt much of the confusion in this area arises from the fact that the central feature used to distinguish between these types of transactions--delivery--is nonetheless integral to all them. The CFTC has consistently held in the adjudicatory context that it is the absence of delivery, that is, the absence of physical transfer of an underlying commodity that distinguishes futures from spot or forwards contracts. It has tried to distinguish futures from forwards by asserting that futures generally do not contemplate or result in delivery, while forwards do. But this position does not square with various interpretations that the Commission itself has issued in the regulatory context rejecting the notion that delivery must be intended and occur most of the time with every forward contract. Indeed, in these interpretations, the Commission has emphasized that certain transactions could constitute forward contracts notwithstanding the fact they do not contemplate delivery “in all or most instances.”
The Commission’s emphasis on delivery in the adjudicatory context placed us at odds with the position of the Seventh Circuit, which in the Nagel case stressed the importance of a contract’s fungibility—or lack thereof—and which relegated consideration of delivery to whether or not it would eventually occur, and which in Zelener, went even further, saying that our reliance upon the presence or absence of delivery to distinguish between futures and forwards or spots was “implausible.”
Adding to this problem was the Commission’s adherence, until recently, to a legal standard that held that one must look at all the facts and circumstances surrounding a transaction to determine its legal nature. This approach, referred to as the “facts and circumstances” or “multi-factored” approach held that there was no “bright line” list of invariable elements of a futures contract, but instead held that one must take into account all relevant circumstances. Suffice it to say, such an approach offers little real guidance to market participants, regulators, and judicial decision makers alike.
The Commission's emphasis on delivery, its avoidance of criteria that the court clearly considered vital, such as fungibility, and its message to the courts that there is no "bright-line" definition put us at odds with the Seventh Circuit, which beginning in Nagel clearly began to search for more "objective" criteria to distinguish between futures, forwards, and spots, and which in Zelener, explicitly rejected the amorphous multi-factor approach of the CFTC.
In short, I believe the primary problems we encountered in Zelener can be addressed by a more focused litigation strategy that takes into account the characteristics of fungability, its delivery obligations, as well as extrinsic evidence surrounding those features. In my view, any attempt to address those particular implications in the legislative process at this time, in my view, is fraught with the risk of both intended and unintended consequences. Specifically, I am concerned that attempts to define futures contracts broadly in the statute could interfere with the legitimate risk management function of the OTC derivatives marketplace where transactions are entered into by commercial parties. Further, it could provide competitive advantage to one segment of the industry over another. Needless to say, we should avoid adopting any “solution” that leads to these harmful results.
That suggests that any legislative solution should be narrow, one that is carefully tailored to the problem, and one that avoids inadvertently impeding legitimate market activity. Given that the problem in retail forex originates from the way that Section 2(c) of the CEA is written, the legislative solution, if any, resides in fixing that section of the Act to close the loophole created by the language of that section. It is also important to remember that the window for necessary changes to our statute does not close once the CFTC is reauthorized. If we cannot prevail in fraud cases generally with our new litigation strategy, then at that point it may be necessary to consider a different solution. In my view, we should eschew any fix that is overbroad in scope. We should be careful that any attempt we make to solve what is fundamentally a law enforcement problem not discourage innovation or stifle legitimate market activity.
In the forex and energy areas, Congress should be wary of a return to a regulatory model that was characterized by legal uncertainty and inflexibility. Under the old model we had a one-size-fits-all model that required everything to be traded on an exchange under a prescriptive regulatory regime. Some legislative proposals in the forex and energy area would revise the tiered oversight model and unwisely apply many of the regulations designed for the exchange-traded market to the over-the-counter market.
Many of you have heard me suggest that I believe there is an optimal regulation that recognizes a “mapping” from the regulatory structure to the market, its products and its participants --- a calibration of regulation to fit the particular risk characteristics of different markets and market participants. The CFMA certainly incorporated this “mapping” concept by instituting a principles-based approach that allows the Commission 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. That is why I believe that very targeted, narrow changes should be contemplated in the energy and forex areas.
My greatest concern has been, and continues to be, that we not stifle innovation or build competitive disincentives into our regulatory model. Developing OTC markets in forex and energy are far more transparent and liquid than the brokered markets of the past. Markets like Intercontinental Exchange have made numerous improvements in their rules and platform that raise our confidence in their integrity and have enhanced the quality of information about transactions available to both regulators and to the marketplace. When you see these markets take off, and the positive effect they have on the competitive landscape and expansion of risk management products to market users, you must recognize how mandates may impact them. In my view, some proposals in these areas could potentially harm these developing markets, possibly forcing those markets back into the closet and/or offshore.
In the energy and forex areas, we should be careful that any legislative remedy not be worse than the problem it is attempting to solve.
I would be happy to answer any questions you may have regarding these or any other issues.
 Pub. L. 106-554, 114 Stat. 2763 § 2 (2001).