Commodity Futures Trading Commission
Office of External Affairs
Three Lafayette Centre
1155 21st Street, NW
Washington, DC 20581
MARKET INTEGRITY: A SHARED MISSION
Address by Chairman Reuben Jeffery, III
U.S. Commodity Futures Trading Commission
• International Swaps and Derivatives Association, Inc.
December 6, 2005, New York
Thank you. This is an exciting time to work in this industry. The derivatives markets as a whole have grown -- not only in terms of the volume transacted but also in its importance to the overall U.S. economy.
Since 1995, global futures and futures options volume has arisen more than six-fold. Today, more than 6 billion contracts a year trade globally. We see a constant stream of new products, markets, clearing arrangements, intermediary services and technology not only in the United States but all over the world.
And over the years, we have seen that the derivatives markets -- whether on-exchange or over-the-counter -- are inter-linked and complementary in many ways. Continued success in the derivatives markets is now, in no small measure, dependent on the integrity of the marketplace as a whole.
Your efforts are vital in this regard. Your work on a wide array of issues -- ranging from developing master agreements to producing legal opinions on the legality of netting and collateral arrangements -- promotes sound risk management practices and fosters opportunities for financial innovation.
Today, I want to talk about what the CFTC, for its part, is doing to build and protect market integrity: first, I will discuss how the CFTC oversees futures trading through its market surveillance and enforcement programs; and second, how the CFTC takes a proactive approach to fostering innovation and competition, especially as it relates to the energy markets.
The Role of Market Oversight
First, market oversight: Under our authorizing legislation, the Commodity Exchange Act (the Act), the CFTC’s mission is to foster competitive and financially sound markets and to protect market users and the public from fraud, manipulation and other abusive trading practices. In short, the CFTC’s primary role in the futures markets is to protect market integrity.
At the most fundamental level, market integrity requires protecting the people who rely on the proper functioning of the futures markets -- and today nearly everyone is affected by activity in these markets, whether they choose to participate in them or not. The price paid for goods across a range of industries -- heating oil being a prominent one -- is determined, in large measure, in the futures markets.
That goal -- to put the interests of the public first -- is paramount. In the futures industry, the flexible, principles-based regulatory framework of the Commodity Futures Modernization Act (CFMA) places greater responsibility on the industry itself for maintaining the public trust. The CFMA relies not on prescriptive regulations, but on a commitment to ethics and professionalism that must be self-imposed and vigilantly monitored by the industry itself. Having public trust and confidence in turn guarantees that the futures markets will continue to flourish.
The self-policing mechanism takes on greater importance in markets that are not subject to rigorous government regulations -- particularly in times of explosive market growth such as that we have all experienced in the derivatives markets. It requires the industry to continue to have a broad and long-term perspective on business practices and appreciate that the way to ensure continued market success is to protect its most vital asset -- public confidence.
Once lost, trust is difficult to regain. We have all learned this lesson from the Enron scandal. And more recently, while we are far from writing the final chapter on it, Refco is yet another reminder that reputation is fragile, and in building and maintaining the public’s confidence, there is no substitute for sound ethical judgment and strong risk management systems.
Vigilant market surveillance, backed by a muscular enforcement program, is the cornerstone of the CFTC’s market oversight. Ultimately, the public must be assured that the rules of the marketplaces are consistently and fairly enforced.
On each trading day, the CFTC staff monitors trading activity on the futures exchanges to detect unusual activity or price aberrations that may indicate actual or attempted manipulation.
The heart of the CFTC’s market surveillance program is the large-trader reporting system. Through the large trader reporting system, the Agency closely monitors the futures and option activity of all traders on the regulated exchanges whose positions are large enough to potentially impact the orderly operation of a market.
CFTC surveillance staff also monitors futures and cash market positions for unusual movements in price relationships, which often provide early indications of a potential problem.
The CFTC’s comprehensive market surveillance program allows the Agency to combat manipulation not just after-the-fact, but also proactively by identifying and mitigating potential price manipulation or other disruptions to the regulated futures markets.
When problems are found, the CFTC does not hesitate to act resolutely. The CFTC’s enforcement efforts have been critically important in the energy markets -- as one cannot overstate the importance of a strong and visible deterrent to any behavior that would hurt market participants and others who rely on futures prices as accurate signals of market fundamentals.
While the CFTC does not comprehensively regulate the over-the-counter markets, the CFTC has used its authority under the Act to investigate and prosecute false reporting and manipulation occurring in those markets. This is a logical and vital exercise of the CFTC’s enforcement powers -- since one can manipulate prices in one market to influence prices and trading in another.
To date, the CFTC has been very aggressive in tracking down and prosecuting misconducts in the energy markets. For example, the CFTC filed various enforcement actions charging some 50 defendants with violations involving false reporting of energy prices, manipulation, and attempted manipulative behavior in over-the-counter markets that affected or tended to affect trading in energy markets. These enforcement actions have thus far resulted in civil monetary penalties totaling nearly $300 million.
Cooperative enforcement is critically important to the Agency’s success in fighting market abuse. The CFTC recently signed a Memorandum of Understanding with the Federal Energy Regulatory Commission. This MOU will improve the process by which we exchange information concerning the energy markets and their participants -- and enhance the CFTC’s efforts overall to protect the integrity of the futures markets.
With effective market surveillance and vigorous enforcement programs, the CFTC and the industry can assure that competition takes place on a fair, open, and level playing field, and that competitive pressures do not put at risk market integrity or investor protection.
This leads me to discuss competition -- and what we at the CFTC have been doing to help foster a market environment that invites competition and innovation.
Since late 2000 when the CFMA was adopted, the number of new products traded on U.S. exchanges has more than tripled. Eight new contract markets and nine new derivatives clearing organizations have been approved by the CFTC, and 17 exempt markets have filed notifications with the Commission. Electronic trading has soared from less than 10 percent of total volume of futures and options trading in 1998 to approximately 60 percent this year, and that percentage is increasing on a daily basis.
These changes in the futures markets reflect new competitive challenges, to be sure, but also new growth opportunities. Product innovation and the increasing use of technology offer the prospect of continued growth in the futures markets, in the form of new trading venues, new trading strategies, new risk management tools, and new customers.
For example, exchange-traded contract volumes are at all-time highs, notwithstanding that the over-the-counter markets for financial derivatives also are thriving. Far from being zero-sum competitors as many had feared, the OTC and exchange-traded derivatives markets are serving as natural complements to one another.
In large measure, the landmark CFMA legislation, enacted over five years ago, has provided a firm foundation for us to build on. In place of the traditional one-size-fits all framework, the CFMA established a flexible principals-based regulatory model -- which tailors regulations to fit the particular risk characteristics of different trading platforms, products, and participants.
Exchanges can now choose to operate under one of several tiers of regulatory oversight, depending on the products traded, the system in which they are traded, and the sophistication of the market participants. At each tier of oversight, prescriptive rules have been replaced by core principles governing operational integrity.
In the energy markets, this multi-tiered system has spurred the growth of trading through electronic trading facilities, known as exempt commercial markets. Transactions conducted on these exempt commercial markets, though free from many regulatory requirements, remain subject to the fraud and anti-manipulation provisions of the Act.
The CFMA unbundled the clearing function from the trade execution function, and granted the CFTC explicit authority over derivatives clearing organizations, which are authorized to clear both on-exchange and over-the counter transactions.
The CFMA also provided a much-needed legal certainty for off-exchange activity. That is, bilateral swap transactions between sophisticated counterparties -- involving financial commodities that are not readily susceptible to manipulation -- are no longer at risk of being found in court to be illegal off-exchange futures contracts.
Nowhere is the benefit of competition and innovation more evident than in the energy markets. With the introduction of OTC clearing, the energy markets have seen an explosive growth in the form of new trading venues, new trading strategies, new risk management tools, and new customers.
Introduced in 2002, OTC clearing has taken off and has paved the way for greater growth of the energy markets as a whole. In 2004 the New York Mercantile Exchange, through its ClearPort facility, and the Intercontinental Exchange, through its partner LCH.Clearnet, cleared more than 30 million OTC energy contracts. The 2005 figure is expected to be even higher.
OTC clearing mitigates counterparty credit risk by mutualizing risks at the clearinghouse, and by facilitating offset and netting. It is a good example of industry creativity stepping in to fill a gap – a need, in this case, exposed by the collapse of Enron in late 2001. In the aftermath of the collapse, counterparty credit risk became a formidable obstacle to conducting OTC transactions in the energy sector. The OTC clearing -- with the help of the CFMA, which paved the way for the clearinghouses to clear OTC products -- revitalized the OTC energy markets by adding the necessary credit support.
Today, OTC clearing is still largely limited to the energy sector, but its success could attract other OTC products. The CFTC looks forward to working with market participants to explore additional opportunities in the clearing of OTC products, while ensuring that credit and potential systemic risks are carefully and appropriately addressed.
The developments in the energy markets serve to remind us that product innovation and the increasing use of technology tend to deepen and broaden the market as a whole -- and as with all other free markets, competition and innovation will ensure continued growth in the derivatives markets.
Looking ahead, the CFTC will continue to play an active role in promoting the highest degree of market integrity.
But ultimately, maintaining market integrity is a task that falls upon all of us -- the regulators and the industry. It is a shared responsibility, which calls upon us all to hold ourselves to the highest standards of ethics and professionalism. It is a common mission that we must embrace with unwavering commitment and vigor.
I would be happy to take your questions.