Keynote Address of Commissioner Walter Lukken
U.S. Commodity Futures Trading Commission
China Financial Derivatives Forum
Monday, September 26, 2005
I am honored to represent the Commodity Futures Trading Commission (CFTC or Commission) at this important forum on derivatives and I offer you greetings from the Chairman of our agency, Reuben Jeffery. I want to thank our gracious Chinese hosts, the Shanghai Futures Exchange and the Shanghai Stock Exchange, as well as the Chicago Mercantile Exchange (CME) for organizing this conference. I am also grateful for the support shown for this event by the China Securities Regulatory Commission (CSRC) and other Chinese government officials in attendance.
This is my third trip to China and each visit leaves me more impressed with the rich cultural history of the Chinese people. I am equally inspired by the entrepreneurial spirit in China and the growing economic sophistication of its markets and traders. This is a direct result of China’s free market reforms over the last quarter-century and I am confident that the best is yet to come.
The financial well-being of the U.S. and China are increasingly interdependent given the symbiotic relationship of our economies. Together, the U.S. and China represent over one-third of the world’s gross domestic product (GDP), respectively accounting for approximately $11.8 trillion and $7.3 trillion of the estimated $55 trillion world GDP in 2004. Last year, China’s gross domestic product grew a robust 9.5 percent and its total foreign trade volume soared $1.1 trillion, making it the world’s third largest trading nation behind the U.S. and Germany. A year ago, the U.S. overtook Japan to become China’s number one export customer and China now ranks third among the trading partners of the U.S. behind Canada and Mexico. Bilateral trade between our two countries now exceeds a quarter of a trillion dollars a year. Clearly, the economic interests of both nations are substantially interwoven.
With China’s recent adoption of a managed float of its currency and some indication that more adjustments for the RMB may be in store, the need for a vibrant derivatives market—both on-exchange and over-the-counter—becomes increasingly important. A free and efficient derivatives market helps ensure that capital and resources are appropriately priced and allocated, that financial risks are effectively managed, and that standards of living are ultimately enhanced.
Employing a more flexible currency regime has many positive macroeconomic effects. But let there be no mistake: such a move comes with certain transitional uncertainties that can and should be minimized. Market participants are now exposed to price risks that did not exist before and demand will grow for risk-shifting instruments to hedge this exposure. China can ease this transition by fostering the development of its derivatives market just as the U.S. did 30 years ago when the U.S. dollar was taken off the gold standard. Many of the same political and fiscal policy considerations in play at that time exist today in China. As a “second mover,” however, China enjoys a significant head start by being able to learn from the lessons of others and take advantage of regulatory and market models already in place. Indeed, Chinese regulatory authorities should be congratulated for the important steps they have already taken, including the recent announcement allowing joint ventures between Chinese and foreign futures brokers. Through close regulatory cooperation and private sector partnerships, I am confident that the Chinese derivatives market will soon rival the elite markets of the world.
In preparing for this forum, I was struck by the similarities between the development of the Chinese financial derivatives market and that of the U.S. In the fall of 1971, Nobel Prize winning economist Milton Friedman published a prescient article in which he predicted that the end of the Bretton Woods system for fixed rate global currencies would necessitate the creation of a derivatives market in foreign currencies. Mr. Friedman wrote, “Under a system of rigidly-fixed rates that do not change . . . there is only limited room or need for a broad, resilient public futures market in currencies... [But] the demand that will rise for forward cover under [a flexible currency regime], and the greater opportunities for speculation, mean that the present futures markets are bound to expand – soon and rapidly.”
Friedman believed that the formation of a foreign currency futures market in the U.S. was in the national interest because it would encourage growth in the financial services sector, improve the functioning of foreign trade and enhance the central bank’s ability to manage monetary policy. He also noted the importance of providing a role for speculators in these markets, which he believed to be an essential source of liquidity and stability to the marketplace.
When President Nixon closed the gold window on August 15, 1971, the demand for risk management in financial products blossomed. Friedman’s article served as part of the intellectual foundation on which the CME established the International Monetary Market (IMM) in 1972 to trade foreign currency futures. The IMM is an example of the adage, “Necessity is the mother of invention,” as it filled an important commercial need in the world of floating exchange rates. Today, the CME conducts markets for 15 national currencies and the Euro, and also offers a dollar index based on a basket of seven currencies.
The volatility engendered by the dismantling of the Bretton Woods system over 30 years ago created not only a vibrant exchange-traded market in foreign currencies, but the beginnings of the now-dominant interbank currency market, which today is the deepest, most liquid financial market in the world. Other futures products quickly followed currencies. Interest rate volatility during the early 1970s led the Chicago exchanges to expand their financial offerings by listing futures on long-term government debt and short-term interest contracts such as the Eurodollar. Equity futures were next in the queue, including index products on the S&P 500 and the Dow Jones industrial average. The early pace of financial innovation was breathtaking and one wonders whether a similar situation is developing in China today.
U.S. market innovation in the early 1970s also became the impetus for a major modernization of the laws governing the futures industry. In 1974, Congress passed legislation that created the independent financial agency for which I serve, the CFTC, and laid out a regulatory structure to commence oversight of financial futures contracts beyond the traditional agricultural ones. The law required that the trading of all commodity futures contracts occur on a registered futures exchange under the exclusive oversight of the CFTC. Seen as revolutionary at the time, this regulatory structure ensured that trading of standardized futures contracts occurred in specific locations under the watchful eye of a federal regulator.
As the industry matured, the rigidity of this structure led to certain growing pains for both the exchanges and regulator. Over the last 30 years, we have witnessed our share of industry scandals and jurisdictional feuds. More importantly, however, time revealed that the fundamental structure of our markets was dramatically changing. The advancement of electronic trading and the demand for faster product innovation made it clear that the regulatory design and approach for futures markets needed a major revision.
Five years ago, Congress passed the Commodity Futures Modernization Act (CFMA or Act) to modernize the laws overseeing our industry in order to meet the new challenges of the marketplace and in doing so, incorporated some of the valuable insights that our agency gained over its 30 year history. These lessons did not come easy and our agency still has some scars from battle. But I am hopeful that our experience might greatly hasten China’s progress toward developing a world-class derivatives market. Allow me to share the five regulatory lessons that I believe might be constructive to China’s derivatives market development.
Lesson One: Flexibility is imperative. The regulatory structure for futures trading must be flexible and tailored to market risks in order for regulators to keep pace with, but not unnecessarily stifle, market innovation. Early in futures market development, a rules-based regulatory regime is essential as regulators seek to meet public goals while gaining appropriate experience and understanding of the markets. At the outset, certainty of compliance and regulatory caution outweighs the ultimate need for market flexibility. But as the markets advance, prescriptive rules lag behind market innovation and regulatory constraints hinder the proper functioning of a competitive marketplace. The nature of the modern marketplace is to innovate, compete and arbitrage opportunities with lightning speed. Fortunately, a regulatory structure can be designed to leverage these market characteristics to the advantage of the public.
Instead of a one-size-fits-all model, the CFMA laid out a sliding scale of regulation for exchanges, depending on a product’s susceptibility to manipulation and the sophistication of its traders. This tiered regulatory structure allows exchanges to innovate more rapidly to meet competitive challenges while enabling the CFTC to adopt a more risk-based approach tailored to those areas requiring greater government scrutiny.
This new structure also utilizes a principles-based approach to regulating, rather than a rules-driven one, to enable participants in these markets to use different methodologies or “best practices” for achieving statutory requirements. For example, one core principle for exchanges states, “To reduce the potential threat of market manipulation or congestion,...[a] board of trade shall adopt position limitations...for speculators, where necessary or appropriate.” While the CFTC monitors whether a core principle is ultimately met, the exchanges with their hands-on experience are given discretion to tailor their rules, such as position limit levels, to the special circumstances of each contract market. In fact, the Chicago Board of Trade recently passed a rule instituting position limits on its 10-year Treasury Note contract in an effort to “insulate Treasury futures from potential manipulative conduct,” as noted by the exchange. Allowing the industry to develop its own methods for compliance with the core principles, in conjunction with strong CFTC oversight, better promotes the practices reflective of the marketplace.
In addition, exchanges now have the authority to approve new products and rules through a self-certification process without prior CFTC approval. After the certification, the CFTC has the authority to reject a product or rule if it is found to be in violation of the Act. Before 2000, the CFTC approved all rules and products before they could be implemented. But bottleneck delays at the CFTC, along with the recognition that these decisions were largely business-driven rather than regulatory in nature, led to this change in 2000. This was necessary to allow exchanges to react quickly to the competitive challenges of the new marketplace.
Lesson Two: Strong enforcement is essential. This lesson, which happens to be a corollary of the first, is that a “lighter touch” regulatory regime must be accompanied by an aggressive enforcement presence. With our agency’s recent shift from rules-based regulation to risk-based, it is essential that the Commission be properly equipped in the enforcement arena to take swift legal action when wrongdoing is detected. “Real-time” enforcement has proven effective at punishing violators of our statute and at deterring further wrongdoing with minimal impact on legitimate market participants. Our agency has been aggressive in its enforcement efforts – whether shutting down boiler-room operations that are defrauding the public, working with state and federal authorities to lock up criminals or pursuing corporate malfeasance as part of the President’s Corporate Fraud Task Force. Such robust law enforcement authority serves as a powerful deterrent to wrongful activity and represents an important component of the CFTC’s overall regulatory program.
Lesson Three: Self-regulation works. Self-regulation – the regime in which agencies delegate and share certain regulatory responsibilities with exchanges and other private-sector entities – has proven to be an invaluable part of our regulatory fabric in the U.S. and has served the futures industry well over the last two decades. Both the National Futures Association (NFA) and the exchanges have proven essential compliments to our agency in protecting the integrity of our markets from fraud, manipulation and wrongdoing. Without their help, our 500-person agency would be overwhelmed in its oversight of this multi-billion dollar industry. Self regulation works because the interests of an exchange are primarily aligned with that of the public in protecting the integrity and reputation of the marketplace. Self-regulatory organizations (SROs) also enjoy a proximity to the markets that government regulators do not have, and can often act more quickly to stop harmful market behavior. Additionally, there are significant savings to the taxpayers in having the industry police itself.
Having said this, the CFTC must maintain adequate checks to make sure that self-regulation is functioning correctly. Conflicts of interest among the SROs and the exchanges must be minimized and independent decision-making should be guaranteed. Our agency conducts regular audits of SROs to ensure that they are functioning properly. As our agency nears completion of an extensive study of the SRO structure, more guidance may be forthcoming to further the effectiveness of these entities. With the proper oversight and protections in place, I have found that self-regulation has been invaluable in helping us meet our mission. I am pleased to have met the Chairman of the China Futures Association in Beijing in August and hope that this organization will serve a similar public good in China as your markets progress.
Lesson Four: Legal certainty is vital. A successful derivatives market requires a clear and predictable legal framework for trading these instruments and a consistent adherence to the rule of law. Markets require that the rules of the game be transparent and unambiguous. Although complex in nature, derivatives instruments at their heart are contracts and as such, require the parties to the agreements be confident in their enforceability, whether on-exchange or over-the-counter (OTC). Any legal doubt to whether a party is able to perform its obligations under a derivatives contract could severely dampen the ability for this market to grow. This means a nation’s laws —whether derivatives statutes, contract law, or bankruptcy law—must be clearly crafted to allow for the proper functioning of such private instruments without hindering market discipline, demand or innovation.
Because exchange trades are marked-to-market and settled at least daily, the uncertainty to whether parties will perform on their obligations is minimized. The advantageous development of these structural mechanisms over the years has alleviated these risks for exchanges. Although some OTC derivatives are beginning to utilize clearing to manage credit risk exposure, most OTC derivatives largely rely on the parties’ ability to pay and the enforceability of such agreements as dictated by the host nation’s contract and insolvency laws. Even the U.S. has struggled with providing adequate legal certainty for derivatives and several recent revisions to our futures and bankruptcy laws were needed to ensure that the legal treatment of these products does not jeopardize the integrity of the market or risk a systemic event in the economy. The development of the Chinese derivatives market would be significantly advanced by keeping this lesson on legal certainty in mind.
Lesson Five: Regulatory cooperation matters. The need for regulatory authorities to cooperate, both internationally and domestically, is my final lesson but a significant one. As markets have become integrated and global, agencies do not have the resources or abilities to sufficiently monitor the breadth of markets and participants and must rely on the expertise of others in fulfilling their public mission. Whether it is cross-border fraud or the international linking of markets and clearing facilities, agencies must work in close tandem to get the information needed to protect markets and participants.
Such coordination is enhanced through participation in international regulatory organizations like the International Organization of Securities Commissions (IOSCO), in which the CFTC is an active participant. IOSCO facilitates international cooperation by developing and promoting information sharing and a high standard of regulation. It is important that countries participate to the fullest of their abilities in such organizations. I note that the CSRC is already an active member of IOSCO and the Shanghai Stock Exchange is an affiliate member.
Bilateral arrangements among regulators are equally important to ensure the free flow of information and ideas between national authorities. In 2002, the CFTC and the CSRC entered into a Memorandum of Understanding regarding a mutually acceptable basis for regulatory cooperation and technical assistance. It is also important that the CFTC and the CSRC cooperate on enforcement matters. Fraudulent activity knows no boundaries and it is critical that our authorities cooperate on cross-border investigations of potential criminal wrongdoing.
International cooperation is also advanced through conferences such as the one we are having today. These types of events enable our agency to improve upon its own system of surveillance and oversight by learning from the methodologies of other countries. The CFTC’s Chicago Regulatory Conference that we host each fall typically includes presentations and roundtable discussions by non-U.S. regulators on global approaches to oversight. I am pleased that the CSRC will be participating in this event and I hope that they will learn as much from the experience as we gain from their attendance.
The import of cooperation is not limited to the international arena; domestic coordination has also proven important in the U.S. as our financial markets have converged. Without close coordination, the potential for regulatory gaps or overlaps exists. To minimize this possibility, the CFTC participates in the President’s Working Group on Financial Markets (PWG), which formed after the stock market crash in 1987. The PWG, consisting of principals from the Treasury Department, the Federal Reserve, the Securities and Exchange Commission (SEC) and the CFTC, meets multiple times a year to discuss policy matters that impact the broader marketplace. In the past, the CFTC and the SEC have experienced situations in which their jurisdictions overlapped, putting a strain on the missions of the respective agencies and on the industries we oversee. In such cases, the PWG has proven effective at coordinating the efforts of these governmental bodies so a consensus might be reached among the major U.S. financial regulators. Some type of policy coordination mechanism might also be considered in China as its government and regulators discuss the proper oversight structure for derivatives.
We meet at a time of great challenge and opportunity for China. Trepidation is understandable. However, I am confident that if the Chinese utilize their broad expertise and take note of the lessons learned in the U.S. – and many other nations where derivatives have traded successfully – the continued transition to a more market-based economy will pay great dividends to your people. I guarantee that, during this endeavor, the U.S. will learn several insightful lessons of its own from China. I look forward with anticipation to this coming dialogue as we advance the markets and economies of our great nations. Thank you.