Remarks of Commissioner Thomas J. Erickson, Derivatives Deregulation and Financial Markets: Right Medicine at the Right Time?, Economic Strategy Institute
July 27, 2000
I should preface my remarks with a couple of disclaimers. First, my comments are mine alone and should not be considered to be those of the Commission. Moreover, I will not be commenting directly on those portions of the bills intended to implement the Commission’s proposed regulatory framework. As you probably are aware, the Commission has issued a proposal and the comment period closes on August 7. I concurred in the release of that proposal and expressed several concerns about the proposed framework. I am hopeful that my expressed reservations will be addressed during the comment period -- perhaps even in today’s public forum.
At the outset, I think you should know that I have a bias -- not for turf -- but for the value of functional or market regulation. Functional regulation is over in the area of derivatives should either of these bills pass. And this is despite the fact that U.S. equity and derivative markets have thrived over the years, at least in part because of the combination of institutional supervision -- which has been successful in ensuring the safety and soundness of financial institutions -- on the one hand, and functional, or market, regulation on the other. Together, the SEC and CFTC have carried out market regulatory mandates for a quarter century. Certainly, the SEC has created an environment of investor confidence in capital formation markets. Closer to home, the CFTC, together with Congress and the industry, has fostered an environment that has enabled innovation and growth in on- and off-exchange traded derivatives over the years.
Thus, exchanges that were once almost exclusively used as vehicles for hedging risk in agricultural products now provide sophisticated risk management tools for those dealing in all manner of commodities from agricultural to financial products. And the CFTC has grown along with the markets. Admittedly, the Commission has struggled over the years to achieve the proper balance between providing the industry with the latitude it has needed to innovate and grow while at the same time fulfilling our mandate to ensure the safety and integrity of the markets. For the most part, I think we’ve been successful. For example, I think the Commission has been especially effective in detecting and deterring abuses such as manipulations. Most recently, the Commission reached a $150 million settlement with Sumitomo for the manipulation of global copper markets. Similarly, in 1996 the Commission settled a case against Fenchurch for the manipulation of the U.S. treasury bond futures market.
With that as background, I believe that the bills pending before the Congress would end the quarter century of what I consider largely successful market regulation of derivatives. It seems to me that, if enacted, the bills would have the following ramifications:
- Most of the U.S. portion of the $190 trillion derivatives market will be outside the reach of any of the U.S. federal or state financial regulators.
- For those parts of the derivatives markets that arguably remain under some regulatory authority, either of the bills would create anomalous results that I think would increase legal uncertainty.
Let’s take a closer look.
Legal Certainty Not So Certain
The CFTC currently has jurisdiction over transactions -- transactions for future delivery and options. The bills exclude commodities, participants, and trading facilities, but then attempt to define narrow bands of regulatory interests for the CFTC for certain portions of these excluded "things." This is not an easy exercise because, as recognized by the PWG, there are fewer and fewer real distinctions between transactions in the OTC market and the exchange markets. This "regulation by exclusion" raises a number of questions about what lands where in the regulatory scheme. For example:
- What is a retail swap in an excluded commodity?
The bills carve out OTC transactions so long as they’re among and between sophisticated parties. I suppose this means retail swaps are illegal, but who has jurisdiction to address problems. The CFTC? Only if the swap can be called a future. The SEC? Only if the swap can be called a security. The Fed? Stay tuned, we’ll see.
- Do we really mean exclusion of all electronic trading facilities?
Under either bill, an electronic trading facility is defined as little more than an electronic platform that provides real-time audit trail capabilities. Under either bill, electronic trading facilities are excluded from federal oversight. In our zeal to embrace innovation, do we necessarily have to abandon the field? Is there no federal interest in overseeing, for example, electronic trading facilities that provide a platform to retail customers who want to trade swaps?
Make no mistake, there are today in existence electronic trading facilities that meet these definitions and that are affirmatively regulated by the CFTC. Do these bills mean that that the Cantor Financial Futures Exchange, CME’s Globex system, CBOT’s Project A (soon to be Eurex), and NYMEX’s Access would all be excluded from CFTC jurisdiction? If so, how could the CFTC continue its regulation of futures on these otherwise excluded systems? Moreover, what about all the systems to come, such as FutureCom, the Merchants’ Exchange of St. Louis, BrokerTec, and Intercontinental, to name a few.
- Can the CFTC really enforce its fraud and manipulation authority over things that are, by definition, excluded from the Commission’s jurisdiction?
Both bills hang on a complex lattice of exemptions and exclusions, but both attempt to preserve the Commission’s authority to address fraud and manipulation in certain excluded markets. I’m interested in seeing some legal analysis supporting the idea that the Commission can exercise its authority in markets that are specifically excluded from its jurisdiction.
Foreign Exchange Transactions
- Pursuant to the recommendations of the PWG, the bills allow "otherwise federally regulated entities" and state regulated insurance companies to sell foreign currency derivatives to retail customers without any requirement for basic customer protections.
Do other state and federal regulators have the experience and resources to address forex fraud? Do they even have the interest? Most importantly, do they have the necessary legal authority to address these concerns?
More broadly, if a commodity is excluded from the CFTC’s jurisdiction, and no other federal regulator is affirmatively vested with the authority to investigate fraud and/or manipulation with regard to these commodities, who will investigate incidents of suspected fraud or manipulation? And what tools are available to other authorities to undertake such investigations?
Don’t misunderstand me, I don’t have a quarrel with the policy decisions reflected in the various bills. As one charged with carrying out the public policy enacted by Congress, my job is to fulfill the Commission’s statutory mandate. I am concerned, however, that the policy debate has not focused attention on the potential ramifications of these decisions. To a certain extent, this is embedded within the recommendations of the President’s Working Group report on OTC derivatives to the Congress. Certainly, the federal government may find that these markets are immune from the types of disruptions we’ve seen historically, and therefore that no regulation or oversight should be applied. But that debate has not taken place this year.
As things stand at the moment, and given the muted debate that’s taken place to date, my primary concerns focus on the CFTC’s ability to do what it’s mandated to do if either of these bills becomes law. To varying degrees, both bills rely on voluntary compliance or mandatory compliance but with fairly vague standards.
I’m reminded of a short-lived experiment that recently took place in Montana. Now, I’m from South Dakota, and in that part of the country, we value our personal freedoms. But in Montana, when freed from 55, and in a heightened moment of federalist fervor, the state decided to do away with the prescriptive speed limit and mandated, instead, that motorists drive at a rate of speed that was reasonable given the prevailing conditions.
Imagine if you will being a Montana state trooper who pulls over a Ferrari for travelling 120 mph on a straight stretch of traffic-less interstate highway on a clear day and having to make the case that 120 mph was inappropriate for the conditions. Until recently, that was the state trooper’s charge. Next year, presuming passage of the pending legislation, that will be mine. And you know what, I don’t know if our vehicle will even go 120 mph if one of these bills is passed.
In all seriousness, I think the most important thing to recognize about the proposed legislation is that it defines a good portion of derivatives transactions as outside anyone’s jurisdiction, and the remaining transactions are subject to legal uncertainty from an industry perspective and regulatory uncertainty from mine.