Remarks of Commissioner Thomas J. Erickson before the Chicago Bar Association's Committee on Futures and Derivatives, Chicago, Illinois
October 19, 1999
Good afternoon. I appreciate your kind introduction and warm welcome. I was delighted when Ken called me last spring during my period of nomination purgatory to invite me to speak before the Chicago Bar Association’s Committee on Futures and Derivatives. I am pleased to be here.
In the interest of full disclosure, I thought that either Ken or I should inform you of our pre-existing relationship. I guess by default Ken has left me with the privilege. Many years ago, I had the good fortune of working with a then-talented young lawyer – Ken – on a project of great import. The goal was to define and distinguish futures from cash forward transactions. Before you reach for your copy of the "White Book," let me reassure you that there is no such definition in the Commodity Exchange Act (Act); the effort was in vain.
The Commodity Futures Trading Commission (CFTC or Commission) is a small agency with a very important mission. The Commission’s statutory mission is to protect market users and the public from fraud, manipulation and abusive trade practices and to foster open, competitive and financially sound futures and option markets. In practical terms, the Commission’s job is to make sure people don’t lie, cheat or steal – simple rules for complex markets.
As practitioners in this specialized area of the law, you have witnessed how derivatives markets have been invigorated by innovation over the past decade. These changes have pushed new competitive issues and public policy concerns to the forefront of the regulatory landscape. Federal regulators must not only balance these discrete private interests but must advance a public interest in open, competitive and sound markets. Regulators also cannot outpace the financial marketplace and instead must have the opportunity for direct communication with market participants and the multiplicity of economic interests that comprise the markets in order to respond to changing markets. I have pledged to work closely with the other CFTC Commissioners, with members of our industry and with other interested members of the public in fashioning regulatory responses that are timely, responsive to the market and mindful of the public interest.
I have been a consistent proponent of change and believe change can only come to be embraced if the Commission and others are willing to ask and answer the hard questions. This afternoon, I would like to discuss several of these issues and continue the process of asking some of the difficult questions.
Regulatory Relief for Domestic Futures Exchanges
On June 25, 1999, the Commission received a joint petition from the Chicago Board of Trade, the Chicago Mercantile Exchange and the New York Mercantile Exchange (the Exchanges) requesting broad regulatory relief from certain statutory requirements for all boards of trade previously designated by the Commission as contract markets. For the moment, the Exchanges’ Section 4(c) petition is the central focus of relief under consideration by the Commission. The comment period on the petition closed last week, and the CFTC is considering the comments and plans to address the issues highlighted in the petition very soon.
The Exchanges are requesting an exemption in three areas. First, the petition requests relief from the contract market designation process for new contract submissions. The Commission already has taken steps to try to provide some meaningful regulatory relief to the exchanges regarding the contract designation process. Most recently, on July 27, 1999, the Commission published a proposed rule that would establish a two-year pilot program allowing exchanges to begin trading new contracts immediately upon notice to the Commission. The proposal still would require approval of applications for contract market designation after trading commenced. The Exchanges’ comments have expressed concern that the proposed pilot program would expose transactions in new contracts to a level of legal uncertainty that would discourage trading. The Commission currently is considering how best to address the designation process for new contracts in light of comments received on the proposal.
Second, the petition requests relief from the contract market rule review process. The Exchanges propose that domestic contract markets be required to provide only notice of new rules or rule amendments to the Commission ten days in advance of their effective date. Pursuant to the petition, proposed new rules or rule amendments would not be stayed unless the Commission determined that they were likely to cause fraud, render trading readily susceptible to manipulation, or threaten the financial integrity of the market. On July 15, 1999, the Commission published proposed amendments to Rule 1.41, which would expand the number of exchange rule amendments eligible for automatic approval upon adoption and would require only a later single summary filing with the Commission. I understand this proposal does not address all rule change submissions. However, the Commission is reviewing the public comments on this proposal and the Exchanges’ petition and is considering ways to address many of the Exchanges’ concerns.
Third, the petition requests relief from the relevant provisions of the Act that would otherwise prevent the immediate adoption and implementation of trading rules and procedures comparable to those of a competing foreign exchange with electronic trading terminals in the United States. In essence, the petition requests that a domestic designated contract market be permitted to immediately implement trading rules and procedures comparable to those of a foreign exchange, provided that the implemented rules and procedures apply only to contracts listed by the domestic contract market subject to direct competition with the foreign exchange.
As you can see, the issues raised by the Exchanges’ petition are more than a little interesting and, if adopted, would have a significant impact on the oversight of U.S. futures and option markets.
Changing Markets: Electronic Trading and Demutualization
Today’s markets are facing change at an exponential rate – a rate some suggest may cause a regulatory crisis of worrisome proportions. I beg to differ from that assessment. I prefer to look at change and any potential for crisis from the perspective of the Chinese language character for the word "crisis". The character "weiji" is comprised of the characters for danger and opportunity and teaches us to learn from our difficulties. Such an age-old philosophy would serve us well as we move into the next century.
It is true that the introduction of electronic trading platforms and systems is well under way and is one of the most significant issues that will confront the Commission, other federal financial regulators and the Congress. Financial and legal scholars continue to expand our discourse on electronic financial markets and their effect on regulation. The CFTC and the futures industry together must continue to address the impact of electronic trading on our financial markets. The Commission must ensure that its regulatory framework encourages innovation, but not at the expense of market participants or market integrity. This will require of the industry a readiness to share information with the Commission about developments and potential regulatory implications.
Moreover, technological innovation already has begun to test our regulatory structure. Increasing numbers of potential commercial and retail customers have easier access to a wider range of financial products, challenging all of us to balance innovation with concerns about customer protection and systemic risk. Several questions come to mind. For example:
- Technology increasingly will enable customers to bypass traditional market intermediaries in trading financial products. Should this trigger modifications in our current regulatory safeguards?
- How should the Commission address concerns regarding system capacity and security as increased access continues to test the boundaries of our markets?
- As trading hours expand and raise the possibility of 24-hour online trading, how should the Commission approach issues involving market liquidity?
- Are current guidelines adequate to address cross-border access to foreign markets by U.S. customers?
While change always poses some risk, we would do well to view any so-called "crisis" as an opportunity to strengthen our markets and to refine our regulatory structure . To the credit of Congress, the Act is flexible enough to allow the Commission to respond to these challenges and to provide a framework that recognizes the different regulatory interests presented by our changing financial markets. I look forward to grappling with the novel issues presented by technology and hope the Commission will continue to craft a useful, common-sense regulatory framework that responds to today’s – and tomorrow’s – innovations.
The demands of today’s marketplace also are challenging exchanges to face fundamental questions about their own governance structures. Both securities and futures exchanges are considering whether they should move from a membership structure to a for-profit structure in an effort to enable themselves to respond more quickly to changes in the markets and pressure from competitors. This, in turn, is raising important concerns, including:
- How should an exchange convert membership into an ownership stake in the exchange?
- Can a for-profit exchange adequately fulfill its self-regulatory responsibilities?
- Should self-regulation be centralized in a single national overseer, as Securities and Exchange Commission Chairman Arthur Levitt has suggested?
These questions will be debated in the coming months, as exchanges – both large and small – strive to remain competitive in a changing financial marketplace. I am confident that the CFTC will continue to encourage the dialogue and to support exchange efforts to adapt to today’s challenges. We all must work together to find opportunity within these challenges.
Perhaps the single biggest Y2K glitch ahead of the Commission and the industry will be reauthorization legislation next year. Congress already has begun the reauthorization process: Hearings have been held (with many more undoubtedly to come), questions have been submitted to the industry for consideration, and suggestions have been solicited from the industry on how to improve the Act.
The issues involved in reauthorization are numerous and complex. Various "fixes" have been proposed: more regulation, less regulation, statutory fixes, new regulators, fewer regulators, consolidated regulators and many more with which I am sure you are familiar. Some reauthorization issues are the subject of a study by the President’s Working Group on Financial Markets, which is reviewing the over-the-counter (OTC) derivatives market. I am hopeful that, with the genuine goodwill of all members of the Working Group, productive recommendations on these issues will emerge.
Perhaps the most uttered phrase in the futures industry over the past year – perhaps the last decade – has been "legal certainty." It has been repeated in a mantra-like manner when discussing many issues affecting the derivatives market. In order to be successful, any resolution of the Commission’s reauthorization must achieve legal certainty, particularly in the area of OTC derivatives.
For me, this means clearly defining the OTC derivatives market, stating the degree of regulation – if any – to be imposed on the various parts of that market, delineating the jurisdiction of the CFTC and other regulators over the market, and clarifying the role of the various federal financial regulators in promulgating and/or enforcing any regulatory regime in the OTC market. To do otherwise would be counterproductive and unfair to both the industry and end-users.
We find ourselves in an era where everyone is looking to increase efficiencies in market performance and in the regulation of the markets. Given that increased efficiency is a common goal, I think it is fair to ask whether it makes sense to carve-up the regulation of derivatives markets – on- or off-exchange. More fundamentally, have we reached the time when it is appropriate to choose one form of regulation over another: market regulation versus entity regulation?
The Commission’s reauthorization likely will resolve many of the issues I just mentioned. I believe that groups like this Committee on Futures and Derivatives have a significant interest in helping the Commission and the Congress arrive at solutions for shaping the future of derivatives regulation. I believe that the Commission and the industry can work together to craft an appropriate, workable proposal for resolving many of these most important issues. I believe that a consensus proposal is not a luxury, but a necessity to ensuring that the Commission and the industry move together into the new millennium as partners in maintaining the integrity and innovative spirit of our derivatives market. I look forward to your full participation in this most important process.
Thank you once again for inviting me to be with you today. I welcome any comments or questions you may have.