Remarks of Commissioner James E. Newsome, before the Risk Management Technology Conference 2000, E-Commerce for the Capital Markets
June 19, 2000
Thank you. I am honored to be here today to discuss regulatory issues in today’s technology-driven workplace. I would like to give you some personal perceptions of today’s marketplace, then discuss some specific things we are working on at the Commodity Futures Trading Commission.
I did not come to the Commission two years ago with a background in trading or finance. My experience was in the agriculture sector, so I believe this allowed me to take a fresh look at the regulatory landscape and the state of the industry as a whole.
It did not take me long to realize that regulatory change was in order, given the many outdated rules on the books at the Commission. I believed we needed change mindful of technological advances, dynamic market structures, and innovations by not only our traditional exchanges, but also by new firms and individuals having the vision to design trading platforms cheaper and more efficiently than in the past.
Emergence of Technology
The emergence of technology is obviously a driving factor in today’s markets. Some of our regulatory principles date back to the 1920s, when Congress recognized the need for some oversight of futures trading. We all know how much has changed since that time.
Technology has led to globalization, new market opportunities, and increased competition for domestic futures exchanges from foreign exchanges, from over-the-counter markets, and even from new exchanges.
Technology has helped lower the barriers to entry for new exchanges by effectively lowering start-up costs. Until a few years ago, the CFTC had minimal interest or inquiry from industry participants wanting to create new ventures in the futures market.
In fact, the Commission received only two applications for new exchange designations in the first twenty years of its existence. Neither of them ever got off the ground.
However, recently—especially in the last year—we have received an overwhelming level of interest and even some formal applications from start-up exchanges. The Commission has approved some applications, while others are currently being reviewed.
With all of these changes comes the responsibility of market regulators to meet the challenges of emerging technology by defining the future of regulation. Some of these challenges are: embracing technological advancements, rewarding--not punishing--those who are innovative, creative, and think outside the traditional box, harmonizing our international regulatory structure, updating or negating rules that no longer apply, and developing quicker response times.
Essentially, we must adapt to this modern environment. However, realization of these goals will require flexibility from Congress in our statute and adoption of a flexible regulatory structure in anticipation of future innovations.
Creation of Technology Advisory Committee
To assist us in keeping abreast of technological advancements in the futures industry, the Commission formed a Technology Advisory Committee. Last December, as a prelude to structuring the Committee's activities, the Commission conducted a Technology Roundtable at which leading representatives from both the derivatives and technology industries participated.
The agenda included discussions of current trading technologies, the effects of new technologies on markets, technologies envisioned for the future, and appropriate regulatory responses to this technology. Shortly thereafter, we formalized the membership of the advisory committee, which includes representatives of the exchanges, intermediary and compliance communities, technology providers, and others with knowledge of the legal issues surrounding the Commodity Exchange Act.
In April, we conducted our first meeting. The agenda included discussions of automatic order routing and execution systems, detecting fraud and manipulation in an electronic environment, common trading platforms and common clearing of multiple products. We concluded the meeting with a free-form discussion of cutting edge trends in the industry.
It was obvious from the discussion that technology has made it logistically and economically feasible to offer multiple products on a single trading platform and there is a growing desire in the industry to do so. In keeping with that trend, there is a strong desire for common clearing. An important issue that lawmakers will have to address in the future is whether current statutory barriers to common clearing should be removed and if so, how and by whom this activity should be regulated.
In addition, the participants discussed how the ability of customers to access the marketplace through automatic order routing systems might change current risk management practices. According to some on the committee, it will be possible in the future to perform real-time credit filtering as customers enter the market. This may have significant implications for the efficiency of executing orders and where the responsibility for risk lies in case of default.
Another point brought out at the meeting was that technology will change the nature of trade practice violations and therefore the method of regulation. In open-outcry settings, the focus for detecting certain violations has been on the audit trail, the integrity of which depends upon careful documentation by each person in the process, from order placement to execution.
In an electronic environment this is done automatically. Thus, the potential for manipulating that process to the disadvantage of customers will be reduced. This, of course, will not eliminate fraudulent activity, but most likely will change the method by which certain violations are committed.
Finally, the participants at the meeting stressed that technology has accelerated the pace of innovation in marketplace and the need to get to market quickly with new ideas in order to remain competitive.
The success of market providers will increasingly be determined by the speed with which orders are executed, the lowering of transaction costs, and the choice of services made available to market participants. With that in mind, the Commission is striving to eliminate regulation where it acts as an unnecessary barrier to entry.
Regulatory Reform Package
Under the leadership of the Commission’s Chairman--Bill Rainer, the Commission began a comprehensive review of our rules and regulations. Chairman Rainer created a full-time Task Force of several CFTC senior staff members to formulate this regulatory reform package. Their specific goals were to eliminate unnecessary rules and to generally review the one-size-fits-all style of regulation and its appropriateness in today’s market environment.
Also, the task force considered internationally accepted regulatory principles in the context of our own U.S. markets to address globalization and take a step toward international harmonization of regulatory structures. Finally, they recommended changing the agency from a frontline regulator with specific step-by-step prescriptive rules to an oversight regulator with flexible "core principles."
Task Force Recommendations
The Task Force presented a general framework to the Commissioners and to our authorizing committees in late February 2000. This framework established three regulatory tiers for markets--all subject to varying levels of Commission oversight.
The first level of regulation, the "recognized futures exchange," is most like the current regulatory structure. It will offer the most customer protection and be available to retail investors. The second level of regulation, the "derivatives transaction facility," will be limited mainly to products that are not susceptible to manipulation and which are traded by or through appropriate persons.
The third level of regulation, the "exempt multilateral trade execution facility," will be open only to large or sophisticated investors who trade on products that are considered not susceptible to manipulation. Therefore, the oversight level is dependent on the nature of commodities traded on the facility and the sophistication of the market’s participants.
For example, derivatives on commodities with finite supplies such as agricultural products and those traded by retail customers will be subject to the highest levels of regulation. However, derivatives on products with a nearly inexhaustible supply, like financial products, and commodities whose derivative traders are "institutional" in nature will require lower levels of regulation.
Finally, the task force provided an expansion and clarification of the current swaps exemption aimed at providing the maximum amount of legal certainty for the over-the-counter markets, utilizing the administrative powers of the Commission.
Recently, our staff completed specifics for the general framework. The package was brought before the Commission, where we voted to publish the document as a proposed rule. It was published last week in the Federal Register for a 45-day public comment period.
Upon completion of the comment period, the Commission will review all comments received and incorporate any modifications deemed favorable into a final rule. As I have only presented the general framework of the proposed rule, I encourage you all to review it in more detail. It can also be found on our website, www.cftc.gov, under "What’s New and Pending." Generally, most informal industry comments have been favorable to this proposal.
In addition, both Houses of Congress recently introduced similar bills, with both effectively codifying the framework outlined in our reform proposal. Generally, these bills are intended to provide legal certainty for the over-the-counter derivatives market, reform the Shad-Johnson jurisdictional accord by allowing financial exchanges to trade single stock futures, and reform the Treasury Amendment to clarify the Commission’s jurisdiction over "bucket shops" and strengthen our ability to take enforcement action with respect to retail fraud and other unfair practices in the foreign currency market.
As you can see, there are many challenges that lie ahead for market regulators worldwide. I am hopeful that through the intensive review of our overall regulatory structure and the creation of beneficial advisory committees, such as the Technology Advisory Committee, the Commission will be well positioned to meet the challenges of today, as well as obtain the necessary statutory and regulatory flexibility to accommodate the dynamic market of the future.
Thank you for the invitation to join you today. Please feel free to contact my office should you have any questions regarding the statements I have made to