Speech by Chairman Reuben Jeffery III
U.S. Commodity Futures Trading Commission
Futures Industry Association
31st Annual International Conference
Boca Raton, Florida
March 16, 2006
Good morning. It is a great pleasure to be here in Boca Raton at the Futures Industry Association’s annual conference. I’d like to thank the FIA, Richard Berliand and John Damgard for inviting me.
Let me begin by welcoming Ms. Cherie Booth to the colonies and saying what a personal honor it is to meet you. I had the privilege of living in London and calling it home for much of the 1990s. The United Kingdom, under the steadfast leadership of Prime Minister Blair, continues to stand among the truest and most loyal of America’s allies. But our nations are more than allies: we are friends. Not just our governments, but our peoples feel a kindred bond with each other. In his speech to the British Parliament in 1982, given at Westminster Hall, President Ronald Reagan referred to the moment of his visit as one of “kinship and homecoming.” I think that says it all. Perhaps Thomas Jefferson was right when he said that “a little rebellion now and then is a very good thing.”
On the eve of St. Patrick’s Day, it seems fitting to mention the story told in a book some of you may be familiar with: ‘How the Irish Saved Civilization’ by Thomas Cahill. In the Fifth Century, after the fall of the Roman Empire and inspired by St. Patrick, Irish Monks worked as careful scribes, copying every piece of western literature they could uncover. The Monks approached their work with good spirit and cooperation. They preserved and eventually spread literacy and scholarship throughout early medieval Europe. In his introduction, Cahill says, “without the mission of the Irish Monks...the world that came after them would have been an entirely different one...”
I raise this not because I have mistaken any of you for Irish Monks or because the issues faced by the futures industry are on par with saving western civilization, although some of you might argue that point. I raise it because, in a similar vein, without the Commodity Futures Modernization Act of 2000 (CFMA), the futures world would be entirely different from what it is today.
Since the CFMA, we have seen a remarkable surge in market innovation and growth. When the Chicago Board of Trade was formed in 1848, who could have foreseen futures contracts based on snowfalls in New York City, or buying and selling shares in exchange-traded funds (ETFs) tied to futures contracts on crude oil, gold, and wheat? Only 25 years ago, open outcry pits on exchange floors were the exclusive venue for futures trading. Now, more than 60% of futures trading in the U.S. takes place on electronic networks. And it was not too long ago that futures trading was almost uniquely American. Today, there are over 50 futures exchanges worldwide, and trading is becoming increasingly inter-linked across national borders.
I’m sure that you are all familiar with the statistics. In the past five years, the U.S. futures industry’s trading volume in futures and futures options contracts increased 28% on average each year. Last year, the total volume exceeded two billion contracts for the first time. The CME set a milestone by becoming the first U.S. futures exchange to go public. Listed on the New York Stock Exchange, CME now has a market capitalization of over $14 billion. The phenomenal domestic growth has been matched by gains in trading overseas. During the last five years, the volume of futures and options traded worldwide has increased from 1 billion to 2.5 billion contracts. Eurex AG reported one of the largest gains in volume, with an increase from 320.7 million contracts in 2000 to 843 million in 2005.
We at the CFTC have seen firsthand the forces of innovation and competition at work. In 2000, U.S. exchanges submitted 46 new futures and futures options contracts; in 2005, that number increased to 340. These include contracts based on the number of “frost days” in Amsterdam to protect against losses due to construction delays in cold winters, and contracts based on soybeans delivered in Brazilian ports. In the first three months of 2006, we have already received certifications for 56 new contracts.
The regulatory framework established by the CFMA has been a strong contributor to this unprecedented market growth. At the same time, innovation in technology and increasing competition, fostered by the CFMA, have changed the dynamics in the marketplace and produced some growing pains. As a consequence, we now face some tough issues -- issues on which various segments of the industry hold sharply differing views. Our objective of ensuring market efficiency and integrity, while not impeding competition, has become an increasing challenge in this environment.
Today I’d like to discuss three such issues that are significant priorities for the CFTC. First, I’ll comment on self-regulation in the industry; second, the increasing diversification of participation in the futures markets; and third, the implications of globalization. How we confront the challenges posed by these issues today will help shape the development of the industry in the years to come.
Self-Regulation in the Futures Industry
First, let me address self-regulation in the futures industry, an issue of vital importance to all of us. Throughout most of their history, U.S. futures exchanges have been member-owned, non-profit entities. During the past 5 years, however, the industry has been going through a profound transformation. The two largest U.S. futures exchanges, CME and CBOT, are now for-profit companies listed on the New York Stock Exchange, and NYMEX may soon join them. The conversion to a for-profit, public ownership structure is taking place against a backdrop of increasingly competitive and technology-driven derivatives trading. But ever changing market dynamics and the trend to for-profit, public ownership beg us to ask the question: Are the current SRO governance structures still appropriate?
As we heard at our recent Hearing on Self-Regulation, and in the course of the public comment process, there is a wide array of opinions on this question. Even among those who believe that changes are needed to strengthen the self-regulatory system, views differ on the proper measures to achieve that goal. Some push for a greater role and representation of “independent” or “public” directors on exchange Boards; some believe that an independent oversight committee is necessary to ensure Board accountability; and still others argue for a functional separation of the regulatory and commercial functions within an exchange.
The focus on good governance is not new or unique to our industry. Elsewhere - in the U.S. and abroad - major corporate governance reforms are either under way or under deliberation. While the scope and direction of these reforms may differ, they share a common understanding that good governance is the first line of defense against corporate misconduct. The bar has been raised, and fairly or not, what we do to address SRO governance will be measured against similar initiatives undertaken in the broader financial arena, particularly in the securities industry.
To be sure, there are no easy answers, but one thing is absolutely clear: An exchange is more than just a corporate entity: it is also a keeper of the public trust, and as such, must be a model of good governance. Whatever the ownership structure, all exchanges must vigorously fulfill their obligations to enforce their rules and ensure sufficient funding to support an effective surveillance and examination program. This duty applies equally to exchanges and to member-funded SROs such as the National Futures Association. And they must not allow fairness and impartiality to take a backseat to the parochial interests of dominant members.
In the coming weeks, as we continue to carefully deliberate on the various options before us, you can be assured that we will strive to preserve those elements that give self-regulation its strength and vitality. At the same time, we are committed to doing whatever is necessary to ensure an independent and robust system of self-regulation in the futures industry. The challenge before the CFTC and the industry is to strike an appropriate balance so that the SROs - the industry’s front-line regulators - continue to best serve the public interest. Later this spring, you can expect the CFTC to complete its SRO Study, publish its conclusions concerning SRO conflicts in today’s market environment and issue a set of proposals.
Ultimately, however, it is the industry -- all of you here today -- that must take the lead and recognize that it is in your self-interest to be proactive and forward-thinking in dealing with the issue of conflicts. As one participant at our Hearing noted, “[i]t is incumbent upon us all that the U.S. futures industry establish standards that recognize and are responsive to the realities of our changing industry and marketplace and are fair and without any appearance of conflict.” I couldn’t agree more. Anything less from the industry puts at risk the public trust and confidence that you all have worked so hard to develop and preserve.
Diversification of Participants in the Futures Markets
A second changing dynamic of today’s futures industry is the unmistakable trend towards increasing diversification of market participants. As we all know, commodities as a group are now a distinct and growing “asset class.” Today, pension fund managers, university endowments, hedge fund investors, and other major financial institutions are increasing their participation across the broad swath of markets for physical commodities, including trading in the futures markets.
This trend towards greater diversification in the marketplace is best illustrated by the proliferation of commodity-linked products, including the development of commodity-based indices. One of the more popular commodity indexes is comprised of futures contracts written on 24 different commodities including corn, soybeans, and crude oil. Demand for these products comes from various corners of the marketplace - from hedge fund managers making a tactical bet that commodities might outperform stocks or bonds, to prudent investors seeking portfolio diversification, to institutional traders seeking to hedge price exposure resulting from their OTC trades. And the investor universe is likely to expand further as more new products enter the marketplace, the latest being exchange-traded ETFs on commodity-based indices.
Commodity-linked products are meeting the needs of multiple types of market users. We at the CFTC have observed that open interest in the futures markets attributable to commodity-index trading has grown considerably in recent years. For example, on a recent date swap dealers, who primarily hedge OTC transactions through commodity-index products, held about 25 percent of the long open interest in the corn market - an increase from 9 percent in 2001. The total investment this year in commodity-linked products by pension funds, hedge funds and other institutional investors has been estimated to exceed $100 billion.
But the greater role of fund and commodity index investing has raised questions about their potential impact on futures trading of physical commodities, and in particular whether their activity is distorting prices in those markets. These issues strike at the heart of what the futures markets are all about - and of course, the CFTC’s primary mission. Futures markets exist because they provide two vital functions for the marketplace: risk management and price discovery. Our job as regulators is to ensure the integrity of these vital market functions and public confidence in them.
In that regard, some in the industry have urged greater transparency in the CFTC’s Commitment of Traders Report (COT) by distinguishing among the market participants that currently comprise the category of “commercials.” They argue that the current reporting system does not appropriately distinguish between traditional commercial activity and non-traditional commercial activity, such as that involving hedging of commodity index exposure by swap dealers. Questions also have been raised whether the COT report should show professionally managed funds, including hedge funds, as a separate category, rather than include them with other non-commercial traders. On the opposing side, however, are those who argue that greater transparency may come at the cost of compromising the confidentiality of traders' proprietary information.
In the coming months, the CFTC will consider these issues in a deliberative fashion and engage market participants in a public dialogue. We have already heard some ideas on how we might proceed. We look forward to hearing more from you as we move forward.
Implications of Globalization
Let me now turn to globalization, which has played a significant role in the growth of the U.S. futures industry. Globalization is a fact, and it is the future. We operate today on a global platform with technology that makes it possible for futures contracts to be traded anywhere, anytime; for an exchange to offer products and services to traders and customers in multiple jurisdictions; and for contracts to be listed on one exchange and cleared on the other side of the world.
From its earliest years, the CFTC has shaped its cross-border policy based on the notion that globalization is inevitable and has great potential to enhance market depth and competition. Ultimately, we all benefit as more choices are made available to market participants, as competition between exchanges is enhanced, and as the efficient movement of capital across the globe is facilitated.
The CFTC’s cross-border policy is also firmly rooted in the belief that market forces, not government mandates, should determine outcomes. Our role is not to pick the winners and losers but to provide a level playing field for fair and aggressive competition, so that globalization serves as a catalyst for market growth and prosperity, without compromising the integrity and public confidence in the markets.
A good example of this approach is our practice of permitting bona fide foreign markets to maintain direct screen access from the United States. Today, 16 markets from 10 non-U.S. jurisdictions have received such permission, subject to access to books and records, submission to U.S. jurisdiction, and effective information sharing and cooperative surveillance arrangements.
Industry experience to date affirms our judgment. Our forward-leaning approach towards globalization allows U.S. businesses and investors to safely access derivatives markets abroad. In fact, foreign brokers have served U.S. customers in a growing number of jurisdictions, without incident, for more than 15 years. At the same time, the U.S. futures markets continue to prosper, driven in part by global competition. In addition, the CFTC actively engages other regulatory authorities to address their interests so that they can permit U.S. regulated exchanges to compete for business in other jurisdictions, while the foreign regulators appropriately rely on our home market supervision. Globalization, far from being a zero-sum game, expands the playing field and the growth opportunities for all.
Borderless markets, however, also mean erosion of the traditional functional differences between trading on a U.S. exchange and on a foreign board of trade, and give rise to new regulatory complexities. Consider, for example, that with today’s technology, an exchange’s management, trade-matching platform, self-regulatory staff and clearing operations can each be located in different jurisdictions, while the majority of its trading volume comes from still another jurisdiction.
Of course, it is not just the markets that are borderless. We are now seeing situations where the products themselves no longer respect borders. Exchanges with price discovery contracts like the CME, CBOT, NYMEX, and ICE Futures are being challenged by exchanges in other countries listing clones of those dominant contracts, sometime even relying on the original contract’s settlement prices. While national borders and physical separation would probably have doomed this type of strategy in the past, electronic trading has enabled some of these competitive contracts to achieve respectable market shares for themselves. This phenomenon - of trading closely related or fungible products on different exchanges in different countries - is bound to increase over time.
Today’s increasingly global, borderless markets and products raise difficult competitive issues for industry, and equally difficult regulatory issues for the CFTC. In practical effect, the listing of related products in different countries means that transactions executed or cleared on one market potentially can raise market and customer protection concerns on the other market. However, it is possible that no one regulatory authority will have supervisory authority over all key aspects of the market, nor will it have access to all of the information that may be needed to obtain a comprehensive view of what is happening in that market.
The CFTC is determined to address the complicated issues associated with cross-border trading in a deliberate and transparent manner. One thing is clear: It is critically important that the CFTC continue to maintain bilateral and multilateral information sharing arrangements, exchange technical assistance with its counterparts overseas, and participate in international standard-setting bodies.
The goal of cross-border regulation is not to stymie the increased efficiencies that technological developments and globalization have brought to the futures markets. Rather, it is to enable regulators to rely on each other, as appropriate, and effectively share information in order to streamline industry access to cross-border business opportunities, while fully maintaining market and customer protections.
The futures industry has come a long way in the five years since the CFMA was enacted. The principles-based approach codified in the CFMA combined the best forces of the free market with a truly flexible and fair approach to regulation. As a result, we have witnessed unprecedented growth in the amount of money invested, volume, new products, trading platforms, and market participants.
However, the phenomenal progress in the industry, for all its benefits, carries with it new responsibilities and challenges. As the leaders of this industry, we cannot accept the successes flowing from these changes without meeting the resulting challenges as well. The three topics that I have touched on today -- the appropriate self-regulatory model, the growing diversification of the futures customer base, and the increased globalization of the futures markets -- are but illustrative examples of the complex issues that must be confronted head-on as we seek to position the industry for the balance of the decade and beyond.
It has been said that “Honest differences are often a healthy sign of progress.” Welcome to the futures business. By rolling up our sleeves and tackling these thorny issues, the futures industry is poised to make as much progress in the coming years, if not more, as it has in the last five. While we cannot predict the future, we can prepare to meet the challenges it holds. We must do this together and now is the time to start.
Last Updated: April 2, 2007