Remarks of Chairman Heath P. Tarbert on Self-Regulation at Northwestern University’s Brodsky Family JD-MBA Lecture
November 09, 2020
(Chairman Tarbert’s remarks begin at 9:02)
Well thank you so much Steve, and I also want to thank Dean Speta, Dean Cornelli, the Brodsky family, faculty, students, staff, distinguished guests, and visitors. It is a true honor for me to be here today.
Northwestern University is obviously one of the country’s—if not the world's—top schools. In particular the Pritzker School of Law and the Kellogg School of Business are really outstanding. That's an understatement to say, and I can say personally throughout my career I have encountered Northwestern grads, and particularly a law school and business school grads from Northwestern in my private law practice, as a clerk on the U.S. Supreme Court, in the halls of the Treasury, elsewhere in government as well as the private sector, but Northwestern, and again in particular Pritzker and Kellogg, have also played a really important role in the CFTC.
There are a number of graduates that serve not only as staff at the CFTC, but as leaders at the CFTC, so I've included a couple of the different titles that Northwestern grads have at the CFTC: Chief Trial Attorney, a Division Director, Senior Trial Attorney, and there are a number of others as well, and we have we have law school and Kellogg school graduates in most of our offices in Chicago, in New York, and in Washington, so it is particularly wonderful to be here at Northwestern given not only the national and international stellar reputation of both of these schools, but also the close and important connection with my agency.
There's also a close and important connection with, of course, Bill Brodsky and the Brodsky family, so Bill, of course, it's hard to say that this man is not one of the most famous people in the derivatives industry in the United States and throughout the world. He is literally a member of the futures hall of fame. He's not only served as Chief Executive of one of the world's largest exchanges, he served as Chief Executive of two of them—spending 15 years at the Chicago Mercantile Exchange and then another 16 years at the Chicago Board of Options Exchange. He also was the spokesperson for the industry having been Chairman of the World Federation of Exchanges.
I was privileged earlier in my career, 11 years ago, to meet and work with Mr. Brodsky at the Committee on Capital Markets Regulation, and I will tell you that Bill has been one of the greatest advocates for transparency and our derivatives and financial markets, and he left an impression on me so much so that I went on to serve on the Senate Banking Committee staff during the Dodd-Frank Act and focus on greater transparency and then later on, of course now in my current position, I continue to hold those principles and think about Bill's example, so it is a tremendous honor for me to be here, and then of course Bill is not alone.
If we go to the Brodsky family as a whole, and I would say if you're impressed by Bill then you should meet Joan. Joan knows many things, among them is Latin. She taught Latin, she's an expert in library science, and she serves on the boards of a number of national important libraries and conservation facilities, and of course their three sons Michael, Stephen, and Jonathan, who are all with us today, are all Northwestern JD MBA grads, and they have played an important role in the derivatives industry alongside their father. They're shown here in this picture with their lovely spouses. What I'm talking about today is really important because the self-regulation regime that exists in the United States depends on people like the Brodsky’s and thousands of others, and so it is really important that that we honor them and that we honor a number of Northwestern graduates, not only those at the CFTC, but also those that are playing an important role in our system of self-regulation
Since this is an academic lecture, I will ask the question, “What are derivatives?” But the good news is because we're on zoom, I'm not going to use the Socratic method. Well, derivatives are financial products that are valued based on the price movements of an underlying asset, and so derivatives are very unique because the underlying asset can be virtually anything, any commodity, so I like to say that the derivatives markets cover everything from corn to crypto. We literally have derivatives on bushels of corn, we have derivatives on Bitcoin and Ether, and 21st century commodities, and all sorts of stuff in between.
What are the types of derivatives? Just as a refresher, we have futures, which are an agreement to buy or sell something at a future date. We have options, which is not an obligation, but rather a right to buy or sell something at a later date, and we have swaps, which is essentially an exchange of value at various intervals throughout the duration.
But what role do derivatives actually play in our financial system and our economy more generally? Well, they really have two big purposes. The first purpose is a tool for hedging risk. They started a long time ago right there in Chicago where farmers and other people in the agriculture industry wanted to be able to lock in prices at some point in the future when they were to sell their grain, when they were to buy things like milk and things for baking, and all sorts of things having to do with our real economy. Derivatives, just as they did back in the day and just as they do at this very moment, allow people in our real economy to hedge risk. It's a way of transferring and mitigating risk, but the derivatives market also plays another critical role, and that's that by virtue of them existing alongside the underlying markets, which we call the cash markets, derivatives play a price formation role in the real economy. The price that you pay for groceries in the grocery store, the amount that you pay on your home mortgage, for example, and the price that you pay for gas at the gas station—all of those are affected by the trading in the derivatives markets, and in some cases, they're determined by those markets.
So, there's a really critical role that the derivatives markets play with respect to the underlying economy, and that role is also evidenced by the magnitude of derivatives. When you look at the notional amount of the U.S. derivatives markets, it amounts to 300 trillion dollars, keeping in mind that U.S. GDP is somewhere between 20 and 21 trillion dollars, so they literally are the largest financial markets in the world.
So what about me talking about the CFTC? What is the CFTC? Well I like to say, given the fact that we just mentioned the magnitude of the derivative markets, we are the regulator of the derivatives markets, and as a result we may very well be the most important financial regulator you've never heard of. We have more than 700 employees across four offices, but we also have 300 contractors, so we have about a thousand people strong and our mission is to promote the integrity, resilience, and vibrancy of U.S. derivatives markets through sound regulation. But, of course, a thousand people in four offices can do a lot, but we can't do everything, and that's one of the key takeaways of this lecture. Our system of regulation works and works well because we don't act alone. Self-regulation helps us regulate these markets.
So what is self-regulation? Well, it's industry-based regulation operating under government oversight and there are a series of self-regulatory organizations in the derivative space. First of all, there's something called the National Futures Association. The National Futures Association, or NFA, many of whom are watching this and our Northwestern graduates, basically is an organization where all the market participants sign up to participate and they're regulated and examined accordingly, but it's more than just the NFA. Every single exchange is itself a self-regulatory organization because there's members of the exchange, and that's where the trading takes place, and the clearing houses where basically the financial risk is mitigated of those trades, they are also self-regulatory organizations as well, and there are a series of clearing members that are members of that. So again, talking about the magnitude, NFA reports over 3,000 member firms and over 46,000 individual associate members and one of the ways to think about this one analogy, if you will, it's not perfect but I think it does shed some light on it, is to think about it in this way: you've got the federal government, which is like the CFTC, and then you've got a self-regulatory regime of the NFA of exchanges and clearinghouses that are sort of like the states, and so we have this dual system where we have regulation at each level.
One of the things I want to hopefully demonstrate today, and I do so in the longer article that Steve mentioned, is that this is really a way to get to sound regulation, that the two of these systems work together, traditional government regulation alongside self-regulation. To give you a glimpse of that article today, I want to briefly talk about the advantages of self-regulation, the role of government in buttressing that regime, and then I'm going to end with a real-life example of how it all works.
First of all, the advantages of self-regulation. Well, first and foremost are cost and financing. Self-regulatory organizations are member-funded, which means all of us who are on here, most of us at least, are U.S. taxpayers, so we actually don't pay a dime for self-regulation. The market participants themselves do. Secondly, SROs avoid the appropriations process, and that's really important because when your appropriations for a regulator are subject to budgets, to larger political questions, to members of Congress having to vote for it, oftentimes you end up with uneven funding and uncertainty. The fact that the SROs are able to have budgets that are apart from the political climate is really important and offers sound regulation.
Secondly, expertise. Well, these individuals that are in the SROs are much closer to the pulse of the market than the government regulators are, and if you think about it, the exchange in fact is the market. So the exchange is right there, it's seeing everything in real time, it's incredibly important. The other thing is that we rely on self-regulators because they're close to the market to propose to us regulations, so there's an ongoing dialogue between the CFTC and NFA and the various exchanges as to what they're seeing in the markets and whether there needs to be government regulations.
The third major advantage is trust. If you think about it, if you're members of the self-regulatory organization, you have sort of an automatic degree of buy-in that let's say you don't have if you're a government agency headquartered in Washington, and there's a suspicion that some of the decisions you make may be subject to political and other considerations, and I would say that there's a trust factor there with the SRO, and that trust factor also directly relates to incentives for compliance. If you're a member of an SRO, you want the other members to play by the rules, and there's an incentive to comply there that arguably is additional from traditional government regulation.
Fourth, speed and flexibility. This is really important. Many of you, particularly those of you in the Pritzker school of Law, have studied the Administrative Procedure Act and government rulemaking. Well, it takes a long time in part because there are public comments that need to be considered, there are a number of procedural protections that make sure the government does its job and does it thoroughly, but of course the disadvantage of that is it takes an immense amount of time. I've been able to move a number of rules through the CFTC during my tenure, but even for things that are relatively simple, it'll often take when you start initially putting pen to paper about a year to get something from an initial draft into a final regulation. Self-regulatory organizations can move far quicker than that.
They also have expertise in dealing with enforcement. That’s really important there, and if you think about it, SROs have the ultimate sanction, which is you get thrown out of the SRO. If you are a member firm of an exchange and you have been for 30 years, the last thing you want is to be ejected from the exchange, so there's a really important enforcement tool there that self-regulatory bodies have. It also reduces the cost for the CFTC. We can go out and we can pursue maybe some tougher cases with the FBI, with others outside the United States if we know that a number of the infractions are being dealt with directly by the SROs. Then, finally, the SROs allow the CFTC to collaborate. We have an outstanding investigatory team at the CFTC, but we don't spot everything, and more often than not many things are spotted by the exchanges. They're spotted by the NFA or they're spotted by clearinghouses and referred to the CFTC.
What I’ll ask is, with all of these advantages, why on earth would we have the government involved with regulating our derivatives markets? Well, they say that a picture is worth a thousand words and the simple answer is that we need to ensure that responsible self-regulation doesn't turn into the proverbial situation of the fox guarding the hen house. In other words, we want to make sure that the SROs continue to work on behalf of the American people and the American public, and not just industry interests, and this in my view is where government can play a constructive role.
So how do we do that? Well, the role of the CFTC is essentially, as the SROs regulate and supervise their members, the CFTC regulates and supervises the SROs themselves. This provides accountability, it preserves trust in the SRO system, and it avoids conflicts of interest where there is an inherent conflict: that's when the CFTC can step in and sort it out. Here are a couple of examples of that. For SROs registration rules and, in particular for example, the National Futures Association, the rule is that they need to have rules and regulations that are at least as stringent as those of the CFTC, so anytime they propose a new rule or regulation, the CFTC effectively reviews and approves those regulations.
The CFTC also has a series of core principles that both emanate from our statute, the Commodity Exchange Act, but also from our regulations that lay out and say “these are the core principles that every exchange, for example or every clearinghouse, must comply with” and then we review on an annual basis, if not more frequently, compliance with those core principles, and that ensures the accountability that I mentioned.
The biggest role that the CFTC plays in the self-regulatory system is essentially the supervisor and regulation of the SROs, but we also play a number of additional roles as well, roles that the SROs themselves can't play. So, for example, administrative law functions. Only the CFTC can authoritatively interpret statutes written by congress. Only the CFTC can also issue relief from rules and regulations, as well as laws by congress. We have no action authority that non-governmental SROs simply don't have. Another— hearkening back to that analogy I mentioned before between the federal government and the states—if you think about the U.S. Constitution of course, states are prohibited from entering into foreign treaties. Only the national government can do that. Well, when you think about international harmonization, our derivatives markets are by their very nature global, and so we're constantly dealing with other countries, with other regulators, whether they be market regulators or central banks. Only the CFTC can essentially sign into legally binding obligations and agreements. Only the CFTC can make determinations that, for example, another country's regime is the equivalent of our regime, and so the CFTC essentially steps in at the international realm working with both the exchanges as well as NFA and other self-regulatory bodies to make that happen.
The other unique feature about the CFTC is that, is that unlike an exchange or a specific clearinghouse, we are looking at the entire market and we are looking at systemic risk, for example. One of the things we do is we actually examine the clearinghouses, and two of our clearinghouses in the United States have been declared by the United States government to be systemically important. So, in particular, the government regulates and supervises the clearinghouses themselves consistent with what I said [earlier].
Finally, there are a number of individuals that are in our markets, thousands of them in fact that are not actually members of SROs, so someone has to think about how to handle those and to the extent they perpetrate fraud and manipulation. Again, if they're not a member of the SRO, the SRO has a little recourse. That's where the CFTC steps in.
At the end of the day, it's about finding the right balance. I would say if I leave you to today with one thing, it's the important point that there’s not a false dichotomy. It's not as if we can just have self-regulation on the one hand or we can just have government regulation on the other hand. The real key is finding a way to blend the two in an optimal way looking at those advantages that I outlined in the previous slides about what makes self-regulation so dynamic and so important and so effective, but also understanding their limitations.
This isn't just simply a theory, but this is actually evidenced by decades of success, and so let me finally end my comments with an example with the COVID-19 response. Many of you may not know this, but the volatility that we saw in our derivatives markets in March in relation to COVID-19, its spread, and essentially the shutdown or pause of the global economy, that volatility went far beyond the volatility that we even saw during the 2008 financial crisis, so this was really critical that we work together both the financial regulators in the United States as well as those around the world, but also the CFTC with the derivatives markets self-regulatory organizations to essentially make sure that the biggest economic and health crisis of the last century did not turn into the biggest financial crisis, and we did that by using a number of different aspects.
First of all, formal coordination and data sharing. We saw different things. The SROs were clearly closest to the market participants so they could tell us what was going on, they could tell us whether clearing members weren't meeting margin calls, whether there were problems with customers, whether market makers had the requisite liquidity to stay in the markets, for example. The CFTC on the other hand, we were talking to the Federal Reserve, we were talking to the U.S. Treasury, we were understanding what was going on more broadly, and we were talking to our foreign counterparts to understand what markets were doing in other countries that could affect our own markets, and we were able to share all that information to come up with a coordinated response. Volatility in systemic risk management was absolutely critical.
Margin and clearinghouses stand at the very center of our system and literally every day, several times a day, we would be calling the clearinghouses asking whether people made their margin calls. If you think about it, during this crisis, the derivatives markets played a critical role in not being amplifiers of systemic risk, which some could argue they did-at least the uncleared, non-regulated markets back before 2008-but in this crisis the derivatives markets were actually shock absorbers for systemic risk. At a time when the U.S. economy, as well as millions of people around the world needed to lay off risk, they went to the derivatives markets and we kept our markets orderly and liquid.
We did all of this while people were engaged in the new reality, in what we're doing right now—social distancing. We had never thought about how do people trade from home. It wasn't something that we had really thought about, but by working with NFA, by working with the exchanges and the clearinghouses, we were able to make social distancing work in a way that didn't shut down the markets. Business continuity plans by market participants were absolutely critical and they indicated to us, the CFTC, as I mentioned before, we're the only ones that can issue letters saying, “Yes that's technically what the law says or what the regulation says, but given the circumstances we're going to relieve you of that.”
So, for example, voice recordings are something that are critical in regular times to be able to understand when the trade has been made—who made the trade, etc.—but the systems weren't set up for people trading from home. We didn't want trading to stop when we needed it the most, so we were able to do temporary targeted relief from some of the regular rules and regulations so the markets could become orderly and liquid, and ultimately, market resilience. We knew that was what Congress wanted to focus on at that time as opposed to all the little nitty rules and regulations, so we were able to give that targeted relief. But in order to figure out what should we be doing, we relied heavily on the SROs and their members for recommendations.
I will leave you today with what I think is a bottom line and that's that the U.S. system of derivatives and our derivatives markets are really the world's global standard. I would argue there are many reasons for that. The fact that we have the United States, the system of laws, all the things that you learn in law school, and all the things that you learn in business school but I would also add that our unique system of self-regulation alongside of government regulation really is a powerful way to ensure that our markets remain resilient, that they have integrity but at the same time they're vibrant, and so people can rely on our markets and say they're soundly regulated because we have this very unique blend of self-regulation and government regulation. With that, I will conclude my remarks. Thank you.