Statement on Manufactured Credit Events by CFTC Divisions of Clearing and Risk, Market Oversight, and Swap Dealer and Intermediary Oversight

April 24, 2018
 
Washington, DC — The Commodity Futures Trading Commission (CFTC) Divisions of Clearing and Risk, Market Oversight, and Swap Dealer and Intermediary Oversight today issued the following statement regarding manufactured credit events in connection with credit default swaps (CDS):
 
"The CDS market functions based on the premise that firms referenced in CDS contracts seek to avoid defaults, and as a result, the instruments are priced based on the financial health of the reference entity.  However, recent arrangements appear to involve intentional, or ‘manufactured,’ credit events that could call that premise into question. In a public statement dated April 11, 2018, the International Swaps and Derivatives Association’s (ISDA) board of directors criticized manufactured credit events, writing that they ‘could negatively impact the efficiency, reliability, and fairness of the overall CDS market,’ and ISDA’s board indicated that it advised its staff ‘to consult with market participants and advise the Board on whether...amendments to the ISDA Credit Derivatives Definitions should be considered’ to address manufactured credit events.     
 
"Manufactured credit events may constitute market manipulation and may severely damage the integrity of the CDS markets, including markets for CDS index products, and the financial industry’s use of CDS valuations to assess the health of CDS reference entities.  This would affect entities that the  CFTC is responsible for overseeing, including dealers, traders, trading platforms, clearing houses, and market participants who rely on CDS to hedge risk. Market participants and their advisors are advised that in instances of manufactured credit events, the Divisions will carefully consider all available actions to help ensure market integrity and combat manipulation or fraud involving CDS, in coordination with our regulatory counterparts, when appropriate.”

Remarks of Chairman J. Christopher Giancarlo before the Sims Lecture At Vanderbilt Law School, Nashville, Tennessee

Derivatives Regulatory Reform: A Principles-based Software Upgrade

April 13, 2018

Thank you.  Good afternoon.

I thank Dean Guthrie and the faculty of Vanderbilt Law School.

I especially thank the Sims family for their continued commitment to the lecture series and to the law school.  The Cecil Sims Lectures are important.  They are followed closely by legal practitioners and scholars the world over.

When I left these Vanderbilt halls thirty-four years ago, I never dreamed that I would be asked back to give the Sims Lecture.  It is a profound privilege and I am humbled by it.

Thank you for inviting me here.  This law school continues to earn national prominence based on its principles-based education and breadth of scholarship.  I am impressed with its forward looking curriculum, including its new program on law and innovation, preparing lawyers for a digital 21st Century.  That is part of what I want to talk to you about today.

Introduction: A Lifetime of Change

First, a word about Cecil Sims.  He was born in 1893, two generations removed from the Civil War. He grew up when the past still had a strong hold on the South.  Upon graduation as valedictorian from Vanderbilt Law School at age 19, and admission to the bar in 1914, he joined the Army and the First World War.  At his death in 1968, he had lived through vast changes in the South and in the world, through the Second World War, Korea, and Vietnam.  A year after he died, Neil Armstrong stepped on the moon.

Cecil Sims saw a rapidly changing world in culture, communication, technology and much more.  He also the law itself change, evolve, reflect the changing needs of society and the pace of technological evolution.

In 1957, Mr. Sims wrote a visionary article for the American Bar Association Journal.  The title was “Lawyers and the Classics:  The Spreading Technological Illiteracy.”  He argued that lawyers need a far-ranging education that included the law and information technology, but also history, classics, philosophy and more.[1]

Why?  So a lawyer would assume his or her place as an “architect in public affairs.”[2]  Let’s explore some public policy architecture that Mr. Sims would consider if he were with us today.

What impact do the transformational power of digital technology and the accompanying social evolution have on:

• The adaptability of law and regulation for changing modes of trade and commerce,
• The work of traditionally principles-based agencies like the US Commodity Futures Trading Commission, and
• The relevance of a principles-based approach to legal education that Cecil Sims received and is present today at this law school?

I want to address these questions this afternoon.

The pace of technological change in the course of my own professional career has been stunning.  At age twenty-one, I was employed for several months during the first term of Margaret Thatcher’s British government as a researcher for Sir Ronald Bell, MP.[3]  I wrote research reports outside his office on a manual typewriter.  He forbid use of the new memory typewriters, telling me that “word processing will allow governments to snuff out liberty through thousands of pages of legislation that no one will ever read.”

Alas, time and technology marched on.  When I left Vanderbilt for a Wall Street law firm in 1984, the technology that was changing the practice of law was Federal Express that compressed the legal process into overnight hours.  In the thirty-five years since, digital communications technology has pinched the timeframe into milliseconds.

The Digitization of Financial Markets

So much of our world today – from information to journalism, to music to manufacturing to transportation to commerce to agriculture, even legal services – is undergoing a digital transformation.[4]

It should be no surprise then that our financial markets are going through the same digital revolution.  In my thirty years practicing law and in business operating derivatives trading platforms, and now four years as a market regulator, I have seen how emerging technologies are impacting trading markets and the entire financial landscape with far ranging implications for capital formation and risk transfer.  They include machine learning and artificial intelligence, algorithm-based trading, data analytics, “smart” contracts valuing themselves and calculating payments in real-time, and distributed ledger technologies that may profoundly disrupt traditional market infrastructure. These technologies are reshaping the world around us.  It is no surprise that they are having an equally transformative impact on commercial law, with some of the best new scholarship coming out of this law school.[5]

Yet, technology may be having an even more fundamental change – a cultural one.  Two months ago, I was called to testify before the Senate Banking Committee alongside SEC Chairman Jay Clayton.  The topic was virtual currencies.

As you might expect, I first submitted an extensive forty-page written testimony including attachments and detailed footnotes.[6]  I was up to speed on the issue because our agency, the CFTC, had spent much time grappling with the recently self-certified launch of Bitcoin futures by two of our registered futures exchanges.[7]

Yet, in the weekend before the hearing, I reflected on conversations about Bitcoin I had participated in during our New Year’s ski vacation with my kids, nieces and nephews - all Millennials and GenZers.  I spent time online reading blogs and watching videos about virtual currencies.  The more I watched, the more I saw that the energy and momentum behind virtual currencies was not just driven by technological innovation.  There was something else going on – something cultural.

I decided to use my opening oral remarks at the Senate hearing to make a point.  Let me take you to Capitol Hill.  I began with the following statement:

As I then returned to my formal remarks, something remarkable happened: my Twitter account exploded, gaining thousands of followers in minutes and over 40,000 in the next few days.  My remarks were celebrated by virtual currency fans around the globe, who devised clever memes like “#CryptoDad and #FUDBuster[8] and photo shopped my likeness into dozens of online images and videos.

I neither expected nor desired that a few words spoken during a Senate hearing broadcast on C-SPAN would lead to an Andy Warhol “fifteen minutes of fame.”

Nor was I – or am I – a virtual currency evangelist.

Technology as Agent of Social Change

The cryptocurrency universe sadly contains a large share of get rich quick schemers, shady entrepreneurs and transactions in illegal goods.[9]  It also appears to have a growing contingent of professional, institutional users.[10]  Yet, it is also favored by advocates for the poor and unbanked, libertarians, pacifists, Occupy Wall Streeters, earnest tech geeks, economics buffs, long-term investors and many, perhaps naïve, but well-meaning young people.[11]

What I had acknowledged at that Senate hearing is the existence of a community that views technology as an agent of social change.  Many of them have come of age during the 2008 financial crisis - the same crisis to which Bitcoin had emerged in response.[12]  They have lost faith in the leadership that presided over that mess, in the same way that that fifty years ago the Baby Boomers lost faith in their parents’ leadership of wars over civil rights and Vietnam.  They have also lost faith in traditional news media that more often lampoons their interest in technology than tries to understand it.

Cecil Sims said we should look for “parallels in history.”[13]  Here parallels are evident.  Just as the Baby Boomer generation strove to change the world through social change – sex, drugs, and rock n’ roll.  The new generation of Millennials and GenZ sees generational change driven by technological disintermediation of distrusted institutions.  They see virtual currency – along with social media - as a means to bypass control by a failed generation of leadership.

How much of our political and social institutions have lost the faith of these new generations?  Will they also lose faith in enduring principles of law – the same principles taught here at Vanderbilt.   How does market regulation accommodate such profound generational and technological change?

A Principles-Based Approach to Market Regulation

A quick word about the CFTC that I have the privilege to chair.  It was founded as an independent agency in 1975.  It is composed of 5 commissioners, chosen by the President and confirmed by the Senate.  No more than three of the five Commissioners can be of the same political party as the President.  It has close to seven hundred career staff.  The CFTC regulates markets for derivatives trading, such as exchange traded futures and options on oil, natural gas, wheat, corn, gold, silver, and other commodities.  It also oversees some of the world’s largest financial markets in listed futures and over-the-counter swaps on rates of interest, credit default, and foreign exchange.  For the most part, these are markets for commercial risk transfer and institutional trading.

Historically, the CFTC has been a principles based regulator relying on clearly stated principles and outcome-focused, high-level precepts to achieve desired regulatory outcomes, rather than compliance with detailed and prescriptive rules.[14]  The agency began to stray from that approach in some of its implementation of swaps market reforms under the Dodd-Frank Act (Dodd-Frank). [15]

I believe the CFTC must reaffirm its historic character as a principles-based regulator.  The relentless advance of technology and evolution of market structure requires a flexible, principles-based approach to oversight of some of the world’s most dynamic commodity and financial derivatives markets,

When it comes to the challenge of crypto, it is clear that our governing statutes were not designed for this technology.  The CFTC’s governing law, the Commodity Exchange Act (CEA)[16], was first passed in 1936 and has been amended several times since then.  Unsurprisingly, it contains no reference to virtual currencies.  It is like an old computer operating system that struggles to support this new and complex application.  In the absence of a legislative update, existing law and regulation must be interpreted on the basis of core principles to keep pace with technological change.

The Regulation Development Lifecycle

Let me now turn to a broader challenge for principles-based regulation: the continuous process of reviewing, updating and optimizing policy applications amidst constant market evolution and technological change.  Specifically, I want to talk about ongoing steps to improve the CFTC’s initial implementation of swaps market reforms under Dodd-Frank.

We now have more than four years of U.S. experience with the CFTC’s initial swaps reform and their varied strengths and shortcomings.  Four years provides a statistically significant sample size, if not a long period of history, to evaluate the effects of these reforms and their implementation.  Based on that experience, we can now consider ways to better implement Congressional reforms and optimize achievement of the goals of the Pittsburgh Summit.

Why should regulators improve and optimize their rule frameworks?  Well, let’s consider the evolution of computer software.

The modern software industry is built upon a range of common methodologies and developmental frameworks, such as the software development life cycle, the purpose of which is to preserve the value of software over the time.  That value can be enhanced by addressing flaws, enhancing functions, meeting additional requirements, becoming easier to use, more efficient, accommodating newer technology and expanding the user base.

In many ways, regulatory frameworks are like software applications.  They are a set of rules and algorithms that direct action to certain desired ends.  Often, they guide behavior toward a range of functions, tasks or activities determined to be in the public interest.

Regulatory frameworks also have a development cycle.  In the United States context, the cycle begins with Congressional passage of an authorizing statute.  Then, it advances through regulatory agency action subject to relevant administrative procedural requirements, including public input and comment.

The maintenance stage is in the hands of regulatory agencies, which gather data and empirical information and can propose rule changes or provide rule relief as appropriate.  Their task is also to preserve the value of the core regulatory framework over time.  The value can be enhanced by expanding the user base, meeting additional requirements, improving features, clarifying terms of use and increasing efficiency.  In the case of some regulatory frameworks, for example CFTC’s authorizing statute, the maintenance process is entering its eighty-third year.

Like software users, market participants will always look to participate in well-designed, regulatory frameworks.  Trading counterparties seek neither the least nor the most regulated marketplaces, but market places that have the right balance of sensible, objective and well-maintained regulation – in other words: good software.  It is in the interest of the United States to achieve such balance.

Financial regulators have a duty to apply the policy prescriptions of their legislators in ways that enhance markets and their underlying vibrancy, diversity and resiliency.  That duty also includes the responsibility to continuously review past policy applications to confirm they remain optimized for the purposes intended. It means adopting a forward-looking approach that considers the impact of technological innovation and anticipates changing market dynamics.

Similarly, futures exchanges should continuously review and refresh their futures products.  That means a continuous process of reviewing contract design and market conditions and taking affirmative steps to foster trading liquidity, enhance price convergence and deter fraud and manipulation.  It is in the interest of the United States that US Dollar-denominated markets for commodity futures remain deep, liquid, well-functioning, diversified and globally competitive.  The CFTC has an important role in supporting that vital national interest.[17]

Swaps Reform Version 2.0

The CFTC has been a consistent leader amongst regulators of the world’s major swaps and derivatives markets in enacting effective regulation and oversight.  It was the first and it remains the most successful implementing body of the core G20 swaps reform here and abroad.

The CFTC remains fully committed to the cause of swaps market reform.  That commitment includes a responsibility to pursue improvements to the CFTC version 1.0 swaps regulations that enhance market health and safety while respecting the spirit of global swaps reform and the law embodied in the Dodd-Frank Act.  Yet, within that commitment, we must also incorporate lessons from the CFTC’s initial reform efforts into a new and improved framework:  “Swaps Reform Version 2.0”.  This is something that I will talk further about in the weeks to come.

Conclusion

In drawing to a close, I want to address the question I asked earlier: how do we accommodate profound technological and generational change?

As CFTC Chairman, I believe the transformational power of technology and the social evolution that accompanies it necessitates the adaptability of law and regulation for changing modes of trade and commerce.  I believe that the CFTC, as regulator of the world’s largest and most dynamic commodity and financial derivatives markets must continue its historic character as a principles-based regulator.  That includes continuously reviewing past policy applications, including the CFTC’s initial Dodd-Frank reform implementation, to confirm that it remains optimized for the purposes intended.

This is how a principles-based regulatory approach guides our response to market and technology evolution.  It is part of the CFTC’s historic DNA.  It is part of keeping faith with new generation of market participants.  And it is part of keeping market regulation and oversight alive and vital.

And, yes, I believe a principles-based education is the right course for a life in the law, just as it was for Cecil Sims.  This has been my experience as a Vanderbilt lawyer through a career spent amidst rapid technological change.

Seventy years ago, in a similar setting, Judge Learned Hand gave the Holmes Lecture at Harvard Law School.   As a graduate of Harvard, he thanked the school and its faculty for making his legal career possible.  He said, “The memory of those (teachers) has been with me ever since.  Again and again they have helped me.”

He then paused, looked over the audience, as said “Go ye and do likewise.”[18]

Tonight, as a graduate of Vanderbilt Law School, I echo those words.  And memories of many extraordinary Vandy professors, who encouraged me to look to the future while drawing on enduring principles from the past.

That is the task for each one of us, as graduates and as professionals.  We must never live in fear.  Rather, we must be a constant reminder of the best in the law: truth, intellectual rigor and courage to adapt to a changing world on the foundation of a principles-based education.

Cecil Sims understood that.  And, each year, the Sims lecture reminds us of his legacy and that of Vanderbilt Law School.

Thank you.

Remarks of Chairman J. Christopher Giancarlo for the Jacobson Global Lecture at Concordia College, Bronxville, New York

“Financial Market Regulation: A Moral Framework”[1]

April 9, 2018

Thank you and good evening.  It is an honor to come here, to Concordia.  This is a great school with sound scholarship, a spiritual tradition, and passionate, outstanding students.  Your emphasis on individual responsibility, the liberal arts, science and public service makes Concordia an exciting, inspirational seat of learning.

It is also a privilege to be the latest lecturer in this distinguished series named for the late David Jacobson, provost and legendary professor of philosophy.[2]  His memory remains; his influence lingers.

Tonight, in honor of Dr. Jacobson, we turn to a philosopher he knew well:  John Stuart Mill, the proponent of act utilitarianism, which is to do that act which will create the greatest amount of happiness for the greatest number.[3]  Dr. Jacobson had much to say about Mill and utilitarianism … more about that later.

Mill had a virtually unknown side:  his employment by the East India Company.  Two hundred years ago, one of the most extensive and profitable concerns was the East India Company, headquartered in London.[4]  The company was involved in commerce, trade, developing markets, and territorial acquisition throughout the world, with most of its trade focused on the Indian sub-continent.  The company was multinational, powerful and global - long before globalization was even a concept.[5]

The East India Company was a closed private corporation, controlled by a small, select few, selling stock only to its own chartered members.  Yet, the company also advanced official British interests, to the point where the interests of Britain and company shareholders were often one and the same.  The British government followed the East India Company into India.  Not coincidently, the East India Company was granted exclusivity (monopoly) to its markets, and, control and oversight.  They were labeled by one historian as “both regulatory body and sole operator,”[6] overseeing markets for their trade, and having a virtual monopoly over them.

Their corporate structure was, in the words that that same historian (John Keay), “a half-way stage in the evolution of the medieval guild into today’s public limited company.”[7]

In short, because of its profitability and contribution to the economy through trade and taxation, the East India Company was both private and public, a business and quasi-governmental, and often unaccountable to anyone other than itself.  You may know some of its infamous history, which included some of the worst excesses of imperialism and conquest.  And, I repeat, it was self-regulating over its own empire.  It is of interest to me because the trade involved commodities and the use of futures, long before we used that name.

In 1823, John Stuart Mill joined the company and was employed there until 1858, 35 years.  While much has been written about his work on utilitarianism developing the ideas of his father, James Mill, and Jeremy Bentham, almost nothing has been written about John Stuart Mill’s time at the East Indian Company.  While there, he became one of the foremost voices for economic and judicial reform, women’s rights, and universal suffrage.  But, Mill the businessman, Mill the market regulator, Mill the man of empire, remains virtually unknown.

Think of the possibilities.  What if philosophers ran Fortune 500 companies, regulatory agencies, or central banks?  Imagine if Socrates had conducted internal audit at Goldman Sachs or Simone de Beauvoir was a governor of the Federal Reserve.  What if St. Thomas Aquinas had my job at the CFTC?

Well, the philosopher John Stuart Mill had a job like that.  He handled external communications for one of the 19th Century’s most powerful business enterprises, allowing him the opportunity to influence decisions through the utilitarian calculation in his writing.

I mention Mill for two reasons:  he brought philosophy to his work and that philosophy was an inconsistent check on the exploitation of native populations, and sometimes surprisingly consistent, with market needs, profitability, wealth creation, trade, and other actions that brought the greatest good to the greatest number of people.

Philosophy matters, and as Dr. Jacobson reminded us, there are more than one theory of ethics, such as Platonic forms, ethics in the Old Testament, Stoicism, Christian ethics, the Categorical Imperative, Moore’s goodness as self-evident simples, Marxism, social justice, justice as fairness, liberation theology, community norms, and relativism, among others.  Especially in government.[8]  And, Dr. Jacobson asked to apply those ethics, to make the world better through our decisions and actions.  Or, as another philosopher much read on this campus, Reinhold Niebuhr, called it: “political wisdom.”[9]

As a lawyer, former business executive and, now a regulator, I find fascinating the scope of activities of the East India Company.  A business should not serve the role of government in the way it did.  The work of the East India Company will always be haunted by secrecy, greed, unseemly enrichment, and, ultimately, failure, closing its doors in 1874.  We have also learned over time that regulators should not run the very businesses they are regulating nor be captured by them.  It is appropriate that there be a proper zone of separation between business and government.[10]

Speaking of government, in the United States, we often concentrate on the President, the Congress, and the courts.  There is more to government.  For example, we have administrative agencies to regulate commercial activity, starting in the late 1800s with the creation of the Interstate Commerce Commission. The agencies prescribe what may or may not be done, determine whether the law has been violated in particular cases, and proceed against violators, to impose fines, or other actions.  These types of agencies are called regulatory agencies because they deal with the private rights of individuals and regulate the manner in which those rights may be exercised.  These agencies have been delegated both legislative and judicial powers. They often have power over licensing, ratemaking, business practices, and other activities.[11]

And then there are those agencies that exist outside the federal executive departments and are considered independent agencies because the president's power to dismiss the agency head or commissioners is limited.  The independent structure is designed to insulate the agency from the political winds that sweep over Washington.  The most well-known independent agencies are the Federal Reserve Board, the Securities and Exchange Commission, and the Federal Communications Commission.

In my case, I am Chairman of a less well known independent Federal agency, the Commodity Futures Trading Commission (known as the CFTC).  The CFTC was established to be a legal and moral authority over markets that would counter expediency or short-sighted politics.  We operate under the Commodity Exchange Act (CEA)[12] that was originally passed in 1936.  The law has been amended several times since then. The CEA establishes the statutory framework under which the CFTC operates, both judicial and legislative.

The CFTC is composed of 5 commissioners, chosen by the President and confirmed by the Senate.  No more than three of the five Commissioners can be of the same political party as the President.  The Commission is a creation of Congress, which has delegated power to us.  The delegation was necessary because the markets are so large, vast, and ever-changing that close scrutiny is necessary.  Congress does not have the time for daily oversight of these markets.  So, authority was delegated to us.

The CFTC has close to seven hundred career staff.  It regulates markets for derivatives trading, such as exchange traded futures and options on wheat, corn, gold, silver, oil, natural gas and other commodities.  It also oversees some of the world’s largest financial markets in listed futures and over-the-counter swaps on rates of interest, credit default and foreign exchange.  The CFTC has been in the news lately because of its regulation of new futures contracts on Bitcoin.  You may have read about that.

Tonight, I have been asked to talk about a moral approach to market regulation.  Like Mill, market regulators bring moral frameworks to our work.  Of course, that work must proceed within the limits set by the Constitution, our governing statute, US administrative law, the Congress and the Courts.  But within those foundation stones, there is scope for regulator discretion and judgment.  That is the terrain that I want to explore with you this evening.

I am not unique in being a great grandchild of humble Europeans who immigrated to the United States in search of economic opportunity.  They prospered in America’s private sector-driven market economy with its free market economic incentives and emphasis on fiscal responsibility.  They embraced and contributed to America’s pluralist culture, representative democracy and rule of law.  They absorbed and instilled in me these enlightened economic, social and political values.

Together, these values make up what is known as democratic capitalism, a system that is a proven success. It is not a matter of opinion, but a matter of economic fact, that everywhere there are free and competitive markets, combined with free enterprise, personal choice, voluntary exchange and legal protection of person and property, you will find the underpinnings of broad and sustained prosperity and human advancement.[13]

I have on my desk a valuable volume titled “The Spirit of Democratic Capitalism” by the theologian Michal Novak.[14]  He argues that “Of all the systems of political economy which have shaped our history, none has so revolutionized ordinary expectations of human life – lengthen the life span, made the elimination of poverty and famine thinkable, enlarged the range of human choice – as democratic capitalism.”[15]

Let’s borrow Novak’s title to examine an ethical approach to regulatory power over financial markets based on these advanced economic, social and political values.  Let’s think in terms of that spirit.  Let’s think of market regulation as something more than an approach to economics, but a set of moral injunctions.  In other words, there is a moral content – moral necessity -- to democratic capitalism.

The first is the Golden Rule.  There is a reason that C.S. Lewis said that the Golden Rule appears in every great civilization….it is the foundation for civilization.[16]

We should treat each other in the marketplace with the respect and regard we want for ourselves, with business practices that we want for ourselves.  It is also how market regulators must treat market participants.  It is how market participants must respond to regulation.

Second, market regulation in the spirit of democratic capitalism respects the exercise of civil freedom, the foundation of our constitutional republic.  We each have inalienable rights.  Life, liberty, and the pursuit of happiness are about the freedom of the individual – not just his or her moral and political freedom, but economic freedom, as well.  This is the “freedom of creative choice”[17] that allows the individual to live a life and pursue work of his or her choosing, not chosen by government.

Accordingly, market regulators must not limit economic freedom without serious justification.  In fact, regulators swear an oath to support and defend the US Constitution and its limited powers in the Bill of Rights, including the Tenth Amendment’s reservation of rights to the states and the people.[18]  Accordingly, market regulators are duty bound to protect Constitutional freedoms and civil liberty including economic and market activity.

Third, free markets provide exercise for our civil freedoms. Free markets encourage innovation, productivity, job creation, better health and progress.  But this freedom is not unlimited.  It cannot be used to create monopoly, defraud others, manipulate markets or engage in other actions that ultimately undermine free markets.  Free markets must not be exploited in ways that can destroy those same free markets.

That is where market regulators come in.  Their mission in the spirit of democratic capitalism is to prevent such exploitation.  They do so by placing reasonable limits on market activity.  Yet, any limitation on free markets must be carefully calibrated to apply to those activities that degrade free markets, without constraining those that enhance them.  Distinguishing the two must be based on careful, data driven econometric analysis and not anecdote and political expediency.

As a general approach, good regulation must solve for demonstrable problems, not mere incidents of bad behavior; rely on solid evidence, not assumptions; represent an optimal approach among alternative courses of action; measure success through rigorous econometric analysis; and advance innovation and competition through flexible and technology-neutral rule frameworks.

Fourth, market regulation in the spirit of democratic capitalism also encourages professionalism.  Qualifications matter.  Job-holders must be prepared for their jobs.  Accordingly, market regulation should encourage high standards of market conduct and behavior.  At the same time, regulatory agencies must have funding adequate to fulfill their missions.  It is a matter of public trust.  It is the essence of a politics of trust.

I have to share something with you…I work with some very brilliant, talented people in the Federal government.  They are a credit to the nation.  It is too easy today to mock government employees as underworked and overpaid and out of touch with the concerns of ordinary Americans.  Well, I spent 30 years in the private sector and the past four in the Federal government.  Let me tell you, my CFTC colleagues serve this nation earnestly and well.  They are professionals.  They bring expertise, intelligence and commitment to complex markets in the global economy.  They are proof that American public service remains a noble calling, worth a young person’s consideration.

Fifth, democratic capitalism treats individuals as important, by themselves and for themselves.  I want to add something from Mill.  In several places he talks about human “dignity.”[19]  I think he may have been the first to bring attention to this topic.  Markets should not exploit a worker or trader or participant.  Human dignity must be protected, not forgotten, in our regulatory efforts.  In other words, people matter and, are not a number, a category, a file or a social media account.  Far too much of today’s media saturated, on-line world dehumanizes us, takes away our dignity.  In a world of seven billion people, each one is a unique, singular person, and must be treated that way.

And, human dignity encourages thinking and education, not propaganda or dogma.  This campus stands up for individual freedom precisely because Concordia is pledged to the true concept of education: exploration of ideas and free thought.  Sadly, few American campuses honor that pledge any more.  Conformity, rather than intellectual diversity, is the tenor of our pedagogical times.  Intellectual conformity is equally anathema to democratic capitalism, healthy and dynamic markets and the type of sound market regulation on which they depend.[20]

Sixth, democratic capitalism requires that regulators vigorously protect market integrity by enforcing the laws that ensure it.  There must be no tolerance for fraud, deception or manipulation in financial markets.  Criminality takes away our freedom for the personal gain of the few.  Market regulators must maintain bulwarks against such misbehavior, protecting the markets and the American people from those who would do harm.  As an agency head, the mission of legal enforcement is especially clear to me.  I know from first-hand experience as a former marketplace operator that market integrity is essential to fostering robust trading and responsible risk taking.  Enforcing the law is intimately tied to our freedom.  Enforcement is necessary to preserving it.

Seventh, there must be fairness.  Regulators must not take sides, nor favor one set of market actors over another. We must operate within the limits set by Congress.  We are not free agents or rogue actors.  We must follow the law.  We must be perceived as fair and just agents.  Our personal and institutional character matters.  I always feel we have done our job if people welcome adjudication or agency action because they know we will be fair.  Regulators must have what has been called “moral capital.”

Eighth, and last, the markets must make us better as family members, colleagues, citizens, businesspeople, market participants and regulators.  Aristotle felt that the polity, if moral, should ennoble us, make us better.[21]  I feel that way about free and well-ordered financial markets.  They must make us more virtuous and better people.  Financial markets must be a source for human good, not exploitation.

This brings us full circle, back to the Golden Rule.  We must see ourselves in each other, finding a mirror that reflects the soul.  There must be honesty, integrity, and reliability in our dealings with others.  And, we must live without fear.  For those who seek it, there must be the freedom to find God in our work.  Freedom is God’s gift to us.

I would like to leave time for questions.  But, before ending this lecture, I would like to recall Mill.  At one point, Mill’s friend and neighbor, was John Austin, that lion of jurisprudence.  Austin advocated that we find, in his words, the “moral sense” in things.[22]  Like Mill, Austin, and others, I encourage you to continue your own search for a moral sense in life.  Mill felt that such a search was part of a larger inheritance in our civilization, what we give to each other and to those who follow.

I am delighted to have been part of your search for moral sense.  And, through our discussion tonight, you have been part of mine.

All of this would have made Dr. Jacobson proud, and justified his belief in the goodness of a philosophical and religious education.

Thank you.

Keynote Address of Commissioner Brian Quintenz before the 2018 Agricultural Commodity Futures Conference

The Weed Garden

April 6, 2018

Thank you for that kind introduction.  Before I begin, let me make the usual disclaimer and quickly say that the views contained in this speech are my own and do not represent the views of the Commodity Futures Trading Commission (CFTC or Commission).

When I first heard that the Commission was partnering with the Center for Risk Management Education and Research at Kansas State University to host “Protecting America’s Agricultural Markets: An Agricultural Commodity Futures Conference,” I was delighted.  The conference is the first-of-its-kind, and hopefully the first of many conferences, that focuses on how our state-of-the-art futures markets impact America’s agricultural community.  Given the fundamental transformation that both the commodity markets and the agricultural futures market have undergone over the past few years, it is critical to have conferences like this one, where farmers, industry, and academia can come together to share their insights about liquidity, market developments, and the integrity of the marketplace.  I am honored to be with you today.

Our Chairman started yesterday with a story about Winston Churchill.  I am going to begin with something much smaller and less grand:  a personal story about Newark Street in Washington D.C.  That is where, for the past two years, I have had a small community garden plot.  After what seemed like an incredible amount of work to clear out the overgrowth due to the past occupant’s neglect, I planted my first crop. To say it was unsuccessful is a massive understatement.  In fact, after two years of ownership, I have come to one strong conclusion:  unless there is a market for weeds, I am not cut out to be a farmer.  In fact, as far as weeds go versus the seeds and bulbs that I have tried to cultivate, it is amazing to see how much I can grow of what I do not want and how little I can grow of what I do.  If my 15x15 foot area takes this much attention, it is hard to fathom how much effort a 1,000 acre farm requires.  But it is not hard to fathom that America’s farmers and ranchers are up to the challenge.

I used to work on Capitol Hill as a policy aide. When you work in a Congressional office as a policy aide, you cover a number of different issues—some with which you are quite familiar, and some with which you are not.  One of the areas I covered, and with which I was not that familiar, was agriculture.  But it was a fascinating experience—as I have told many friends and strangers since leaving the Hill, the farmers with whom I met on Capitol Hill were some of the most impressive people I have ever encountered.  And with all due respect to my very distinguished colleagues at the CFTC, that remains true to this day.

Yesterday, Dean Floros was discussing the need to train today’s college students for the possibility of having six or seven different professions over their career.  I believe that has always been true of America’s farmers—they are economists, they are accountants, they are traders.  They are marketers, logistics experts, conservationists, and land stewards.  They are scientists: ecologists, biologists, chemists, and botanists.  And, if you have ever shaken a farmer’s or rancher’s hand, you know that many are also physical laborers.  When I say that I think America’s farmers are an impressive bunch, I do not say that just to get into everyone’s good graces.  I say it because I have seen it, I know it, and it is true.

The moral of my community garden story is that in order to grow something, in order to build something, it is not enough to simply plant seeds in the ground, walk away, and wait impatiently for them to mature.  Instead, it takes constant vigilance, care, hard work, patience, ingenuity.  America’s farmers and ranchers tirelessly dedicate themselves to the future success of their farms and ranches.  So must we, the regulators, as well as the futures exchanges and market intermediaries, work tirelessly to ensure the vibrancy of our futures market, so that it remains a reliable, efficient hedging tool for the Ag industry and so that all of the intelligence and sweat which farmers and ranchers put into their product does not go to waste.

Understanding the Needs of American Farmers and Ranchers

I grew up in the Midwest and in close proximity to American agriculture – close enough to have always had an appreciation for the important role that agriculture plays in the economy.  And while I visited some farmers in our Congressional District when I was a policy aide, I did not have much first-hand experience with farming before I became a CFTC Commissioner.  As I prepared for the role of CFTC Commissioner, the agency’s history of protecting America’s farmers and ranchers stood out quite clearly for me. It is those farmers and ranchers who depend upon liquid, well-functioning agricultural futures and swaps markets to hedge production risks.  One of my first acts as Commissioner was to travel to Kansas and Missouri where I met with farmers, grain elevators, processors, and ranchers to learn about their businesses.

Since that time, I have also visited Tennessee, Mississippi, Louisiana, Arkansas, and Texas to meet with Ag producers, cooperatives, energy producers, and manufacturers to learn first-hand about their experiences with our futures and swaps markets.  I have been consistently impressed and humbled by their work ethic, sophistication, and dedication to growing their businesses, many of which are family-owned, in the face of historically low commodity prices and intense international competition.  Indeed, the combination of steep declines in the prices of physical commodities and global supply and demand forces has put unrelenting pressure on America’s farmers to increase yields, cut costs, and drive efficiencies to remain profitable.  For the fifth consecutive year, the American farmer is expected to see a decline in net farm income.[1]

And yet, despite these challenges, America’s farmers remain the most productive in the world.  The agricultural output per U.S. farm has more than doubled since 1948.[2]  In 2015, output from U.S. farms contributed $136.7 billion to the American economy—about one percent of GDP.[3]  In 2016, direct on-farm employment accounted for about 2.6 million jobs.[4]  Agriculture-related industries, like forestry or food manufacturing, accounted for another 3.3 million jobs.[5]  This expansion has been spurred by American technological innovation and ingenuity.  Since 2000, many crops have experienced upwards of a 30% yield increase per acre.[6]  Perhaps this phenomenal growth in the face of significant challenges should be unsurprising; as I recently heard someone state:  In the city, you work until quitting time.  On the farm, you work until the job is finished.

Well, that saying is undoubtedly true of the American farmer and rancher.  And that is why it is incumbent on the CFTC now more than ever to ensure that the futures markets continue to work for Ag producers as they have for over 100 years.  Faced with slimmer profit margins and intense competition, the ability of our famers to manage risk nimbly and effectively has never been more important to their survival and long-term health.  During my visits with Ag producers and cooperatives, I asked about their experiences using the futures markets.  Many stated they largely continued to use the futures markets as they had in the past.  But some expressed that they no longer felt comfortable using the futures market to hedge their risks.  Instead, these producers felt like the market had become too complex for them.

The CFTC has five advisory committees which solicit the input of outside experts on different topic areas to advise the agency on developments, risks, and regulatory issues.  In fact, the Agricultural Advisory Committee had its first meeting since 2015 yesterday morning in this building.  I have the privilege of sponsoring the Technology Advisory Committee (TAC)—we had our first meeting in two years back in February, with one result being the recommendation of forming a subcommittee to explore the complexities and risks associated with the modern electronic trading environment.  I was interested to hear from some of this Conference’s participants yesterday about their concerns regarding market structure issues, from matching engines and order book visibility, to the amount of message traffic and the timing effect of speculation-induced price moves.  I would welcome the TAC’s automated trading subcommittee’s exploration of these topics.

During my meetings with farmers and ranchers, I was also concerned to hear of isolated instances where producers were forced to liquidate their hedge positions because they were unable to secure financing to meet their margin calls.  I understand that historically low commodity prices have put strain on farm equity and made it more difficult for some to receive extensions of credit.  Although the CFTC has no role to play over global commodity prices, the agency’s authority over futures exchanges gives it tools to promote convergence between the futures and cash markets, so that hedgers can trust that amounts lost on futures hedge positions will be offset with gains in the cash markets.

I take the concerns I heard seriously.  I am committed to working with the agricultural community and the exchanges to strengthen the trust that Ag producers have in our futures markets.  I know this is also a priority for Chairman Christopher Giancarlo, who has asked the CFTC’s Office of Customer Education and Outreach to help assess whether there are information gaps that may prevent the next generation of farmers and ranchers from accessing the futures market.[7]  I support this effort.  Additional information and transparency about the mechanics of the futures market will boost knowledgeable participation.  More so than many other risk management techniques, futures contracts enable farmers to execute precise hedges highly correlated to cash market prices.  I hope that through continued outreach and education, we will continue to be responsive to the needs and concerns of smaller Ag producers.

Market Integrity and Vigilant Oversight

Market integrity is essential to ensuring that Ag producers and cooperatives feel comfortable participating in our futures market.  One of the CFTC’s core duties is to promote futures markets that reflect supply and demand fundamentals and remain free from fraud and market manipulation.[8]  In order to have well-functioning, efficient markets, the terms of the futures contracts themselves must be sound.  This is why the CFTC requires all futures exchanges to monitor the terms and conditions of any futures contract that it offers.[9]  In particular, exchanges monitor to ensure that the terms of futures contracts keep pace with developments in the underlying cash markets and that futures and cash price convergence occurs.[10]  Without consistent convergence, market participants will not trust the contract to provide a reliable hedge, with the long term result that the futures markets will no longer provide a means of price discovery and risk mitigation.

While it is not the CFTC’s role to design futures contracts – that job belongs to the futures exchanges – it is the CFTC’s responsibility to oversee the exchanges and ensure they are proactively and appropriately monitoring the performance of their contracts.  If problems arise, CFTC staff work with the exchanges and market participants to resolve any issues.  We have seen this most recently with exchanges adjusting the design of certain contracts by adding or removing delivery points, in the case of the CME Live Cattle futures contract, or implementing a market-based storage rate, in the case of CBOT’s Hard Red Winter Wheat contract.  Of course, these modifications are part of an ongoing, iterative review process.  I encourage market participants to continue voicing their concerns and experiences, both good and bad, to the exchanges and CFTC staff.  I know the Commission and the exchanges are committed to improving contracts so they perform as intended.

FCM Concentration

Another crucial aspect of ensuring farmers and ranchers continue to use the futures markets to hedge risk is access.  Futures commission merchants (FCMs) are the gateway to participation in our futures markets.  Over the past 10 years, the FCM sector has consolidated at an alarming rate.  Just prior to the 2008 financial crisis, there were 154 registered FCMs;[11] today there are only 55 FCMs actively carrying customer accounts.[12]  That is a 64% decrease in the number of FCMs available to facilitate customer access to the futures markets.  Moreover, within this ever-shrinking population of FCMs, clearing business is becoming increasingly concentrated.  As of 2017, the top ten FCMs clearing futures and options for customers controlled approximately 70% of the business.[13]

There are many reasons behind this mass exodus and the increasing concentration in the FCM industry:  persistent, historically low interest rates, increasing regulatory costs, and the impact of the supplementary leverage ratio (SLR), to name a few.[14]  This confluence of factors has a uniquely harmful impact on Ag producers and processors, who have found that some of the remaining larger FCMs are limiting the services they offer to smaller, less-active clients.  I am concerned that without a robust, healthy FCM industry, smaller end-users will lose their ability to hedge their risks in our futures markets.

In the past, I have spoken at length about how the SLR penalizes banks’ provision of clearing services by treating segregated customer margin as an exposure of the bank.[15]  I believe that if the SLR calculation is not rationalized to accurately reflect the risk-reducing nature of segregated margin, the health of the U.S. clearing industry will continue to be jeopardized.  For example, there are now real concerns about the viability of porting customer positions in the event of a clearing member default, given the punitive capital charges the accepting FCM would face.

I am encouraged by the growing momentum to address this issue and ensure that client clearing services are encouraged, rather than penalized.[16]  I stand ready to help in any way I can.

Leading the Way:  Innovation in the Agriculture Markets

Agricultural technology, or AgTech, is paving the way for America’s next generation of farmers to feed the world.  Today, the average American farm feeds 165 people annually.[17]  During the next 30 years, the global population is expected to increase to 9.7 billion, which means the world’s farmers will have to grow about 70 percent more food than what is currently produced.[18]  Technological innovations are occurring now that will enable this growth.  In particular, blockchain technology has demonstrated its ability to modernize the burdensome, paper-based, back office operations of the Ag supply chain.

Using blockchain for supply chain management helps companies make decisions that improve the quality, yields, and profitability of their crops.  For example, blockchain can be used to record measurements of environmental factors so that farmers can make informed decisions about irrigation, fertilization, or harvesting.[19]  Introducing real-time transparency into the supply chain can also help farmers optimize their profitability by enabling them to better set their own prices and determine how much of their products they wish to sell in certain markets.

From a transactional perspective, blockchain also has the potential to ensure that payments occur simultaneously with title transfers.  Earlier this year, Louis Dreyfus Company completed the first agricultural deal using blockchain.  The transaction involved the sale of roughly 60,000 tonnes of U.S. soybeans to China.  Louis Drefyus noted that the elimination of paperwork involving letters of credit and inspection documents resulted in a processing time that was about a fifth of their paper-based process.[20]

Similarly, this year an agriculture blockchain start-up in Australia received a $5.5 million investment for a private blockchain that records grain transactions and supply movements. [21]

The blockchain has over 1,300 users and has facilitated transactions involving $1.5 million tonnes of grain and $360 million in payments.

Blockchain also has the potential to provide consumers with knowledge about the origins and journey of their food from farm to table that before now has been impossible.  In a time when consumers are calling for greater transparency and food safety requirements are increasingly stringent, blockchain can help companies track food more efficiently than the existing technologies.  This past Thanksgiving, Cargill tested blockchain technology for this purpose on a smaller scale by using blockchain to enable families to track their turkeys back to their original farms and read comments from the farmers themselves.[22]

AgTech holds promise in other areas as well.  Recently, a company used data analytics and facial recognition to track and monitor cows’ living conditions and behavior, with the result that farms were able to increase milk production by 11.7 percent while decreasing costs.[23]  Other companies are investing in artificial intelligence to teach machines how to farm by identifying patterns in data that could predict crop threats like pests and disease.[24]  Although agriculture may be one of the world’s oldest industries, it certainly remains on the frontline of innovation and experimentation today.

Conclusion

In closing, for over 150 years, the U.S. futures markets have enabled farmers and ranchers to hedge their commercial risk in the most liquid, competitive, and vibrant futures market in the world.  This is no small accomplishment.  It has taken generations of hard-working, creative, and aspirational thinkers to build today’s futures industry.  I am committed to ensuring this longstanding tradition continues for America’s next generation of farmers.

[1]     U.S. Dep’t of Agric., 2018 Farm Sector Income Forecast, https://www.ers.usda.gov/topics/farm-economy/farm-sector-income-finances/farm-sector-income-forecast/.  In 2018, the net farm income is forecast to decrease $4.3 billion (6.7 percent) to $59.5 billion, which is the lowest level in nominal terms since 2006. 

[2]     U.S. Dep’t of Agric., Economic Research Service, Summary of Recent Findings, https://www.ers.usda.gov/data-products/agricultural-productivity-in-the-us/summary-of-recent-findings/.

[3]     U.S. Dep’t of Agric., Economic Research Service, Ag and Food Sectors and the Economy, https://www.ers.usda.gov/data-products/ag-and-food-statistics-charting-the-essentials/ag-and-food-sectors-and-the-economy/.

[4]     U.S. Dep’t of Agric., Ag and Food Sectors and the Economy, https://www.ers.usda.gov/data-products/ag-and-food-statistics-charting-the-essentials/ag-and-food-sectors-and-the-economy/.

[5]     U.S. Dep’t of Agric., Ag and Food Sectors and the Economy, https://www.ers.usda.gov/data-products/ag-and-food-statistics-charting-the-essentials/ag-and-food-sectors-and-the-economy/.

[6]     See U.S. Dep’t of Agric., Nat’l Agric. Statistics Service, Crop Production Annual Summary (1.12.2018), http://usda.mannlib.cornell.edu/usda/current/CropProdSu/CropProdSu-01-12-2018.pdf and Crop Production Annual Summary (1.12.2000), http://usda.mannlib.cornell.edu/usda/nass/CropProdSu//2000s/2000/CropProdSu-01-12-2000.pdf.

[7]     Remarks of Acting Chairman J. Christopher Giancarlo on Comments before the Montana Ag Summit (June 1, 2017), https://www.cftc.gov/PressRoom/SpeechesTestimony/opagiancarlo-23a.  For more information about the Office, please see https://www.cftc.gov/LearnAndProtect. 

[8]     CEA Section 3(a) (noting that transactions subject to the CEA “are affected with a national public interest by providing a means for managing and assuming price risks, discovering prices, or disseminating pricing information through trading in liquid, fair and financially secure trading facilities”); CEA Section 3(b) (“[I]t is further the purpose of this Act to deter and prevent price manipulation or any other disruptions to market integrity; to ensure the financial integrity of all transactions subject to this Act and the avoidance of systemic risk…”).

[9]     17 C.F.R. § 38.252.

[10]    17 C.F.R. § 38.252.   See also Core Principles and Other Requirements for Designated Contracts Markets; Final Rule, 77 Fed. Reg. 36612, 36636 (June 19, 2012) (“The Commission is of the view that a DCM must monitor the performance of its contracts to ensure they continue to perform their economic function.”). 

[11]    CFTC, Selected FCM Financial Data as of December 31, 2007, https://www.cftc.gov/files/tm/fcm/fcmdata1207.pdf (excludes firms registered solely as retail foreign exchange dealers).

[12]    CFTC, Selected FCM Financial Data as of January 31, 2018, https://www.cftc.gov/sites/default/files/idc/groups/public/%40financialdataforfcms/documents/file/fcmdata0118.pdf (excludes firms registered solely as retail foreign exchange dealers).  Of the 63 FCMs registered with the Commission, only 55 hold customer funds required to be segregated under CEA Section 4d(a)(2).

[13]    Percentage calculated using total customer segregated funds for futures and options as a proxy for total clearing activity.  See FIA FCM Tracker, FCM Comparison Table, available at https://fia.org/fcm-comparison-table.     

[14]    Joanne Morrison, CFTC Examines FCM Consolidation, Market Voice: FIA’s Magazine of the Global Futures, Options and Cleared Swaps Markets, Nov. 15, 2015, https://marketvoice.fia.org/articles/cftc-examines-fcm-consolidation.

[15]    Remarks of Commissioner Brian Quintenz before the Structured Finance Industry Group Vegas Conference (Feb. 26, 2018), https://www.cftc.gov/PressRoom/SpeechesTestimony/opaquintenz7; Keynote Remarks of Commissioner Brian Quintenz before the Federal Reserve Bank of Chicago’s Fourth Annual Conference on CCP Risk Management (Oct. 17, 2017), https://www.cftc.gov/PressRoom/SpeechesTestimony/opaquintenz2. 

[16]     See, e.g., Remarks by Randal K. Quarles, Vice Chairman of Supervision, Board of Governors of the Federal Reserve System at the ABA Banking Law Committee Annual Meeting (Jan. 19, 2018); Economic Growth, Regulatory Relief, and Consumer Protection Act, S. 2155, 115th Congress (allowing custodial banks to exclude funds held at central banks from the SLR calculation),  https://www.congress.gov/115/bills/s2155/BILLS-115s2155es.pdf; https://www.congress.gov/bill/115th-congress/senate-bill/2155/text; H.R. 4659, 115th Congress (excluding initial client margin from inclusion in SLR), https://www.congress.gov/115/bills/hr4659/BILLS-115hr4659ih.pdf.; U.S. Treasury Report: “A Financial System that Creates Economic Opportunities: Capital Markets,” October 6, 2017, https://www.treasury.gov/press-center/press-releases/Documents/A-Financial-System-Capital-Markets-FINAL-FINAL.pdf.

[17]    American Farm Bureau Federation, Fast Facts about Agriculture, https://www.fb.org/newsroom/fast-facts.

[18]    American Farm Bureau Federation, Fast Facts about Agriculture, https://www.fb.org/newsroom/fast-facts.

[19]    Analog Devices’ Monitoring Initiative Aims to Improve Crop Quality and Yields and Boost Profitability of Local Farmers, Business Wire, Aug, 23, 2017.

[20]    Emiko Terazono, Agriculture Deal a First for Blockchain, Fin. Times, Jan. 22, 2018.

[21]    James Eyers, Agriculture Blockchain Start-Up Raises $5.5M, AFR Online, Feb. 26, 2018.

[22]    Nikhilesh De, Turkeycoin? Food Giant Cargill Launches Blockchain Tracking Pilot, Coin Desk, Oct. 26, 2017, https://www.coindesk.com/turkeychain-food-giant-cargill-launches-blockchain-tracking-pilot/.

[23]    Mario Parker, Cargill’s Big Data Makes Happier—And More Productive—Cows, Bloomberg, Sept. 12, 2017, https://www.bloomberg.com/news/articles/2017-09-12/cargill-data-helps-farmers-make-happier-cows-that-make-more-milk.

[24]    Jacob Bunge, Agriculture Giants Teach Computers to Farm, Wall St. J., Sept. 13, 2017, https://www.wsj.com/articles/leaf-recognition-technology-agriculture-digs-into-artificial-intelligence-1505300400.