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June 19, 2003

TESTIMONY OF DANIEL J. ROTH
PRESIDENT AND CHIEF EXECUTIVE OFFICER
NATIONAL FUTURES ASSOCIATION

BEFORE THE SUBCOMMITTEE ON GENERAL FARM COMMODITIES AND RISK MANAGEMENT
OF THE
U.S. HOUSE OF REPRESENTATIVES
COMMITTEE ON AGRICULTURE

JUNE 19, 2003

My name is Daniel Roth, and I am President of National Futures Association. NFA appreciates the opportunity to appear here today to present our views on some of the issues arising under the Commodity Futures Modernization Act of 2000 ("CFMA").

As the industrywide self-regulatory organization, NFA occupies a unique position in the futures industry. Like the exchanges, we are a self-regulatory body, but, unlike the exchanges NFA does not operate a marketplace. Self-regulation is not part of what we do - it is all that we do. Like the trade associations, we are a membership organization, but, unlike those associations, we are not a lobbying organization. We are first, foremost and only a regulatory body devoted to customer protection.

Our 4,000 Members include futures commission merchants ("FCMs"), introducing brokers ("IBs"), commodity pool operators ("CPOs") and commodity trading advisors ("CTAs"). We also regulate the activities of approximately 50,000 registered account executives who work for those Members. Our mission is to work as a partner with the CFTC to provide the industry with regulation that is both as effective and as efficient as possible. We think that this partnership has been an extraordinary success. In the twenty-one years since NFA began operation, trading volume on U.S. futures exchanges has increased by over 400%. During that same time, customer complaints have actually dropped by over 70%.

We all know, though, that a successful past does not ensure a successful future. The need for regulation that is both effective and efficient has never been greater. Effective regulation is the best way to assure public confidence, and we have all seen what happens to markets that lose the public's confidence. The best way to preserve that confidence is to deserve it - to ensure that the highest levels of integrity are demanded of all market participants and intermediaries. At the same time, the world becomes a more competitive place every day. The race belongs to those who can deliver the best products at the lowest price, and barriers and inefficiencies, including those regulatory in nature, simply cannot be tolerated.

I believe that the passage of the CFMA helped the industry and the regulators ensure effective and efficient regulation, but all of our problems have not gone away. I would like to tell you about some of the challenges NFA is facing now, the problems we are trying to solve by working with the CFTC and the industry. I would also like to bring you up to date on how NFA has performed the tasks assigned to us in the CFMA regarding single-stock futures.

CFTC IMPLEMENTATION OF THE CFMA

Before I turn to those issues, though, I want to make a point of commending the CFTC, in general, and Chairman Newsome in particular, for their leadership in implementing the CFMA. The Commission and its staff have worked hard to reduce unnecessary and costly regulatory burdens without reducing customer protection. They have done that by embracing the core principle regulatory philosophy adopted in the CFMA. The CFMA required the Commission to review the Act and the Commission's rules to ensure that regulatory requirements for intermediaries are flexible enough to address the industry's constant and rapid innovation.

The CFTC has done just that. For example, the Commission:

  • Expanded the range of instruments in which FCMs and clearing organizations may invest customer funds;

  • Replaced its detailed ethics training rule with a general standard;

  • Provided customers and account controllers with greater choice in how they close out offsetting positions;

  • Expanded FCMs' ability to hold customer funds in other currencies and in foreign depositories;

  • Provided temporary relief and proposed permanent relief from CPO and CTA registration where certain conditions are met;

  • Proposed rules to extend the pricing advantages of bunched orders to retail customers; and

  • Proposed changing how CTAs calculate performance so that customers receive more accurate information.

Efficient regulation is not just a question of how you write the rules - it also involves making the best use of regulatory resources. For the last twenty years the CFTC has delegated certain of its frontline regulatory responsibilities to NFA to avoid duplication of effort and to direct its own resources where they are most needed. That trend has continued and accelerated since the passage of the CFMA. Let me give you just a few examples.

  • In early January, the Commission delegated to NFA the authority to review the annual financial reports that commodity pool operators are required to provide to the CFTC and to their customers. This delegation eliminated the burden of filing those reports with both the CFTC and NFA. At the same time, NFA collaborated with the CFTC to implement technology that allows CFTC staff to electronically access and query information NFA maintains relating to pools in our databases. During the last six months, NFA's compliance staff has analyzed over 2,100 pool financial statements filed by CPOs with NFA.

  • In mid-March, the CFTC authorized NFA to review the prospectus-type disclosure document that CPOs provide to customers for publicly-offered commodity pools. In 1997, the CFTC delegated this responsibility to NFA for disclosure documents for privately offered pools of CPOs and managed account programs offered by CTAs. NFA's team of specialists review about 200 disclosure documents each month. Our turnaround time averages a few days. We still have not eliminated all duplication of effort, however, since public pool documents are still reviewed by both NFA and the SEC. We hope that we can eliminate this duplication in the future.

NFA believes that we can also eliminate duplication of effort in the area of dispute resolution, but that would require congressional action. As we have testified before, we believe that the CFTC's reparations program has outlived its usefulness. When NFA began operations, the CFTC received almost 1,000 cases a year from retail customers - the reparations program was a valuable forum for those customers. Last year the Commission processed just 80 cases while 136 cases were filed with NFA's arbitration program. That's good news - it means that the combined enforcement efforts of NFA and the CFTC have had a real impact and that the public has great confidence in NFA's program. It also means that Congress should eliminate the requirement that the CFTC be the only federal financial regulator that operates a dispute resolution program.

In addition to the formal delegations I just mentioned, NFA constantly works informally with the CFTC. For example, during the last two months, NFA has assigned three of our staff to work full-time with the CFTC on investigations relating to energy and off-exchange foreign currency transactions. We value our partnership with the CFTC and will always strive to find new ways to work together to provide effective and efficient regulation.

RETAIL FOREX TRANSACTIONS

As I mentioned, the passage of the CFMA has not solved all of our problems. There are a number of important customer protection issues facing us today. I would like to explain those issues and what steps we are taking to address them.

The first area relates to off-exchange foreign currency transactions with retail customers. In passing the CFMA, Congress attempted to clear up confusion involving the Treasury Amendment and the CFTC's jurisdiction over off-exchange forex contracts sold to retail customers. Simply stated, the Congress intended to provide that "otherwise regulated entities," such as FCMs, broker-dealers and insurance companies, could sell forex contracts to retail customers outside of the Commodity Exchange Act. Unfortunately, the actual wording of the statute may have closed one loophole and opened another.

The CFMA provides that if an otherwise regulated entity is a "counter party" to the retail forex trade, the regulatory provisions of the Commodity Exchange Act do not apply. That language leaves open the possibility that the counter party to the trade could be an FCM, but the person actually working the phones selling the product can be completely unregulated. That is just what has happened. As a result, hundreds of unregistered and unregulated entities - that do not act as counterparties - are currently soliciting retail forex customers. In fact, NFA has received information that several individuals that we charged with fraud in the futures industry are linked to these soliciting firms.

A second problem involves "otherwise regulated entities" that are not really otherwise regulated. Let me explain. A number of firms that have never done any futures trades and never intend to do any futures trades have recently registered as FCMs and become NFA Members. They have done this for the sole purpose of qualifying as "otherwise regulated entities" so they can do retail forex trades outside of the Commodity Exchange Act. From NFA's perspective, these firms are not really otherwise regulated because all of our rules apply to exchange-traded futures and options transactions and do not generally apply to off-exchange forex transactions.

To address these problems, we created a special Forex Dealer membership category for firms that register as FCMs so they can act as a counterparty to retail forex transactions. NFA currently has fourteen active Forex Dealer Members and ten more registered or pending firms that have indicated they intend to become Forex Dealer Members. In the aggregate, Forex Dealer Members hold approximately $170 million in retail customer funds, with the minimum retail account size ranging from $500 to $10,000. In the last eighteen months, we have reviewed approximately one hundred customer complaints relating to these firms' forex activities. NFA has also taken three emergency actions against Members for forex activities within the last twenty months. Due to the disproportionate number of complaints we have received relating to these transactions, forex clearly has demanded a lot of our regulatory resources during the last year.

Since the applicability of our compliance rules is limited to exchange transactions, NFA's Board adopted and the CFTC approved an anti-fraud rule to cover the activities of these firms. Additionally, NFA's Board recently adopted several additional rules designed to protect retail forex customers against unethical business practices and loss of funds due to insolvency or related problems, and we will put them into effect once they are approved by the CFTC.

Our rules should help with both of our problems. First, the firms themselves will be subject to the type of regulatory oversight that Congress intended. These rules require Forex Dealer Members to:

  • observe high standards of commercial honor and just and equitable principles of trade in connection with their retail forex business;

  • supervise their employees and agents and any affiliates that act as counterparties to retail forex transactions;

  • maintain minimum net capital based on the notional value of the open positions they carry for retail customers; and

  • collect security deposits from those customers.

Second, with respect to the unregistered and unregulated persons soliciting retail customers for forex trades, one of the key provisions in NFA's pending rules gives NFA authority to discipline Forex Dealer Members for the activities of unregulated entities who introduce accounts to them or manage accounts for their customers.

We hope our proposed rules will help close any loopholes that may have been created. NFA will, of course, continue to carefully monitor its Forex Dealer Members' activities and the complaints filed against these firms. If at some point we determine that our rules are not effective and that congressional action may be called for, we will certainly communicate those concerns both to the CFTC and to Congress.

CUSTOMER RESTITUTION

A second problem that NFA and the CFTC have tackled relates to how best to return money to victims of fraud. Obviously, it is better to prevent fraud than to prosecute it, and the drop in customer complaints that I mentioned earlier shows that the CFTC and NFA have had success in those efforts. But even the best prevention efforts fail at times and some customers will be victims of fraud. I note that a subcommittee of the House Financial Services Committee is considering a bill with two basic purposes - to strengthen the SEC's enforcement powers and increase its ability to return funds to defrauded investors. Obviously, those goals are important to all of us, and I wanted you to know what the CFTC and NFA have already done to address the problem.

Together the CFTC and NFA developed a creative solution to the problem of how best to return funds to fraud victims several years ago. Specifically, in many circumstances, NFA has acted as a restitution service for cases that involve commodity fraud. Most of these cases are ones settled by the CFTC against non-Members of NFA. NFA receives copies of the signed settlement order that outlines the specifics of the case and the amount of restitution to be paid. These non-Members are ordered to pay a percentage of their income each year to the customers they have harmed. Our job is to make sure that the individual complies with the settlement's terms, which usually requires reviewing financial disclosure statements and tax returns. The individual submits a check made payable to the settlement account we set up and we then send a check drawn on that account to the defrauded investors.

To give you some idea of the scope of this service, we have opened bank accounts and administered funds for approximately 50 cases, with monies deposited in these cases ranging from as little as $1,000 to nearly $1 million. Since we began performing this restitution service fifteen years ago, NFA has paid out over $3 million to approximately 3,000 defrauded investors. We offer this service without charging any fees to the settlement account so that all the money possible is available for distribution to harmed investors. Frankly, in most cases the victims still receive only a small portion of their losses, but every cent paid into the restitution accounts goes to customers.

ANTI-MONEY LAUNDERING

One additional regulatory issue I wanted to address is anti-money laundering ("AML"). All of the financial regulators have adopted or are adopting all of the anti-money laundering rules required by the USA Patriot Act. The question now becomes how best to monitor all of the affected firms for compliance. As always, NFA’s goal is make the most efficient use of the regulatory resources that are available.

The USA Patriot Act imposes significant new AML requirements on all financial institutions. In April 2002, NFA adopted requirements necessitating that FCMs and IBs have an AML program. NFA worked very closely with the Commission, U.S. Department of Treasury, and the industry in adopting these requirements. At the present time, NFA examines FCM and IB Member firms for compliance with these requirements and has worked with firms to ensure that they fully understand the elements of an effective AML program.

We also expect that Treasury in the near future will issue final AML rules for CTAs and unregistered investment companies, including commodity pools. At that time, we will adopt AML requirements for these Members and add steps to our audit programs to check for compliance with those rules. The fact is, though, that many of our CPO members operate other types of investment funds, either directly through our Member firm or though an affiliate of our Member firm. For example, 18 of the top 25 (55 of the top 100) hedge fund complexes are operated by NFA Member CPOs or their affiliates. Since we will already be auditing our Member firms for AML compliance, it only makes sense that we should examine their other funds and their affiliates for AML compliance as well. That's the only allocation of resources that makes sense, and we have informed the Treasury Department that we would be willing to take on that additional responsibility.

I should also note that the dramatic growth of the managed funds industry has, for the most part, been problem-free. CPOs and CTAs make up 60% of our membership but account for only 2% of customer complaints. We will continue to work closely with the CFTC to ensure that trend continues.

SECURITY FUTURES PRODUCTS

The CFMA not only emphasized the elimination of regulatory inefficiencies but also product barriers. With passage of the CFMA, Congress removed a barrier that prevented security futures products from trading for the last twenty years. The Act specified a very important role for NFA with respect to these products by designating NFA as a limited purpose national securities association. Before these products could begin trading, the CFMA specified that NFA had to have customer protection, suitability and sales practice rules for security futures that are comparable to National Association of Securities Dealers’ ("NASD") rules.

NFA worked cooperatively with both the CFTC and the SEC, as well as the industry, and met all requirements well before security futures were ready to trade. Among other things, NFA implemented rules and interpretive notices that: (1) apply NASD's options suitability and promotional material requirements to security futures; (2) require Members to comply with relevant provisions of the Securities and Exchange Act of 1934, including the insider trading prohibitions; (3) require firms to have one or more designated security futures principals and adopt additional supervisory procedures for security futures products; and (4) impose best execution and fair commission requirements on firms.

In addition to adopting these rules, NFA also assumed responsibilities for processing the notice-registration forms for both the SEC and the CFTC, meaning that we now process some securities registrations as well as all futures registrations. We also worked cooperatively with NASD and other self-regulatory organizations to draft a separate risk disclosure statement for security futures products and developed a web-based training program – in partnership with NASD and the Institute for Financial Markets – that qualifies futures and securities registrants to offer security futures. While all three partners collaborated on the content, NFA developed the software and persuaded NASD that the training should be offered without charge.

NFA's responsibilities relating to these products did not stop the day they began trading six months ago. Since then, NFA has educated firms about the regulatory requirements for trading these products and closely monitors the sales practice activities of those firms that offer these products. At this time, we have received no customer complaints regarding these products.

SRO CONFLICTS OF INTEREST

Nobody in this room is a larger proponent of self-regulation than I am. Over the last twenty years NFA has shown how effective self-regulation can be in providing regulation that is both effective and efficient. At the same time, no one in this room would deny that there are certain conflicts of interest inherent in the concept of self-regulation. The CFTC's successful management of those conflicts has been one of its most important achievements over the years. Now, though, the industry is going through a period of dramatic change. As exchanges demutualize and become for-profit, and as the roles of intermediaries are changing, the nature of the conflicts of interest in the self-regulatory process need to be reexamined. To that end, we welcome Chairman Newsome's recent statement that the Commission will be examining whether changes to the market could affect the self-regulatory process. Obviously, the self-regulatory process has served this industry very well, but the Commission's inquiry is an appropriate one and NFA will cooperate in any way we can.

CONCLUSION

NFA's mission today is the same as it was twenty-one years ago. Everything we do is designed to protect customers, protect market integrity and protect the public's confidence in these vital markets. We are proud of what we have accomplished with the CFTC, but we recognize that challenges lie ahead. The industry we regulate is changing rapidly and dramatically and both the CFTC and NFA will have to respond to those changes. We are confident that we can and will work closely with Congress and the Commission to do so.

NFA is the premier independent provider of efficient and innovative regulatory programs that safeguard the integrity of the derivatives markets.
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