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The Honorable Henry M. Paulson, Jr.
Secretary of the Treasury
1500 Pennsylvania Ave., N.W.
Washington, D.C. 20220
Re: TREAS-DO-2007-0018; Review by the Treasury Department of the Regulatory Structure Associated With Financial Institutions
Dear Secretary Paulson:
National Futures Association ("NFA") is a registered futures association under Section 17 of the Commodity Exchange Act1 and a limited-purpose national securities association under Section 15A(k) of the Securities Exchange Act of 1934.2 As a self-regulatory organization for the futures industry and a very narrow segment of the securities industry, we welcome this opportunity to comment on the Treasury Department's review of the regulatory structure for financial institutions.
The Federal Register release associated with this review indicates that this review is one of many Treasury Department initiatives associated with "maintaining the competitiveness of the United States capital markets." NFA strongly believes that every regulatory scheme should be examined from time to time to ensure that it continues to operate efficiently, effectively, and in the public interest. Therefore, we commend the Treasury Department for instituting this review.
In recent years, the futures industry's regulatory approach has yielded significant benefits for both the industry and customers. Today, there are currently few voices claiming that the futures industry is not competitive globally due to its regulatory structure. In fact, U.S. futures exchange-traded volume has grown explosively in recent years, and media reports continually note that this growth is the envy of securities markets worldwide. This growth and competitiveness can be credited, in large part, to the efforts of the Commodity Futures Trading Commission ("CFTC"), which embraced a principles based regulatory approach in 2000 with the adoption of the Commodity Futures Modernization Act ("CFMA"). Even prior to the CFMA, however, the CFTC has encouraged global competition through its regulatory efforts.
Of course, competition and principles based regulation are appropriate only if the industry's market participants are properly safeguarded. Our experience over the last several years has shown that the futures industry's regulatory approach and philosophy have not sacrificed any customer protections. Currently, customer complaints relating to on-exchange activities in our industry are near an all-time low, and they have been for many years. While more can always be accomplished, NFA believes that both the CFTC and the industry's various self-regulatory organizations deserve credit for this record of protecting market participants against fraud, manipulation, and abusive trading practices.
Our comments on the release will be limited to the futures and securities markets, with which we are the most familiar. The dichotomy between these two regulatory schemes cannot be properly understood and evaluated without knowing how they developed. Therefore, our letter begins with a historical overview, continues with a discussion of the regulatory differences between the CFTC and the SEC, and concludes with our response to this review. We are confident that our views will show that futures regulation works well under the current structure, which should be retained and even emulated.
From the earliest days, securities and futures have been subject to separate regulatory schemes under different regulators. The U.S. futures markets have been federally regulated since 1922.3 The initial scheme imposed by the Grain Futures Act was truly "regulation lite" and was limited to futures on domestic agricultural products. Because of its narrow reach, the Secretary of Agriculture was primarily responsible for administering this statute.
After the 1929 stock market crash, President Roosevelt called on Congress to bring the securities markets under federal jurisdiction and revise the legislation governing the futures markets in order to curb excess speculation in both. Responding to that call, Congress adopted legislation giving jurisdiction over the securities markets to a newly created independent regulatory agency and adopted the Commodity Exchange Act of 1936 (CEA) to strengthen the pre-existing futures regulatory scheme. Under these new laws, the Securities Exchange Commission was given oversight of the securities markets while the futures markets-which were still limited to domestic agricultural products-remained under the Secretary of Agriculture's regulatory authority.
By the 1970s, the futures markets had expanded to include non-agricultural products (e.g., precious metals and currencies) and agricultural products produced outside the U.S. (e.g., coffee and sugar), which were not covered by the CEA.4 In the early years of that decade, grain prices reached record highs, which some consumer groups blamed on excessive speculation and alleged manipulation in the futures markets. The Department of Agriculture, with its many other responsibilities, had a difficult time devoting its resources to exercising even the limited powers available to it under the then current law.
Congress responded to these concerns by adopting the Commodity Futures Trading Commission Act of 1974 (CFTC Act). The CFTC Act, which amended the CEA, created a new independent federal regulatory agency with enhanced powers and extended its jurisdiction to any product "in which contracts for future delivery are presently or in the future dealt in."
A significant amount of congressional debate focused on the nature of the regulator and, more particularly, how closely the new regulator should be tied to the Department of Agriculture (Department). The two primary reasons for separating them were that the new legislation would reach products outside of the Department's expertise and a fear that the Department had an inherent conflict of interest between its statutory duty to support farm prices and its obligations to the futures markets. In connection with this later concern, the Senate Report states:
The proper regulatory function of an agency which regulates futures trading is to assure that the market is free of manipulation and other practices which prevent the market from being a true reflection of supply and demand. Therefore, the agency which regulates futures trading must have a neutral role on commodity prices. The Committee felt this neutral role can best be maintained by a completely independent agency. (S. Rep. No. 93-1131.)
The hearing testimony also includes suggestions that the Department gave the CEA a low priority in terms of staffing, funding, and access to shared services (such as the Department's legal staff).
In the end, full independence won the day, although the legislation did provide for a liaison between the two. It is interesting to note, however, that the jurisdictional tussle was between the Department of Agriculture and a fully independent new regulator. The legislation never contemplated either giving the SEC jurisdiction over futures or making this new regulator an adjunct of the SEC.
Soon after the CFTC Act was enacted, the U.S. futures exchanges began trading contracts on exempt securities and eventually branched out into futures on stock indices. As the securities exchanges followed their lead, the SEC and CFTC skirmished over jurisdiction, with the CFTC winning each time before the Seventh Circuit.5
As a result of these disagreements, Congress has over the years given the SEC limited jurisdiction over futures and options based on securities instruments or dependent on securities for their pricing. Overall, however, it has left the CFTC to regulate futures and commodity options, regardless of the underlying product, while leaving the SEC to regulate securities and options directly on securities. In other words, regulatory authority is divided on functional lines, with the SEC overseeing instruments used to raise capital and the CFTC overseeing products used for risk management and hedging.6
As noted above, the last significant modification to the regulatory scheme occurred in 2000 with the adoption of the CFMA, which made four major changes: 1) it moved to principles-based regulation over the exchanges (and created several new categories of markets), 2) it excluded or exempted most off-exchange transactions between sophisticated parties, 3) it authorized the use of security futures products under a shared regulatory regime, and 4) it attempted to plug a regulatory gap to protect retail customers trading off-exchange foreign currency futures and options contracts (forex). As discussed later, the CFMA was an unqualified success in the first two areas and an unsatisfactory response to the last two.
Two Distinct Regulatory Cultures
Regulation does not exist in a vacuum, and there is no ideal regulatory structure. Regulatory systems are primarily a product of national or local history and culture and tend-rightly or wrongly-to respond to events that affect their markets rather than to anticipate them. Therefore, what works best in one country may be ill suited to another.
These historical and cultural differences are also found, on a smaller scale, among different regulators within the same country. Although many causes factored into the CFTC's creation in 1974, its primary mission was-and still is-to protect the price discovery and risk-management functions of the futures markets or, in other words, to preserve the integrity of those markets by ensuring that they accurately reflect supply and demand. These were-and still are-rapidly changing markets with mostly institutional participants, where entrepreneurs continually develop new and novel products that expand users' options for managing their price risks. As a result, the CFTC's regulatory philosophy and internal culture provide flexibility and encourage innovation and competition.
Although the futures industry's regulatory history extends farther back, the SEC itself is much older than the CFTC. According to the SEC's web site, "Congress established the Securities and Exchange Commission in 1934 to enforce the newly-passed securities laws, to promote stability in the markets and, most importantly, to protect investors." (Emphasis added.) The SEC's original regulatory scheme was primarily designed to ensure that investors had the opportunity to know the risks that came with purchasing capital-raising instruments in general as well as with each individual stock and bond they purchased or held on to.
These differences in philosophy are reflected on the "About" pages of the agencies' web sites. The CFTC's tag line is "Ensuring the Integrity of the Futures & Options Markets," and the first heading proclaims it has "An Important Mission in the Ever-Changing World of Finance." Within this section, it states:
Today, the CFTC assures the economic utility of the futures markets by encouraging their competitiveness and efficiency, protecting market participants against fraud, manipulation, and abusive trading practices, and by ensuring the financial integrity of the clearing process. Through effective oversight, the CFTC enables the futures markets to service the important function of providing a means for price discovery and offsetting price risk.
The SEC's "About" page begins with the words: "The Investor's Advocate: How the SEC Protects Investors, Maintains Market Integrity, and Facilitates Capital Formation." The sixth paragraph begins:
The laws and rules that govern the securities industry in the United States derive from a simple and straightforward concept: all investors, whether large institutions or private individuals, should have access to certain basic facts about an investment prior to buying it, and so long as they hold it.
The two agencies even speak different languages. To the SEC, "margin" is a down payment, while to the CFTC it is a security deposit. To the SEC, "short sales" must be restricted, while to the CFTC they are the very life blood that ensures futures prices mirror prices in the cash markets. To the SEC, "speculation" has a negative connotation, while to the CFTC it provides the liquidity that makes the futures markets run.
We realize that this discussion is rather simplistic. Both agencies have-and recognize-the same three fundamental regulatory purposes: customer protection, market integrity, and financial system stability. Nonetheless, these two industries have different primary market participants with significantly different uses for the instruments offered. These differences are embedded in the culture of each agency's regulatory philosophy. The way they achieve these three goals is influenced by their perception of which purpose is paramount, and simply revising the regulatory structure will not change their internal cultures. Differences in their histories, philosophies, and markets simply make these two agencies incompatible.7
NFA's Response to the Current Review
NFA appreciates this opportunity to comment on the Department's questions. As noted above, we will limit our response to those areas within our particular expertise. Furthermore, since there is significant overlap among the answers, we will provide our input in a narrative form rather than addressing each question separately.
To start with, we want to put one myth to rest. Larger does not necessarily mean better. Combining regulators may produce some economies of scale, but it is just as likely to produce bureaucracies of scale where some products get lost in the shuffle. It may also create inherent conflicts of interest when risk-management contracts and their underlying goods, services, or financial instruments are regulated by the same agency. As noted above, this potential conflict is among the reasons why responsibility for futures regulation was taken away from the Department of Agriculture three decades ago.8 As further evidence that size can be a negative, we note that the CFTC, which is a relatively small agency, has proven to be less bureaucratic and more nimble than some of the larger agencies. (See questions 1.2.1, 2.3.1, and 2.3.2.)
The Treasury release asks for comments on the key objectives of financial regulation. The short answer is that financial regulation should produce a healthy economy. In reality, this answer is far more complex, however. A healthy economy requires thriving markets. To thrive, markets must reflect supply and demand. To reflect supply and demand, markets must be liquid. To be liquid, markets must attract a large number of buyers and sellers. To attract buyers and sellers, the market must generate public confidence. And public confidence requires all three of the elements commonly cited as regulatory objectives: customer protection, market integrity, and financial system stability. These elements are highly interdependent, and each is equally important. NFA considers itself to be primarily a customer protection organization, but we recognize that customers can get hurt just as badly when they are on the wrong side of a squeeze or when significant financial failures bring down the system as they can when a con artist talks them out of their money. Therefore, all three elements must be accounted for if any regulatory scheme is to be truly effective. (See questions 1.1, 1.3, and 2.3.3.)
In the U.S. financial markets, these three elements are handled by the same market regulator, but the regulator differs depending on the financial product (so-called "functional regulation"). As you know, banking products are regulated by various federal and state banking agencies, insurance products are regulated by the states, the SEC and the states regulate securities, and the CFTC regulates futures. While no regulatory scheme is perfect, our experience shows that functional regulation works well in the futures industry.
Although the links between securities and futures have increased in recent years and many intermediaries handle both, these two markets remain functionally distinct. For this reason, attempts at joint regulation have had limited success, at least in the United States where the two regulators have vastly different cultures. The regulatory scheme for security futures products (SFPs), for example, gave exchanges the option of choosing whether to be primarily regulated as futures exchanges or as securities exchanges, and they all chose to be regulated as futures exchanges because SFPs fall functionally among those products that the CFTC has regulated for decades. Congress gave the SEC a role in these markets, however, and it brings a different history and point of view to the table. Since it does not have the CFTC's experience and philosophy, however, it has been reluctant to approve futures-type margining and to expand the market for SFPs to include international products and participants-both areas where the CFTC has seen marked success.9 (See questions 2.3.1 and 2.3.2.)
The release also asks if the functional regulatory system poses undue difficulties when dealing with overall risk to the financial system. In our experience, the answer is a clear "no." As noted above, the securities and futures markets and the instruments they trade serve entirely different functions: securities are for capital formation while futures are for risk management. The financial regulators in this country have mechanisms in place to coordinate and work together when necessary. The President's Working Group was specifically formed to deal with high-level policy issues that affect all markets. When a financial crisis arises requiring a more immediate response, the agency staffs cooperate to protect investors and stave off systemic effects. Although this process may not be free of agency self-interest, cooperation is a better solution than merger, which could silence one or more of those interests. Even if the merged agency retained the expert staff from the original regulators, senior policy-making officials at the new agency might favor one or the other functional line and take a myopic stance. With different agencies, some may speak louder than others but at least all points of view are represented. (See questions 1.2.2, 2.3.1, and 2.3.2.)
Treasury also seeks comments on the efficacy of using a principles-based regulatory approach. That approach has worked extremely well in the futures industry since Congress adopted the CFMA. Furthermore, both the CFTC and the SEC are active participants in the International Organization of Securities Commissions (IOSCO), which frequently adopts high-level principals for its member nations. This type of regulation is preferable when the core principles can be written narrowly enough to give direction, yet broadly enough to provide flexibility. Regulators and market participants must also recognize that not every regulation can be replaced with a core principle. Capital and segregation requirements, for example, must be spelled out in detail to ensure the integrity of customer funds. In other instances, specific guidance can help regulated entities understand their responsibilities and provide them with some legal certainty.
A set of uniform principles that cross functional boundaries would, of necessity, be so broad that they would lose much of their usefulness in already well-developed financial systems. For example, one core principle under the CFMA prohibits futures exchanges from listing contracts that are readily susceptible to manipulation. While a similar principle might (or might not) work for issues listed on securities exchanges, applying it to securities markets as a whole would deprive small companies of the opportunity to raise additional capital-a result that runs contrary to the very purpose of those markets. On the other hand, a core principle that states "no exchange or market participant may encourage, aid, or engage in manipulation" could be applied to both the futures and the securities markets but would provide no more guidance than the current statutory prohibitions.10 (See questions 1.3.4, 1.3.5, and 2.3.6.)
Question 1.6 asks how U.S. regulators can encourage greater global competitiveness. We believe that U.S. individuals and entities should have access to foreign markets (and foreign individuals and entities should have access to U.S. markets), but that access should not come at the expense of customer protection. Global regulatory convergence, while good in theory, should not result in a race to the bottom. Twenty years ago, the CFTC had the foresight to adopt its Part 30 regulations, which facilitate international trading while providing regulatory protection for U.S. customers who participate in foreign markets. Under these rules, U.S. and foreign intermediaries who solicit, manage, or carry accounts for U.S. customers trading on foreign exchanges must register with and be subject to CFTC regulation. There are exceptions, however, including one for foreign futures commission merchants who are subject to comparable (but not identical) regulatory schemes in their home countries. To ensure this comparability, the CFTC requires the home regulator to apply for and receive Part 30 relief.11 It also requires them to provide reciprocal access and to enter into adequate information-sharing arrangements. This approach has opened up our markets to foreign participants and provided our citizens with access to foreign markets while ensuring that U.S. customers receive adequate protections. Part 30 is a model for cross-border cooperation that can be utilized by other functional regulators, and it came about because the CFTC's culture encourages innovation, competition, and flexibility within the agency as well as within the futures markets. (See question 1.6.)
Treasury has also asked commenters to address the adequacy of protections for retail participants and whether regulators should make regulatory distinctions among different types of investors. In our experience, a tiered regulatory system that provides differing levels of protection based on the nature of the customer ensures adequate protection without intrusive regulation. Both the futures and the securities regulatory systems recognize and implement this principle. On the futures side, for example, the CEA excludes or exempts most off-exchange transactions between eligible contract participants who have the resources to protect themselves, and the CFTC's regulations waive or modify various requirements applicable to on-exchange transactions (e.g., certain standard disclosures) when the customer has a high net worth or other indicia of financial sophistication. Similarly, the securities laws and SEC regulations recognize issuer distinctions based on the nature of the investor. (See questions 1.4 and 2.3.5.)
The current functional regulatory scheme generally provides appropriate protection for retail customers in both the futures and the securities markets. There is one area, however, where the current framework falls short. The CFMA attempted to protect retail customers trading off-exchange foreign futures and options contracts (forex), but hindsight shows it was only partly successful. These customers will not be adequately protected until there are appropriate counterparty standards, solicitors and account managers are required to register, and leveraged forex contracts offered to retail speculators are brought under federal anti-fraud requirements.12 (See question 1.4.)
We would also like to respond to Treasury's questions about the states' position in the regulatory structure. While the states do not have regulatory jurisdiction over futures contracts, they do play an integral role in those markets. Under the CEA's "open season" provisions, states may enforce the CEA by suing firms and individuals who prey on their residents. They may also bring criminal or civil actions under state antifraud and similar statutes of general applicability. This allows them to protect their citizens while freeing up CFTC resources for use in other areas. Because the states do not have regulatory jurisdiction, however, reputable firms and individuals only have to deal with one set of regulations, making it easier to understand and comply with their obligations. The CEA's approach has proven to be an efficient and effective use of resources at both the federal and the state level. (See questions 1.5 and 2.3.4.)
While any regulatory scheme can be improved, functional regulation works well in the United States, and the futures regulatory scheme is particularly effective. Merging agencies with incompatible mandates and philosophies will result in a clash of cultures where might will inevitably win even if the smaller agency has the more successful track record. We are confident the Treasury Department will reach the same conclusion after completing its review.
Very truly yours,
Daniel J. Roth
PLEASE NOTE: As of December 17, 2007, National Futures Association will be located at:
300 South Riverside Plaza, Suite 1800
Chicago, Illinois 60606
1 7 U.S.C. 21.
2 15 U.S.C. 78o-3(k).
3 The first attempt came a year earlier when Congress passed the Futures Trading Act of 1921. The Supreme Court subsequently invalidated that law because it was an unconstitutional use of the taxing power. Hill v. Wallace, 259 U.S. 44 (1922). Congress then passed the Grain Futures Act of 1922, which the Court upheld as a constitutional exercise of the commerce clause. Board of Trade v. Olsen, 262 U.S. 1 (1923).
4 Although many of these products were traded on U.S. exchanges and subject to those exchanges' rules, the exchanges had no jurisdiction over non-members' activities.
5 Board of Trade of the City of Chicago v. SEC, 187 F.3d 713 (7th Cir. 1999); Chicago Mercantile Exchange v. SEC, 883 F.2d 537 (7th Cir. 1989); Board of Trade of the City of Chicago v. SEC, 677 F.2d 1137 (7th Cir. 1982), vacated as moot, 459 U.S. 1026 (1982).
6 This is not a perfect distinction since the SEC regulates certain derivatives (e.g., exchange-traded stock options) that are primarily used for risk-management rather than for raising capital, but the historical separation is mostly maintained.
7 Contrary to what some people may believe, eliminating functional regulation in the U.S. would not have the same results as the United Kingdom saw when it brought financial services regulation under one umbrella. Unlike the U.S., the U.K. did not have significant national regulation covering the securities and futures industries until it adopted the Financial Services Act of 1986, and, although it began with a variation of functional regulation (different self-regulatory organizations that were responsible to the same oversight agency), the functional regulators shared a similar philosophy-principles-based regulation utilizing a tiered regulatory approach and a pro-competition mindset. Therefore, when the functional lines eventually came under a single regulator, that regulator did not have to deal with either a long history or significant cultural differences.
8 The SEC's focus over the years has been on shoring up the price of securities, as its short sales rules demonstrate. This creates the same type of conflict that Congress moved to alleviate in 1974.
9 In fact, given the SEC's internal culture, including its aversion to risk, one must wonder when, or even if, financial futures would have found regulatory approval if they were within the SEC's purview rather than the CFTC's.
10 We note that IOSCO regularly adopts high-level core principles to be applied across international and sometimes functional lines, but those principles are primarily designed to increase the level of protection in countries with less developed regulatory schemes.
11 Australia, Brazil, Canada, France, Germany, Japan, New Zealand, Singapore, Spain, Taiwan, and the United Kingdom have all been granted relief under CFTC Regulation 30.10.
12 In 2004, the 7th Circuit ruled that certain contracts that walked and talked like futures but did not provide an automatic right of offset were not futures contracts and, therefore, not subject to the forex anti-fraud provisions in the CEA. CFTC v. Zelener, 373 F.3d 861 (7th Cir. 2004).