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September 09, 2003

The Bond Market Association
New Domestic Landscape for Financial Futures Seminar
September 9, 2003
New York

Remarks by Daniel J. Roth
National Futures Association

"Redefining the Role of Regulation in a Changing Marketplace"


Thanks very much for the opportunity to visit here with you at this seminar. New Domestic Landscape for Financial Futures is certainly the right topic for this seminar. The landscape for all of futures, for that matter for all of the financial services industry, continues to evolve at an accelerating rate. The regulatory landscape changed with the passage of the Commodity Futures Modernization Act. That has led to a more flexible, core principles approach to regulation by the CFTC. The competitive landscape among exchanges has changed with the pending arrival of Eurex as a U.S. contract market. Just the prospect of that competition has affected longstanding partnerships, like the CBOT and BOTCC, and longstanding rivalries, like the CBOT and CME.

The self-regulatory process has changed some in the last few years, but I suspect larger changes are on the horizon. New electronic exchanges that have entered the fray have all adopted a less traditional approach to their self-regulatory responsibilities. Rather than build their own SRO infrastructure, they have all out sourced those functions, most of them to NFA. I am sure that Eurex will follow that same approach.

The larger changes that could be coming could stem from the concern that as the marketplace changes, the conflicts of interest inherent in the self-regulatory process will change as well and that the government may need to find new ways to manage those conflicts. Depending on how those changes are brought about, we may see some real improvements in effective and efficient regulation or real growth of ineffectual bureaucracy.

Part of the problem is the way we typically review regulatory structures. Regulation, whether it's performed by government agencies or by industry self-regulatory organizations, is a service. Regulators are service providers with a very diverse customer base. At NFA, our customers include the CFTC, the Congress, 4,000 member firms and all of the members of the public who use the futures markets. They may have diverse interests, but they all look to NFA for the same thing-they want NFA to provide the best possible regulation to ensure the integrity of the markets, and they all want us to do it at the best possible price. All regulators need to periodically reexamine their operations to see if they are meeting their customers' needs:

  • Are we providing the highest level of service we can? The ultimate mission of financial regulators is to help maintain efficient markets. Regulators do that by maintaining both the integrity of the marketplace and, just as important, the public's confidence in the integrity of the marketplace. Markets cannot be efficient if they are not liquid, and they cannot be liquid if customers are not sure they will get a fair shake. Every regulator has to constantly examine whether it can do more to protect market integrity and public confidence.
  • Second, are we delivering our service at the best possible price. The fairest market in the world can still lose liquidity and market share and efficiency if the costs of doing business in that market are prohibitive. Like any other service provider, regulators need to watch the price of their services. For regulators, that price is measured both by direct regulatory fees and the indirect costs of compliance.

Ideally, these are the types of questions that should be examined carefully and calmly with deliberate introspection and careful benchmarking of other regulators. In reality, it never seems to happen that way. Instead, the review of regulatory structures is usually scandal driven. Something blows up, the people look to Congress, Congress looks to the regulators and regulators start writing new rules as fast as they can. That's certainly what has been happening in the securities markets, with each week bringing new headlines that erode public confidence in the markets and the regulators.

Self-Regulation Under Review

The scandals have prompted not only rulemaking but an examination of the regulatory structure itself, particularly the role of self-regulatory organizations. Elliot Spitzer has labeled the efforts of the securities SROs "an abysmal failure." The SEC was asking pointed questions about conflicts of interest in SROs even before we all learned of the full extent of Mr. Grasso's negotiating skills. The NYSE has its own special committee looking at the issues and suggesting changes, which prompted the Council of Institutional Investors to issue a scathing critique of the self-regulatory process.

Intense scrutiny of the self-regulatory process has spread to the futures industry as well, but for different reasons. The futures industry has not been rocked by scandal in recent years. To the contrary, there has been a steady trend over the last twenty years that has seen dramatic reductions in customer complaints. In 1982, the year NFA started, customers filed almost 1,000 complaints with the CFTC's reparations program. Last year, there were 80. When you add in the complaints filed with NFA's arbitration program, you still see a 70% reduction in customer complaints during a period in which volume on U.S. futures exchanges increased by over 400%. Nevertheless, Chairman Jim Newsome of the CFTC has announced a thorough review of the current self-regulatory structure and his senior staff has undertaken an intensive fact-gathering effort.

Because the CFTC inquiry is not scandal driven, it may present an opportunity to really examine how demutualization of exchanges, the emergence of for-profit exchanges and the changing roles of FCMs have affected the conflicts of interest inherent in the self-regulatory process and how the government should best manage those conflicts of interest. Take the SRO disciplinary process as an example. The traditional regulatory concern has focused on the "fox watching the hen house" issue. Specifically, the CFTC was concerned that those serving on SRO disciplinary committees might be reluctant to impose necessary sanctions on their buddies, both because of personal relationships and a recognition that the exchange action could set a precedent that could be used against the committee members themselves.

The Commission therefore required that at least half of an SRO's disciplinary committee must be drawn from membership categories different than the respondent's. That regulation certainly seems to have been a rational response to the perceived problem. Now, though, members of the brokerage community feel that the potential conflict of interest in the SRO disciplinary process has a different twist. With firms trading a wide range of OTC products and seeking to internalize order flow, firms feel they are being regulated by exchanges that are actually their competitors.

On the futures side, some brokerage firms feel that when most of the members of the disciplinary committee are floor brokers and floor traders, they can't get a fair shake. They feel that many of the rules passed by the exchange are designed to hurt them and help the floor and that they have no real voice in the governance of the exchange. They feel that exchange audits are sometimes used to examine firm books and records for competitive information. I haven't sat in on any of the meetings the CFTC staff is having with FCMs, but I'm sure that's what they are hearing because FCMs have been saying it for years in various public forums.

Data on SRO disciplinary fines against brokerage firms does not exactly paint a picture of a grand conspiracy on the part of the SROs. Fines have increased significantly at some exchanges but not all, in some years but not others. But when it comes to the disciplinary process, the perception of fairness is as important as the fairness itself. Given the changes occurring in the industry, the CFTC's review is both timely and appropriate and, hopefully, will be a thoughtful exercise since it is not scandal driven.

The bottom line is that in both the futures and securities industries, self-regulation is under very close scrutiny. Given the need to shore up public confidence and the changes occurring in the markets, I think it is inevitable that the self-regulatory structure will change significantly in the next few years. The question is not whether the SRO structure will change but how. Let me talk first about changes that should not happen, changes that will make the process more expensive but not more effective.

Bad Ideas

The most radical, and least likely, restructuring of the SRO process would be the elimination of SROs altogether, or at least a reduction in their role. Such a move would not be without precedent. For example, though the creation of the FSA in London left the exchanges' SRO functions largely intact, SROs other than exchanges, such as SFA, IMRO and SIB, were completely eliminated and their functions assumed by the government. Similarly, the Singapore Monetary Authority recently took over audit responsibility for brokerage firms from the exchange SROs.

In the U.S., though, the role of the SROs in both the futures and securities industries is so deeply imbedded, and the resources of the government regulators already so strained, that a major reallocation of responsibilities from the SROs to the government is very unlikely. In fact, at least on the futures side, the recent trend has been just the opposite. Over the last several years, the CFTC has been delegating more and more of its frontline regulatory responsibility to NFA. NFA performs all of the CFTC's registration functions, reviews disclosure documents for both public and private pools and reviews all pool financial statements. The CFTC keeps giving NFA more responsibility for the simple reasons that it makes sense for them. NFA has done every job they have given us well and the Commission frees its resources to concentrate in other areas, such as enforcement. The notion that the government will rely less on self-regulation seems highly unlikely.

It is also just a bad idea. The goal is to provide regulation that is both effective and efficient. Assuming for the sake of argument that reducing the role of SROs would provide more effective regulation, a pretty big assumption, to be sure, I know of no conceivable argument that greater reliance on the government would be more efficient. One of the basic reasons for any self-regulation is the recognition the private sector can always bring efficiencies the government cannot duplicate. There's got to be a better way to manage conflicts of interest than to lose all of the benefits the government has enjoyed from self-regulation.

A more realistic possibility, but not a better one, would be to reduce or eliminate the "self" in the process of self-regulation. Actually, this has already been done in other contexts. Congress created the Public Accounting Oversight Board as part of Sarbanes-Oxley and went to great lengths to point out that this Board constituted private regulation, not self-regulation. The legislation specifically provides that a majority of the Board of Directors must come from outside of the public accounting industry and all of the Board members are appointed by the SEC. This is a step beyond SEC requirements that 50% of the directors on the Boards of securities exchanges be public directors.

The danger here is that a "private regulator" could become a privately funded bureaucracy. This private regulator has the authority to tax public accounting firms without really being accountable to them. It's not just that this structure smacks of taxation without representation-the structure lacks any real fiscal discipline. I've worked for NFA for over twenty years. In that time our Board has never once refused any spending or staffing increase that staff recommended, but I guarantee you that in each and every budget we prepare, we have to make our case to the Board. The very structure of an SRO imposes a discipline on spending that helps bring private sector efficiency to the business of regulation. That's why NFA has responded to record volume by cutting its fees by 66% over the last two years, why we have held our average annual increase in administrative spending to just 2% over the last ten years. There's no need to strive for greater efficiency, to be smart in allocating resources, if the private regulator has basically unfettered ability to tax the industry it regulates. Again, there's got to be a better way to manage conflicts of interest than by creating a structure that has little or no incentive to be efficient.

Good Ideas

If reducing the role of self-regulation or taking the self out of self-regulation are bad ideas, then what are some good ones? What can we do to make self-regulation more effective, more credible without sacrificing the efficiency and fiscal discipline of self-regulation?

What it really boils down to is ensuring the credibility of self-regulation with two distinct groups. First, market participants have to know that they will get a fair shake, that the markets are well regulated. They have to know that there are tough rules in place, meaningful surveillance to ensure compliance with those rules and vigorous enforcement actions if the rules are violated.

Members have to have faith in self-regulation as well. They have to be deterred from wrongful conduct, of course, but they also have to believe in the fairness of the process, in the impartiality, independence and neutrality of the SRO-from making the rules to enforcing them. Members have to believe that the SRO's regulatory and enforcement authority can't and won't be used as a competitive weapon.

How can self-regulation be structured to bolster credibility with both of these groups? How can we protect the integrity of the regulatory process and insulate that process from improper influences and conflicts of interest? Some have suggested that self-regulatory duties should be divorced from the operation of a marketplace and vested in an independent SRO, such as NFA. That may be flattering, but I'm not sure it's the right response, at least not now. The exchanges argue that they have a huge stake in maintaining their market's reputation and that certain regulatory functions, such as market surveillance, are core to their brand and their business model. I'm not sure that the argument applies as well to regulatory functions that don't pertain to a particular market. For example, promotional material issues, capital requirements, supervision, books and records are all areas that SROs have to audit for and none of them pertain to the reputation of a particular market. Nonetheless, suggesting that exchanges should be completely out of the self-regulation business strikes me as going too far. If a particular exchange chooses to outsource its market surveillance function, that's their business decision, but it shouldn't be mandated by the government.

I do think, though, there are changes that we can and should make. I have already argued that it would be unwise to take the self out of self-regulation, but I think we can and should reduce the self in the enforcement process.

Members have to be involved in the disciplinary process. They bring a depth of knowledge that members of the public just do not have. But no one constituency of the SRO should control the disciplinary process. The Commission was right to provide that a majority of the enforcement committee must come from a membership category other than the respondent's. By the same token, a majority of the committee shouldn't come from other membership categories either. The missing component of the disciplinary process is the public-public representatives should play a role in the rule enforcement process. SRO enforcement committees should be structured to ensure that public representatives have an equal voice with various membership categories so that neither the respondent's colleagues nor competitors control that critical regulatory function.

What else can we do? We need to change the mindset that all regulators can lapse into-reacting to the last problem instead of anticipating the next one. The members of the SRO have to be partners in that process. Senior staff from NFA try to visit as many of our members as we can for one-on-one meetings, not to talk about the last audit but to talk about what's going on in the industry. What we are working on and, more importantly, what we should be working on. As I mentioned before, the futures industry has been relatively scandal free in recent years, but we cannot kid ourselves into a false sense of security. We work with both our members and with the Commission staff to try to think about any ticking time bombs that could be out there. We need to do more of that.

The last thing I'll mention may sound odd coming from an SRO but I think we can hold the SRO's feet to the fire by enhancing the oversight function of the government agencies. I think the agencies need to reconsider their enforcement philosophy regarding SROs. Obviously, both the CFTC and the SEC have the authority to bring enforcement actions against SROs that haven't done their jobs correctly. Historically, that authority has been used only in extreme cases, where there has been a highly publicized calamity or meltdown, such as the SEC and Justice Department action against the NASD several years ago. The agencies need to examine whether that makes sense, whether smaller lapses by SROs shouldn't result in smaller, but more frequent, enforcement actions. Justice Douglas referred to the threat of government enforcement actions against SROs as the "well oiled shotgun behind the door" that makes the SRO process work. It may be contrary to my interest in some ways, but maybe the shotgun has become a little rusty and needs to be oiled up again.

I think increased federal oversight of the SRO process and adding greater public participation in the enforcement process are both steps that would be thoughtful responses to the current issues facing self-regulation. They would improve the effectiveness of the SROs and bolster public confidence in the process without sacrificing the traditional benefits that come from active industry participation in the self-regulatory process.

The days and years ahead pose challenges for all of us, market participants and regulators alike. Changes are coming and from the regulatory side it's all of our jobs to make sure those changes are positive, that self-regulation changes in ways that enhances performance, that provides the best possible service to all our customers at the best possible price.

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