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August 21, 2003

Self-Regulation in the U.S. Futures Industry
Yvonne Downs, National Futures Association

1 Congresso Internacional de Derivativos e Mercado Financiero
August 21, 2003, Campos de Jordao, Brazil

Introduction and Background
Self-regulation has a proud heritage in the futures industry, dating back to the mid-1800s. For more than 100 years, futures exchanges have successfully regulated their members and the business conducted on their trading floors. In several jurisdictions around the world, effective self-regulation existed before statutory regulation. As markets developed, market participants recognized that regulation was necessary in order to protect the integrity of the market. Industry participants recognized that those who were most familiar with the customs and practices of a particular trade were best suited to create rules related to that trade, to enforce those rules and to resolve the disputes that arose from those rules. Moreover, the familiarity with the concepts involved ensured that such disputes were quickly resolved and that the rules for commerce in that particular market continually and quickly adapted to the evolutions in the manner in which the trade was conducted.

Self regulatory organizations, or SROs, often occupy the front lines of industry regulation. Be they voluntary associations, or mandated by legislation, SROs tap into the knowledge of the industry they regulate. The evolution of many financial markets has gone hand-in-hand with the development of a solid belief in, and a practical application of, self-regulation. Self-regulation, typically involving a unique combination of private interest with government oversight, is an effective and efficient form of regulation for the complex, dynamic and ever-changing financial service industry. As the International Organization of Securities Commissions (IOSCO) stated in its report on Objectives and Principles of Securities Regulation, "self-regulatory organizations can be a valuable component to the regulator in achieving the objectives of securities regulation."1

The role of self-regulation and, indeed, its very existence differ country to country, across market sectors and across the developed and emerging markets. SROs that have a significant role almost invariably have a long track record of responsible behavior, under the oversight of statutory regulators, which allows them to contribute to the quality of regulation and to the content of policy in the public interest.

The broad objectives of self-regulation are very much the same as those identified for government regulation of financial markets in the IOSCO Objectives and Principles of Securities Regulation: to preserve market integrity (fair, efficient and transparent markets), to preserve financial integrity (reduce systematic risk) and to protect investors2. Financial markets can achieve these objectives through many different forms of self-regulation. There are industry self-regulatory organizations, exchange self-regulatory frameworks and private associations that define and encourage adherence to standards of best practice among its participants. Self-regulation typically focuses on oversight of the market itself, qualification standards for market intermediation and oversight of the business conduct of intermediaries including their relationship with their client market-users. These areas of responsibility may be performed by a single SRO or they may be divided or shared among SROs within a given country or market sector.

Self regulation provides an industry or an enterprise with an alternative to imposed regulation. Commerce has always sought to find the most effective and efficient ways to operate profitably and to ensure ongoing success. All industries understand that there must be rules and codes of conduct for business to be sustained. The imposition of regulations on a business can be costly, both for the oversight efforts and the legal recourse when issues arise. Therefore, it is imperative that the regulations and the monitoring of compliance with these regulations are both efficient and effective in meeting the stated objectives.

In the U.S., all recognized contract markets and regulated securities exchanges are designated SROs, as are the National Association of Securities Dealers (NASD) and the National Futures Association (NFA), subject to the oversight of the Commodity Futures Trading Commission, for futures and options on futures products, the Securities and Exchange Commission, for equity and equity options, and both agencies for securities futures products. "In the optimal model, self-regulators are subject to oversight, so that the exercise of self-regulatory responsibilities within the regulatory framework fosters a culture of compliance. The regulator can use the self-regulator to develop, implement and enforce rules that govern its activities; to conserve government resources; and to ensure workable rules to provide greater flexibility in resolving complex problems."3

Evolution of the markets, creation of CFTC & NFA
The relationship between government and the futures markets has grown as the economic need for the markets has become entrenched in America's financial system. "Futures markets have existed in the United States for well over a century and are here to stay, because they stem from and meet an economic need. Governmental regulation of these markets is likewise here to stay. Public and private sector interests affecting futures markets promote the same ends: market integrity, competitive pricing, commercial freedom, and government restraint. If commodity futures markets can aid debt funding and capital formation and provide risk transfer for commercial users, higher prices for producers, and lower prices for consumers, then futures markets will have performed a great service for all involved in them."4

In the early 1970s, a series of economic events brought dramatic changes to the U.S. futures industry. Global demand for agricultural products grew while supplies dwindled, resulting in wide price fluctuations. New contracts on commodities such as metals, lumber and currencies attracted a flood of new market participants and sharply increased trading volume. With growth came unethical business practices, and the industry's reputation was threatened.

The futures industry was suffering a crisis in public confidence. More and more firms were doing business with the public without any effective regulatory framework or oversight. As a result, boiler rooms had sprung up all around the country, luring unsophisticated customers with pitches that promised huge profits with little or no risk. In addition, brokerage houses holding customer funds were often thinly capitalized, had poor recordkeeping and inadequate accounting controls, and customer losses due to broker insolvencies were staggering. The industry was not recognized as a marketplace for effective risk management, and its reputation was threatened.

The U.S. Congress responded to this crisis in 1974 by establishing the Commodity Futures Trading Commission, a federal regulatory agency with jurisdiction over futures trading. The same legislation authorized the creation of "registered futures association," which gave the futures industry the opportunity to create a nationwide self-regulatory organization to work in conjunction with CFTC oversight.

In 1976, National Futures Association (NFA) was organized as a not-for-profit membership corporation. NFA was formed to become a futures industry's self-regulatory organization under Section 17 of the Commodity Exchange Act. Section 17 was added to the Commodity Exchange Act by Title III of the Commodity Futures Trading Commission Act of 1974 and provides for the registration and CFTC oversight of self-regulatory associations of futures professionals. NFA's formal designation as a "registered futures association" was granted by the CFTC on September 22, 1981.

Public comments had been solicited by the CFTC and hearings were held before the CFTC on June 4, 1981. Speaking on behalf of NFA, organizing committee chairman Leo Melamed emphasized NFA's goal of integrated, coordinated self-regulation:

    In an era of deregulation long overdue in my opinion, and essential to the long-term health and economic survival of America - it would be ironic, if not tragic, if NFA were to represent yet another layer of regulation. Duplicative, costly, inefficient, suffocating regulation. A fundamental goal of NFA organizers has been, and is, to avoid just this. We do not want NFA to become but another regulatory layer. We do not want to duplicate existing self-regulatory efforts. Rather, we want to complement and perfect existing programs. [...]

    Thus the NFA proposal of integrated, coordinated self-regulation is the only rational one, the only one, we submit, that Congress could have intended. Our plan fully complies with the spirit and the letter of the law. Moreover, it best reflects what is the essence of futures trading: In the words of Holbrook Working, "Futures trading is trading conducted under special regulations and conventions, more restrictive than that applied to any other class of commodity transactions, which [regulations and conventions] serve to facilitate hedging and speculation by promoting exceptional convenience and economy of transactions." Regulators - self or otherwise - must never lose sight of that.

When NFA opened its doors in 1982, work immediately began to develop programs and practices that would be applied to all futures market professionals. A thorough and rigorous registration screening process for all firms and individuals wishing to do business with the public on any U.S. futures exchange was implemented. Stringent rules covering a wide variety of areas such as advertising, risk disclosure, capital requirements and proficiency testing were adopted. The basic functions that were to guide NFA's rulemaking were: setting standards that embody regulatory objectives; monitoring for compliance with those standards; and taking disciplinary actions when violations of the standards occur. In writing its rules, NFA does not act alone. Congress set the standards that NFA's rules must meet in Section 17 of the Commodity Exchange Act and the CFTC has added its own customer protection regulations. All NFA rules must be consistent both with the Commodity Exchange Act and CFTC regulations, making the development of standards of conduct for NFA members a shared responsibility between NFA, the CFTC and industry participants.

NFA Today
The continued strength and vitality of the futures industry relies on the confidence of the investing public in the integrity of the marketplace. To maintain that market integrity, NFA has developed rules, programs and services that encompass its four congressionally mandated responsibilities.

    NFA's responsibilities begin with the screening and registration of all firms and individuals who wish to conduct futures-related business with the public. Applicants must meet stringent fitness requirements, including providing fingerprint cards for background checks. They also must demonstrate their knowledge of the industry by passing the National Commodity Futures Examination. NFA's current membership includes over 4,000 firms and over 50,000 individuals.

    Once a firm or individual becomes an NFA member, they must comply with a variety of NFA rules that address all aspects of the member's business practices, such as advertising, telemarketing solicitations, recordkeeping, supervision and disclosure documents. To ensure consistent adherence to these rules, NFA's Compliance Department conducts periodic audits of member firms, analyzes member financial statements, reviews promotional material and investigates possible rule violations. In the past year, NFA has conducted over 800 audits of its members.

    Safeguarding market integrity requires strict enforcement of NFA rules and regulations. And although the overwhelming majority of NFA Members successfully meet all of their regulatory requirements, NFA has found it necessary throughout its history to take action against rule violators. In 2002, NFA issued 27 Complaints against 100 respondents. Decisions were issued against 63 respondents, resulting in over $600,000 in fines, 24 expulsions and 23 suspensions. NFA also issued three Member Responsibility Actions in cases where there was an immediate threat to customer funds and market integrity. Finally, although most cases are settled prior to a hearing, NFA's Hearing Committee held six hearings and NFA's Appeals Committee heard four appeals in 2002.

    NFA is committed to providing its Members with the education and resources they need to fulfill their regulatory obligations as efficiently and cost-effectively as possible. NFA's Web site contains the most current information about educational seminars and training opportunities for NFA Members. All of NFA's publications, the NFA rule book and web-based training, as well as background and disciplinary information on all futures industry participants (NFA's BASIC system) can be found at the NFA web site: www.nfa.futures.org.

    The purpose of arbitration is to provide a method for the fair and impartial settlements of disputes that the parties are unable to resolve between themselves. NFA arbitration is generally faster and less expensive than alternative methods of settling controversies. And if hearings are necessary, they are informal, don't require that either party have a lawyer and can often be scheduled at a location convenient for the parties. On October 1, 2001, NFA became the first regulatory organization in the financial services industry to accept arbitration claims online. NFA's turnaround time on an arbitration case averages just under seven months.

Each of these functional areas contributes to the overall success of the organization. This success is difficult to measure statistically; however since NFA began operations, trading volume on U.S. exchanges has grown over 400%. During that same period of time, customer complaints have dropped dramatically-by over 75%. Customer losses due to brokerage house insolvencies have been virtually eliminated.

A hallmark of the SRO system of oversight has been the delegation of certain responsibilities from the statutory regulator to the SRO. In part to take advantage of the expertise of the industry participants, through their SRO, and in part to reduce redundancy and improve efficiency, regulators such as the CFTC continually review their programs and delegate responsibility to NFA where appropriate.

Throughout NFA's history, the CFTC has authorized NFA to conduct additional regulatory functions. As a result, NFA now processes registration applications for all futures industry participants, initiates actions to revoke and/or deny registrations, acts as agent for service of process for foreign firms under Part 30 of the Commodity Exchange Act, and reviews Commodity Pool Operator (CPO) and Commodity Trading Advisor Disclosure Documents and pool financial statements.

Market Monitoring Services
Self-regulation, like the entire financial services industry, is not static. It must evolve as the industry changes to address new business models. Most of NFA's self-regulatory activities have been focused on the market intermediaries and their relationships with the market users. A part of NFA's success is that NFA has responded to the evolution of the financial industry by providing regulatory services to new electronic markets. NFA's trade practice and market surveillance services are designed to ensure the fair treatment of market users/customers and maintain orderly markets.

Over the past few years, NFA has provided market monitoring services as an outsourcing agent to regulated electronic futures exchanges, using NFA's custom-built software to review trading on both macro and micro levels, looking for market manipulation and illegal trade practices. These services have been traditionally part of an exchange's role, but efficiencies of scale, and the added bonus of having market surveillance performed by an independent and reputable third party, have made this regulatory outsourcing model attractive. This is especially true with new electronic exchanges, which do not have an existing self-regulatory infrastructure and may find the costs of erecting one to be prohibitive.

Other Elements of a Successful SRO
SROs can be successful only if they can operate independently and transparently. An SRO must also have a reliable and adequate funding source, have the support of the industry that it regulates, be accountable for its activities and require mandatory membership.

    An SRO needs a source of funding that is adequate to meet its needs. Just as important, though, the SRO's funding sources must ensure its independence. The SRO must not be beholden to the firms it is supposed to regulate. If the SRO were dependent on a small percentage of its members for the majority of its funding, the SRO's independence and its neutrality could be called into question. NFA was founded on the premise that those who benefit most from regulation should bear most of the burden of funding it. NFA is entirely funded by the industry and receives no funding from any governmental bodies.

    Industry Support
    No self-regulatory organization can succeed if it does not have the support of the industry it regulates. That support usually stems from two sources. First, industry leaders recognize that effective regulation bolsters public confidence and adds value to their business. Second, if the industry does not take on the job of effective regulation, the government will.

    When NFA was formed, Congress directed the CFTC to report to Congress within three years evaluating NFA's performance in certain specified areas. Since then, in addition to the continual oversight by the CFTC, other report cards have been issued. These report cards are an important tool for both NFA and the CFTC in ordering priorities and evaluating performance.

    Mandatory membership
    Another important element is mandatory membership. If the goal of self-regulation is to ensure that all of the members of a particular industry or a particular part of an industry, meet certain minimum standards of conduct, then each firm that is part of the target group has to be subject to the self-regulatory process. The rule enforcement process has to have teeth, which it will not have if the firms that are the intended subjects of self-regulation can choose whether or not to be members. If participation is voluntary, then those firms which need self-regulation the most will be the least likely to join.

Co-ordination and Information Sharing with Other Regulatory Bodies
The oversight role of the CFTC includes the approval of NFA rules and review of NFA's audit and surveillance systems. The two agencies work closely to co-ordinate investigation activities. NFA also co-operates with other securities regulatory bodies and law enforcement at the state, federal and international level.

With the increasingly global nature of financial markets, it has become essential that regulators share information with regulators outside their national borders. NFA is committed to working with international organizations, such as IOSCO, the World Bank and the Association of Financial Markets to contribute to the development of sound regulatory programs. NFA provides training classes for international regulators and exchanges. Throughout our history we have provided training programs to international regulators and exchanges, from Singapore to Lithuania, customized to fit the needs of the marketplace and regulatory bodies.

Because of the global economy, regulators must be kept informed on a timely basis of the registration status, financial condition and fitness of firms and individuals in foreign jurisdictions that have access to the regulator's domestic market. NFA, in partnership with the Commodity Futures Trading Commission (CFTC), developed the International Regulators Alert System to automatically communicate relevant information and alerts to other regulators around the world.

This system is provided free of charge, all information is sent by email and reciprocation is not necessary. As all of the information that we send is public, recipients need not necessarily be signatories to a Memorandum of Understanding with the CFTC.5

Current Review of SROs
Finally, it is paramount for any industry to take time to reflect on the rules and regulatory structures that provide its governance, to ensure ongoing adherence to its principles and reassure participants and the public that its regulatory objectives are being met. Regular, structured reviews provide this reassurance and better prepare the organization to evolve and meet new challenges. Recently, CFTC Chairman Newsome announced that the CFTC will soon begin a review of the roles, responsibilities, and capabilities of SROs in the context of market changes. 6

Self-regulation combines oversight with industry knowledge, appropriate rules with practical enforcement. It must evolve and adapt to the industry it is supporting, and it must always keep in focus its regulatory objectives and its essential role in the marketplace.

1 This report, published in September 1998, was prepared by the government regulators that belong to IOSCO. The report states that the words "securities markets" are used, where the context permits, to refer to the various market sectors. In particular, where the context permits they should be understood to include reference to the derivatives markets. The same applies to the use of the words "securities regulation."
2 IOSCO, 1998. http://www.iosco.org/pubdocs/pdf/IOSCOPD82-English.pdf
3 Dowers, Kenroy. Focus on Capital: New Approaches to Developing Latin American Capital Markets. Washington: Inter-American Development Bank, 2003. p. 377.
4 Seeger, Charles M. Congress and Financial Futures. Futures Markets: Regulatory Issues. p. 35.
5 For further information or to sign up, please contact Derek West at dwest@nfa.futures.org.
6 Newsome, James Hon. May 28, 2003: http://www.cftc.gov/opa/speeches03/opanewsm-40.htm

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