Speeches and Testimonies

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November 06, 2003



November 6, 2003

My name is Daniel Roth, and I am President of National Futures Association. NFA appreciates this opportunity to appear here today to present our views on some of the issues arising in connection with Eurex U.S.'s pending application for designation as a U.S. contract market ("DCM"). At the outset, let me preface my remarks by stating that I am not here to take a position as to whether the CFTC should approve or disapprove Eurex U.S.'s application as a DCM or, for that matter, what the Commission's timetable for reviewing that application should be. However, I wish to describe for you how NFA operates as a registered futures association ("RFA") and what regulatory services NFA's Executive Committee has authorized the organization to provide Eurex U.S. if it is approved as a DCM.

First, for those of you that may not be familiar with NFA, we are an industrywide self-regulatory organization occupying 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. NFA's twenty-five person Board of Directors ("Board") has representatives from all our Member firm categories as well as six futures exchanges and five public directors. 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 this partnership has been an extraordinary success. In the twenty-one years since NFA began operations, 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.

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-one years, NFA has steadily expanded its regulatory role through either delegation of responsibilities from the CFTC or actively seeking additional regulatory responsibilities. Regardless of how our role has expanded, we have always made a commitment to retaining any expertise necessary to perform any additional responsibilities in a high- quality manner. At this time, let me describe each area of our expanded roles.

Delegations by the CFTC

Over the years, the CFTC has entrusted NFA with certain of its frontline regulatory responsibilities to avoid duplication of effort and to direct its own resources where they are needed most. That trend has continued and accelerated since the passage of the Commodity Futures Modernization Act of 2000 ("CFMA").

For example, last January, the Commission delegated to NFA the authority to review the annual financial reports that CPOs 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 2,600 pool financial statements filed by CPOs with NFA.

Additionally, 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 commodity pools, and managed account programs offered by CTAs. NFA's team of specialists review about 200 disclosure documents each month, with an average turnaround time of a few days.

These two delegations are just the latest example of a long list of additional responsibilities that the CFTC has given to NFA over the years. The Commission has delegated to NFA responsibility for processing registration applications for all categories of registrant; for revoking and denying registrations where appropriate; and for processing applications for exemptions from registration for foreign firms. To enhance and bring greater efficiency to our registration responsibilities, NFA internally developed an Internet based registration system - NFA's Online Registration System. During the Summer of 2002, this system went live and has been met with virtually unanimous approval by both Members and the CFTC. This system allows an individual to receive registration instantaneously and allows a firm to easily monitor its registration activities.

In addition to these formal delegations, NFA constantly works informally with the CFTC. For example, NFA and the CFTC both take their customer protection mandates very seriously and have always had an excellent relationship working together on enforcement matters. I should note that last year NFA alone issued over 27 disciplinary complaints against 100 respondents, and issued 35 disciplinary decisions that ordered 24 expulsions and 23 suspensions from membership, and assessed over $650,000 in fines. Additionally, during the last year, NFA has assigned three compliance employees to the CFTC to help the Commission conduct investigations relating to energy and off-exchange foreign currency transactions.

Delegations by Contract Markets

Section 113 of the CFMA allows, in part, contract markets to comply with their self-regulatory responsibilities by delegating any relevant function to NFA, an RFA. If a DCM elects to make such a delegation, the CFMA provides that the DCM shall remain responsible that the function is carried out. Section 113 essentially codified a position previously taken by CFTC staff in a 1975 staff advisory.

As early as the Spring of 1999, NFA's Board discussed and approved the first of several strategic planning reports. One key initiative of the 1999 report focused on NFA adding value to the industry by offering to perform self-regulatory functions on behalf of existing and new electronic futures exchanges. In February 2001, the Board again discussed and reviewed NFA's strategic plan and unanimously approved an amendment to Article III of NFA's Articles of Incorporation to make clear that the new regulatory services offered by NFA were consistent with NFA's fundamental purposes. Specifically, NFA's Articles were amended to state that one of NFA's fundamental purposes is to provide such regulatory services to such markets as the Board may from time-to-time approve. This Articles amendment was subsequently adopted by membership vote and approved by the CFTC.

The strategic plan adopted by the Board allowed staff to offer regulatory services to both traditional DCMs and to those markets that are not required to perform self-regulatory responsibilities but voluntarily chose to do so. During the last four years, staff has worked to implement the Board's strategic initiatives and has continually kept NFA's Board advised of its progress.

To date, NFA's Executive Committee has unanimously authorized staff to execute Regulatory Services Agreements with four electronic exchanges - BrokerTec, Merchants Exchange, Island Futures Exchange, and OnExchange. Each time this Committee authorized staff to enter into one of these agreements, staff informed the entire Board at its next scheduled meeting. At the present time, staff performs services for two markets - Merchants Exchange and BrokerTec, which both currently operate at low volume levels. NFA did not perform regulatory services for these exchanges until the CFTC approved their respective DCM applications. The Committee should also be aware that NFA has previously offered to perform these services for two other DCMs - OneChicago and NQLX - but these exchanges selected others to provide these services. For example, OneChicago, owned by the CBOE, CME and CBOT, contracted with the CME and NQLX, owned by Euronext.liffe, through the legal entity LIFFE (Holdings) plc, has an agreement with NASDR.

At this time, it is very important for me to note that NFA's senior management and Board both recognized that NFA would need to obtain special expertise to perform trade practice and market surveillance functions delegated to NFA by a DCM. Therefore, our first step in implementing NFA's strategic plan was to hire Yvonne Downs in early 2000. Prior to joining NFA, Ms. Downs worked at the CBOT for almost 20 years. In 1995, the CBOT promoted her to Senior Vice-President and Administrator of the Office of Investigations and Audits. In that position, her responsibilities included the supervision of five regulatory divisions: audits, financial surveillance, investigations, market surveillance and regulatory reporting. Under Ms. Down's direction, NFA developed its own market surveillance and trade practice program ("TPMS"). The principal tool NFA uses for trade practice and market surveillance is the internally developed Trade Analysis and Profiling System ("TAPS").

NFA's market surveillance activities are focused on detecting potential manipulations and price distortions and ensuring the orderly liquidation of expiring contracts. In performing this responsibility, staff uses online quotation systems, computer-generated reports and other tools to conduct daily monitoring of prices, volume, open interest, clearing member and large trader positions, and market news for all contracts listed on an exchange. Through TAPS, staff has access to a contract's historical price record and provides exception report alerts whenever upward or downward price moves exceed preset parameters. Staff can also review the previous day's trading volume and open interest for each contract. TAPS also enables staff to view trade and volume information by clearing member or by firm, and to rank positions in each contract by size. TAPS sends an alert to staff if any trader has a percentage of either volume or open interest beyond preset parameters.

Obviously, an exchange's large trader reporting system is an integral function of TAPS. The system has preset alerts that inform staff whenever a trader has met the threshold for large trader status. NFA then obtains a large trader report from the trader, and enters the information into TAPS' large traders list, which aggregates all positions held by related parties. Once this information is compiled, staff monitors large trader positions for concentrations of ownership and potential collusive or concerted activity by market participants. If it appears that any one trader or account controller has a concentration in a given commodity, staff will contact the trader or controller to determine the reason for the concentration. TAPS also enables NFA staff to view complete information regarding each large trader's trading history at any time.

As contracts approach their expiration dates, staff uses the information in TAPS about the trading patterns of firms and traders to pay particular attention to large trader open interest and volume. TAPS also produces exception reports which alert staff whenever basis relationships do not narrow as expected with the approach of a contract's expiration.

TAPS also creates exception reports designed to identify various types of potential trading abuses and other anomalous trading activity. TPMS staff reviews all of the exception reports on a daily basis. The types of exceptions include trading ahead of customers, wash trading, and marking the close. In addition to conducting an exception report review, staff also uses TAPS to conduct customized searches or reviews of an exchange's audit trail data. Staff thereby has the flexibility to tailor queries based on, for example, the time of a transaction, order type, quantity or price.

TAPS also maintains trader profiles, which include average time logged on, average number of trading days per month, frequency of trading, average trade size, profit and loss history, frequent counterparties, and percentage of total volume in a given market. The system's exception reports alert staff to deviations from a trader's profile, such as those involving unusual profit patterns, significant changes in volume, and unusual concentrations of trading activity between the same counterparties.

Obviously, NFA staff works closely to coordinate its market surveillance and trade practice activities with exchange compliance staff. As previously noted, the exchange is ultimately responsible for fulfilling its self-regulatory functions. The exchange staff also has market supervision responsibilities and an obligation to closely monitor the daily activities on its market. If NFA staff determines that trading activity requires further scrutiny, staff will initiate an investigation and, if in our view the facts warrant formal disciplinary charges, staff prepares a report that is forwarded to the exchange. If the exchange's compliance department concurs with staff's analysis, then the action will proceed to the exchange's disciplinary committee for resolution.

For each of the four exchanges that has executed an RSA with NFA, the CFTC was aware in reviewing each DCM application for approval that NFA had been selected to perform regulatory services for the exchange. Prior to approving each exchange's application, the CFTC performed an extensive review of NFA's TPMS program, including TAPS and our staffing levels. Additionally, just earlier this month, the CFTC completed a rule enforcement review of BrokerTec's market surveillance, audit trail, trade practice surveillance and disciplinary programs. In this review, the Commission found that NFA had adequate programs in place to monitor BrokerTec's trading.

Each RSA previously approved by our Executive Committee sought to ensure that NFA was not exposed to either financial or reputational risk by performing these regulatory services. We have followed that same course in negotiating an RSA with Eurex U.S. This RSA's financial terms are designed to recover NFA's costs, providing for payment of a fixed monthly fee and a fee that is scalable to volume, allowing us to add staff to match an increase in activity. Additionally, we realize that NFA's reputation could be harmed if Eurex U.S. either imposes barriers that make it difficult for NFA to perform regulatory services and uncover wrongdoing or fails to follow our recommendations in addressing regulatory problems. If either event occurs, NFA has the right to cancel the RSA with Eurex U.S. and inform the CFTC of our reasons for doing so.

NFA's Executive Committee met last month and voted 7-1, with one abstention, to authorize staff to execute an RSA with Eurex U.S. NFA will inform our Board of the Executive Committee's action at the next Board meeting and like any other Executive Committee action, the Board may elect to review NFA's agreement with Eurex U.S.

Although both Congress and the Commission have allowed NFA to expand its role, our mission today is the same as it was twenty-one years ago. Everything we do is for a regulatory purpose designed to protect customers, protect market integrity and protect the public's confidence in these vital markets.

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