Speeches, Testimonies & Briefing Documents

TESTIMONY OF DANIEL J. ROTH
VICE PRESIDENT AND GENERAL COUNSEL
NATIONAL FUTURES ASSOCIATION

BEFORE THE SUBCOMMITTEE ON RISK MANAGEMENT, RESEARCH, AND SPECIALTY CROPS OF THE U.S. HOUSE OF REPRESENTATIVES COMMITTEE ON AGRICULTURE

My name is Daniel Roth, and I am Vice President and General Counsel of National Futures Association. NFA appreciates the opportunity to appear here today to present our views on some of the issues facing Congress as it begins the reauthorization process. Ultimately, it's up to Congress to ensure that the regulatory structure for the futures industry keeps pace with the changes in the industry itself. Given the profound changes sweeping the industry, the challenge facing Congress is huge.

Change and innovation have always been the lifeblood of the futures industry, but the most dramatic change over the last couple of years has been the pace of change itself. The futures industry is going though a period of constant and rapid innovation. The continuing revolution of technology has changed every facet of the industry-who trades on these markets, where they trade and how they trade. In fact, about the only thing that hasn't changed in recent years is the basic regulatory structure that Congress created in the Commodity Exchange Act.

When the regulatory structure lags so far behind the industry, all of us are in a precarious position. Exchanges and futures commission merchants may differ strongly on certain points, but they all have one thing in common. They all face intense competition every day. The race belongs to those who can deliver the best products at the lowest price, and inefficiencies of any kind simply cannot be tolerated. That goes for inefficient regulation too. Rules which are unnecessarily burdensome were once a costly nuisance. Now they are potentially fatal to any business in this industry. All of these factors frame the basic question confronting Congress in this reauthorization process: How can Congress reduce the regulatory burdens imposed on every sector of the futures industry without reducing core regulatory protections?

Before I go over our thoughts on that question, let me remind you that our perspective is a little bit different than the other witnesses you will have heard from. Like the exchanges, we are a self-regulatory body, but, unlike the exchanges, we operate no marketplace and do not face the competitive issues which confront exchanges. Like the trade associations, we are a membership organization, but we are not a lobbying organization. We are first, foremost and finally a regulatory body. Our 4,000 members include futures commission merchants ("FCMs"), introducing brokers ("IBs"), commodity pool operators ("CPOs") and commodity trading advisors ("CTAs"). We regulate not only our Members' dealings with the public but also the activities of the 50,000 registered account executives who work for those Members. We do that job with a staff of approximately 280 people and a budget of $30 million, all of which is paid by the futures industry.

Which brings us back to the basic question facing Congress-How to reduce regulatory burdens without reducing regulatory protections. That's really the thrust of the five-point program outlined by the exchanges, a program which NFA supports. To NFA, though, a central point in the exchange proposal is the greater use of self-regulation to achieve regulatory efficiency. Self-regulation is a known and proven commodity-you know it works because you have seen it work. Let me give just one example.

Each CPO and CTA is required to give each prospective customer a prospectus type document called a disclosure document. Until October 1997, CPOs and CTAs had to file their disclosure documents with both the CFTC and NFA. NFA had to review the documents because we perform the audits of CPOs and CTAs. The CFTC reviewed the document to ensure it was in compliance with CFTC rules. It never made a lick of sense to us to have both organizations reviewing the same documents for the same basic points.

The Commission finally agreed with us and delegated to NFA the responsibility to review the vast majority of disclosure documents. It is now about a year-and-a-half later, and if you check with CPOs and CTAs, you will hear that they are very pleased that we listened to their complaints about the CFTC review process and did something about it. Our turnaround time averages five days. If there's no problem with the document, the Member hears about it right away. If there is an issue, the Member receives guidance that is personal, prompt and accurate. If you check with the CFTC, they will tell you that they have reviewed every aspect of our program and are completely satisfied with the job NFA is doing. In the meantime, valuable Commission resources have been freed up which the Commission can apply where they are most needed. In the grand scheme of things, the review of CPO and CTA disclosure documents by NFA may seem like a minor point, but I think the example is an illuminating one. Everyone wins when we make the best use of self-regulation.

With respect to CPO disclosure documents, there are still inefficiencies built into the system which Congress should eliminate. CPOs which offer public pools are subject to regulation not only by the CFTC and NFA but also by the SEC. The SEC, for example, reviews the same disclosure documents which are already subject to review by the CFTC and NFA. There just has to be a better way to spend SEC resources than by duplicating the efforts of the CFTC and NFA. Regulation of these public pools by the SEC is a redundancy which Congress should cure by giving the CFTC exclusive jurisdiction over those pools.

I should also point out that reviewing disclosure documents is just the latest example of a long list of additional responsibilities NFA has assumed 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; for tracking compliance with ethics training requirements and approving ethics training providers; and for processing applications for exemptions from registration for foreign firms.

Though the concept of self-regulation is a proven success, the current regulatory structure not only doesn't take full advantage of self-regulation but actually undercuts its effectiveness. Self-regulation works best when the Commission plays a true oversight role and doesn't attempt to micro-manage the self-regulatory process. The Commission performs periodic rule enforcement reviews of every part of our operation-from arbitration to registration to compliance and everything in between-to see if we are meeting our statutory obligations. In fact, NFA pays far more in CFTC oversight fees than any exchange and we don't object because we feel that this sort of periodic monitoring is consistent with the Commission's oversight role.

"Oversight" becomes micro-management, though, when every rule change we propose is subject to an elaborate and prolonged examination by the CFTC. The rule approval process can drag on literally for years as the Commission examines every comma in excruciating detail. The Commission ceases to act as an oversight agency when it, instead, acts as our Board of Directors. It's even worse for the exchanges because this sort of approval process applies to new products as well as to new rules. Like any other marketplace, success is often determined by who is the first to develop and implement a bright new idea. For the exchanges, though, building a better mouse trap is only the start of the process. Obtaining approval for that mouse trap is the real key and real disadvantage in dealing with over-the-counter and foreign competitors who do not have to clear that hurdle. When you consider the mortality rate of new contracts, it's clear that the marketplace is ruthlessly effective in its own "contract approval process." The bottom line for us is that the Act should not require Commission approval of each new contract offered by an exchange and each new rule developed by any self-regulatory organization ("SRO"). The question the Commission should address is not whether it happens to agree with each rule the SRO adopts but whether the SRO is fulfilling its statutory mandate.

The Commission also strays from its appropriate role as an oversight agency when it performs front line regulatory responsibilities that are already carried out by an SRO. The Commission's reparations program is a perfect example. When it was originally established, there was no NFA, boiler rooms were rampant, and there was no real alternative to litigation for the legions of small customers victimized by those boiler rooms.

The world is a much different place now. Together, the CFTC and NFA have cracked down on sales practice fraud and, while there are still problems to be addressed, the large scale boiler rooms are, thankfully, a thing of the past. In addition, NFA's arbitration program has grown and matured. NFA's program offers a more informal alternative to reparations. NFA has arbitrators all across the country and hearings can generally be held in the customer's backyard. Our average turnaround time is just seven months and, according to the General Accounting Office, our recovery rates are almost identical to the reparations program's.

The impact of all of these changes on the reparations program has been dramatic. In 1982, before NFA began operations, there were 1,079 cases filed with the Commission. Last year there were 215, almost the same number that were filed with NFA. Simply stated, the reparations program has outlived its usefulness and we see no reason why the CFTC should be the only federal regulatory agency that maintains a dispute resolution forum. Just like the delegation of the disclosure document review function, elimination of the reparations program would allow the Commission to reallocate valuable resources where they are most needed. For example, the Commission is the only cop on the beat for all of the fraud committed by unregistered firms and individuals. I am sure the Commission would love to find a way to put more of its energy into that area.

When you consider the general topic of sales practice fraud by unregistered firms, you have to confront the Treasury Amendment. For the most part the Treasury Amendment has done just what Congress intended-it has allowed a marketplace of sophisticated, institutional participants to grow and develop unencumbered by regulatory protections intended for less sophisticated customers. But Congress could not have intended in 1974, and cannot intend today, to deprive retail customers of the important regulatory protections provided by the Act simply because a boiler room happens to be selling currency products. From a regulator's viewpoint, it's very frustrating to see individuals and firms that we expel from NFA for fraud, open up a new boiler room under the protection of the Treasury Amendment where they are beyond the reach of either NFA or the CFTC. Whether Congress ultimately adopts the exchanges' proposal or some other approach, the result has got to be the same-retail sales of Treasury Amendment products by otherwise unregulated entities should be covered by the Act.

Customer protection is the heart of what we do at NFA and I would like to clear up one possible misconception that is relevant to the repeal of the Shad-Johnson accord. Some have voiced concern that the futures industry's sales practice rules don't provide the same protection that "suitability" rules in the securities industry provide. The fact is that NFA adopted a Know Your Customer Rule in 1985 and has vigorously enforced it ever since. The only real difference between the rules is based on basic differences between the futures and securities industries.

In the securities industry, account executives have a range of financial products to recommend to their customers, all with varying degrees of risk and all serving different investment objectives. Therefore, the suitability rules require account executives to obtain basic information about their customers and to recommend only those transactions that are appropriate in light of the customer's experience, needs and financial situation. By contrast, futures and options contracts all involve a high degree of risk and volatility, and there is little or no basis for assuming that a trade in soy bean futures contracts would be appropriate for a particular customer but that a heating oil contract would not. The more appropriate focus in the futures industry is whether the customer should be trading futures at all. Therefore, NFA's rule requires that the Member firm obtain the same type of information about the customer that suitability rules require. If the customer has no business trading in these markets, the firm has to tell him exactly that. In short, the differences between suitability rules and our Know Your Customer Rule are not significant and the basic type of protection afforded by each is the same.

The final point I would like to make returns to the basic question of how to reduce regulatory burdens without reducing regulatory protections. The issue has come up most recently in connection with the placement of foreign terminals here in the U.S. NFA supports the Commission's recent move to expedite relief for foreign exchanges and to withdraw the complex rules the Commission had proposed. An equally important part of the Commission's initiative, though, is to review the regulatory burdens imposed on electronic trading by U.S. exchanges to address any competitive disadvantages current regulations may create. The Commission has created a subcommittee of the Global Markets Advisory Committee to undertake this task. The subcommittee, which is chaired by Leo Melamed, includes representatives from NFA, U.S. exchanges, money managers and FCMs. We are very hopeful that the subcommittee will come up with recommendations that have a broad base of industry support within the next few weeks. If any of those recommendations require legislative action, I am sure those issues will be brought to your attention.

In closing, let me state again that NFA is proud of the efficiency we have brought to the regulatory process, we are confident that expanded use of self-regulation will help ensure that regulation keeps pace with changes in the industry, and we stand willing to help in that effort in any way the Commission or Congress deems appropriate.