Speeches, Testimonies & Briefing Documents

SPEECH OF YVONNE DOWNS
SENIOR VICE-PRESIDENT, COMPLIANCE
NATIONAL FUTURES ASSOCIATION
AT NFA MEMBER WORKSHOP HELD IN CHICAGO

Regulatory Responsibilities for the 21st Century

I would like to take this opportunity to thank all of you for coming to NFA's Member workshop. We are very pleased with the response we have received from the industry and hope that you will find today's programs valuable.

I know that many of you were expecting Bob Wilmouth, our President and Chief Executive Officer, to be addressing you today. I have the pleasure of speaking to you today because Mr. Wilmouth is currently in Washington at the invitation of Chairman Ranier of the CFTC who is holding two days of meetings to discuss the CFTC's proposed New Regulatory Framework. Today I'd like to take a few minutes to discuss with you the changing regulatory environment in the futures industry and the future of self-regulation.

The futures industry is rapidly changing and facing greater competition than ever before. This competition is coming from many different markets, both on and off shore. It has become apparent that the regulation of the industry needs to be overhauled and streamlined if regulated markets are to remain competitively attractive. We need to change to attract new entrants and new customers to the business.

In an effort to begin to address some of the changes that need to be made to move the industry forward, the CFTC has issued a report entitled, A New Regulatory Framework. I would like to take a minute to discuss this proposal with you. I think that you will see that it has the potential to substantially affect the industry and how it operates.

The New Framework establishes three kinds of trading facilities, which would be subject to varying levels of Commission oversight. The degree of oversight applicable to each kind of facility would depend on the nature of the products traded on it and the sophistication of the market's participants. This framework replaces the current prescriptive rules with "core principles". Core principles are designed to give trading facilities flexibility as to how they achieve the core principles while continuing to maintain integrity in the marketplace.

The three types of facilities under the New Regulatory Framework are:

1. Recognized Futures Exchanges (RFE) - These are facilities that trade all types of commodities (no limitations) and service all types of traders, not just institutional traders. Of the three types of trading facilities, RFEs are the most similar to today's contract markets.

2. Derivative Transaction Facility (DTF) - These generally trade products that do not have a limited supply (i.e., the products are not generally subject to manipulation) or the facility only has commercial traders. The framework does allow non-institutional traders to use this market if they go through a well-capitalized intermediary.

3. Exempt Multilateral Transaction Facility (MTEF) - These are facilities that offer products that have inexhaustible supplies and only provide for institutional traders. These types of entities may not hold themselves out as regulated.

Each one of these types of trading facilities comes with core principles that address their regulatory requirements. The RFEs (which are the closest to the way contract market designations operate today) have 15 core principles. I won't go into the details of the core principles with you today. I have provided a summary of them for you to take with you.

As the sophistication of users increases and the products become less susceptible to supply concerns, the number of core principles declines. DTF's core principles are approximately one-half of the number required for RFEs. DTFs have seven core principles.

With MTEFs, the third type of trading facility, the number of core principles is reduced to a couple of issues. These facilities are subject to the anti-fraud and anti-manipulation provisions of the Commodity Exchange Act. Again, they may not hold themselves out as being regulated by the CFTC but the new framework does allow them to operate with legal certainty.

Under this new framework, new entrants can operate as any one of the three types of trading facilities or they can operate as more than one. For example, a trading facility can be an RFE for some products and a DTF for others. This would allow the new entrants the ability to tailor their business for the type of customers and products they envision as opposed to trying to match their business plans with specific CFTC requirements.

Recognized Clearing Organizations (RCO)

Another aspect to the New Regulatory Framework that I have not yet mentioned is the impact on ClearingHouses. The proposal requires that organizations that clear transactions for RFEs and DTFs be authorized by the CFTC. The RCOs can clear both OTC products with futures and options products. Core principles for these entities have been established as well. They can be summarized as follows:

1. Adequate financial resources

2. Established standards for participants and the products cleared

3. Risk management programs (which include Risk analysis, Collateral, Credit limits, Margin reduction programs)

4. Settlement procedures

5. Treatment of client funds - (Safe custody, Segregation, and Investment standards)

6. Default rules and procedures

7. Rule enforcement

8. System safeguards

9. Reporting to CFTC

10. Recordkeeping

11. Public information dissemination

12. Information sharing

13. Competition

14. Fraud and manipulation

Intermediaries

The last portion of the framework deals with intermediaries. There are eight core principles that apply to these entities. The framework document indicates that the core principles will be clarified using statements of "Best Practices" from the CFTC and others. Once again let me just highlight the areas addressed by the core principles.

1. Registration
2. Fitness of the registrants
3. Financial requirements
4. Risk disclosure
5. Trading standards
6. Supervision
7. Reporting of positions - large traders
8. Recordkeeping

What's missing from the Proposal?

Several intermediaries have raised questions about the details of the CFTC's proposal. Although existing FCMs are generally supportive of the concept of core principles, it is still unclear as to the extent that intermediaries will be able to use these core principles and the flexibility associated with that concept or if their flexibility will be limited. The CFTC has recently published a proposal to revise its rules relating to intermediaries to implement the changes recommended in the Report. This approach has caused some concern, as it would appear to simply amend the existing regulations to adopt the ideas behind the core principles rather than to adopt the core principles in lieu of the existing regulations. Nonetheless, some of the proposed regulatory changes could reduce some of the duplicative processes among regulators, depending on the type of business the intermediary is engaged in. Some examples of this are reduced registration requirements, more flexible ethics requirements, and several modifications to segregation requirements.

One area not addressed by the New Regulatory Framework, is the issues associated with CPOs and CTAs. NFA, in conjunction with the Managed Fund Association, has drafted nine core principles to address the regulatory requirements that will impact these registrants. The core principles proposed by NFA deal with the following matters:

1. Registration required

2. Fitness of registrants

3. Membership in a registered futures association
All CPOs and CTAs must be members of a registered futures association.

4. Disclosure
CPOs and CTAs must disclose all material information.

5. Pool assets
CPOs must safeguard pool assets.

6. Client funds
CTAs may not accept or hold money or assets belonging to their clients unless registered as futures commission merchants.

7. Supervision

8. General conduct

9. Recordkeeping

Best practice guidance will be provided to CPOs and CTAs to adopt and enforce reasonable procedures associated with these Core Principles.

These core principles have been reviewed and approved by NFA's Board of Directors and have been sent to the CFTC for their consideration.

Best Practices for the New Regulatory Framework

Best Practices and other guidance are also areas in which NFA hopes to contribute to this New Regulatory Framework proposed by the CFTC. As I mentioned earlier, the framework does contemplate that the CFTC and NFA will issue these Best Practices to provide market users and registrants, like yourselves, with interpretations and guidance on the core principles. Whenever we talk about best practices, or "acceptable practices" as the current proposal calls them, we have to consider the basic question of "best practices from whose perspective." To be effective, these practices have to be considered from the perspective of the customer, both the users of the markets and the people we regulate. The best way to ensure that involvement is through the self-regulatory process. In fact, NFA has been working with the industry to produce a document tentatively called Recommendations for the Development of Best Practices in Order Entry and Transmission of Exchange-Traded Futures and Options. This undertaking is a result of the CFTC's request, and this has been done with much input from experts in various aspects of the business. These experts include representatives from Exchanges, compliance and legal staff, end users of the markets, technology representatives and individuals from industry groups such as FII and FIA. We expect that this report will be issued within the next couple of months. So watch for it!

What do these changes in the industry and the CFTC's proposal mean to NFA?

Certainly one of the main challenges facing any regulator is the need to keep pace with changes in the industry it regulates. We certainly have been aware of that need throughout our 18-year history and believe that we have successfully met the needs of a changing futures industry. Now, however, the challenge is greater than ever. Given the changes sweeping through the industry, we started out by asking ourselves three fundamental questions about NFA's future:

• How do we see the industry changing over the next several years?
  
• In light of these changes how can we add value to the industry?
  
• How must we change to fulfill the role we envision for ourselves?

To answer these questions and formulate plans we assembled, under the direction of our Executive Committee, 12 of our most senior staff members to research each of these questions and to get the views of over 40 leaders from the financial services industry. Throughout our interviews and research we heard nothing but praise for the work that we had performed in our four major areas of responsibility: compliance, registration, education and arbitration. In our earlier days of existence we were looked at with a wary eye, particularly by the exchanges, who saw us only as another layer of regulation. But once they saw the advancements we have made they asked us to assist in the simplification of the floor registration procedures. Other organizations such as the Managed Funds Association also have asked us to assist them in updating and introducing new rules and procedures to make it easier for their members to do business.

And so, with that background, let me take you very quickly through some highlights of what we are attempting to achieve as we move forward into a futures world that is evolving in a different way every single day.

1. Expansion of regulatory services to new electronic exchanges

The changing environment of the industry and the deployment of technology have provided us with an opportunity to expand our regulatory services into new areas and expand the existing services that we offer. To that end -- one of our goals for the year 2001 is to develop and implement a cohesive plan to conduct trade practice and market surveillance for new electronic exchanges and trade execution facilities. I am happy to say that the reception to this idea has been very encouraging. We have met with 15 such entities and have plans to meet with several more. I would just like to take a minute to describe what I mean by Trade Practice and Market Surveillance Programs for electronic Exchanges.

First, Trade Practice is the review of all the individual transactions that take place on a electronic exchange to find patterns of conduct that indicate that a potential rule violation of a trading standard (set by the exchange) has occurred. In addition to routine trades, these transactions include Exchange for Physicals, Transfer Trades, and Errors. The type of violative conduct that we are looking for includes trading ahead of customers, wash trading, marking the close, etc. Our program is modular in nature to address the different ways these exchanges conduct their business.

If a pattern were found that warrants further review we would conduct a full investigation. This would include analyzing the trades around the suspicious ones, gathering additional information from the traders, taking statements, looking to the related cash or other futures markets, writing up a report and presenting it to a disciplinary committee.

Market Surveillance focuses on the market as a whole. We need to understand the products traded on an exchange and its relationship to the relevant cash market or another futures or options market. We are monitoring the integrity of the prices established in a particular market and ensuring that the expiration occurs in an orderly fashion. Market surveillance also monitors for manipulation, squeezes and corners in a market place.

As I indicated we have met with 15 potential customers of NFA's services. These electronic exchanges are quite varied in their development and business plans. Some have trading engines (such as technology companies) but are in the process of determining their products and clearing arrangements; some have determined the initial products and clearing and are finalizing their engines.

Other NFA regulatory services

I would be remiss if I did not also indicate to you that the Exchanges that we are talking to have also asked NFA to use many, if not all, of our existing services and one or two new ones. The Exchanges have asked us to consider additional work in the financial and risk management areas, in particular for firms that are not presently NFA Members (i.e., FCMs and CPOs and CTAs). They have also contracted with us to use NFA's arbitration, audit, and financial surveillance programs. New to NFA, they have asked that we expand our services to perform financial background checks on their behalf to assist them is their screening of potential users of their systems beyond our existing registration function. Thus, we believe the future is bright for NFA as we continue to seek out exchanges and other trading facilities to offer NFA's services to. We are hoping to build on NFA's existing infrastructure and expertise in new areas for the future by offering these new regulatory services in a cost-effective manner. We also believe that these efforts will help expand the business that exists today, to your benefit.

2. With the changing environment NFA also has another goal, and that is to continue to pursue additional audit responsibilities from the existing exchanges.

As these exchanges continue to pursue restructuring themselves into for-profit companies there will be a substantial change in their focus. We continue to believe that there are cost saving for the users of our markets and the existing exchanges themselves by outsourcing that activity to a central SRO-NFA.

3. Also, as part of our 2001 goals we hope to expand our Dispute resolution services by introducing a new service called a pre-Arbitration mediation Service. We think this new service will improve the efficiency and timeliness of the current dispute resolution process for NFA Members.

While I'm on the topic of Arbitration, I would like to touch on another initiative that is very important to NFA and that is our effort to eliminate the CFTC's reparations program. As many of you know NFA has a successful record of operating a respected arbitration and mediation forum. We question why the CFTC remains the only federal financial regulator to operate a customer dispute resolution forum. NFA feels that the Commission's resources could be better directed and that Congress should eliminate the reparations program as part of the CFTC's reauthorization. NFA's testimony always has and will continue to raise this issue until we are successful in eliminating the reparations program at the CFTC.

4. Another of NFA's ongoing initiatives is enhancing the coordination of audits with other regulators.

We realize that for many Members, the issue of dealing with multiple regulators is an important one. NFA has always worked closely with other regulators to avoid duplication of effort, but we recognize that we have to do more. We have developed a coordinated auditing approach - all of the audits that we share with the New York Stock Exchange are joint audits. While the audits we share with the NASD are not all joint audits at this time, we have been coordinating scheduling of our audits with the NASD. We think this will benefit our firms and reduce the time it takes to conduct these exams.

5. Paperless Registration

As all of you know, NFA and CFTC rules were, for the most part, written for a "paper world" which is further and further away from the way business is conducted today. NFA has embarked on a project to create a Paperless Registration Process. We have already made great strides in automating registration through the direct entry program. However, even with direct entry, the CFTC requires firms to submit hard copies of relevant forms, causing the firm and NFA to maintain the paper filings. We have received conceptual approval from the CFTC on the idea of a paperless system and are moving forward towards its creation and implementation. We anticipate that this new process will begin in the summer of 2001.

Disciplinary Checks on BASIC

Last April NFA rolled out its BASIC system, which we have been demonstrating here today. BASIC is an Internet-based system that replaced our clearinghouse of disciplinary information. We think this is an essential step in the sharing of information among regulators. We have enjoyed tremendous success with BASIC - hits to NFA's web site have increased dramatically while calls to NFA's Information Center have been reduced, allowing people to obtain information from the system whenever they want it. We are thrilled with the cooperation we have received from the CFTC and U.S. Exchanges. We believe that the BASIC system is a perfect example of sharing information among regulators and that the system goes one step further in making the information available to members of the investing public.

In these uncertain, times where the business landscape is changing daily, charting a course for NFA in the 21st century requires foresight and flexibility. The journey will be a challenging one. We believe that our long-range planning and the initiatives I just discussed provide NFA with the road map by which we can forge ahead. As we move into the 21st Century, NFA is poised to assume whatever regulatory responsibilities this industry needs us to fulfill.

Thank you for your time and attention this afternoon. I'd be happy to entertain any questions you may have.