Speeches, Testimonies & Briefing Documents

SPEECH OF KAREN K. WUERTZ
SENIOR VICE PRESIDENT, STRATEGIC PLANNING AND COMMUNICATIONS
NATIONAL FUTURES ASSOCIATION

REMARKS GIVEN AT THE
WORLD FEDERATION OF EXCHANGES
FEDERATION MARKETS SURVEILLANCE WORKSHOP
WARSAW, POLAND, APRIL 25-26 2002

Introduction

I would like to thank the World Federation of Exchanges and its members as well as Thomas Krantz and Peter Clifford for inviting me to speak to you today. The World Federation of Exchanges enjoys a reputation both in the developed and emerging markets as a facilitator of best practices, a forum of communication and a standard-bearer for the financial marketplace and I am truly honored to have the opportunity to be here today.

In your kind invitation to NFA to participate you stated:

"Federation member exchanges have placed surveillance of markets and listed companies at the top of the list of priorities; it is at the heart of an exchange's role as a Self Regulatory Organization. At a time when most exchanges are for-profit businesses, and all are more commercially oriented, some observers question whether cost pressures will diminish market integrity."

Before that question is properly answered it is important to reflect on the strong forces that are causing exchanges to re-examine their business structures in order to remain competitive. The globalization of the markets, advances in technology, a concentration of new investment capital, competitive pricing pressure and government deregulation are all contributing to the allure of demutualization and for-profit exchanges.

Let's also look at a marketplace's general regulatory objectives: to ensure market integrity and to protect the investors in the marketplace. Given those general objectives, each exchange's self-regulatory responsibilities involve three basic functions. One, establishing rules to govern the conduct of those with direct access to the market and those intermediaries authorized to access the market on behalf of others. Two, monitoring compliance with those rules. And three, taking prompt enforcement actions when potential rule violations are noted.

So now let me answer the question as to whether competitive cost pressures will diminish market integrity. Regulatory requirements do not change when an exchange demutualizes. As you stated in your invitation, "Member exchanges have affirmed that the quality of the markets they operate is their key asset and the distinguishing feature which they must protect." I can't agree with you more, but I will say that what may change is how an exchange chooses to meet their regulatory requirements.

It is unlikely that any exchange, whether it demutualizes or not, would cede the authority to write the rules that govern its marketplace to another entity. Similarly, the ultimate authority to interpret and apply those rules should rest with the exchange itself. However, there are several self-regulatory practices and procedures relating to the core function of monitoring market participants that exchanges may incorporate into new business models. Those practices and procedures include:

• Enforcing rules and regulations through investigations and disciplinary action;

• Conducting financial operations and sales practice examinations;

• Conducting fitness screening for access to the marketplace;

• Handling customer complaints;

• Having surveillance programs to detect unlawful conduct;

• Sharing information and cooperating with other SROs; and

• Providing a dispute resolution forum.

As you will hear throughout this workshop, while markets have continued to move more and more towards automation and many have developed into highly efficient electronic trading platforms, the job of the regulator has remained the same — to ensure fair, transparent marketplaces with adherence to trading rules. Having said that, and before I get into detail about our market surveillance programs, perhaps I should give a brief introduction to NFA for the benefit of those who are not familiar with our organization.

NFA Background

NFA is a not-for-profit self-regulatory organization for the futures industry. We do not operate a market; we are independent. Independence allows us to remain neutral on exchange issues and eliminates any competitive issues with the entities we regulate.

Any definition of NFA must begin with its congressional designation as a self-regulatory body for the futures industry; charged with maintaining the integrity of the marketplace and protecting the public investor. The United States Congress mandated four major areas of responsibility for NFA: registration, compliance, arbitration and education. One of the hallmarks of this organization is our commitment to fulfill each of these responsibilities cost-effectively, while constantly striving to develop new programs that will enable our members to meet their regulatory responsibilities as efficiently as possible.

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 areas of responsibility. The Association screens all firms and individuals wishing to conduct business with the investing public. It develops a wide range of investor protection rules and monitors all members for compliance. NFA also provides investors with the information they need to make educated financial decisions and offers a fast, efficient method for settling disputes when they occur.

Over the past few years, NFA's role in the financial services industry has expanded far beyond what our founders could have anticipated. NFA is no longer a new organization, I am pleased to announce that this year we are recognizing 20 years of operations.

NFA's Regulatory Services for Electronic Exchanges

As new, electronic, for-profit exchanges have emerged over the course of the past few years, they are adopting a business model that stems directly from a drive to maximize profits by finding more efficient ways to provide the services traditionally performed by exchanges.

New exchanges are essentially unbundling these services by contracting with different organizations to provide clearing, trade practice and market surveillance, rule enforcement and dispute resolution services. We are finding this to be 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. I can tell you from my own experience at NFA that outsourcing is becoming a popular alternative. NFA currently performs self-regulatory functions for some open outcry exchanges. We have also signed contracts with four electronic exchanges to conduct surveillance and other regulatory services on their behalf, and are in talks with several others.

Because of NFA's reputation, knowledge and experience as a provider of effective regulatory services that contribute to market integrity, many of these exchanges have turned to us as an alternative to establishing their own internal compliance and surveillance departments. We have helped several markets through the regulatory submission process with the CFTC, and as our systems and surveillance programs have been vetted by the Commission, this process is greatly expedited. I should add that our focus is not only on the traditional regulated derivatives exchange, but any electronic marketplace. Completely apart from the legal requirements regarding self-regulation, new exchanges have to demonstrate an effective self-regulatory presence because it's just good business. Any exchange, new or old, electronic or open outcry, principal to principal or intermediated, must win the confidence of its participants and to do so must demonstrate that there is integrity in its market and that all will be treated fairly.

Any exchange, whether it chooses to maintain a compliance department in-house or outsource it to a third party, must, in order to attract liquidity and ensure confidence in its market, provide certain basic functions:

• Background checks: a market must have good faith users that can fulfill their obligations;

• Ongoing financial surveillance of market users to ensure that the participants are meeting their financial obligations and to monitor the effects that current market conditions have on a firm's finances;

• A resolution process for the inevitable disputes between and among participants and intermediaries; and

• Market Surveillance to ensure the fair treatment of customers and maintain orderly markets. Market Surveillance Overview

I'd like to spend the rest of my time this afternoon on market surveillance. NFA's trade practice and market surveillance services give new electronic markets the benefit of our experience and reputation, helping them attract liquidity by increasing confidence in the transparency and fairness of their marketplace. This experience and our independence can be tremendous assets to any developing market and we are very willing to share our regulatory experience with any marketplace. We can tell you what has worked and what hasn't.

NFA's market surveillance application was designed and developed with significant input from market professionals with a vast amount of experience in this regulatory area. All in all, the software was developed with the understanding that while surveillance systems can accomplish a great deal in terms of complex pattern identification and modeling, the strength of any surveillance system depends upon the interpretive and investigation skills of a skilled analyst, deeply familiar with the market and its participants. That's why we had people with years of market and investigative experience develop this system. This kind of practitioner expertise cannot be purchased from a software vendor.

Our prime directive when designing the system was to give the analyst the necessary tools to leverage this knowledge in the most effective way possible. Several key factors guided the designers along the path to this goal. Among the most notable was "usability". We wanted to make the software easy to use by coordinating system automation with actual investigative methods. For example, the system uses a set of sophisticated pattern definitions to flag potential problems. From there, it allows the analyst to investigate these problems by drilling-down to the relevant trade data or summary information. By taking the user from one piece of information directly to another related area with just the click of the mouse, these drill-downs offer the analyst the ability to view relevant data in a logical progression and thus maintain an investigative focus. Another notable design factor was "flexibility". Trading and markets are in a constant state of evolution and it is imperative that a surveillance system be flexible enough to react to these changes. That's why we designed the system to include several parameters and settings that users can quickly adjust on their own whenever ongoing market conditions change. Overall, our system represents a unique blending of traditional investigative methods with modern technology. The software itself is used to analyze market activity at both the macro and micro levels. At the micro level, the system performs Trade Practice Surveillance by examining the entire trade record for certain complex patterns of activity. At the macro level, the system performs Market Surveillance by searching for broader market trends and concentrations of ownership that may indicate price manipulations.

The system can be divided into three key components. First, the data processing component. This essentially coordinates the various incoming data feeds, normalizes the data and inserts it into our database structure. The data is sent to us directly from the exchange and/or the clearinghouse over dedicated high-speed lines after the end of the trading day. We receive not only matched trades, but also all bids and offers entered into the order book during the day, as well as any off-exchange or reconciled transactions that occur after the end of trading.

Next, at the heart of the system, are the various analytical engines. Depending on the nature of the targeted activity, these engines essentially replay the trading day from start to finish and look for suspicious patterns of activity commonly referred to as "trade exceptions". The system has several rule-based engines that utilize sets of sophisticated pattern definitions to identify various types of problematic activity. Of course, surveillance doesn't end simply with pattern identification. Once the problematic activity has been identified, we turn to the last primary component of the system, the user interface. This component essentially consists of a variety of interactive tools for viewing data. The system make extensive use of On-Line Analytical Processing or OLAP-type features such as drill-downs to allow staff to view relevant data in a logical progression. It also incorporates other OLAP type features so users can chart and analyze data visually. Furthermore, data aggregations provide valuable insight into unusual activity by presenting in-depth profiles of individual traders. These profiles enable users to identify deviations from normal trade activity for future follow-up.

The primary goal of any surveillance program is to ensure the overall integrity of the market. This is typically achieved through two different channels. First, we have Market Surveillance where the goal is to ensure the integrity of price discovery. Specifically, we're looking for price manipulations that occur through concentrations of ownership or disingenuous trading activity. Next, we have Trade Practice Surveillance where the goal is to ensure the integrity of individual transactions. In this case, we're examining trade activity for specifically defined patterns of conduct.

Trade Practice

Trade practice surveillance deals with the integrity of individual transactions. Therefore, the actual type of surveillance is usually based on the sequence, pattern or timing of the individual trades. A typical example of what we are looking for is "Trading Ahead". This prohibited trade practice is a common problem in both the electronic and open outcry worlds. Trading ahead generally consists of instances where an executing broker places orders for his own account within a defined period of time in advance of orders for his customers.

• Front Running is a subset of the Trading Ahead category. A subset because not only could the broker be trading ahead of his own customers, but he could also be trading ahead of other customers based on privileged information he obtains about their trading intentions. In other words, the broker learns through privileged or non-public information about a large trade that could potentially move the market and so he executes his own trade beforehand in order to take advantage of that move. NFA's system extends its analysis to scan for brokers who demonstrate a pattern of entering the market just before large market moving orders. The system can then be used to investigate any patterns of such trading to determine whether it was done based on privileged information.

• We use similar but more complex logic to determine if there is direct or indirect crossing, direct or indirect money passes, pre-arranged trading, wash trades, and the like. NFA's system also looks for "Market Manipulation Trades." From a broader market surveillance perspective, price manipulations usually take place through positional control. However, on the trade surveillance side, price manipulations can take place through individual trades or collusive trade activity.

• One such manipulation is stop order fishing. Sometimes a market professional will bid up or sell down a market in order to set off the protective stops of positional traders. The resulting artificial price shifts can create easy profit opportunities for these traders. As a result, it is important to monitor for this type of activity by looking for any unusual rises or declines in market prices that promptly reverse after a series of stop-loss orders have been activated.

• Another example of transactional market manipulation is "marking the close"; the system will identify large trader positions open at the close of the previous trading day by contract. It will then determine if the day's last trade was executed outside of the expected price range by one of the large traders from the prior day.

Other transactional information that is analyzed by our system includes error trades, transfers, adjustments or cancellations, exchange for physical, pre-arranged or block trades, and even login and logoff times, as we search for abnormal exchange activity that requires further review. As well, our system each day builds a trader profile for each exchange participant. This profile will include the types of information based on all trades placed by that user: average time logged on per day, profit and loss, frequency of trading, average size of trades, specific users who are frequently on the other side of trades, average number of days logged on per month, percentage of trading done for one's own account or as an intermediary and the percentage of total volume in a given market. In addition, deviations from established profiles such as increases in customer volume, unusual profit patterns, drastic changes in volume, or unusual concentrations of trading activity between the same counterparties will signal the need for a detailed review of the component trading activity.

Market Surveillance

As I mentioned earlier, the goal of Market Surveillance, as opposed to Trade Practice Surveillance, is to ensure the integrity of price discovery. This can be accomplished in a number ways but for the most part, we mainly concentrate on monitoring concentrations of large positions and unusual price patterns. Our system monitors market factors like price, volume and position concentrations for potential price manipulations. Certain anomalies are automatically flagged for analysis and analysts are given access to the necessary market detail to complete an investigation. For much of market surveillance, our focus is on market participants whose positions may be large enough to influence the market. The "size" threshold is a relative one, but traditionally, exchanges set their own position limits while the CFTC sets mandated "reportable position" limits. When the reportable position limits are reached, the exchanges or the CFTC request additional information regarding account ownership from its intermediaries. For these "large traders", one needs to pay particular attention to non-trade transactions such as exchange for physicals, transfers and adjustments. In addition, as delivery approaches, one must determine whether there is a balance between these large positions and deliverable supply.

Our system enables the analyst to identify large traders and track their activity via a two step process. First, it enables users to aggregate different accounts under a single large trader identification number. In this case, the analyst must perform a review of available background and position data to determine if account holders or controllers are related. Then, a determination must be made as to whether or not these accounts should be combined for Large Trader analysis. Once aggregated, the system then enables the analyst to monitor large trader positions for concentrations of ownership and potential collusive or concerted activity by market participants. Of course, our analytical systems are only a part of the surveillance process. We perform real time market supervision of both the exchange and the underlying cash markets, providing a second set of eyes to the market's supervision efforts, and ensuring quick reaction to market events. Throughout the surveillance process, it is important to keep in mind that NFA is providing the market surveillance function on behalf of the exchange, and the final authority and responsibility for ensuring market integrity and adherence to rules rest with the exchange. If NFA identifies any irregularities, we will complete the appropriate investigation work. We will then continue to work closely with exchange personnel and communicate the findings of the investigations to the exchange to determine any appropriate disciplinary action.

Our system is considered state-of-the-art and was designed to exceed the requirements of the CFTC. As an outsource provider for regulated exchanges, our system is subject to periodic review by the Commission to ensure that each exchange meets its regulatory responsibilities. Let me take a moment and run through the other applications we have developed over the years to improve our efficiency and our effectiveness.

BASIC

NFA has long had a clearinghouse of disciplinary information regarding firms and individuals that have registered with us. Our Information Center telephone representatives provided this information to anyone who called our toll-free number. In 1999, this information was provided to the public via the World Wide Web, using our BASIC system — the Background Affiliation Status Information Center. This system provides the public, participants and regulators, free of charge and 24 hours a day, current and historical registration and disciplinary information, data about customer arbitration cases and ethics training data about individuals. About 50,000 BASIC searches are performed each month. The BASIC system also allows exchanges to meet their CFTC reporting requirements about enforcement actions electronically, reducing paperwork and the inefficiencies that it brings.

Online Registration

NFA was the first financial services regulator to operate an electronic registration filing system in 1990, and we are currently developing a new internet-based registration system that is intended to lead us to a truly paperless environment. The electronic submission, executed on NFA's web site, will be the filing of record. The official record will be the data in our database. This new system is scheduled for implementation this summer.

Regulators Alert System

At the same time, we will be unveiling the Regulators' Alert System, which we are developing with the Commodity Futures Trading Commission. The regulatory objective of this system is to provide pertinent information regarding US registrants to other jurisdictions where the registrants are carrying out business. The new system will link registrants and regulators, automatically sending email notification when a significant event effecting the registrant has been entered into our systems.

FACTS & WinJammer^TM

NFA has long used analytic tools to assist our audit staff in performing on-site examinations of our member firms, as well as periodic reviews of their financial situation. Recently, in collaboration with other SROs, we have upgraded the filing software that firms use to transmit their required financial statements. When their data is incorporated into our financial analysis database, these analytic tools provide a comprehensive and detailed picture of the firms' financial situation and market position.

Conclusion

Our industry is undergoing continual, rapid change and as exchanges evolve, we regulatory bodies must adapt and develop our programs along with them. Ensuring market integrity is a necessity, an absolute; we must maintain the technological and, equally as important, the human intelligence, to enforce exchange rules and maintain this trust. We feel that our people and our technology are at the forefront of market regulation and we will continue to invest and develop our programs to ensure that we stay there.