Speeches, Testimonies & Briefing Documents

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

REMARKS GIVEN AT THE
ELECTRIC UTILITIES CONSULTANTS, INC. CONFERENCE
PORTFOLIO OPTIMIZATION FOR ELECTRIC UTILITIES
NEW YORK, NY, DECEMBER 5-6, 2002

Two Decades of Investor Protection in the U.S. Futures Markets

Since it was formed in 1982, NFA has been the industry-wide self-regulatory organization (SRO) for the U.S. futures industry. Self-regulation has long been a hallmark of the U.S. futures industry, and the securities industry as well. NFA was the first SRO in either industry that was formed solely to act as a regulator. NFA has never operated any marketplace or engaged in any commercial activity. NFA is the premier independent provider of innovative and efficient regulatory programs that safeguard the integrity of the derivatives markets.

When regulation is done right – efficiently and effectively – it adds value to the marketplace because it instills public confidence, and public confidence is critical to any market's success. A lot of the issues currently impacting the energy market appear to be the result of a crisis in public confidence.

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. However, 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.

Congress responded to that crisis in public confidence by doing two things. First it created the Commodity Futures Trading Commission (CFTC), but it also allowed for the creation for a new kind of self-regulatory body - one that didn't operate a marketplace, one whose only mission was customer protection. That new SRO was NFA. Twenty years later, trading volume on U. S. futures exchanges has grown by over 400%. During that same time, customer complaints have dropped by over 80% and customer losses due to broker insolvencies have been virtually eliminated. There were a lot of factors contributing to those results, including all of the hard work of the CFTC. NFA has been a big part of that success story. These statistics demonstrate that self-regulatory organizations working in close partnership with federal oversight agencies can produce dramatic results.

Functions of an SRO

Self-regulation requires three basic functions:

• Setting standards that embody identified 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 (the Act) and the CFTC has added its own customer protection regulations. All of the rules developed have to be consistent both with the Act and the CFTC's rules, which makes developing standards of conduct for NFA members a shared responsibility (NFA, CFTC, membership involvement).

Core Services

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. 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.

Registration:
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.

Compliance:
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.

Education:
NFA has established a number of information resources for its members, the investing public, other regulatory agencies and the media. NFA communicates with its members through training sessions and workshops, newsletters, regulatory guides, and special notices to help them meet their regulatory requirements. It also produces publications and web-based resources for the investing public, both general investor protection advice and information specific to futures trading.

Arbitration:
NFA's arbitration program has become the primary method for futures industry customers and NFA members to resolve their disputes. Subject to certain exceptions, arbitration is mandatory for all NFA members when requested by a customer. Less formal than many alternative methods of settling disagreements, NFA arbitration is inexpensive and expeditious.

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 several years, NFA has provided market monitoring services as an outsourcing agent to several regulated 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 venture particularly successful. 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. 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 NFA as an alternative to establishing their own internal compliance and surveillance departments.

NFA's 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 by demonstrating that there is integrity in its market and that all will be treated fairly. Any marketplace 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.

NFA's trade practice and market surveillance services give new electronic markets the benefit of NFA's 20 years' experience and its superior reputation, helping them attract liquidity by increasing confidence in the transparency and fairness of their marketplace. NFA's market surveillance application was designed and developed with significant input from market professionals possessing a vast amount of experience in this regulatory area. It creates exception reports to identify such activities as wash trading, stop order fishing, marking the close and front running. NFA also profiles markets and individual traders to dynamically assess market participants' trading patterns for unusual activity, and monitors concentrations of ownership and position limitations. 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. This experience and NFA's independence can be tremendous assets to any existing or developing market. NFA is very willing to share this regulatory experience with any marketplace – what has worked and what has not worked.

Other Elements of a Successful SRO

There are other elements of a self-regulatory infrastructure that need to be considered in the development of an effective and efficient SRO. An SRO must have a reliable and adequate funding source, have the support of the industry that it regulates and be accountable for its activities.

Funding – 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 is dependent on a small percentage of its members for the lion's share of its funding, the SRO's independence and its neutrality can 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. Roughly 66% of our revenue comes from assessments imposed on members of the public that trade on futures exchanges with the rest coming from membership dues and other forms of fees. 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. Most business people recognize that paying for thorough, meaningful, top-notch self-regulation can be a lot cheaper than paying the government.

The bottom line, though, is that a regulatory structure that is forced on the industry will not work. Without industry input and support, a regulatory structure that is imposed upon it will be designed to meet the needs of the regulator, not the industry. Those who are involved in the industry, those who understand the way it works and its shortcomings, are best able to design an appropriate oversight structure. The industry can either take it upon itself to devise a self-regulatory structure that meets the minimum standards set by Congress or it will be forced to accept heightened federal oversight.

Accountability – Accountability and performance issues take on added importance when creating a new SRO. It is also especially important in today's environment. 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. That "report card" was an important tool for both NFA and the Commission 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. Of course, there is always a possibility that such a mandatory structure will not be workable. Perhaps then a voluntary system with a high profile would accomplish a similar function: providing a structure that ensures fairness and transparency for those who do not wish to trade in murkier waters, essentially allowing those markets that wish not be to under the umbrella of a market monitor to continue to exist at the mercy of the marketplace.

Closing Remarks

In closing, NFA does not have the blueprint for any regulatory structure for the energy industry. Whether a regulatory framework is imposed upon the industry by legislation, or the industry determines that it is in its best interest to develop an industry-driven regulatory structure, there are precedents.

Over the years, NFA has worked closely with other regulators and organizations, both here and outside the U.S., to help them develop effective self-regulatory programs. NFA has worked closely with the International Organization of Securities Commissions (IOSCO), and chaired an IOSCO Consultative Committee report titled "A Model for Effective Self-Regulation" which is attached to this paper. NFA has worked through a lot of these issues, and is more than happy to share its expertise – what has worked well and what has not worked so well.

Effective self-regulation combines effective 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.