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INTERNATIONAL SEMINAR ON LEGISLATION OF FUTURES LAWS
NOVEMBER 12, 2014
"American Experience in Self-Regulation Over Futures Markets
and Jurisdictional Boundaries Between Futures and Securities in U.S."
Daniel J. Roth
President and CEO
National Futures Association
I would like to thank you for the opportunity to speak today at the International Seminar on Futures Law. I would particularly like to thank the China Securities Regulatory Commission and the Zhengzhou Commodity Exchange for their hospitality. I would also like to thank the China Futures Association, with whom NFA has a long-standing Memorandum of Understanding. As always, we are grateful for their cooperative efforts. The task of drafting legislation to govern China's futures markets is both complex and critical. I hope my remarks today can in some small way help you with that effort. Today I would like to discuss the role of self-regulation in the U.S. futures markets and also the jurisdictional boundaries for securities and futures regulation in the U.S.
Self-Regulation In U.S. Futures Markets
Historical Roots of Self-Regulation
Self-regulation has always played a central role in the regulation of U.S. futures markets, in large part because of the historical evolution of those markets. The United States Congress first passed legislation regulating futures markets in 1922. By that time, self-regulatory mechanisms for those markets had already been in place for over 74 years. The Chicago Board of Trade began operations in 1848 and from its earliest days featured a form of self-regulation to ensure that its members were dealing fairly with each other and meeting their financial obligations. It was only natural, then, that when Congress first began regulating futures markets that it chose to build on the self-regulatory structure that was already in place. Obviously, the markets themselves, government regulation and self-regulation have all changed dramatically over the years, but to this day privately funded self-regulation remains the first line of defense to ensure that markets and market professionals operate in a professional and ethical manner.
The futures exchanges themselves remain vital and essential parts of the self-regulatory process. In the 1970s, however, we began to see an increasing number of futures professionals who were not members of any exchange dealing directly with the public. These included FCMs, the brokerage houses that execute customer orders, and other types of businesses, such as commodity pool operators and commodity trading advisors. The increasing number of firms that were not members of an exchange created a widening gap in the regulatory structure. To close this gap, Leo Melamed and other industry leaders undertook the creation of a new self-regulatory organization that became National Futures Association.
NFA was different than the exchange self-regulatory organizations in several ways. First, NFA does not operate any markets. Its sole function is the regulation of its members. Second, NFA's membership encompasses a wide range of industry professionals. All firms who deal directly with the public must be members of NFA. NFA's 4,000 members include futures commission merchants, commodity pool operators, commodity trading advisors, introducing brokers and swap dealers. In other ways, NFA is very much like exchange SROs—we pass rules requiring fair dealing by our members and we enforce those rules. Those accused of violating the rules are judged by their peers and face severe sanctions if found to have violated those rules. Also like the exchanges, every aspect of our regulatory activity is closely overseen by the CFTC, the government agency responsible for regulating U.S. futures markets.
NFA's responsibilities have steadily grown since we began operations in 1982. NFA's main areas of responsibility fall into seven categories:
Registration—All market professionals are required to register with the CFTC and are granted registration only after a thorough investigation of their background to determine if they meet the fitness standards set forth in the Commodity Exchange Act. The CFTC has delegated registration responsibility to NFA. On behalf of the CFTC, NFA conducts all of the background checks of applicants for registration and, where appropriate, initiates a proceeding to deny or revoke registration.
Rule Development—The essence of self-regulation involves identifying industry best practices in certain areas and then mandating those practices for the entire industry. NFA identifies areas that may require additional rulemaking, works with committees of members to develop appropriate proposed rules and then presents those rule proposals to NFA's Board of Directors. All rule changes approved by the Board are subject to CFTC approval.
Rule Enforcement—Adopting stringent rules does little good if those rules are not vigorously enforced. NFA's largest departments are devoted to monitoring members for compliance with our rules and investigating possible violations. If violations are noted, the offending firm is subject to a disciplinary process which can result in the firm being expelled from NFA. Given the mandatory nature of NFA's membership, firms that are expelled from NFA are effectively barred from the futures industry. In addition, NFA regularly meets with the CFTC and with law enforcement officials to refer violations noted by NFA for criminal prosecutions. During the last five years, over 10 individuals who were expelled or disciplined by NFA have been successfully prosecuted and have received sentences of up to 15 years in prison.
Swap Dealers—After Congress passed the Dodd-Frank Act that required swap dealers to register with the CFTC, the CFTC passed a rule requiring all swap dealers to be members of NFA. NFA currently has approximately 100 swap dealer members and now conducts examinations of those members to monitor their compliance with CFTC requirements.
Market Regulation—Dodd-Frank also created a new type of trading venue for standardized swaps called Swap Execution Facilities, each of which has self-regulatory responsibility to monitor trading on its trading platform. To date, 16 of the 22 SEFs registered with the CFTC have contracted with NFA to perform market surveillance activities on their behalf.
Arbitration—From time-to-time, customers may have disputes with an NFA member. NFA offers an arbitration program to customers to provide a prompt, inexpensive and fair forum to resolve those disputes.
Education—NFA's educational efforts have two distinct audiences. First, we produce and disseminate information for customers to ensure they understand the risks inherent in the futures markets and can identify misleading sales pitches when they hear them. Second, we try to make sure that member firms, both large and small, understand their regulatory obligations.
As a result of Dodd-Frank, NFA's responsibilities have increased dramatically and, as a result, so has its staff and its budget. Just three years ago, NFA had a staff of 300 and an annual budget of $49 million. Since then, NFA has taken on responsibility for swap dealers and SEFs. In addition, the CFTC withdrew certain exemptions from CPO registration. As a result, we have seen a 60% increase in CPO membership and a 300% increase in the number of pools operated by CPO members. Based on all of these factors, NFA has increased the size of its staff by 60% over the last three years. Our staff is projected to average 482 this fiscal year. Our budget has nearly doubled over the last four years and is now over $80 million.
It is important to note that NFA's operations are privately funded—NFA receives no funding at all from the government. NFA's regulatory programs focus on four distinct areas:
Exchange Traded Futures—the regulation of FCMs, CPOs, CTAs and IBs;
Swaps—the regulation of swap dealers and major swap participants;
Market Regulation—providing trade practice and market surveillance services to contract markets and SEFs; and
Retail Forex Dealers—the regulation of forex dealers that offer retail customers off-exchange forex contracts.
The underlying philosophy for our funding is that each of the four main areas of NFA's regulatory programs must pay their own way, covering both direct costs of regulation, a pro rata share of NFA's overhead expenses and pro rata contributions to NFA's operating reserves. The bulk of NFA's futures-related activities are funded by a fee assessed to every futures contract purchased or sold by a non-member of the exchange. That fee is currently set at $.01 per contract, is collected by FCM members from their customers and paid to NFA monthly. NFA's swaps and forex dealers are funded through membership dues. Dues for swap dealer members range from $150,000 to $1 million per year, based on their size. Forex dealers pay membership dues of $6.2 million. SEFs and contract markets that contract with NFA for market regulation services pay monthly fees that are approximately $45,000 per month.
Creating an appropriate governing structure for an organization like NFA is no small task. NFA's membership consists of firms in almost every category of registration under the Commodity Exchange Act: exchanges, FCMs, CPOs, CTA, IBs, Swap Dealers and Major Swap Participants. In most of these categories, the members range in size from huge international institutions to very small family operations. NFA's Board is structured to ensure representation of each category and from the different types of firms within each category. Member directors are selected by the members they represent through an election process. Given the critical role played by NFA, it is also important to ensure that the public is represented on the Board as well; so 30% of the Board consists of non-members of NFA. As a result of the need to ensure that so many viewpoints are represented, NFA's Board is unusually large and consists of 35 directors. Because a group that large can become unwieldy, much of the day-to-day work of the Board is performed by a 14-member Executive Committee that includes representatives of all categories.
NFA's Relationship with the CFTC
Given the important role that NFA plays in the U.S. regulatory structure, it is essential that NFA's activities are closely reviewed and monitored by the CFTC, NFA's oversight agency. NFA works very closely with the CFTC in all of our activities. The Commission's oversight of NFA's activities include both formal actions, required by the statute or regulations, and informal actions, which have evolved over time.
At the formal level, all of NFA's most significant actions are subject to direct review and approval of the CFTC:
Rule Changes—Any changes to NFA rules must be submitted to the CFTC and are subject to the CFTC's review and approval.
Registration Actions—NFA is authorized to deny an application for registration or to revoke registrations on behalf of the CFTC if the applicant or registrant fails to meet the fitness standards set forth in the Commodity Exchange Act. Any such action by NFA is subject to CFTC review, either on the CFTC's own motion or on the request of the person adversely affected.
Enforcement Actions—NFA can initiate a rule enforcement action against any member for violations of NFA rules. A committee of members preside over a hearing and decide if the member has, in fact, violated NFA rules and, if so, what the appropriate penalty should be. Sanctions can range from significant fines to expulsion from NFA membership. Any decision rendered by NFA is subject to review by the CFTC, either on its own motion or at the request of the member.
Rule Enforcement Reviews—The CFTC performs frequent exams of NFA's work in each of our areas of responsibility to ensure that NFA is meeting its regulatory obligations.
Over the years we have also developed more informal means of communicating with the CFTC.
Investigations—We meet on a quarterly basis with CFTC staff to discuss all pending investigations of possible rule violations. We do this both to avoid duplication of efforts if the CFTC is investigating the same firm and to bring to the Commission's attention matters in which it may want to bring their own enforcement action.
Regulatory Issues—Since all NFA rule changes have to be approved by the CFTC, we inform CFTC staff early on of any regulatory issues on which we are considering rule changes. These meetings also occur quarterly. We seek the Commission's input, which improves the rulemaking process and expedites CFTC approval.
Commissioner Meetings—We also meet on a quarterly basis with each of the Commissioners to brief them on issues facing NFA and to answer any questions they may have.
Regulation of Swap Dealers—Because NFA's regulatory programs for swap dealers are relatively new, we meet on a monthly basis with CFTC staff to discuss issues related to NFA examinations and registration issues.
Market Regulation—NFA staff meets weekly with the CFTC's Division of Market Oversight to discuss regulatory issues related to SEFs or to contract markets for which NFA performs services.
In addition, we are in daily contact with the CFTC regarding pending investigations or exams that uncover deficiencies which should be brought to the Commission's attention.
Advantages of Self-Regulation
As mentioned above, the important role played by self-regulation in U.S. futures markets was initially the result of the fact that self-regulation predated governmental regulation by decades. Certainly many jurisdictions around the world have had a different history and have not embraced self-regulation. The growth of self-regulation in the U.S., however, is not the result of any historical accident but on a record of solid accomplishment. Congress has revised and amended the legislation governing the futures markets on numerous occasions and has never sought to curtail the role of self-regulation. To the contrary, the responsibility of self-regulation in general and NFA in particular has been steadily increased, most recently with the Dodd-Frank legislation effectively mandating self-regulation for swap dealers.
Based on the experience in the U.S., there are several distinct and important advantages to relying on self-regulation as a first line of defense in regulatory matters:
Cost—Self-regulatory organizations like NFA and the CME Group expend over $120 million per year and do not receive any funding at all from the government. Rather, these costs are allocated to the market professionals and participants who benefit most directly from effective regulation.
Insight—Involving market professionals in the regulatory process brings an insight and perspective to the issues that professional regulators cannot supply, no matter how well informed they are.
Responsiveness—Any action taken by governmental regulators, whether it involves rulemaking or rule enforcement, is subject to multiple layers of review. Self-regulatory bodies, in contrast, can and do respond much more quickly to rapid developments in the market. The ability to respond quickly and decisively can often be key to restoring or maintaining public confidence in the markets and SROs have a decided advantage.
Requirements for Effective Self-Regulation
Though self-regulation can have decided advantages, those advantages will not be realized unless the overall regulatory structure has certain essential attributes:
Mandatory Membership—The basic mission of any self-regulatory organization is to ensure a high degree of professionalism and ethics in all of its member firms. If, however, firms are free to join or not join a self-regulatory organization, then precisely those firms that are most in need of self-regulation will simply evade it.
Industry Leadership—The market professionals that play a leading role in the self-regulatory organization must have sufficient vision to realize that strong and effective self-regulation is in the best long-term interests of the industry. Leaders who view self-regulation as a shortcut to lax regulation could be disastrous.
Board and Committee Structure—The structure of the Board and all of its committees should ensure that no one industry sector dominates. All types of firms, regardless of their registration category or size, should have representation on the Board.
Management—The senior management of the SRO must be committed to the ideals of self-regulation. Part of this is recognizing the need to work in partnership with the members. The management must recognize the invaluable insights of the members and not be so arrogant as to assume that the staff has all of the answers.
Government Oversight—No single factor is more important to effective self-regulation than effective government oversight. This oversight should be pervasive in that it covers all aspects of the SRO's regulatory activity. At the same time government oversight should not be oppressive. If the oversight agency dictates in detail how the SRO should perform its activities, it could negate many of the advantages of self-regulation.
Boundaries of Regulatory Jurisdiction
Finally, let me offer a few remarks on the necessity and difficulty of clearly delineating jurisdictional boundaries of regulators, particularly with respect to securities and futures. The whole point of regulation is quite simple. Modern economies cannot realize their full potential without efficient futures markets that allow firms and individuals to hedge their risk. Futures markets cannot be efficient if they are not liquid and they will not be liquid unless market users have confidence in the financial stability and integrity of those markets. The regulator's job is to foster efficient markets by instilling that public confidence.
Jurisdictional disputes between regulators create legal uncertainty, and legal uncertainty saps the innovation that is key to efficient markets. In short, jurisdictional uncertainty can impair the market efficiency that regulation is designed to foster in the first place. I think there is ample evidence to support this view in the occasional jurisdictional questions that arise in the U.S. between the SEC and the CFTC. The most glaring of these disputes involved jurisdiction over stock index futures contracts, and that dispute took time, money, litigation and legislation to resolve. Ultimately, the CFTC retained jurisdiction over broad based stock index products while the SEC had jurisdiction over narrow based stock index products.
Single stock futures were initially banned by Congress, but years later the law was changed to provide that both the CFTC and SEC would share jurisdiction over single stock futures. This approach, not surprisingly, was completely unworkable. The morass of regulations which resulted from joint jurisdiction insured that these products would never succeed because their regulatory costs were so high.
From all of this, several points seem clear to me with regard to setting jurisdictional boundaries between futures and securities regulators. First, I think it will always be a bad idea to have two different regulators share jurisdiction over the same futures products. This will result in unnecessary costs and confusion and the products will never thrive. Second, if a regulator wants to kill a particular product, it will. The SEC was hostile to the creation of single stock futures products and the regulations they developed ensured that the product would fail. Third, futures and securities markets are certainly linked but they are distinct in their purposes, their market procedures and their regulatory needs. Granting jurisdiction over a futures product to a regulator that does not understand those differences will lead to problems. Finally, legal uncertainty stifles market innovation. If jurisdictional lines are to be drawn between regulators, they must be drawn clearly. Let there be no confusion. Market participants need to know who is writing and enforcing the rules. They should not have to guess.
As I mentioned at the outset, the work before you in drafting futures legislation is both complex and important. Luckily for you, it is also very interesting and immensely rewarding when you can look back and realize what a big difference all of your hard work made.
Thank you again for inviting me to be part of this seminar. I wish you the best of luck in your work.