Speeches, Testimonies & Briefing Documents

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October 3, 2019

Association for Financial Markets in Europe
Annual Compliance and Legal Conference
October 3, 2019
Paris, France
Keynote Address by
Thomas W. Sexton, III President
National Futures Association

Opening Remarks

Good afternoon and thank you for the very kind introduction and the opportunity to speak today at the Association for Financial Markets in Europe's 3rd Annual Compliance and Legal Conference. National Futures Association is thrilled to be part of this strong agenda, with a diverse line-up of excellent speakers including regulators, compliance professionals, standard-setters, legal experts, market participants and many others. As I looked over the agenda, I noted that although many of us come from different segments of the derivatives markets, we would all agree that market integrity and investor protection are critical to our regulatory efforts and vibrant successful markets.

I would expect that many of you in the audience today may not be familiar with NFA, as the self-regulatory model does not exist in many jurisdictions outside the U.S. Therefore, very simply, we are an industrywide self-regulatory organization for the U.S. derivatives industry including exchange-traded futures, OTC derivatives (or swaps) and retail off-exchange foreign currency (or forex). We pass rules relating to business conduct, sales practices and financial requirements for our Members and enforce those rules. Those accused of violating NFA's rules are judged by their peers and face severe sanctions if found to have violated those rules.

Every aspect of our regulatory activity is overseen by the CFTC, the government agency responsible for the regulation of the U.S. derivatives markets. Although we work independently of the CFTC, we are subject to CFTC oversight, and we and the CFTC act as strong partners in regulating the derivatives industry.

It is also important to highlight what we are not. We do not operate a market, we are not a trade association, and we are not a statutory regulator.

I'd like to take my time here today to:

• Provide a bit of history of self-regulation;

• Summarize important elements of our structure and responsibilities;

• Highlight the importance of the CFTC's oversight of NFA;

• Examine how NFA has evolved since its inception;

• Address international regulatory coordination; and

• Close with an overview of the advantages and necessary elements of self-regulation.

Finally, I will leave time to answer questions at the conclusion of my remarks.

History 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 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 self-regulation remains the first line of defense in the U.S. to ensure that markets and market professionals operate in a professional and ethical manner.

In the 1970s, an increasing number of futures professionals who were not members of any derivatives exchange started dealing directly with the public. These included futures commission merchants, the brokerage houses that execute customer orders and hold customer funds, 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, industry leaders undertook the creation of a new self-regulatory organization that became National Futures Association. One important step undertaken by the industry was to educate Congress about the required elements of self-regulation and its effectiveness. In 1974, the U.S. Congress passed legislation that both established the CFTC and authorized the creation of registered futures associations or what are commonly referred to as industry-wide self-regulatory organizations. NFA's formal designation as a registered futures association was granted by the CFTC and NFA began operations in 1982. Our responsibilities have steadily grown since then.

Now that I covered a bit about the history of self-regulation and NFA's creation, I would like to talk about our membership, our governance structure, funding and primary regulatory responsibilities.

NFA Membership, Governance and Funding

NFA's sole function is the regulation of its Members. With limited exceptions, the CFTC requires that firms conducting derivatives business in the U.S. be NFA Members. Membership is therefore mandatory. Today, NFA has approximately 3,500 Member firms and 48,000 individual Associate Members. Our membership includes futures commission merchants, swap dealers, commodity pool operators, commodity trading advisors, introducing brokers and retail foreign exchange dealers.

NFA is governed by a 29-member Board of Directors which serves as its principal governing and policy development body. The Board consists of both Member Directors and Public Directors. NFA's Board is structured to ensure representation of each membership category.

NFA is funded primarily from membership dues and assessment fees, and our operating budget is approximately $107 million. We have approximately 550 employees. Our largest departments are the regulatory (futures and swaps) and technology departments.

NFA's Responsibilities

We have six primary functions—registration, rulemaking, monitoring Members, enforcement and disciplinary process, market regulation and dispute resolution. Let me take a few minutes to give you some details regarding these responsibilities.

Registration

The U.S. Commodity Exchange Act or CEA requires certain firms and individuals that conduct business in the derivatives industry to register with the CFTC. The CFTC initially delegated the registration responsibility to NFA over 30 years ago. On behalf of the CFTC, NFA registers firms and market professionals after a thorough investigation of their background to determine if they meet specified fitness standards. CFTC regulations also require, with few exceptions, CFTC-registered firms to be NFA Members. As I mentioned earlier, NFA membership is mandatory, one of the hallmarks of effective self-regulation.

Rulemaking

The essence of self-regulation involves identifying industry best practices in certain areas and then mandating those practices for the entire industry. NFA identifies an issue or a problem that may require rulemaking, works with NFA Member Advisory Committees, industry trade associations, and the CFTC to draft 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 review and/or approval. Prior to implementing a new or amended rule, NFA develops and delivers education to Members to help them understand their regulatory requirements.

Monitoring Members

As I mentioned earlier, NFA's largest departments are devoted to monitoring Members for compliance with NFA rules and CFTC regulations and investigating possible violations. If material violations are noted, the offending firm may be subject to a disciplinary process.

Our key monitoring efforts include among other things:

• Risk-based examinations;

• Analysis of Member financial and operational data;

• Reviews of retail foreign exchange trade data; and

• Reviews of swap valuation dispute and key market and credit risk data.

Enforcement and Disciplinary Process

Adopting stringent rules and monitoring for compliance with those rules does little good if those rules are not vigorously enforced. To enforce its rules, when appropriate, NFA takes disciplinary actions against its Members. The penalties that may be imposed in an NFA disciplinary proceeding include expulsion or suspension from NFA membership, fines, or any other appropriate penalty or remedial action. Given mandatory membership, a firm that is expelled or suspended from NFA membership is effectively barred from the derivatives industry.

Historically, NFA's enforcement efforts have focused on serious types of misconduct including Ponzi schemes, improper loans and advances from commodity pools, misleading and high-pressure sales practices, electronic trading platform abuses, abusive trading strategies and anti-money laundering deficiencies, to name a few.

NFA works very closely with the CFTC's enforcement division to not duplicate enforcement actions so that we can properly allocate our regulatory resources. Moreover, if our exams or investigations uncover emergency situations, then we immediately coordinate our responses with the CFTC. Importantly, we also work cooperatively with law enforcement agencies when we observe or suspect criminal activity. Over the years, NFA and the CFTC have brought many cases that have rapidly closed down Ponzi and fraud schemes. Subsequent criminal prosecution of the individuals involved has often resulted in significant prison sentences.

Market Regulation

NFA's Market Regulation Department performs trade practice and market surveillance services on behalf of certain derivatives trading platforms. Each trading venue may enter into a regulatory service agreement with NFA to perform specific outsourced compliance functions. NFA currently provides regulatory services to thirteen swap execution facilities and four futures exchanges.

Dispute Resolution

Finally, NFA offers an affordable and efficient arbitration program to help customers and Members resolve futures-related and forex-related disputes. In general, NFA's dispute resolution program is less expensive, faster, and less formal than civil litigation or other dispute resolution forums.

NFA's Relationship with the CFTC

Given the important role that NFA plays in the U.S. financial regulatory structure, it is essential that our activities are closely reviewed and monitored by the CFTC to ensure NFA is fulfilling its regulatory responsibilities. NFA works very closely with the CFTC in all of its activities. The CFTC's oversight of NFA's activities includes 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 the CFTC's direct review and approval. The CFTC also performs frequent exams of NFA's work in each of our areas of responsibility to ensure that NFA is meeting its regulatory obligations. Informally, NFA is in daily contact with the CFTC to discuss ongoing investigations, registration matters, examinations, rulemaking issues or any of the myriad of issues that can arise.

Evolution of NFA

Now that I've covered why NFA was created and given you some detail about our structure and regulatory responsibilities, I'd like to talk about how NFA's regulatory role has evolved over time. As I mentioned earlier, NFA began its regulatory operations in 1982 focusing strictly on exchange-traded futures and the regulation of futures commission merchants, commodity pool operators, commodity trading advisors and introducing brokers. Although NFA was created decades ago, much like every organization, our work continues to grow and evolve with each new regulatory challenge and in certain instances must re-create itself. I'd like to go through two examples illustrating how NFA developed rules and regulatory programs from scratch to first oversee the OTC retail forex markets and subsequently to oversee swap dealers.

My first example takes place in the late 1990s and early 2000s. An OTC retail forex market aimed at unsophisticated retail customers grew rapidly and many customers were victimized in a completely unregulated market. Therefore, in the early 2000s, Congress passed legislation requiring certain firms acting as counterparties to retail forex transactions, as well as forex pool operators, trading advisors and introducing brokers to register with the CFTC and become NFA Members. We immediately passed rules addressing financial requirements, sales practices, trading abuses and several other areas and we were very aggressive in our enforcement activities involving forex. At one point even though the percentage of NFA Members engaging in retail forex was relatively small, these firms accounted for over 50% of our emergency enforcement actions.

The second example which brought about the most changes to NFA's self-regulatory role came as a result of the July 2010 enactment of the U.S. Dodd-Frank Wall Street Reform and Consumer Protection Act and the adoption of related CFTC regulations. The Dodd-Frank Wall Street Reform and Consumer Protection Act gave the CFTC rulemaking authority and oversight over swaps and swap dealers and the CFTC subsequently passed regulations requiring swap dealers to register with the CFTC and become NFA Members. We currently have over 100 swap dealer Members, the vast majority of which are either large U.S. banks or financial institutions, foreign banks or affiliates of one of these entities. Since late 2012, we have added close to 120 swaps compliance professionals as we developed and implemented our swap dealer regulatory oversight program, which includes a number of components.

• We worked closely with the CFTC to initially review each swap dealer's policies and procedures to ensure they complied with the CFTC's regulations.

• We performed our first swap dealer examinations in 2014, and since then we have examined all U.S. swap dealers and nearly all non-U.S. swap dealers for compliance with NFA's Rules and CFTC Regulations. In examining non-U.S. swap dealers, we work cooperatively with the CFTC and coordinate closely with non-U.S. regulators. These examinations focus on regulatory requirements related to the chief compliance officer function, risk management, business conduct standards, swap dealer reporting and the segregation of counterparty collateral. In light of the CFTC's substituted compliance framework, our examinations of non-U.S. swap dealer have focused on a narrower subset of these areas.

• We collect monthly market and credit risk data from swap dealers and standardized data for swap valuation disputes and we use this data to monitor our swap dealer Members and identify firms that may pose heightened risk.

• We review initial margin models for uncleared swaps as the CFTC's margin rules allow swap dealers subject to the CFTC's rules to choose between calculating initial margin using a standardized grid or an internal risk-based model approved by the CFTC or NFA. We also developed and implemented an oversight program to assess whether each swap dealer's ongoing use of the model is in compliance with NFA's approval conditions and the CFTC's margin rules.

NFA's swap dealer oversight program is just over six years old, and we will continue to evaluate and enhance this program as necessary in the future.

Like I mentioned before, NFA continues to evolve as we face new regulatory challenges. At this time, I would like to mention two current regulatory challenges.

You will not be surprised to hear that virtual currencies have been and will continue to be on our radar. In late 2017, a number of CFTC regulated trading venues launched cash-settled derivatives on virtual currency products, including Bitcoin. NFA, working with the CFTC, issued an investor advisory to remind investors that, just like any other speculative investment, trading futures on virtual currencies, including Bitcoin, has certain benefits and various risks. The advisory also addressed the limitations of NFA's regulatory authority over spot market virtual currency products. We subsequently adopted requirements, which require NFA Members to provide detailed additional disclosures to customers. Through specific reporting requirements, we carefully monitor our Members' activities in these products, which have been modest to date.

NFA also faces challenges when examining Members holding spot virtual currencies, particularly with respect to verifying ownership and control of the virtual currencies. Additionally, physically-settled virtual currency derivatives raise questions related to segregation, margin and capital requirements that will need to be addressed well in advance of the launch of these types of products.

There have been a number of discussions regarding the oversight of this market, including talk of a self-regulatory organization. I'd just like to remind you that a self-regulatory organization is not a standard setting organization or one with voluntary membership. To be effective, it needs all of the elements I will detail for you shortly.

Second, Cyber security is an issue that is of critical importance to all of us—regulators, market participants and the general public. NFA makes every effort possible to secure our technology systems and protect NFA Member data and data held on behalf of the CFTC. In doing so, we adopted best practice frameworks and standards (i.e., National Institute of Standards and Technology and the Center for Internet Security) to form a foundation that supports prompt security risk assessment and mitigation. We also engage independent third parties to perform security testing of the technical aspects of NFA's applications and network infrastructure. Last year, we also obtained a SOC2 Certification, which focused on the framework of policies and procedures that serve as the foundation for NFA's security program.

Technology and expert security personnel assist greatly in mitigating NFA's cyber security risks. However, not holding unnecessary data in the first place is the best mitigation of risk. We continually assess whether the sensitive data we collect is necessary for us to fulfill our regulatory responsibilities, and if it isn't then we stop collecting it. Moreover, we use our best efforts to delete sensitive data when the regulatory need no longer exists.

Like NFA, our Member firms face cyber security risks each day. Our Members range in size from large multinational corporations with sophisticated security programs to sole proprietorships. In 2015, we imposed specific cyber security requirements on NFA Members by requiring them to have a written information systems security program, which requires them to adopt specific measures appropriate for their business and size, all Members are required to conduct a security and risk analysis, deploy protective measures against identified threats and vulnerabilities, develop a response and recovery plan from threatening events, train their employees and review their programs at least every twelve months. Since making these requirements effective in early 2016, we have worked with our Members during examinations to ensure that they understand the requirements and comply. Given the nature of cyber threats, we will continue to be vigilant about Members' compliance with our cyber security requirements.

As you can see, what NFA has done in the past is not necessarily what we will do in the future. The derivatives industry is constantly changing and NFA's role has and will continue to change with it. We look forward to future challenges on the horizon.

International Coordination

Since our membership is global, let me take a brief minute to discuss our international coordination activities. We recognize that international coordination and cooperation is key to regulating the international derivatives markets. NFA has Members located across the globe and as I previously noted we have performed examinations of non-U.S. swap dealers and other Member types. Over the years, we have performed on-site examinations of our non-U.S. Members in numerous foreign countries, including the UK, Canada, Australia, Sweden, Hong Kong, and Singapore. In performing these examinations, we offer our global counterparts the opportunity to participate in our examinations and provide a notification of the examination date(s), offer the ability to join NFA on-site, offer to provide periodic examination updates, and offer to provide NFA's examination report and our non-U.S. Member's response to the report. Like our partnership with the CFTC, successful cooperative relationships with international regulators are critical for us to achieve our mission and specifically for addressing the next market crisis when it arrives. We learn much from working with our international counterparts, have hosted many of them at our offices and hopefully they learn from us also.

Much of our success in fostering successful relationships with international regulators is due to our international outreach efforts, which are principally focused on our engagement with IOSCO. For decades, NFA has been actively involved in IOSCO's Affiliate Members Consultative Committee. This committee is made up of over 60 organizations representing self-regulatory organizations, exchanges, clearing corporations, and trade associations. In 2018, NFA assumed an IOSCO leadership role as Chair of IOSCO's Affiliate Member Consultative Committee. This important IOSCO role gives NFA an opportunity to contribute to the work of IOSCO's policy committees covering topics such as cybersecurity, investor protection, OTC derivatives reforms, market fragmentation, outsourcing, and crypto-assets. Through these activities, NFA has strengthened its relationships with non-U.S. regulators leading to increased coordination and cooperation.

Advantages of Self-Regulation

Before I close, I'd like to use the last couple minutes to talk about the 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 different regulatory landscape. The growth of self-regulation in the U.S., however, is not the result of any historical accident but is based on a record of solid accomplishment. The U.S. Congress has revised and amended the legislation governing the derivatives markets on numerous occasions and has never sought to curtail the role of self-regulation. To the contrary, the role of self-regulation in general and NFA's responsibilities in particular have steadily increased as highlighted earlier.

Based on the experience in the U.S., there are several important advantages to relying on self-regulation as a first line of defense in regulatory matters:

• Track Record—Self-regulation has a long history of working effectively. SROs are motivated to act responsibly, developing best practices and monitoring their markets out of economic, reputational and regulatory self-interest.

• Regulatory Resources—Self-regulatory organizations like NFA and the CME Group expend significant resources to ensure market integrity and investor protection. By raw numbers, NFA's budget in FY 2013 was $63.2 million and in FY 2020 it will be $107.2 million. Our employees numbered approximately 331 in FY 2013 and today we have 536 employees. Although the majority of that increase is attributable to staffing our OTC Derivatives Department, we also significantly increased our support areas to support our new OTC staff and our Technology Department to address other technology and cyber security related issues.

• Insight—Involving market professionals in the regulatory process brings an insight and perspective to the issues. Self-regulatory organizations have the experience, resources and commitment to play a constructive role in examining regulatory issues.

• Responsiveness—Any action taken by governmental regulators, whether it involves rulemaking or rule enforcement, is subject to multiple layers of review and takes time. 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 the key to restoring or maintaining public confidence in the markets particularly in times of market crisis.

• Global Reach—Self-regulatory organization contractual relationships can reach across international boundaries. Self-regulatory organizations may be more effective in dealing with global issues because self-regulation is defined by contract, a rulebook versus national legislative acts.

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 a 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. Self-regulation will fail if leaders view self-regulation as a shortcut to lax regulation.

• 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 Board representation.

• Management—The senior management of the SRO must be committed to the ideals of self-regulation. Part of this is recognizing the importance of keeping the word "self" in self-regulation and working in partnership with the Members recognizing their invaluable insights and not assuming that staff has all of the answers.

• Rulemaking and Enforcement Authority—Mandating practices that ensure market integrity and investor protection is essential and those rules must be vigorously enforced.

• Government Oversight—No single factor is more important to effective self-regulation than effective government oversight. This oversight should cover 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 negates many of the advantages of self-regulation. The advantages and requirements for effective self-regulation are further detailed in an IOSCO report published in 2000 entitled "Model for Effective Regulation"¹.

Conclusion

As I've tried to highlight for you today, NFA has and must continue to evolve in order to respond to the regulatory challenges posed by an industry that is constantly changing. However, NFA's mission today is the same as it was when we began operations in 1982—our overriding objective is to protect customers, protect market integrity and fosters the public's confidence in the derivatives markets.

It was an honor to speak with all of you today. Thank you again for inviting me to be part of this conference. I wish you the best of luck in your work and I would be happy to answer any questions.

¹ https://www.iosco.org/library/pubdocs/pdf/IOSCOPD110.pdf