Good morning and thank you, Paul, for that kind introduction. I have known Paul Lyons since he was an editor of Energy Risk magazine, and I am glad to see that he has brought his talents to bear on another uncontroversial and non-complex subject area, Structured Products! But truly, it is my pleasure to join you today to speak on the development of structured products and derivatives-based investments, and more specifically on the impact that regulation can potentially have on innovation in these markets. As Paul mentioned, I am a Commissioner at the Commodity Futures Trading Commission, the oversight regulator of the futures and options industry in the United States. Before coming to the Commission in August 2002, I taught derivatives, risk management, and private capital market finance at George Mason University, and before that, Tulane University. The views I express are my own and do not necessarily represent those of the Commission or its staff.
In the area of structured finance, we have seen numerous innovations in products that combine features of derivatives and cash assets (structured products) and in the area of event and “information” markets. Derivatives, by their very nature, are products whose value is based on the prices of assets such as energy products, precious metals, and agriculture commodities, and financial assets such as stocks, bonds, and currencies. As a vehicle to manage risk, both to shed it and to assume it, derivatives and structured products, or what I will call “risk assets,” provide a low cost vehicle to get market exposure without being in the underlying business itself.
But this feature, the ability to take a position without being in the underlying business directly, has some controversy attached. For a long time derivatives instruments such as futures and options contracts were primarily thought of as a means to hedge price risks or, when someone was not hedging, to speculate on the price of an asset or commodity. The latter purpose, that of the speculator, has always been considered of less importance than that of the hedger, and many a historic battle has been pitched to curtail speculation, through regulatory means ranging from speculative position limits (which still exist on many commodities), to outright bans on trading derivatives on a particular asset (for example, onions) or a particular class of derivatives (for example, the ban on agriculture trade options).
The concept that these risk assets can be incorporated into a portfolio as a more traditional investment vehicle has gained increased standing, but this concept is not without its detractors. Usually the detractors get the most attention, raising concerns about the supposed risks that derivatives themselves pose to investors, the markets, and the economy. For example, in the 2002 annual report of Berkshire Hathaway, Warren Buffet referred to derivatives as “financial weapons of mass destruction,” expressing concerns that the credit risk associated with certain OTC derivatives is like a ticking time bomb ready to explode and that could take the economy with it. In his view, the government has found no way effectively to control or monitor these instruments.
The government, Congress, federal authorities such as the Federal Reserve Board and the Commodity Futures Trading Commission, as the regulator of the futures and options markets, have had to respond to both the criticism and corollary efforts to limit the use of derivative assets through increased scrutiny and regulation. As I have said often, the activities of risk taking and risk management are as fundamental to business as water is to life, since without risk taking, there would be little entrepreneurship, and innovation would likely move at the pace of the Stone Age. But with risk and its expeditious management, individuals and businesses can dare to specialize and innovate in order to maximize their opportunities, expand their wealth and that of investors, and expand the limits of the global economy to achieve greater employment and higher welfare.
Relatedly, and of increasing concern to me are efforts by regulators to more vigorously regulate risk taking. Some discussion seems positive, like utilizing risk-based methods to determine exposure and set collateral requirements, but other efforts are more prescriptive – like endowing overly simplistic and sometimes biased valuation models to define leverage or to divine the purpose of derivatives in a portfolio. While I agree that the monitoring and regulation of risk taking may be appropriate for banking institutions, as a regulator of markets, I am less comfortable with efforts to regulate risk taking by individuals and firms. I believe that the current regulatory model we have for overseeing markets that specialize in risk shifting has proven particularly effective, without unnecessarily constraining the markets and the firms that use them.
The way we go about regulating the industry can have a large impact on how the markets function and how financial assets can be used. This is important because what a regulator does can potentially determine not only what one can trade, but perhaps more importantly, how much it will cost to trade. Regulations usually take the form of capital requirements, disclosure documents, registration requirements, and examination regimes, etc. As a regulator, I believe responsible regulation entails a duty to taxpayers, market users, and the public who benefit from markets to be mindful of the benefits and costs of rules and requirements that we promulgate. Regulatory solutions must be targeted and effective.
As regulators of risk assets, we must use caution to avoid instances where we employ rote and inflexible regulatory programs, inadvertently create moral hazards, or become overly protective of the markets. I hope you will forgive my adaptation of an overused cliché, but too often we regulators are great “inside-the-box” thinkers. That is, there is the temptation to adopt a set of regulations and stick with it regardless of the asset class or the nature of the market. For example, one might surmise that a prescriptive and uniform disclosure and examination model designed for mutual funds would be poorly suited for the managed funds industry, given the diversity of strategies and asset classes under management and the investor base. In other words, trying to fit the managed funds industry into the mutual fund box will be detrimental to that market’s ability to innovated and explore uncharted territory. Similarly, trying to force equity linked products into the securities regulatory box could stifle the expansion of those products if the approach that we choose is not sufficiently flexible.
Without flexibility and context in regulation, we run the very real risk that markets lose their ability to innovate because the innovation does not fit neatly into our box. In my experience, incumbents in a market and in government will argue that if the innovation is contrary to the rule, then the innovation is risky and allowing it could harm customers. However, we must be equally concerned and open to the possibility that it is our approach, not the innovation, which is harmful, and inflexibility may create barriers to competition in markets and in products that could increase value and lower costs for market participants.
Speaking from my own experience with the derivatives industry, I can attest that for a long time the derivatives industry and its regulation was very much inside-the-box. Basically that box contained futures and options on agricultural commodities. For over a century, derivatives in this country were primarily in the form of futures contracts traded on agricultural commodities on exchanges in Chicago. Under the Commodity Exchange Act, or CEA, these contracts were required to be traded on exchanges and were tightly regulated initially by the Commodity Exchange Authority and now by the Commodity Futures Trading Commission. As you can imagine, these tight regulatory controls did not allow for much in the way of innovation. This control, however, began to be challenged in the late 1980s and early 90s as financial engineers, informed by financial modeling and pricing techniques spawned by the Black-Scholes option pricing model, began to develop new products that had desirable characteristics for investors and risk managers.
The development of the swaps market, as well as the emergence of what we called hybrid instruments, which combined features of a debt or security with a derivatives component, were at issue. While structured products had been around for some time before this period—for example the mortgage-back security was created in the 1970s—things like gold indexed bonds and oil bonds that were not backed by the physical holding of a commodity were beginning to emerge in the marketplace.
During this period of financial innovation, the CFTC struggled under the CEA to free these instruments from the exchange-traded regulatory burden that threatened to crush this market innovation. Basically the CEA required that all futures contracts be traded on a regulated exchange. For swaps and hybrid instruments, neither of which was really an attractive candidate for trading on a futures exchange, the issue became whether or not they should be considered futures contracts or whether they could be legally traded off of a regulated futures exchange.
Initially the CFTC took the view that certain forms of these instruments should not be viewed as futures contracts, so long as their structure fell within certain parameters outlined in several statutory interpretations issued by the agency. In the case of swaps, this meant that they were not cleared and were individually negotiated contracts. In the case of structured notes, the contracts had to have a dominant debt or security component as compared to the derivative component.
While this approach prevented these important financial innovations from being derailed, it was not until the Commodity Futures Modernization Act of 2000, or CFMA, was enacted that real legal certainty was brought to these markets. Under the CFMA, the question of jurisdiction over swaps and structured products was settled through several exclusions and exemptions from the CFTC’s and the SEC’s authority.
In addition to this new regulatory approach to over-the-counter derivative instruments, the Commission was given new flexibility with which to oversee the markets. Rather than relying on a set of fixed rules and regulations, the Commission, under the CFMA, now relies on core principles to provide guidance to market participants. The core principles, combined with a tiered oversight model that prescribes different levels of oversight depending on the nature of the counterparties and the transaction, gives innovators in the derivatives space much greater latitude in determining how to meet our critical regulatory objectives. In essence, the CFMA encourages a sort of partnership between the CFTC and the industry it regulates to develop sensible regulation that encourages innovation while at the same time addressing the public policy questions that underlie the Commission’s regulatory goals.
The Commission is now going through its periodic reauthorization. In the course of this deliberation, questions have been raised regarding the regulatory effectiveness of the CFMA and concern has been expressed over the explosive growth of the derivatives markets. There have been calls to “re-regulate” the markets. One area of increased debate has been with respect to energy markets, brought on mainly by high prices and profits in the industry, the collapse of Enron, and the revelation of widespread price misreporting in the natural gas markets. In reaction to these events, congressmen, senators, and energy users have all expressed a desire to more heavily regulate the energy derivatives markets by imposing, for example, greater reporting requirements on market users’ positions and the imposition of tighter daily price limits on energy futures.
What those advocating tighter controls on derivatives may not fully consider is that the prescriptive solutions advocated will not likely lower credit risks or increase liquidity, will not decrease volatility, and will certainly not lower prices (which is the desire of energy market critics); however, constraining or curtailing derivative market use through these measures may lower market quality and ultimately drive up the cost of using derivatives. Derivatives allow businesses and individuals to manage risks. If we restrict access to financial derivatives because we do not like the credit risk or we halt trading in energy futures contracts because we do not like how far prices have moved in a day, we limit one’s ability to control risk. We do not eliminate risks when we curtail the use of derivatives -- we create risk.
Derivatives contracts are of great value to a market economy because of the ability they give to users to unbundle risk and transfer it to investors who are more willing to assume the risk or to use that risk to unbundle their own risks. One champion of markets who is sorely missed by those of us in the derivatives regulatory sphere is Fed Chairman Alan Greenspan. Chairman Greenspan had a deep understanding of derivatives, and as I am sure you are aware, did much to ensure that government did not overreact to market events where derivatives were involved. He once observed in an address before the Futures Industry Association that the market risk that derivatives users assume when they enter into a derivatives contract must be less daunting to the user than the underlying exposures they are hedging or presumably they would have never entered into the derivatives contract in the first place.
Nonetheless, from time to time legitimate public policy issues of concern do arise that grab the attention of Congress and regulators. But the question then is do regulators step in to aggressively regulate the industry or, alternatively, do they reach out to the industry to develop guidance that allows for innovation in the markets while addressing the public policy concerns.
A recent illustration of how regulators and industry can work together is with respect to the backlog in the confirmation of trades in the credit derivatives market that has been the focus of the Federal Reserve Bank of New York and a group known as The Counterparty Risk Management Policy Group, headed by Gerald Corrigan, the managing director of Goldman Sachs and former New York Fed President. The existence of unconfirmed trades and uncertainty over the legal transfer of positions has created some uncertainty in the market, which has threatened its viability and growth.
In the OTC markets, the trade confirmation process has been ad hoc, at least as compared to the futures industry, due to the lack of a centralized entity to deal with confirms and assignments. Nonetheless, the industry has strong incentives to resolve the problem, and under the direction of the Fed, the International Swaps and Derivatives Association and the Managed Funds Association have developed best practices and put forth sound mechanisms to clear it up. I believe that such cooperative efforts under the guidance of a regulator demonstrate the constructive role that a regulator can play in working with market players to prevent problems before they occur.
Another example of where regulators should and have exercised caution is with respect to regulatory capital requirements for banks. As Chairman Greenspan pointed out, dictating specific regulatory capital requirements can be a dangerous practice since it can lead to regulatory arbitrage where banks tend to allocate more of their assets to where regulators have underestimated risks and allocate fewer assets to those areas where they overestimate the risks. I am similarly concerned that certain regulatory prescriptions in the managed funds area, particularly as they relate to valuation and auditing standards, could lead to inefficient trading or allocation practices. Moreover, when regulators get too involved in the day-to-day regulation of entities or over represent their ability to prevent bad behavior, moral hazards develop. When investors come to believe that the government will guarantee or protect them against losses, their incentive to monitor their own behavior is diminished. In such cases, the frontline protections in the markets—that is, the market participants themselves—break down.
Unfortunately, no matter how well intentioned or capable regulators, the protection that we can offer can never be as efficient or effective as that which can be provided by the markets and market participants. For example, the CFTC brings numerous cases against firms and salespersons making fraudulent sales pitches to retail investors. In many cases, once the agency has closed down the operation, the money is gone. But if we can educate consumers to not place their money in such schemes in the first place, we could avoid the problems that follow. Of course an alternative would be simply not to permit any retail investors to put their money in risk assets. In such cases it would be easy for our enforcement lawyers and investigators to identify lawbreakers since anyone offering any contract to a retail investor would be breaking the law. But such draconian measures would deny retail investors the opportunity to place their money with legitimate, law abiding firms who can provide valuable tools to investors to manage their risks and returns.
Structure products have some hurdles to cross if they are really going to gain widespread acceptance in the broader US market, as they have in Europe and elsewhere. In my view, education is the key component of that expansion and industry has to take the lead. With respect to the managed fund industry, including hedge funds (many of which are already registered with the CFTC as Commodity Pool Operators or Commodity Trading Advisors), pension funds, and the financial firms that cater to them, we hear concerns that more regulatory scrutiny must be brought to bear on the valuation models used by hedge funds to determine the worth of the contracts or instruments they hold. But we must be careful as regulators not to be too prescriptive as to what these valuation models must look like. In our regulatory zeal to mandate “the” valuation model we must be careful that we do not mandate a model that works only some of the time.
On model validation, the Managed Funds Association has taken a flexible approach, much as the CEA and CFTC have taken in the form of core principles, to develop a set of guidelines that funds should follow when valuing assets. This approach recognizes that a single approach to valuing assets may not be optimal. Instead, fund managers need to be flexible in the way in which valuations are calculated and reported to investors. Does this mean that managers would be given free rein to indiscriminately value their assets? Of course not! What would be required of managers would be that they be required to demonstrate that their actions and their model selections are based on sound reasoning and judgment. Asset valuation can be a complex task and regulations that influence how those valuations are performed must by their nature be flexible.
In conclusion, the message I have tried to deliver here today is one of innovation and regulatory flexibility. Your business, and the subject matte of this conference, is about innovation. It is about looking for opportunities in new places, in markets that have not been a traditional vehicle for investment.
My business is regulation, but the message I hopefully have delivered is about the need for flexibility of regulation in the face of innovation. While regulators cannot cede their mission of market and customer protection, they cannot become so intransigent so as to stifle legitimate business innovation. When we do that, not only do we imperil business, but we raise costs for investors, both those who use markets and those who benefit from the existence of these markets.
Thank you and I look forward to your questions.
Last Updated: April 18, 2007