Joseph B. Dial, Commissioner
Commodity Futures Trading Commission
18th Annual Commodities Law Institute and
4th Annual Financial Services Law Institute
October 19, 1995
Chicago, Illinois
When it comes to the design of regulatory systems, disaster can teach some powerful lessons. California's building codes are based on that state's experience with earthquakes. Florida's standards owe their structure to hurricanes.
The same principle holds true in the world of finance, where the disasters are usually man-made. Coordinated circuit breakers in the securities and stock index futures markets (as well as a host of other reforms) are an outgrowth of the October 1987 stock market break. The very existence of an independent CFTC, with jurisdiction over futures trading in all commodities, owes a great deal to the early 1970s' Goldstein-Samuelson options fraud, and the $70 million in customer losses it entailed.
The most recent fiscal "earthquake" to shake global financial markets involved trading in a foreign office of a British merchant bank. The losses from this trading topped $1 billion, and ultimately leveled an institution that traced its origins back to the Napoleonic Wars. While the regulatory and self-regulatory responses to the collapse of Barings Bank are still ongoing, and it is unclear what final form they will take, this paper will attempt to provide an overview of the current status of those reform efforts.
The initial regulatory response to any financial disaster is, of course, damage control -- the immediate, often ad hoc, efforts to identify, evaluate and contain the event. In the Barings case, these initial efforts included coordination among regulators, banks, exchanges and market participants in the U.K., the U.S., Singapore and Japan. Those efforts, and a little luck -- in the form of the Dutch firm, ING, which stepped in to take over Barings' operations after it declared bankruptcy -- were successful in confining the disaster to Barings and avoiding any wider, systemic consequences.
Once the initial damage control efforts subside, the usual next step is the drafting of a study or report on the disaster -- often several of them. In the Barings case, the most comprehensive study published to date is the July 1995 "Report of the Board of Banking Supervision: Inquiry into the Circumstances of the Collapse of Barings," ordered by the U.K. House of Commons. This report examines two key questions: (1) "How were the massive losses incurred?" and (2) "Why was the true position not noticed earlier?" The report reaches the following conclusions in answer to these questions:
The report goes on to describe some "lessons arising from the Barings collapse," for both financial institution management and regulators. It then explores potential reform measures in response to these lessons. While the report focuses primarily on the U.K. regulatory system, it also notes the importance of "close collaboration" with other regulators, including those overseas.
In fact, international regulatory collaboration in response to the Barings collapse was well under way even before the Board of Banking Supervision Report was published. These coordinated, international efforts have formed the centerpiece of the regulatory response to the Barings collapse.
On May 16 and 17, 1995, regulatory authorities from 16 countries, responsible for supervising the world's major futures and options markets, met at Windsor, England. The regulators discussed potential steps to strengthen arrangements for supervising international futures markets in view of various problem areas brought to light by the Barings collapse. The meeting concluded with the publication of the "Windsor Declaration," in which the regulators, noted the points of consensus reached, identified regulatory and other actions they would promote, and recommended a program of further work to carry forward action in four areas. These were:
The Windsor Declaration also included a promise to report progress in carrying forward these initiatives to the next meeting of the Technical Committee of the International Organization of Securities Commissions (IOSCO). The Chairman of the IOSCO Technical Committee, in turn, endorsed the Windsor Declaration and pledged to "take matters forward under the auspices of IOSCO, as appropriate." (Subsequently, at IOSCO's 1995 Annual Meeting, in July, the Presidents' Committee endorsed a resolution supporting further work by the Technical Committee in support of the Windsor Declaration and urging IOSCO members to "take all steps that are necessary and appropriate in their home jurisdictions to endorse and promote the measures agreed upon in the Windsor Declaration to all cross-border transactions.")
The Windsor co-chairmen also had followed up the Windsor Declaration with a letter asking the various regulatory authorities to report on initiatives planned or activities underway in their jurisdictions in response to the Declaration. The letter also solicited the authorities' views concerning "international bodies other than IOSCO in which further work could be carried out," as well as "any additional proposals" that might be "relevant to implementing the Windsor Declaration."
The various regulators' "planned or projected domestic initiatives" were outlined in a report from the Windsor co- chairmen to the IOSCO Technical Committee. The CFTC efforts described in this report included directing U.S. exchanges to review their rules, systems and procedures to assure they are "sufficient to address the potential adverse consequences of a major firm failure." The CFTC also encouraged the exchanges to: (1) initiate technical stress testing of their systems for responding to market disruptions; (2) work with the Commission to "develop a model exchange of information mechanism which potentially could be expanded to include foreign markets;" and (3) participate in discussions as to the best way to "present more user-friendly financial integrity information concerning exchange markets."
In addition, the CFTC reported that it is reviewing several issues relating to regulatory rules and procedures, including: (1) whether FCMs should be allowed to continue to maintain segregated accounts at affiliated banks; (2) "the treatment of foreign-based customer omnibus accounts and the treatment of customer funds as they move from jurisdiction to jurisdiction"; (3) whether "enhanced generic risk disclosures" should be "reexamined at an international level;" and (4) whether to issue an advisory to the effect that "the need for adequate 'management controls'" is just as important when trading on an exchange as it is in OTC markets. Finally, the Commission announced it was holding a roundtable in September to consider capital rules and to evaluate "the costs and benefits of movement to a risk-based measure."
A variety of self-regulatory and other private sector organizations have also undertaken initiatives in response to the Barings collapse. In some cases, these actions were a direct response to the Barings events; in others, the Barings collapse influenced regulatory or policy reviews that were already ongoing.
Futures Industry Association (FIA) -- The FIA responded to the Barings events by convening a "Global Task Force on Financial Integrity." This industry/market user Task Force included more than 60 participants, representing 17 jurisdictions. It was divided into three committees -- Exchanges/Clearinghouses, Brokers/Intermediaries, and Customers. The Task Force reviewed such issues as: mechanisms for protecting market participants' assets; "internal controls and risk management procedures;" and "communication of information regarding the activities of market participants by exchanges/clearinghouses and regulatory authorities."
The FIA Global Task Force made some 60 recommendations in a wide range of areas, including:
Group of Thirty (G-30) -- The Group of Thirty, a private sector group representing leading banking and securities firms from around the world, has initiated several projects related to the Windsor Declaration. These include:
Basle Committee on Banking Supervision -- The Chairman of the IOSCO Technical Committee, at the request of the Windsor co- chairmen, has written to the Chairman of the Basle Committee on Banking Supervision, inviting that Committee to "undertake work parallel to IOSCO in relevant areas identified at Windsor."
Derivatives Policy Group -- The Derivatives Policy Group (DPG) is a private sector group made up of representatives of six large financial firms, which are registered as both broker- dealers (with the SEC) and futures commission merchants (with the CFTC). The DPG was formed to address "public policy issues raised by the OTC derivatives activities of unregulated affiliates of SEC-registered broker-dealers and CFTC-registered futures commission merchants."
In March 1995, the DPG issued a "Framework for Voluntary Oversight of the OTC Derivatives Activities of Securities Firm Affiliates to Promote Confidence and Stability in Financial Markets." The DPG Framework was largely completed by the time the Barings events began to surface. Nevertheless, the DPG document addresses many concerns that also were issues in Barings. Thus, the Framework's four components include:
Federal Reserve Bank of New York Group -- On August 17, 1995 a coalition of several groups representing participants in the OTC financial markets,acting under the coordination of the Federal Reserve Bank of New York, issued a voluntary code of "best practices" for OTC financial markets. The document is entitled, "Principles and Practices for Wholesale Financial Market Transactions." While the principles are voluntary, "it is expected that each trade association will recommend [this] best practices code to its members."
The Barings collapse and other recent financial market problems share one, notable common element -- a breakdown of internal management controls. How could these disasters loom up, unchecked and unnoticed, in supposedly sound, well-managed institutions? It is a question of focus.
In the normal conduct of business, it is usual for management to focus more closely on the company, division, department, section, or enterprise that is unprofitable. Profitable units, on the other hand, are seldom seen as problematic and are left alone as long as they keep generating a substantial, ever growing income stream. On the surface, that appears to be a reasonable, pragmatic approach to managing a business.
Appearances can be deceiving, however, as illustrated only too well by recent events involving Barings, Orange County, and Metallgesellschaft. Each of these financial debacles has at least two things in common: (1) a lack or break down of internal management controls; and (2) improper use of instruments that were characterized as derivatives. The first characteristic is so apparent that in each of the various reports mentioned in this article, considerable attention is given to the importance of internal controls. The second element has provoked a media feeding frenzy centered around the "D" word, which in turn has given derivatives and their utility as legitimate hedging instruments, a black eye.
As evidenced by the experience noted above, a failure to properly supervise can have disastrous consequences. Therefore, the private sector needs to redouble its effort to implement truly effective internal management controls -- controls that focus on profitable enterprises just as closely as unprofitable ones -- controls that are a vital, ongoing process. Market users must overcome the tendency to treat internal management controls like an insurance policy, tucked away in a safety deposit box. Insurance policies and internal controls are financial risk management tools. If they are not under the watchful eye of management and kept up-to-date at all times, then neither one has much, if any, value.
Regulators and self-regulators have their own challenges in this arena. They must realize that, in designing and maintaining internal controls, the judgement of market users is by far the best instrument -- with the cold hand of government running a distant second. However, a failure by the business community to make internal controls work increases the possibility of a systemic problem -- and that makes legislators, regulators, and self-regulators very nervous.