FUTURES AND DERIVATIVES:
THE ROAD TRAVELED AND THE ROAD AHEAD

Address by Chairman Reuben Jeffery III
U.S. Commodity Futures Trading Commission

American Bar Association
Committee on Futures and Derivatives Instruments
Winter Meeting – San Juan, Puerto Rico

February 3, 2006

Introduction

Thank you, it is a pleasure for me to be here today. And I appreciate your very kind introduction. While it is a privilege to serve as Chairman of the Commodity Futures Trading Commission during this time of great challenge and opportunity, I don’t lead the agency alone. The CFTC relies on the leadership and judgment of all its Commissioners, and I want to acknowledge the contributions of my outstanding fellow Commissioners Walt Lukken, Sharon Brown-Hruska, Fred Hatfield, and Mike Dunn, some of whom are here as panelists and participants. Furthermore, as you are all well aware, the Commission is endowed with outstanding and seasoned professional staff.

I also want to thank Committee Chair Paul Pantano, and Program Chair Bill McCoy, for the invitation to share some thoughts with you on the topic of futures and derivatives – the road recently traveled and the road that lies ahead. Of course, it has been a short road for me so far, having been in the Chairman’s seat all of 6 months. I would, however, like to talk with you about what has been occupying our attention at the CFTC during that period, the implications for you as practitioners and for us as regulators, and where I see the CFTC focusing its attention on the road ahead in 2006.

The Road Traveled

With respect to the road we have traveled, there are three areas where we have dedicated significant resources since last July: 1) Reauthorization; 2) the Refco bankruptcy; and 3) the regulated energy markets.

1. Reauthorization

No sooner had I walked in the door at the CFTC last summer than I had the good fortune to be thrust head-first into the world of Reauthorization. At the CFTC, staff of our General Counsel’s Office, and the Divisions of Clearing and Intermediary Oversight as well as Market Oversight, have been doing yeoman’s work for many months now in trying to bring the Reauthorization process to a successful conclusion.

In a joint letter of November 3, 2005, the President’s Working Group sent Congress agreed legislative language supported by each member of the PWG to address the retail foreign currency issues raised by the recent Zelener decision. We also provided legislative language setting a deadline of June 30 for the PWG to address making futures on certain debt security and foreign equity indexes available to US customers, and September 30 to address implementing portfolio margining for security futures products.

It is not every day that Secretary Snow, now-former Chairman Greenspan, and Chairman Cox opine favorably on proposed legislation. I was therefore quite pleased that, except for certain natural gas-related provisions, this PWG language served as the basis for the Reauthorization bill that the House of Representatives passed on December 14.

I believe that the current Reauthorization effort encompasses some important legislative provisions that everybody in this room should be able to support. First, while I am encouraged that staff of the PWG agencies are working on the risk-based portfolio margining and security index issues, there is nothing like a Congressional deadline to help focus agencies’ attention on a particular issue. Second, the PWG language addressing the Zelener decision will ensure that the CFTC can continue to crack down on fraudulent foreign currency bucket shops that prey on retail customers. And third, the CFTC and industry representatives have reached consensus on an amendment to Section 4b of the Commodity Exchange Act that will provide an important clarification of the CFTC’s anti-fraud authority with respect to off-exchange, principal-to-principal transactions.

These provisions are important not just to the CFTC, but to the industry and the public at large. The Reauthorization process now moves to the Senate, where it remains a priority for Agriculture Committee Chairman Chambliss and for the Commission. What we need is leadership from industry and a commitment to get Reauthorization done. I urge each of you here today to join us in working with leaders in Congress to complete Reauthorization as early this year as possible.

2. Refco Bankruptcy

Now that I have Reauthorization off my chest, let me turn to the Refco bankruptcy. Not long after arriving at the CFTC, we saw the largest FCM bankruptcy in history – beginning on the morning of Columbus Day with the first wire service story ominously titled “Refco Announces Undisclosed Affiliate Transaction.”

I particularly want to commend the staff of the CFTC’s Division of Clearing and Intermediary Oversight and General Counsel’s Office that took the lead for us on the Refco bankruptcy. In the weeks that followed, our staff worked 24/7, cooperatively and effectively with the relevant self-regulatory organizations, as well as various industry participants and other Federal officials, to facilitate the futures industry’s ability to absorb the failure of the Refco FCM while protecting the public interest.

This was a case where the independent efforts by regulator, self-regulators, and the regulated industry enabled all of us to achieve a common objective. Specifically, these efforts helped to ensure that the Refco FCM was resolved in such a manner that the market positions of Refco customers, and more than $7 billion in customer funds, were safely and securely protected from the collapse of this global financial firm.

While the final chapter on Refco has yet to be written, the successful resolution of the FCM underscores the strength and viability of the customer protections that serve as the backbone of the industry. Looking around this room, I see many of you who have been involved in the Refco bankruptcy proceedings in one way or another. Although it is hard to take comfort in the context of such an adverse event, I believe that throughout the workout of the FCM, we witnessed the futures community at its best – working cooperatively, urgently, and creatively to achieve a common objective.

3. Regulated Energy Markets

Also shortly after joining the CFTC, Hurricanes Katrina and Rita devastated the Gulf Coast region and damaged a substantial portion of this country’s production capacity for oil and natural gas. Happily, this winter has so far proved to be much milder than anticipated (in fact, I understand that last week Paul was trying to move this Conference back to Washington). But still, all one has to do is scan the newspaper headlines to know that not a day goes by when we do not encounter an issue relating to the energy markets.

The CFTC devotes significant resources to market surveillance of regulated futures markets generally, and, due to their impact on the American economy, energy futures markets in particular. As a result of its large trader reporting system, the CFTC has a tremendous amount of data available regarding the regulated futures markets – and, even more important, a talented group of market analysts and economists in our Division of Market Oversight and Chief Economist’s Office to analyze that data.

Last fall, as energy prices rose sharply (with natural gas futures topping out at over $15 in mid-December), and a high degree of volatility in heating oil and natural gas trading on NYMEX, the CFTC was called to testify before the House Subcommittee on Energy and Air Quality. I was pleased to present at that hearing the bases for our view that the high futures prices and price volatility for heating oil and natural gas, at that time, were indicative of market fundamentals, reflecting expectations of market participants in a time of very tight demand-and-supply balances for these commodities, combined with the impact of the damage caused to the energy infrastructure by the hurricanes.

In our ongoing work at the CFTC, we continually tap into the expertise of our economists and market analysts in order to marry economic and legal analyses of the issues we confront on a daily basis. We are proud of the work of these top-notch professionals whose close examination of market fundamentals informs both our understanding of what is occurring in the markets we regulate as well as our interpretations of the Commodity Exchange Act. As reflected in our work last year in the wake of Hurricanes Katrina and Rita, we welcome opportunities to present our analyses, where appropriate, in order to enhance transparency and public understanding on major issues of the day.

The Road Ahead

So, now that we are a month into the new year, what lies on the road ahead? Here, too, I would like to talk about three topics: 1) self-regulation; 2) enforcement; and 3) competition.

1. Self-regulation

One of our most immediate projects, particularly for our Market Oversight staff, is preparing for our upcoming public hearing on the state of self-regulation in the futures industry, which will be held in mid-February. I am sure that we all share the same ultimate goal: A strong system of self-regulation that effectively protects the people who rely on the proper functioning of the futures markets. But as we all know, the devil is in the details. It is no secret that there are strongly differing views on whether, and how, the existing self-regulatory model can continue to effectively serve the public interest in the current market environment.

We look forward to an open, healthy and constructive dialogue with the industry and other stakeholders on these issues. There is no substitute for industry representatives talking with each other – not past each other. We encourage, and applaud, efforts to undertake a meaningful discussion within the industry itself in order to identify areas of common ground. Such efforts will serve the public interest – and, admittedly, make our job at the CFTC easier – by focusing the debate on those issues where reasonable minds truly differ.

That said, however, we as regulators are prepared to make the hard calls that may be necessary in deciding whether any changes to the present system are required. We have a full complement of Commissioners at the CFTC now, and I would venture to say that we, individually and collectively, will not be shy about making difficult decisions. That’s why you pay us.

2. Enforcement

Turning to enforcement, it is an unfortunate truism that the work of enforcement is always with us. I expect the coming year to be no different, as our agenda includes a vigorous enforcement program to deal with those who break the rules at the expense of the integrity of the markets, the customers who use them, and all of us who make a living in the futures industry. Bad behavior tarnishes us all. Accordingly, when a need for enforcement action arises, we will act resolutely.

Because it has garnered increased attention recently, I would like to focus today on the results of our Enforcement Division’s successful investigation of widespread misconduct in the energy markets. In the last few years, the CFTC has filed various actions charging some 50 defendants with false reporting, attempted manipulation, or manipulation in violation of the Commodity Exchange Act. These enforcement actions have thus far resulted in civil monetary penalties totaling nearly $300 million.

Let me offer a few observations about these energy enforcement cases. First, in bringing these cases, we do not intend to expand or alter the CFTC’s jurisdiction in any way. We do not question the legal certainty established by the CFMA for transactions in financial or energy commodities between eligible contract participants.

We have not suggested that the CFTC, or any party to such a transaction, can unwind the contract on the theory that it was an illegal off-exchange futures contract. Nor have we suggested that the CFTC can bring a fraud action based on a transaction in a financial commodity (such as bilateral OTC interest rate swaps) between eligible contract participants. Congress determined in the CFMA that the parties to these transactions have the means to watch out for themselves, and that what occurs between these parties should not be regulated.

What we do intend, however, is to exercise established CFTC cash market enforcement authority, which has long been recognized by the courts, to address instances of market abuse that have ramifications far beyond the particular parties to a given transaction. This market abuse interferes with price discovery and adversely affects all Americans – even those who are not trading. Accordingly, the CFTC has no tolerance for those who willfully engage in false reporting or manipulative conduct with respect to off-exchange energy transactions.

3. Competition

Finally, the CFTC’s agenda for the coming year also includes continuing our ongoing efforts to create a regulatory environment that embraces competition and encourages creativity, innovation, and change. In this regard, we will keep building upon the firm foundation that was established by the CFMA.

For example, in 2005 our Market Oversight staff reviewed over 300 new contract certifications to ensure that these contracts do not violate the Commodity Exchange Act or CFTC regulations. Many of these contracts are innovative or based on new commodities, including futures on ethanol, pollution allowances, weather derivatives, and freight rates.

The creativity of these new product offerings reminds us of the benefits that well-functioning futures markets can bring to the American public. To cite just one example, the CME is developing the first futures contract to be based on a housing price index. Amid news reports of weakening home sales and housing production, this contract seeks to bring risk management to a housing market that has experienced significant price escalation and price speculation in recent years. Regardless of whether this particular product succeeds or fails, we see no indication that the pace of market creativity and innovation in new contract offerings will slacken in 2006.

I expect much of the work on this part of our agenda this year to occur in the international arena. Globalization is a growing reality in the futures industry. Of course, globalization can raise complex questions, as recently illustrated by the ICE-NYMEX foreign terminal discussion that we will be evaluating carefully.

From its earliest years, the CFTC has followed a forward-leaning policy based on the notion that globalization has great potential to enhance market depth and competition. Competition, in turn, promotes innovation in products and services. Ultimately, the public benefits from lower transactional costs, product diversification, market liquidity, and at the most basic level, the ability to trade in markets and products otherwise inaccessible.

By all measures, our experience confirms this judgment. The U.S. futures markets continue to prosper, driven in part by global competition. Globalization, far from being a zero-sum game, expands the playing field and growth opportunities for all markets – to the benefit of market participants and the general public.

It is critically important, however, that competition be open, fair and equitable across international markets in order to sustain a healthy and growing global market. Under the leadership of our Office of International Affairs, the role of the CFTC is to work towards ensuring a level playing field. The CFTC actively supports the applications of U.S. regulated entities to compete for business in other jurisdictions.

Toward that end, we work with other regulatory authorities to address their interests so that they can permit such competition, while appropriately relying on our home market supervision. In the year ahead, I expect that the CFTC will continue to play an active role in working with its regulatory counterparts around the world to achieve common regulatory objectives. This work helps regulators rely on each other, as appropriate, in order to streamline industry access to cross-border business opportunities while maintaining customer protection and market integrity.

Conclusion

In conclusion, we at the CFTC clearly have a full plate of issues to challenge us in the year ahead. We look forward to receiving the benefit of the support, experience, and expertise of each of you as we strive to meet those challenges.

I would be happy to take your questions.

Last Updated: March 29, 2007