SPEECHES & TESTIMONY

Remarks of Commissioner Brian Quintenz at the 14th Annual China International Derivatives Forum (CIDF)

November 30, 2018
[Delivered in Shenzhen, China December 1, 2018]

Introduction

Thank you for that very warm welcome.  It is a great honor to join you today at the 14th Annual China International Derivatives Forum (CIDF) in Shenzhen.  I would like to thank Chairman Wang of the China Futures Association for inviting me and am grateful for the very productive dialogue with the China Securities Regulatory Commission Vice Chairman Fang Xinghai.  Before I begin, let me quickly say that the views contained in this speech are my own and do not represent the views of the Commodity Futures Trading Commission (Commission or CFTC).

I’d like to start today by telling a story about an important event in U.S. history.  It doesn’t have anything to do with the financial markets.  Yet, I believe it holds valuable lessons from which we can all learn about the conditions under which successful markets thrive.

December 2018 represents an anniversary of one of the United States’ great accomplishments.  This month marks the 50th anniversary of NASA’s Apollo 8 space mission, the first manned space craft to leave low Earth orbit, reach and orbit the Moon, and return safely to Earth.  Yet, its accomplishments were not what NASA originally intended, and its success was far from certain.

Apollo 8 was one of many distinct, sequenced missions which were designed to gradually test capabilities, processes and systems that would build up to landing a man safely on the moon and returning him home.  The mission’s original purpose within the planned sequence was only to orbit the Earth to test the Lunar module.  However, upon learning that the Soviet Union was on the cusp of sending a mission to orbit the moon, on August 19, 1968 – just four months before the launch date – NASA changed Apollo 8’s mission to instead target that same objective.

In the intervening four months, NASA scientists worked tirelessly to solve intractable problems that had stymied past lunar missions.  At the same time, NASA employees’ progress was subject to intense scrutiny.  The loss of three astronauts in the tragic Apollo 1 fire in January 1967 was fresh in America’s psyche.  In the aftermath, Congress and the public demanded NASA take all necessary precautions to ensure this tragedy was never repeated.  As a result, NASA engineers were held to an incredibly high level of accountability, all while ferociously competing to make the advancements and improvements needed to transform Apollo 8 into a lunar mission.

Their efforts prevailed.  On December 21, 1968, Apollo 8 launched from Cape Canaveral, Florida, with three American astronauts onboard, and three days later, on Christmas Eve, the crew celebrated the first manned mission to orbit our celestial partner.[1]  During this groundbreaking mission, the Apollo 8 crew captured an iconic photograph, known today as Earthrise, which showed, in color, for the first time, the Earth emerging from behind the lunar horizon.  In reflecting upon the mission and that famous image, astronaut Bill Anders remarked that, despite all the crew’s training and preparation for exploring the moon, the crew ultimately ended up discovering Earth.[2]

Some of you may be asking yourself what the story of Apollo 8 has to do with global financial markets.  I think this story holds an important lesson for all of us.  I believe the combination of stringent competition paired with incredible accountability forced NASA to rise to new levels of excellence.  Failure would result in a loss of agency reputation, superpower inferiority, or worse, a loss of life.  Corners could not be cut.  Every solution had to be precise, reliable, and elegant – but all of it had to be done under extreme time pressure.  Had that mixture of competition and accountability not been present, the result could have certainly been different.

The strongest financial markets are shaped by the same pressures.  People and businesses from across the world strenuously compete based on the merits of their products and services.  At the same time, strong markets are defined by accountability and fairness.  Poor performance is publically known.  Failed firms attach to their operators’ reputations.  And bad actors who commit fraud or impugn market integrity are prosecuted, and the law is applied transparently and without favor.

This combination, of fierce competition, stringent accountability, and legal certainty attracts investors, businesses, and capital.  I believe this has the been the experience of the American financial markets, including our futures markets, which I would humbly say, remain among the most dynamic and liquid, but yet still fastest growing, markets in the world.

Of course, while I believe the free market model results in the optimal outcome for societies, I recognize the wide range of views held on this topic, which has been fiercely debated over recent years, decades, and even centuries.  There is an ever-present tension between open, transparent markets and the natural self-interest of any nation to ensure the prosperity of its economy and people and to control downside risk.

Today I would like to discuss three primary things:  first, the important role derivatives play in supporting economic growth; second, why I believe the open access, principles-based regulatory model of the U.S. derivatives markets has been so successful; and third, the concrete steps taken here in China to achieve similar outcomes. 

Derivatives Markets Support Economic Growth

Since the 2008 financial crisis, derivatives have been portrayed by some as inherently “risky.”  I take issue with this label.  All economic and investment endeavors have risk.  Yet, the derivatives markets actually present the powerful tools to manage and efficiently transfer risk to those market participants who are most efficient at bearing it.

At the macro level, derivatives boost economic growth and employment.  For example, between 2003 and 2012, one study estimates that the use of derivatives boosted employment and expanded economic activity in the U.S. by 1.1 percent, or $149.5 billion.[3]  But the use of derivatives also has implications at the micro level by providing individuals and families with stability; consumers do not have to worry about wild price swings in everyday household goods when they go to the store.  Derivatives are vital to the health and growth of a country’s real economy in any number of ways, but two in particular stand out.

First, derivatives permit banks to extend more credit to the private sector, which spurs economic growth and investment in the real economy.  Derivatives bolster credit extension because they allow banks to protect themselves from their own market risks, thereby strengthening the bank’s own financial position and enabling greater lending to non-financial firms.  From 2003 to 2012, this same study found that banks’ increased extension of credit due to their derivatives hedging increased U.S. quarterly real GDP by about $2.7 billion each quarter.[4]

The second main driver of economic growth from derivatives use is allowing companies to smooth out cost structures, thereby promoting predicable cash flows that better allow for investments in growth.  The same study I just mentioned also found that commercial firms’ use of derivatives from 2003-2012 increased U.S. quarterly real GDP by about $1 billion by improving their ability to undertake capital investments.[5]  Non-financial firms that use derivatives have also been found to enjoy a lower cost of capital and increased expected cash flows, all factors that increase the firm’s value and spur expansion.[6]  In other words, derivatives enable businesses to focus on and expand their core activities, because they can hedge more peripheral risks.  It should be no surprise that a 2009 survey found that 92% of the world’s 500 largest companies managed their price risk using derivatives.[7]

Derivatives also help nations manage their own credit risks.  One recent study found that the availability of credit default swaps (CDS) trading on any nation’s sovereign bonds actually lowered those countries’ cost of debt.[8]  In fact, the borrowers who experienced the biggest cost reductions were those with the highest default risk.[9]

On the whole, I believe that derivatives hold great social and economic value for society.  A diverse, liquid and predictably regulated derivatives marketplace best allows that activity to occur.

The U.S. futures market has a number of attributes which I believe help it thrive.

Regulation of U.S. Futures Markets

In my opinion, there are three characteristics of the U.S. futures markets that have significantly contributed to their resiliency, vitality, and efficiency:  participant diversity, customer protection, and the promotion of market integrity through principles-based regulations.

Participant Diversity.  The U.S. futures markets are used by market participants around the world to hedge their risks.  This policy of open participation has increased liquidity, particularly in times of stress, which allows companies to engage with the market even during periods of intense volatility.  It also means that the pool of participants is quite diverse; a variety of commercial hedgers – with different exposures, timelines, and specifications – along with a variety of speculators – with different strategies, information flows, and analytical judgements – from across the globe can trade the contracts listed on our exchanges and, through their various perspectives and market interactions, create a robust price discovery mechanism.

Diversity within large liquidity pools gives the pool strength, similar to diversity within environmental ecosystems.  As ecosystems become fragmented or increasingly uniform, their ability to adapt to adverse conditions is impaired, which increases their vulnerability to new predators or disease.[10]  The same is true for financial markets.  The strongest, most resilient markets are integrated and diverse.  These markets are best able to withstand market shocks and economic downturns.  I believe that is one of the reasons why the U.S. futures markets performed so well during the financial crisis.[11]

Customer Protection.  Secondly, the legal regime underlying the U.S. futures markets provides strong customer protections.  Both the CFTC and the exchanges themselves police the markets for fraud, abuse, and manipulation.[12]  In addition to these basic market protections, one of the bedrock principles of CFTC futures regulation is the protection of customer funds.  Futures brokers, known as futures commission merchants (FCMs) in the U.S., must always hold customer funds segregated from their own assets.[13]  FCMs are prohibited from using customer funds for their own benefit or for the benefit of another futures customer.[14]  CFTC regulations also provide market participants with certainty about how their funds will be treated in the event of a default by another FCM customer or the FCM itself.  The legal certainty of customer funds’ treatment in bankruptcy promotes the confidence in, and therefore the use of, the U.S. futures markets.

Market Integrity and Principles-Based Regulation.  In addition to ensuring the markets remain free from fraud and market manipulation, one of the CFTC’s core responsibilities is to promote futures markets that reflect supply and demand fundamentals.[15]  While volatility can present challenges for regulators, including potentially intense political pressure to intervene in markets, I believe the choice between controlling volatility and promoting market integrity is zero sum.  The more a regulator chooses to limit participation, speculation, or two-sided price action in an effort to control the market’s movements, the less that regulator allows the market to find a clearing price.

The CFTC is not immune to such conversations.  The establishment of the agency’s precursor, called the Commodity Exchange Commission, in the 1930s was in response to price volatility and the suspicion that speculative activity was its contributing cause.[16]  Even today, there are still debates between different political philosophies on the need to limit speculative activity to protect markets as opposed to the, in my mind, better view that speculative activity provides counterparties and liquidity for natural hedgers and that only a narrow set of this speculative activity may raise concerns of manipulation.[17]

In my mind, the CFTC has seen its greatest success when it maintains its long-standing principles-based approach to regulation, as opposed to a rules-based or prescriptive regulatory approach that is seen in some other jurisdictions.  A principles-based approach has a number of advantages over a prescriptive approach:  it not only allows each market participant to develop internal rules appropriate to its unique business model or marketplace, but principles-based regulation also allows market participants to be individually responsive to market dynamics.  Lastly, enforcing principles as opposed to prescriptive rules encourages the regulator to have a cooperative and informed relationship with its registrants.  We may take the view that a market participant is failing to meet certain regulatory principles, but in order to make such a determination, we must have a detailed understanding of their business and marketplace.

As China continues to develop its regulatory concepts, I would strongly encourage such an approach to futures market regulation.

Growth of China’s Futures Markets

Speaking of China, the U.S. is certainly not the only country with growing, vibrant futures markets.  Almost 30 years ago, futures trading began in the Zhengzhou, Henan Province on the China Zhengzhou Grain Wholesale Market.  Since then, the Chinese futures markets have experienced incredible growth.  In 2017, China’s four futures exchanges – the Dalian Commodity Exchange, the Shanghai Futures Exchange, the Zhengzhou Commodity Exchange and the China Financial Futures Exchange – all ranked among the top derivative exchanges in the world by trade volume.[18]  In 2017, China’s three domestic physical commodities exchanges accounted for over 90% of the volumes traded in the Asia-Pacific region.[19]  Many of the world’s most heavily traded energy, metals, and agricultural futures and options contracts are found on these three exchanges.[20]

The rapid growth of China’s futures markets has been essential to its broader economic growth.  As the largest consumer of raw commodities in the world, and one of the largest manufacturers, it is imperative that domestic Chinese businesses are able to easily and effectively hedge their commodity price risk.[21]  To that end, I think that China’s recent steps to internationalize its futures markets will further spur their growth and give local businesses a larger, more diverse liquidity pool to manage risk.

In the past, due to numerous restrictions, it has generally been very difficult for foreign entities to access China’s domestic financial markets.  But more recently, we have seen incremental steps taken to encourage the liberalization of China’s financial markets.  For example, this past March, the Shanghai International Energy Exchange launched a yuan-denominated crude oil futures contract open to non-Chinese market participants to trade directly for the first time.[22]  In another first, this past August, the China Securities Regulatory Commission authorized foreign companies to hold majority ownership of domestic futures and securities firms, with a commitment to abolish the foreign ownership cap altogether after three years.[23]

I applaud these market reforms.  I believe that greater, more diverse participation in China’s domestic futures markets from both domestic and overseas participants will increase liquidity, reduce volatility, and make it easier for local Chinese businesses to hedge their risks and invest in growth.

Conclusion

Since the iconic photo of Earth rising behind the Moon was first taken, space exploration has marched on.  We now have the first photo of Earth from Mars (2003), the first photo of a planet beyond our solar system (2004), and, most recently, the first photo of an exploding supernova (2018).  During that time, remarkable advances have also been made in technology, medicine, the arts, and our financial markets.

The mission of Apollo 8 was 50 years ago, but the competitive and accountable environment which produced such incredible results are ever present in our global financial markets.  As China’s domestic futures markets continue to grow, I welcome the opportunity for greater participation by outside investors, including American firms, and hope to engage with you on a regulatory approach that provides the greatest price transparency and participant diversity.


[1]     Apollo 8, NASA (last updated July 9, 2018), https://www.nasa.gov/mission_pages/apollo/missions/apollo8.html.

[2]     Apollo 8: Christmas at the Moon, NASA (lasted updated Aug. 7, 2017), https://www.nasa.gov/topics/history/features/apollo_8.html.

[3]     MILKEN INSTITUTE, DERIVING THE ECONOMIC IMPACT OF DERIVATIVES:  GROWTH THROUGH RISK MANAGEMENT 1 (2014), https://www.cmegroup.com/education/files/growth-through-risk-management.pdf (hereinafter Milken Report).

[4]     Id.  These real GDP statistics reflect inflation-adjusted values as calculated in 2014.

[5]     Id.

[6]     Id. at 45.  See also Söhnke M. Bartram, Gregory W. Brown and Jennifer Conrad, The Effects of Derivatives on Firm Risk and Value, 46 J. of Fin. and Quantitative Analysis 967-999, 972 (Aug. 2011) (“Our results suggest, at a minimum, that firms reduce cash flow risk, total risk, and systematic risk significantly through financial risk management with derivatives.  This result is robust to controlling for differences in a large number of firm characteristics, as well as differences in country and industry.”).

[7]     INTERNATIONAL SWAPS AND DERIVATIVES ASSOCIATION (ISDA), 2009 ISDA DERIVATIVES USAGE SURVEY (2009), https://www.isda.org/a/SSiDE/isda-research-notes2.pdf.

[8]     Iuliana Ismailescu and Blake Phillips, Credit Default Swaps and the Market for Sovereign Debt, 52 J. of Banking and Fin. 43-61 (2015).

[9]     Id. at 58.  See also CFTC Chairman J. Christopher Giancarlo Response to Bollettino (July 21, 2018), https://www.cftc.gov/PressRoom/SpeechesTestimony/giancarloresponsetobollettino072118.

[10] Raphael K. Didham, The University of Western Australia & CSIRO Ecosystem Sciences, The Ecological Consequences of Habitat Fragmentation (2010) ; see also Keynote Address of CFTC Commissioner J. Christopher Giancarlo before the ISDA’s Trade Execution Legal Forum (Dec. 9, 2016), https://www.cftc.gov/PressRoom/SpeechesTestimony/opagiancarlo-18.

[11]    ROBERT W. KOLB AND JAMES A. OVERDAHL, FINANCIAL DERIVATIVES: PRICING AND RISK MANAGEMENT 244 (2009) (“Futures markets performed well during the crisis, and (as had been the case for many decades) there were no defaults or serious problems associated futures clearinghouses in 2008.”).

[12]    CEA Section 3(b); Section 5(d)(2)-3; Section 5d(12).

[13]    CEA Section 4d(a)(2.)

[14]    Id.

[15]    CEA Section 3(a) (noting that transactions subject to the CEA “are affected with a national public interest by providing a means for managing and assuming price risks, discovering prices, or disseminating pricing information through trading in liquid, fair and financially secure trading facilities”); CEA Section 3(b) (“[I]t is further the purpose of this Act to deter and prevent price manipulation or any other disruptions to market integrity; to ensure the financial integrity of all transactions subject to this Act and the avoidance of systemic risk…”).

[16]    Position Limits and the Hedge Exemption, Brief Legislative History, Testimony of General Counsel Dan M. Berkovitz, Commodity Futures Trading Commission (July 28, 2009), https://www.cftc.gov/PressRoom/SpeechesTestimony/berkovitzstatement072809#P20_5917.

[17]    Remarks of Commissioner Brian Quintenz before the Commodity Markets Council State of the Industry 2018 Conference (Jan. 29, 2018), https://www.cftc.gov/PressRoom/SpeechesTestimony/opaquintenz5.

[18]    Futures Industry Association (FIA), 2017 Annual Volume Survey (Jan. 24, 2018), https://fia.org/file/7119/download?token=FQ1_cUWh.

[19]    WORLD FEDERATION OF EXCHANGES (WFE),WFE IOMA 2017 DERIVATIVES REPORT 27 (April 2018), https://www.world-exchanges.org/storage/app/media/files/ioma_derivatives_market_survey/2017%20IOMA%20Derivatives%20Market%20Survey.pdf.

[20] Raphael K. Didham, The University of Western Australia & CSIRO Ecosystem Sciences, The Ecological Consequences of Habitat Fragmentation (2010) ; see also Keynote Address of CFTC Commissioner J. Christopher Giancarlo before the ISDA’s Trade Execution Legal Forum (Dec. 9, 2016), https://www.cftc.gov/PressRoom/SpeechesTestimony/opagiancarlo-18.

[21]    Darrell M. West and Christian Lansang, The Brookings Institution, Global Manufacturing Scorecard: How the US Compares to 18 Other Nations, (July 10, 2018), https://www.brookings.edu/research/global-manufacturing-scorecard-how-the-us-compares-to-18-other-nations/.

[22]    Global Trading Giants Dip Toes in China Oil Futures on Debut Day, BLOOMBERG NEWS (March 26, 2018), https://www.bloomberg.com/news/articles/2018-03-26/china-s-first-ever-yuan-oil-futures-begin-trading-in-shanghai.

[23] Measures for Administration of Foreign Investment in Futures Companies, CHINA SECURITIES REG. COMM., Decree No. 149; promulgated and effective 24 Aug. 2018, http://www.csrc.gov.cn/pub/csrc_en//laws/rfdm/DepartmentRules/201811/P020181107362813946307.pdf; Measures for Administration of Foreign Investment in Securities Companies, CHINA SECURITIES REG. COMM., Decree No. 140; promulgated and effective 28 Apr. 2018, http://www.csrc.gov.cn/pub/csrc_en//laws/rfdm/DepartmentRules/201811/P020181107362569572581.pdf.