Address by Chairman James E. Newsome before the Futures Industry Association Law and Compliance Luncheon, Chicago

May 28, 2003

It is an honor to address you this morning. Because I had the pleasure of addressing or meeting with many of you here today at your International Futures Conference in March, I’d like to update you on some of the things that were discussed then, as well as to talk about some of other things going on in the industry and at the Commission. Many of you have heard me speak before and know that I feel strongly about my regulatory philosophy. It is this philosophy that guides how I want to address the issues that come before the Commission, including those I will discuss here today.

I was an early and strong supporter of the Commodity Futures Modernization Act of 2000 and its three key objectives: modernizing rules affecting trading platforms and market intermediaries, providing legal certainty for over-the-counter derivatives, and permitting futures based on single stocks or narrow stock indices. As the CFTC has pursued implementation of those objectives, I have followed a straightforward oversight philosophy: for the legitimate business activities of those who through innovation and vigorous competition bring to the marketplace greater liquidity, more useful risk management tools, more efficient pricing, and enhanced customer service, I want to provide the most flexible and responsive oversight structure possible.

For those who would threaten the integrity of these important markets through attempts at fraud or manipulation, however, I believe in promptly and aggressively exercising our enforcement authority. In my opinion, the proper deterrent to wrongdoing should not be more prescriptive or burdensome regulations that adversely affect legitimate activities but, rather, tough enforcement actions against those who would try to operate outside the established rules. Those rules should lay out a basic legal framework without being overly prescriptive or unnecessarily burdensome. Then they must be enforced firmly.

That is why, at the same time the CFTC has been proposing numerous rule modernizations, we have also been quite aggressive on the enforcement front. For example, when Congress provided helpful legal certainty in the area of retail foreign exchange fraud, our Enforcement Division rose to the challenge and in just over two years has conducted numerous investigations and initiated almost three dozen formal actions, making a huge dent in this type of abuse. I am certain that legitimate market participants want and need a marketplace free from fraud and manipulation just as much as we do.

The Enforcement Division has also been active in the energy trading area and many of you are familiar with the multi-million dollar civil monetary penalties and other sanctions we have imposed within the last six months or so. We remain actively engaged in other energy sector investigations, which may result in further charges being filed, but let me take a moment here to make several important points about our energy cases. First, we continue to conduct these complex and resource-intensive investigations and to bring the necessary cases just as quickly as we possibly can so that, in addition to identifying the wrongdoers, we can also exonerate those who were not involved and allow these important risk management markets to work toward restoring the confidence of market participants and the public.

Second, I want there to be no confusion over our intentions when we bring charges against an entity with regard to illegal futures contracts. We approach the issues of whether the Commodity Exchange Act applies to, and whether we have jurisdiction over, any particular transaction solely on the basis of the economic substance of the transaction. Thus, where we have brought charges alleging operation of an unregistered futures exchange that involved the trading of contracts that may have been labeled or referred to as, quote, “swaps,” it is because the economic substance of those transactions was that of a futures contract. Let me assure you that we are not seeking to expand the scope of our jurisdiction over other transactions, such as the true swaps and forwards that the Congress has determined -- appropriately so, in my opinion -- to exclude under the Commodity Exchange Act. In the case of over-the-counter swaps, for example, such an exclusion was expressly provided by the Commodity Futures Modernization Act following recommendations from the President’s Working Group on Financial Markets, and this brought much-needed legal certainty for counterparties in this important sector of the risk management market.

Finally, I want each of the CFTC’s communications to clearly present our relevant goals, policies, and positions, and this includes even the orders we issue in our enforcement cases. Recently, for example, some in the industry questioned a particular recordkeeping violation that was cited in the Commission’s speaking orders in two energy cases. Let me assure you that while our aim is to be aggressive in enforcement actions, which may lead us to approach some factual circumstances in new ways, our goal is not to blur the lines of our jurisdictional boundaries. If it is ever the case that a Commission communication fails to clearly present our case, or is otherwise vague or confusing, we will appreciate hearing from concerned market participants and we will carefully consider ways to provide additional clarity.

I wanted to emphasize those points because I believe that legal certainty and regulatory clarity are critically important for the efficient and reliable operation of markets generally, but perhaps particularly important for many derivatives markets. If the enforceability of contracts is in doubt among counterparties or if laws, regulations, or even a regulator’s enforcement stance are unclear, then rational market participants must factor that uncertainty into their decisions and this, in turn, can result in unnecessary added costs, missed opportunities, inefficient results, and misallocated resources. I believe that is why Congress, with input from many of you, took care to provide additional legal certainty in various areas through the Commodity Futures Modernization Act and I am committed to adhering to that path as we move forward.

Of course, it is possible for the cause of legal certainty to be harmed as well as helped by governmental efforts, particularly if proposed solutions to perceived problems in the marketplace are pursued without adequate discussion, consideration, and debate. For example, I believe that the Commodity Futures Modernization Act reflected careful consideration and that its passage was preceded by informative discussions with and among the relevant financial regulators, in particular the members of the President’s Working Group on Financial Markets. I would therefore hope that any legislative amendments to the CFMA, particularly those that might impact legal certainty, would be pursued only after a full debate that included close consultation with the PWG. The importance of the over-the-counter risk management markets should not be overlooked nor should the fact that effective control mechanisms within the markets themselves have made defaults and other problems very rare.

I’d like to mention a few of the CFTC’s current efforts. The comment periods recently closed on a number of proposed rule changes that would modernize our oversight in the managed futures area and provide increased operational flexibility for futures commission merchants. My fellow commissioners and I are always grateful for the time and attention that market participants devote to providing us with invaluable feedback and suggestions when we solicit public comment on pending matters. This time was no different, as we received a large number of thoughtful comments.

As you know, the proposed rule changes included various improvements to the rules in the managed futures area, both on the operational side and in disclosure requirements for pool operators and on the trading side, with expanded exemptions from registration requirements for entities that are otherwise regulated, that restrict participation to certain sophisticated persons, or that have limited participation in the futures markets. I am hopeful that the final rules in this area may increase interest in the futures market by entities that have been hesitant to use them before. If that proves to be the case, then I believe that all market participants can benefit from greater activity and liquidity in the futures markets. I should point out that these changes should benefit not only the traditional futures products, but also the new security futures by broadening the scope of potential market users. The many comments that we received on these managed futures proposals were overwhelmingly in favor of making such changes and also contained some helpful technical suggestions that our staff are reviewing. I hope we will be able to finalize our rule modernizations in this area soon.

Last year, the Commission held a very productive roundtable discussion with market participants to discuss rule modernization for intermediaries, including futures commission merchants. Accordingly, our recent rule proposals also included things that I believe are responsive to concerns expressed at the roundtable. A good example is what we have proposed to do to make simplify the bunched order process and clarify respective responsibilities so that this mechanism’s promise of better executions and better pricing will be more accessible. Again, the comments we received were overwhelmingly in favor of the proposal.

We are hard at work examining other areas of potential rule modernization, including potential further refinements to the rules governing the investment of customer funds and moving to margin-based or risk-based capital requirements for FCMs. As I have mentioned on other occasions, rule modernizations are not the only changes we are making. We are also looking at how we approach all of our oversight responsibilities with an eye toward making changes wherever we can increase our effectiveness and make better use of taxpayer resources. For example, earlier this year we announced that we have authorized the National Futures Association to review annual financial reports filed by commodity pool operators because we have been pleased with the success of past delegations to the NFA. I expect that this latest change will not only improve efficiency but also provide our staff with prompt electronic access to information that will put them into an even better position to effectively oversee compliance.

We are also looking at other ways to modernize our oversight, including moving to risk-based audits and developing an oversight framework for futures clearinghouses. This type of move from a strictly compliance-based audit approach to a risk-based approach can better focus the resources of both the Commission and the self-regulatory organizations for maximum effectiveness. We recently initiated the first such examinations and the process still needs work, but appears to be on the right track. My desire to pursue ongoing improvement in our oversight is based on my firm belief that unnecessary regulations and inflexible prohibitions can impose substantial costs on market participants without achieving any increase in protections or reduction in risks. Simply stated, the goal is to eliminate all of these remaining outdated rules from the rulebook.

This might be a good point for me to mention my great satisfaction with the ability of both the CFTC and this industry’s self-regulatory organizations to work productively together and to confidently rely upon each other, something which I believe has been integral to the success of the futures markets. I remain optimistic that, even as the structure of the industry changes with developments such as demutualization and increasing competition, the Commission will be able to work with market participants to ensure that the principles of objectivity, confidentiality, and consistency continue to be adhered to as well as they have always been in this business. In this regard, just as I think it’s important for the Commission to review our own regulatory structure, I also believe it’s equally necessary for SROs, in consultation with us, to do the same. This is especially important, given the CFMA’s emphasis on self-regulation and the changing structure of the business. I have said before that it is prudent for an oversight agency to periodically ask whether the policies, practices, and systems that are in place to ensure market integrity continue to serve their purposes as well as they can and, accordingly, we will soon begin a review of the roles, responsibilities, and capabilities of SROs in the context of market changes. This should not be cause for alarm; rather, it should provide all market participants with the reassurance that we, like the exchanges, consider market integrity to be of paramount importance.

Let me conclude my remarks today by noting the exciting changes that are occurring in the business structure of the futures industry, particularly potential new relationships and arrangements that have been recently announced or proposed. It is my view that such developments directly reflect a competitive environment. The continuing and strong growth in futures trading across the board certainly seems to confirm that. I believe that such growth reflects increasingly widespread recognition of the benefits of futures-based risk management by businesses and investors that today represent virtually every sector of the economy. I have said before that I believe that true economic competition is a dynamic process, one that results in an ever-changing landscape as new entrants bring new products and ways of doing business to the market and existing competitors promptly respond with innovations of their own. I must add, however, that market access does not necessarily mean market success. It is our goal as a regulator to provide a level regulatory playing field so that new and existing competitors alike have an opportunity to compete. But the market itself must sort out the winners and losers. Ultimately, it is the market’s end users, the futures customers, who benefit most by this process.

Questions have been raised regarding new competitors and new market structures. Let me say that, as has been the case throughout my tenure, every market participant will be welcomed and treated fairly and consistently by the Commission. Let me also state my intention to continually approach each new circumstance or proposal with an open mind and a willingness to consider ways in which the CFTC can remove artificial barriers to competition, particularly outdated regulations that might constrain such things as product innovation, capital efficiency, or the cross-border flow of ideas and activity. I should say, however, that I may exercise a bit of caution about attempting to impose a premature regulatory solution that might later prove to be inefficient or ineffective.

I recently made the prediction that, ten years from now, we will all look back on this period in the evolution of the industry as an incredibly exciting time in which fundamental, maybe even monumental changes took place. What I sincerely hope will not be the case at that point is that any of you would look back and perceive the CFTC to be the primary driver of that change. I’ve said before, the kind of changes that improve efficiency and accessibility are most likely to result from the efforts of market participants themselves. The current debate over the optimal structure of the marketplace and its key institutions, particularly with respect to clearing and margin issues is a good example of a situation that, I believe, can best be resolved primarily through business decisions rather than regulatory mandates.

I see my role as one of working closely with all sectors of the industry as they cooperate to work out mutually beneficial solutions to the challenges that lie ahead. My door is always open and I hope that you will continue to provide us with the insights, wisdom, and suggestions that you have generously shared in the past. Thank you for inviting me to address you today.