Home > THE CASE FOR PRINCIPLE-BASED REGULATION
It’s a Matter of Principles
by
Walter Lukken
CFTC Commissioner
University of Houston’s Global Energy Management Institute
January 25,
2007
I
appreciate the opportunity to address this distinguished audience today.
This event is an important forum for gaining a better understanding
of the manner in which the energy markets work as well as how public
policy affects their functioning. Today I have been asked to provide
you with my assessment of how financial regulation may be trending in
Washington, especially as it impacts the energy markets.
Without
a doubt, the largest structural change affecting the oversight of our
markets in the last decade is global competition brought on by the cyber-revolution.
Without leaving their desks, traders now have a variety of choices on
where to trade financial products, regardless of physical borders.
This competition has significantly lowered costs and spurred innovation.
In addition, the abundance of affordable technology and bandwidth has
made trading location almost irrelevant from a latency point of view.
Traders can now plug in and trade from virtually anywhere in the world.
Technology
allows a world marketplace to exist but for the rigid laws and regulations
that hamstring its development. Unfortunately, regulation often
lags behind these global market trends and regulators frequently find
themselves defensively playing catch-up as problems unfold. Regulators
may attempt to meet these challenges by adopting detailed rules, but
the breakneck pace of innovation inevitably changes the landscape, making
the rules outdated almost upon enactment, and the vicious cycle repeats
itself.
How
do policymakers avoid this quagmire? What tools are needed to
help regulators anticipate problems before they arise?
How can regulators carry out their missions when products are being
traded across several regulatory jurisdictions both domestically and
globally? These are difficult policy questions and unfortunately,
there are no easy answers.
This
discussion is being driven by the concern that Wall Street may be losing
its long-held title of global financial center to London. Treasury
Secretary Hank Paulson and other public figures have expressed concern
over these competitive developments that are affecting the U.S. capital
markets and are seeking out the reasons behind them. Recently,
the independent and bipartisan Committee on Capital Markets Regulation
(Capital Markets Committee), chaired by Glenn Hubbard, Dean of the Columbia
Business School, and John Thornton, chairman of the Brookings Institution,
released its interim findings for enhancing the competitiveness of the
U.S. capital markets. The report found that these U.S. markets
are losing ground globally with a significant amount of capital formation
migrating abroad. The report found that only five percent of the
value of global initial public offerings was raised in the U.S. in 2005,
compared to 50 percent in 2000. Over the same period of time,
there has been a significant increase in investment funds going to private
equity firms, which do not bear the regulatory or disclosure burdens
of the public marketplace. In 2005, these firms received more
than $200 billion in capital commitments, most likely at the expense
of exchange-traded markets.
I
recognize, as did the Capital Markets Committee, that these trends may
be explained by natural market realignments as the rest of the world
catches up to Wall Street. Just as manufacturing became less American-centric
decades ago, capital markets are globalizing as market discipline rations
capital to the most efficient jurisdictions around the world.
But the report goes on to state that excessive regulation and litigation
may also be contributing to this shift overseas with the key word being
excessive. Don’t get me wrong. Regulation and litigation
are necessary for maintaining market accountability. But excessive
regulation and litigation can warp their functioning and work against
the public interest. This is what we must guard against and what
the Capital Markets report attempts to address.
Unfortunately,
no silver bullet exists to fix the situation. The Capital Markets
report makes several recommendations falling into four broad categories:
shareholder rights, regulatory process, public and private enforcement
and Sarbanes-Oxley. Policymakers will have to study and adopt
measures in all four areas in order to begin righting the ship.
But for today’s purposes I want to focus on one recommendation in
particular because it is one that the Commodity Futures Trading Commission
(CFTC) has significant experience with and one that I think would benefit
these markets greatly. That is the call for a regulatory regime
utilizing risk-based principles.
Adding
further credence to this recommendation, just released this week was
a study of the U.S. financial services industry, commissioned by New
York City Mayor Bloomberg and U.S. Senator Schumer, which also touts
the virtues of principles-based regulation, among other recommendations.
I was disappointed, however, that the study—while recognizing the
progressive structure of the UK’s Financial Services Authority (FSA)—did
not bother to mention that the U.S. futures industry is thriving under
a principles-based approach, including two futures exchanges in New
York City.
Before
turning to the specifics of risk-based principles, history can provide
some important guidance. Similar to the capital markets of today,
the U.S. futures markets a decade ago began facing significant competitive
threats from emerging all-electronic foreign exchanges. When several
of them petitioned the CFTC to place their trading screens in the U.S.,
the Commission had to grapple with the difficult choice of subjecting
the American futures markets to global competition or adopting a more
protectionist stance against foreign rivals.
The
futures industry came to this global crossroads earlier than the capital
markets partially due to the nature of the marketplace. Futures
products—whether energy, financial, or agricultural—have long been
used as tools for international trade and finance. Also, the relative
lack of retail participation in these markets allowed the Commission
to address these global policy matters without the added customer protection
complexities.
Ultimately,
the Commission made the right call in 1999 by allowing foreign exchanges
access to U.S. customers, but it came with some political risk.
Foreign futures exchanges at the time enjoyed distinct advantages over
their U.S. rivals. These exchanges were more nimble and cost-effective
organizations due to their size, ownership structure and all-electronic
format. They also did not face the same layers of rules and laws
that had developed over the years to support the open-outcry format
that dominated in the U.S.
The
CFTC understood that providing access would exacerbate these competitive
advantages enjoyed by foreign exchanges. So in affirming its stance
to allow greater foreign competition, the Commission agreed to address
its regulatory approach in an effort to level the competitive playing
field between U.S. and foreign exchanges. And with this promise
began one of the driving motives behind the regulatory reform movement
of the Commodity Futures Modernization Act of 2000 (CFMA).
The
CFMA was historic for its progressive and global approach to regulation.
Fortunately, this legislation did not emerge from the shadows of scandal.
It was crafted during a time of relative stability in the markets and
as a result, the CFMA reflects the long-term developments we continue
to witness in the financial services industry—enhanced competition
brought on by globalization and technology.
At
the same time, the United Kingdom (UK) was capping off a similar exercise
with the passage of the Financial Services and Markets Act of 2000.
Despite these two separate efforts from different sides of the Atlantic,
both governments came to the same conclusion: a principles-based
oversight regime—compared to the traditional rules-based one—provides
a more effective regulatory approach for financial services in this
global technological age.
The
reason that British and U.S. lawmakers reached the same conclusion is
simple: a principles-based approach offers a flexible structure
that focuses on identified public risks while allowing for coordinated
global oversight. Six years of experience with a principles-based
regime at the CFTC has validated these attributes. But they have
also highlighted some of the limitations of this approach.
In
general, a principles-based approach requires regulated entities to
meet certain high level principles in conducting their business operations.
Under the Commodity Exchange Act (CEA or Act), both exchanges and clearing
houses must meet a separate set of statutory “core principles” and
must continually adhere to them. For each principle the agency
may set out acceptable practices that serve as safe-harbors for compliance.
Conversely, the CEA allows for industry and self-regulatory organizations
(SROs) to formulate their own acceptable practices and submit them to
the CFTC for approval. With a few exceptions, there are no longer
prescriptive regulations that dictate the exclusive means of compliance.
Rather, exchanges have the choice of following CFTC-approved acceptable
practices or adopting their own measures for complying with the overarching
principle.
Such
an approach has the advantage of being flexible for both the regulated
and regulator. As technology and market conditions change, exchanges
may discover more effective ways to meet a mandated principle.
Although the regulatory mission remains static over time, the means
for achieving it evolves as innovation occurs or circumstances change.
A
second advantage to principles regulation is its focus on risk.
The Capital Markets Committee also recognized the importance of risk-based
regulation in its report. Risk-based regulation is advantageous
because it inherently requires regulators to incorporate cost-benefit
judgments into their decision-making. This provides greater certainty
that both industry and public funds are utilized appropriately.
Focusing on risk also helps regulators to prioritize their responsibilities
and leverage limited resources to their best advantage. For example,
regulators can task their audit staff according to risk, spending time
on firms that pose the greatest threat to the integrity of the marketplace
and devoting less time on firms whose failure would be less likely to
cause a contagion event or harm customers. This approach also
provides greater incentive and accountability for firms in managing
their risk in a more comprehensive and qualitative manner, instead of
relying slavishly on a checklist of rules promulgated by a regulator.
Principles-based
oversight also has a significant advantage over rules-based regimes
because it drastically enhances the regulators’ ability to work cooperatively
with other regulators around the world. For this reason, several
jurisdictions worldwide have adopted this approach, including the UK
and Australia, with even more nations seriously contemplating its implementation
in the near future. Principles compliment the mutual recognition
concept that many international regulators have adopted in building
a more seamless global regulatory structure. Mutual recognition
provides that one nation is willing to allow a regulated foreign entity
to offer its services domestically as long as the foreign jurisdiction
is abiding by comparable laws and regulations. Comparable in this
instance does not mean identical but rather similar in approach.
Principles
are very effective at providing a baseline to which this global comparison
can be made. Because principles focus on outcomes and risk, regulatory
jurisdictions are able to make this analysis without getting bogged
down in whether the methods and means are exactly the same. Principles
have been an effective yardstick at the CFTC as we make these determinations
on whether to recognize foreign exchanges in the U.S.
U.S.
energy markets have benefited from all three of these regulatory attributes—flexibility,
risk sensitivity and global compatibility. Last February, the
all-electronic ICE Futures exchange, headquartered in London and regulated
by the UK’s Financial Services Authority (FSA), began trading a light
crude oil futures contract, in direct competition with the pit-traded
crude benchmark of the New York Mercantile Exchange (NYMEX), utilizing
a CFTC recognition letter to allow U.S. customers to directly trade
this product. Listing of the ICE Futures light crude contract
was unique from a regulatory point of view because it was the first
to peg itself to an existing U.S.-regulated futures contract.
This caused concerns among CFTC surveillance staff that regulators were
not able to observe the entirety of a trader’s position in both markets,
widening the possibility of trading abuses.
Under
a strict rules-based approach, the CFTC might have required ICE Futures
to register in the U.S. regardless of its regulatory status in the UK
Such an approach would have resulted in duplicative regulation without
furthering the public mission. But principles-based oversight
allows a more tailored solution, enabling the CFTC to determine whether
British law is broadly comparable to the principles set out for U.S.
exchanges. In such an exercise, principles provide valuable benchmarks
as regulators look to approve foreign exchanges under mutual recognition
regimes. Principles also help regulators identify the risks in
such arrangements, allowing them to condition such approval based on
alleviating these risks. In the case of ICE Futures, its relief
required that the exchange provide the CFTC with access to its books,
submit to U.S. jurisdiction, and have in place information sharing and
cooperative market surveillance between the affected regulators.
As a result, the CFTC and the FSA now share trading data, allowing a
more comprehensive regulatory view of the crude oil market and a coordinated
enforcement effort should problems arise.
The
over-the-counter (OTC) energy markets have felt the reverberations from
this regulatory shift. As these markets have evolved over time,
the tiered regulatory structure put in place by the CFMA has allowed
the agency to keep pace with them depending on the risks presented.
For example, the Intercontinental Exchange (ICE), based in Atlanta,
is an exempt energy market under our Act, which provides the CFTC with
certain limited authorities depending on the nature of the trading.
As this audience knows, ICE is prominent in the trading of natural gas
swaps that are pegged to regulated NYMEX futures contracts. This
competition has led to significant innovation over the last several
years both in the OTC and regulated marketplaces. From a risk
perspective, this competition raises the possibility that traders could
take positions on one market in order to profit off positions on the
other. To address this concern, the CFTC has utilized its authorities
to request information from ICE regarding trader position data for these
pegged contracts on an ongoing basis similar to what we receive from
large traders on regulated exchanges. This has allowed our surveillance
staff a more comprehensive view of this marketplace. Again, these
tailored actions developed from risk considerations—primarily protecting
the financial integrity of the regulated marketplace and the
price discovery process for energy products. The flexible structure
of the CFMA has enabled this to occur without the need for additional
legislative authority.
While
principles-based oversight has these mentioned advantages, it comes
with certain limitations as well. Principles-based regulation
is not meant for all markets, especially emerging ones where the certainty
of rules is needed by regulators and industry. This approach works
best in mature, self-regulated markets where developed relationships
between the regulated and regulators exist. Otherwise, the trust
and expertise is not present to allow the system to function effectively.
Like
any tool, principles-based regulation also requires proper training
and maintenance. We may have traded in a Model T for a Ferrari,
but if we don’t know how to drive it and the tank is empty, it is
useless. Adopting a principles-based approach requires significant
training of staff who may have worked for many years under the certainty
of rules compliance. With principles-based regulation, staff must
employ their experience and judgment in making sound regulatory decisions.
It is more qualitative than quantitative and this adjustment takes time.
Early in the transition, staff can occasionally be paralyzed by their
fear of making the wrong call and this can lead to a regulatory impasse.
But with proper training and assurance from leadership, most CFTC staff
have found this new regulatory approach to be empowering.
Maintenance
for this tool requires proper funding for the agency. The CFTC
is currently at critical levels in its funding and staffing, which jeopardizes
our ability to uphold the public mission. Despite record exchange
trading volumes, employee levels at the CFTC are at the lowest in the
agency’s 30-year history. Unless the necessary funds are dedicated
to our mission, this regulatory tool could end up sitting idle, gathering
dust, while these markets and investors become increasingly susceptible
to market manipulation and fraud.
In
addition to these limitations, I want to address some claims by critics
of principles-based regulation, claims I believe to be myths.
And the best debunking evidence I have to offer is the experience of
the CFTC staff. Here are a few of the most cited:
Myth 1: Industry cannot function under a principles regime because it wants the certainty of rules.
It
is true that this industry, like all industries, wants to be certain
that it is in compliance with the law. Exclusive rules are one
way in which to provide that assurance. However, principles do
not exist in a vacuum. They come with guidance or acceptable practices
that provide industry with the pathway to compliance. Although
sometimes viewed as exclusive of each other, a principles regime is
really a balanced hybrid of both rules and principles. When the
CFTC transitioned to principles after the passage of the CFMA, there
was a detailed review of our rulebook. Some rules were deleted
but a majority became acceptable practices for principles. With
their systems in place, most, if not all, exchanges continued to meet
the new principles by compliance with these transitioned acceptable
practices. But the new system offered registrants a choice. For
those wanting absolute legal certainty, a principle’s acceptable practices
guarantee compliance. However, the statute specifies that acceptable
practices are not the exclusive means for meeting a principle, giving
regulated entities the choice of adopting alternative means for meeting
a principle. But this flexibility comes with some risk.
The CFTC has the ability to determine, on the basis of substantial evidence,
that the regulated entity is not meeting the core principle and may
request that the regulated entity amend its practices to come into compliance.
In reality, this rarely occurs because there is a strong desire for
compliance with the law, which encourages industry and CFTC staff to
conduct early and informal discussions regarding new compliance methods.
Unlike the more adversarial relationships of the past, this informal
collaboration has been extremely helpful for regulators and industry
in gaining an understanding of each others’ desires and concerns.
Myth 2: Enforcement agencies cannot fulfill their missions without the certainty of rules-based compliance.
The
audience may find this statement slightly amusing given the successful
track record of the CFTC’s enforcement division in the energy trading
space over the last several years. It is true that principles
encourage a more collaborative relationship with the regulated entity
but when wrongful activity occurs, this collaboration on the front-end
must be complimented with strong enforcement on the backside.
This bookends philosophy has been a powerful approach in preventing
and deterring wrongful activity in the industry. In 2003, three
years after the passage of the CFMA, the Commission filed 64 cases;
this was a larger number than any of the previous 10 years. In 2004,
the Commission filed 83 cases, breaking the previous year’s record.
Principles-based regulation has allowed the Commission to respond fluidly
to the new instruments of fraud and manipulation, which evolve as rapidly
as the marketplace itself.
It
is also important to recognize that principles do not affect how wrongful
activity is defined. Fraud, manipulation, false reporting and
trade practice abuse are all well-defined legal concepts in statute
and case law that are not affected by the transition to principles.
Most principles focus on ensuring that the controls and processes are
in place to prevent such wrongful activity. However, the definitions
of such activity are unaffected by the new approach.
Myth 3: Principles-based oversight means less regulation.
Many
in the press tend to treat principles-based regulation as deregulation.
This is oversimplifying the approach. It is true that as market
risks are analyzed, some regulatory requirements may lessen as a result.
Many have at the CFTC. But there have been times when oversight
has increased under this approach in an attempt to alleviate heightened
risks in certain critical areas. For example, the CFTC is presently
completing a comprehensive review of certain registered derivatives
clearing organizations (DCOs). These registrants must comply with
a set of 14 core principles dealing with such matters as financial systems
and controls, recordkeeping, treatment of funds, and default rules.
Before this new regulatory approach was enacted in 2000, the CFTC did
not distinguish between its oversight of clearing houses and exchanges
despite distinct risks between the two. The new approach recognizes
that the heightened systemic risk concerns with DCOs requires that the
CFTC devote more resources to their oversight and this has occurred
as a result. It is also an area where the Commission has purposely
kept more detailed regulations, possibly at the expense of flexibility,
to ensure that the protections are in place to properly address the
risks inherent to the clearing system. Indeed, the safeguards
were recently tested with the financial difficulties of Refco, Motherock
and Amaranth. Despite these significant events, most industry
observers agree that the CFTC’s market protections worked exceedingly
well in preventing a systemic event or a loss of segregated customer
funds.
This
has been our broad experience with principles-based oversight but I
want to conclude by suggesting that other regulators, including the
Securities and Exchange Commission (SEC), could greatly benefit from
such a change in their oversight framework. Like it or not, the
flattening of the global economy will soon require regulators to adopt
compatible regulatory structures. The principles approach is the
most likely regulatory standard to emerge because it greatly improves
the abilities of regulators to address these cross border questions
without having to reconcile the multitude of laws and regulations among
nations. It also facilitates tight cooperation among domestic
agencies by allowing them to speak the same pliable regulatory language.
But
don’t take my word for it. The proof lies in the performance
of the U.S. futures industry—both domestically and overseas—under
such an approach. From the passage of the CFMA in 2000 to 2005,
volume on the U.S. futures exchanges has grown 240 percent, compared
to the 21 percent increase on U.S. securities exchanges. Today
the largest U.S. exchange is located in Chicago, not New York City,
with CME’s market capitalization at roughly $20 billion compared to
the NYSE at $15.5 billion. While U.S. capital markets have been
losing IPOs overseas, U.S. market share on trading volume in the global
futures industry has grown from 34 percent in 2000 to 42 percent in
2005. By all measures, this industry has been enormously successful
competing on a global scale. I hope others will take notice of
this success and understand that the principles-based approach, while
not the reason behind such achievement, has played a significant role
in allowing this growth to occur.
Again,
I appreciate the opportunity to explore this subject in depth with you
today and I would be happy to open it up for questions from the audience.
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