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Regulatory Innovation in a Changing Global Environment Focus Sharon Brown-Hruska, acting Chairman of the U.S. Commodity Futures Trading Commission, advanced the concept of regulatory innovation. In this article, she comments on the organization’s move away from a rule-based approach to the adoption of a core principles-based approach and speaks about her own personal goals and convictions as the top-most derivatives regulator. 8 Probably more than at any other time in history, derivatives markets are thriving. Domestically and globally, we are experiencing a tremendous surge in innovation and change in the derivatives industry, with a proliferation of products and trading systems and concomitant increases in the use of derivatives by a broader spectrum of customers. In order to keep pace with the changing market environment and continue to perform the mission of customer protection and market integrity, regulatory authorities must innovate, too. At the Commodity Futures Trading Commission (“Commission” or “CFTC”), moving away from prescriptive rules and constraints to the adoption of a core principles-based approach has enabled us to promote the growth and innovation in the global markets while ensuring that financial and market integrity are preserved. As Acting Chairman of the Commission, my colleague and I, Commissioner Walt Lukken, bring a diverse, but highly complementary, set of skills to the task of regulating the markets under our purview. Commissioner Lukken came to the Commission with experience in the legislative arena, working on the professional staff of the Senate Agriculture Committee and contributing to the crafting of a regulatory model that has enabled great progress in the derivatives markets. As a college professor and economist, I have spent most of my career studying, writing, and teaching about derivatives markets, and have a pretty good understanding of the markets and the way regulation interfaces with them. “We strive to eliminate regulatory barriers to entry.” While we have had some recent attrition at the Commission level (the Commission normally consists of five Presidential appointees), our respective backgrounds and the depth of talent and experience at the staff level will allow us to perform our duties effectively until new commissioners can be brought on board. Although we may have different backgrounds, Walt and I have sought to accommodate innovation in products and markets by focusing on regulatory innovation. Regulatory innovation is actually the toughest kind, since there are many forces against change in the regulatory arena, often including regulators themselves. Achieving regulatory innovation requires proactive participation not only by regulators, but legislators, the administration, foreign policy-makers, and industry interests like traders, firms and exchanges. This kind of innovation requires a full court press. But the payoff is huge, with markets that are more efficient and agile, igniting innovation in products and services that can lower risks and increase wealth for individuals, business, and the economy. The CFTC, which was created in 1974 and given exclusive jurisdiction over futures markets, has had the unique challenge of regulating derivatives, perhaps the most innovative markets of our time. As such, the derivatives industry has seen tremendous change and concomitant uncertainty. Part of the uncertainty derived from ambiguity over what kind of regulation was appropriate for these products, as well as which regulatory agency had jurisdiction over the variety of derivatives that were being developed. Since its inception, the CFTC has been at the center of a jurisdictional storm, because derivatives, by definition, are contracts whose value is based on prices and rates associated with commodities and assets that are also regulated by various other agencies within the US federal government, as well as by state and foreign regulators. This regulatory environment created significant legal uncertainty for the developers and users of derivative products. Indeed, legal uncertainty was so acute in the territory of derivatives on equities, it took an act of Congress to help resolve the jurisdictional impasse between the CFTC and the Securities and Exchange Commission to finally allow the introduction of security futures products. That act was the Commodity Futures Modernization Act (Modernization Act) of 2000, which not only sought to resolve the legal uncertainty experienced by users of financial derivatives, but it also laid out a blueprint for regulatory innovation. Following the guidance of the President’s Working Group on Financial Markets outlined in the report on Over the Counter Derivatives Markets and the Commodity Exchange Act, the Modernization Act codified changes that were necessary to allow the CFTC to cope with innovation, including that of the rapidly expanding over-thecounter markets and the increasingly electronic and global marketplace. The Modernization Act was the culmination of an ongoing effort to recognize that banks and other financial institutions that market over-the-counter transactions were often already under the purview of other regulatory agencies. Further, given that OTC transactions were typically customized transactions done on a principal to principal basis between professional market participants and sophisticated counterparties, it was recognized that the prescriptive regulatory approach and invasive disclosure requirements typical of exchange-style regulation were not meaningful nor practicable. Replacing the model of day-to-day review and approval is a mechanism that allows markets to self-certify new rules and SWISS DERIVATIVES REVIEW 26 – NOVEMBER 2004
“This approach moves us in the direction of a risk-based model of compliance.” Focus rule changes, proposed contracts, or operational changes that are consistent with core principles. The core principles are complemented by a system that no longer relies on checking the figures on financial statements or checking off boxes in our audit and compliance function, but instead moves us in the direction of a risk-based model of compliance. This is a road that many of our markets and firms have been paving for the last 20 years, using techniques like Monte Carlo simulation and variance at risk (VAR) type models to determine everything from prudent margin levels to minimum capital requirements. Our regulatory model recognizes that not all markets are created equal. The statutory framework adopted in the Act allows different levels of regulatory involvement depending on the type of market one is operating and the sophistication of the market participants using them. For example, institutional market participants not needing the same protections as retail market participants are subject to a less intrusive regulatory framework than traditional markets like exchanges, which are increasingly available to retail customers. Many critics have chimed that this model leaves holes in our regulatory coverage. However, even in exempt markets, we retain and have exercised our authority to police against fraud and manipulation. In the OTC energy markets, for example, we have vigorously pursued those who engaged in false price reporting and manipulation. In the retail foreign exchange markets, we have been equally effective in prosecuting fraudulent activity that takes place outside the confines of our contract markets. Rather than limiting our authority or our juris- 9 SWISS DERIVATIVES REVIEW 26 – NOVEMBER 2004
Page 1 and 2: SWISS DERIVATIVES ISSUE 26 - NOVEMB
Page 3 and 4: Contents Contents SWISS FUTURES AND
Page 5 and 6: Dear Members and Friends of SFOA Ed
Page 7: Focus Treasury. Then came Ginnie Ma
Page 11 and 12: WHEN YOUR FIRST NAME IS “NEW,”
Page 13 and 14: Focus Union’s regulators in terms
Page 15 and 16: “There’s no rule saying banks c
Page 17 and 18: The rush of endless opportunity. Li
Page 19 and 20: Further your future: team up with a
Page 21 and 22: “Investor interest in gold was re
Page 23 and 24: A new standard in the derivatives i
Page 25 and 26: “The Stone Age didn’t end becau
Page 27 and 28: A blazing sponsor for Friday night
Page 29 and 30: CNBC Europe reporting live from Bü
Page 31 and 32: A fascinating presentation by ballo
Page 33 and 34: “Swiss taxation is very advantage
Page 35 and 36: “These results seriously question
Page 37 and 38: D O W J O N E S I N D E X E S THE D
Page 39 and 40: “ ‘Carry’ strategies and even
Page 41 and 42: Education Chart 2 Overbought zone (
Page 43 and 44: Bollinger Bands Let’s briefly rev
Page 46 and 47: Emerging Markets A Perspective on E
Page 48 and 49: Profile IFRI - The International Fi
Page 50 and 51: Profile 50 Official Publication of

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