C. Peter McColough Series on International Economics featuring Walter Lukken

Friday, December 12, 2008
Walter Lukken
Acting Chairman, U.S. Commodity Futures Trading Commission
John G. Heimann
Senior Advisor, Financial Stability Institute

New York City, New York

JOHN HEIMANN:  Well, ladies and gentlemen, it's just about 8:00.  I think we can begin our session today with Walter Lukken, who's the acting chairman of the U.S. Commodity Futures Trading Commission.

Mr. Lukken's going to make a few comments and then we will have questions and answers.  We'll have a little discussion between ourselves and then to the floor.

But before that, the Council on Foreign Relations requires that we read the following -- I shouldn't say "requires"; they suggest it -- but just to point out that this session is on-the-record, which is not the norm; that we are welcome today to the Council on Foreign Relations meeting, which is a part of the C. Peter McCollough Series on International Economics.  Our next meeting in the series will be held on Wednesday, December 17th with John Lipsky.

Please turn off not just your -- not just put on vibrate -- your cell phones, BlackBerrys, all wireless devices.  And I would like to remind you again, that this session is on-the-record.

With that, let me introduce Walter Lukken, whom I think you all know was appointed the commissioner of the CFTC in 2002 and is now the acting chairman.  You have his biography so there is no point in taking the time to go over it.  With that let me turn it over to Walter.


WALTER LUKKEN:  Thank you very much, John.

And I want to thank the Council on Foreign relations -- in particular Ben Steel, who's a friend and invited me up here before the changeover in administration.

I have announced that I'm leaving as acting chairman, stepping aside, come January 20th.  But it's been an incredible, incredible experience over the last 18 months being the head regulator of the commodity futures markets in the United States.

For those who don't know -- familiar with the CFTC -- we're about roughly a 500-person federal regulatory body that oversees the United States futures markets.  And there's about $5 trillion worth of notional-value transactions that flow through those markets every day.

Most people think of pork bellies and frozen orange juice futures as what's traded on those markets.  Actually, that's a very small percentage nowadays.  It's about 7 percent of the markets are agriculture; about 8 percent are energy -- the crude oil which everybody knows about; and the rest is financials.  So it's the euro dollars; it's the LIBORs; it's the long bonds; it's all those equity indexes that flow through the Chicago Mercantile Exchange and the New York Mercantile Exchange.

So it's a very dynamic, exciting industry.  We even have the New York Stock Exchange recently became a futures exchange here in New York.  So it's a growing industry as well.

Certainly, this has been an exciting time.  I mean, this is the time of year when you look back, what's in, what's out, what happened during 2008?  I'm out, a new administration is in.

On that subject, the transition, I think, has been extremely efficient across the government.  The Obama team has come in and done a fantastic job of trying to get information during this period of crisis to make sure there is a smooth transition so I applaud them and we're working as closely with them as possible to ensure that the handoff is seamless.

But 2008 -- I think if you had stood in my seat at the beginning of 2008 and now are looking back, could anybody have predicted the Lehman Brothers, the Bear Stearns, the Citigroups and the others that have happened?  Certainly, the run-up in commodity prices was front and center for us.  Crude oil hit $147 in July and fell $100 by Thanksgiving, due to the slowdown in the global economy.  So it's been an incredible experience.

And the focus on the CFTC has been white hot.  You know, I felt a little bit like that movie, "Groundhog Day" where I'd get up and do the same thing over and over again.  I testified 14 times on the subject matter of speculation and other related matters over my tenure at the CFTC, because this is something that people didn't understand; they needed educating on.  They wanted to understand our markets better and why our markets were functioning the way they do.

Our primary mission is protecting the sanctity of the price-discovery markets in the United States.  Our markets not only provide risk management for people who want to directly use our markets, but for those who want to price off of our markets.  They're not involved in our markets directly, such as those people who want to --

what a bushel of wheat might be or a barrel of crude oil or even what an interest rate might be for a mortgage -- those people utilize our markets as well.  So our job is to protect the sanctity of that price-discovery mechanism and make sure manipulation is not occurring.

And there's been several things -- you know, our job used to be very easy.  It was a brick-and-mortar organization.  We'd oversee these exchanges, mostly here in New York and in Chicago.  We'd keep a watchful eye over them, but as electronic trading and globalization happened, traders dispersed to the winds and could be anywhere.  Location didn't matter.  And so we've, over time, had to sort of rethink our regulatory philosophy, dealing with the swap markets, which many people understand electronic markets have developed into swap markets.  And we worked with Congers to pass greater transparency for electronic energy swap markets such as the IntercontinentalExchange.  In fact, today in the federal register we're putting out for a proposed rulemaking those final -- or proposed rules dealing with exempt commercial markets in those electronic swap markets.

We also looked at foreign boards of trade who may link to our markets and be able to influence prices.  We worked with London and the FSA in London to try to get more transparency and oversight of those markets over the summer.

In the over-the-counter markets in general, certainly people have an attention on the CDS market, but we were looking at the energy swap market even long before that, trying to gain greater transparency to the over-the-counter markets and what swap dealers are doing -- try to get more information.  We had a special call on swap dealers this summer that allowed us to get a lot of information from them to understand exactly what was going on in the over-the-counter market and how it was influencing the regulative marketplace.

In September we came out with a report on that.  And actually, there was a lot of concern that index trading -- this pension money that was coming in through swap dealers -- may be overwhelming our markets and causing this price fluctuation.  Although the amounts were large, we found about $200 billion worth of commodity index trading occurring in our markets; about 161 (dollars) on U.S. markets.  That was much smaller, I think, than was expected.  I think figures that we saw, people were estimating in the mid-$350 billion range for commodity index trading.

And actually, even though -- and we looked, in particular, at crude oil during that -- you know, between January when it struck $100 up to 147 (dollars), we actually saw participants leaving the markets as pension funds counterbalanced their portfolios while the prices rose.  I think it was an interesting phenomenon.

But certainly, we wanted to ask for and made recommendations in that report for greater periodic routine transparency for those markets.  And we continue to work on potential rulemakings that will provide greater transparency in that area.

So I did want to touch on, before we turn it over to John, I have come out in favor of a new regulatory reform approach for the United States.  I believe this crisis -- in my experience sitting at the CFTC -- that we need to start from scratch; that we need to start over.  And I think the stars seem to be aligning politically and substantively to try to get to where we need to be.

I've suggested that an objectives-based regulatory approach is the way to go.  This is something similar to what the Treasury blueprint put out on regulatory reform under Secretary Paulson, something the Group of Thirty under Paul Volcker -- and John's a member of that -- has suggested as one of their alternatives.

But in essence, what this would say is we would have, instead of dealing with product-type securities futures, over-the-counter the functional regulatory way, we would turn to an objectives risk-based approach so we would have a systemic risk regulator, which many have advocated -- a market integrity regulator.  And then at the lowest micro-risk level, a customer protection regulator.

So all of these would be tightly coordinated with information sharing, but rather than get into the argument of what is a security and a future, you know, I've sat in this seat now for six years and before that working in the Senate.  I don't know!  I don't know what it is and I'm not sure anybody can tell you.  So let's try to clearly define our missions as regulators and start regulating based on risk.  And I think it's a good approach.

I also, as part of that, some have suggested -- like the Treasury blueprint -- as an interim step to merge the CFTC and the SEC together.  I don't support that.  I think it would be a waste of political capital to try to do.  It's very difficult.  Once you got there, it would be the final step.  You would never get to the ultimate reform effort that you were after.

So rather than waste effort trying to take this interim step, I say if we're going to think bold during this time of change, let's go for it.  And that's the proposal I've put forward.

So I think I'll cease fire there.  I know there may be questions, but certainly it's been a very interesting ride.  And it's been -- I'm probably the least-known member of the President's Working Group, but it's been incredible to be a fly on the wall and participating in some of those meetings with Secretary Paulson and Chairman Bernanke and Chris Cox during this financial crisis.  And those are some of the great memories that I'll take away with me when I leave this chair.

HEIMANN:  Thank you, Walter.  You're not really turning it over to me.

You've given us an awful lot to chew on.

LUKKEN:  I know.

HEIMANN:  So let me start with a broad subject, because I think it's within that framework that we can discuss the individual issues.

Now, in one of your speeches you said -- and I think I'm quoting you correctly -- that the current crisis is "breathtaking" and so it is.  I'd like your views as what are the implications of this breathtaking crisis -- both domestically and internationally?

LUKKEN:  I think we underestimated A, the interconnectedness of the markets.  So our idea that the market discipline could take care of a lot of the over-the-counter markets -- I think that theory has been thrown out the window.

And so we're having to understanding better how the markets interplay with each other -- both domestically and internationally.

I would say that, you know, I worry that during this time of crisis there will be protectionist creep in the government.  That rather than -- the CFTC has been an advocate for mutual recognition for a long period of time.  And Ben, actually, has participated as we've reviewed our policies in this area.

But we recognize other foreign high-standard governments that regulate in these areas and try to coordinate our efforts with them.  Rather than reregister people here in the United States that are already registered with London or in other places, we would rather recognize what other regulators are doing around the world, coordinate our efforts, coordinate information sharing so that we can create a fabric of regulatory -- regulatory fabric around the world that covers everything without being overly duplicative or protectionist.

So that's something I think we're going to be mindful of as we approach all these issues going forward is to make sure we don't throw away all the good things that work very well right now in the regulatory system.  And I think mutual recognition in defense of it is working very well.  And so that's something I hope that doesn't go by the wayside during these reform efforts.

But certainly, the over-the-counter market is something we're going to have to tackle -- what the approach might be to overseeing that.  We are working with the Fed and the SEC to get a clearinghouse up for credit default swaps.  Our hope is by year's end to have maybe several clearinghouses that are clearing these over-the-counter markets.

But this is an interim step.  Congress and regulators are going to have to deal with the long term -- how do we regulate over-the-counter markets, what's the mechanisms by which we oversee them, get greater transparency?  And that's not a question that I think we'll be able to answer in the short term.

HEIMANN:  Well, you've mentioned the credit derivatives market and the centralized clearing mechanisms that you have begun to work on with the SEC and with the Federal Reserve.

But the EU is rushing to instigate a European clearing solution, so not as to allow the United States to control.  How would you manage this potential conflict?

LUKKEN:  Well, again, I think it's something we have to work closely with the Europeans and the rest of the world to share information.  And I've been a strong advocate that, you know, decision making often works very well at the local level, but information sharing can happen across borders very easily.

So I think it's something that we should not -- we should not say, you know, there's a litmus test that this is purely European and it should happen in Europe; or this is purely in the United States, it should happen here without allowing competition around the world.

And so I think certainly, for example, the New York Stock Exchange and their clearing efforts straddle both New York and London.  That, actually, I think is a beneficial thing for the markets.  I'm not sure whether it's more European or more U.S.  That's a difficult determination.

But I think everybody recognizes that different countries around the world have interests in this.  They should have the information to make smart decisions.  But to say, you know, to sort of direct the market that you can only clear here if you're European or if you're U.S., I think that's wrongheaded.

HEIMANN: Well, let me just see if I understand that.  You're saying that it's all right to have more than one clearing exchange.


HEIMANN:  But would that mean a proliferation of exchanges in the United States or one in the United States and one in Europe and one, let's say, in the Far East?

LUKKEN:  Well, I think whatever the market will allow.  You know, we certainly, on the futures side, have multiple exchanges and more coming in.  I think clearinghouses are the same.  As long as they go through their due diligence, through the regulatory system and are overseen properly and are doing the right things from a legal point of view, they should be able to offer a product and try to provide a market solution.

So that's, you know, I think the markets -- especially on the clearing side -- volume tends to help.  You know, typically, volume goes to one or another -- the best solution.  And I would be surprised on the clearing or on the CDS markets whether one solution is the ultimate winner.  But it's not going to be the regulators who pick that winner.  It's going to be the markets themselves.

HEIMANN: And who's going to oversee these exchanges in your scheme?

LUKKEN: Well, I think it depends on where they're located.  Again, this mutual recognition idea.  If, for example, the Chicago Mercantile Exchange is one of our regulatees.  We're working with them as a primary regulator of them to make sure that they're doing everything proper to list this credit default swap product, but we're closely coordinating with the Federal Reserve of New York that has a strong interest -- as well as the SEC.

So we are the primary regulator -- boots on the ground, making sure they're doing everything properly -- but yesterday I was meeting with the Federal Reserve Bank of New York that had questions and want information.  And that's completely proper, because they have systemic risk responsibility to make sure that this is working properly as well.

So it's a coordinated effort between primary and secondary regulators -- I think that's worked well for us over the years -- that will work well in the clearinghouse space.

HEIMANN:  Well, you've proposed a very ambitious regulatory reform concept -- I should put it that way.  And that would -- you'd shrink the supervisory system to three regulators, as you've pointed out before.

How in that system do you relate to the Federal Reserve, the Office of the Comptroller of the Currency, the Office of Thrift Supervision, the National Credit Union Administration, the Federal Deposit Insurance Corporation and the 50 state banking supervisors -- not to mention the 50 state insurance commissioners.

I mean, how -- your scheme, how do you redo this in terms that you've put forward, when the reality is we have this hydra-headed monster that exists today?

LUKKEN:  Well, definitely on the banking side there's going to have to be consolidation.  I think properly they would probably fall within this market integrity regulator, as has been suggested by Secretary Paulson's blueprint.  To me that makes a lot of sense to try to centralize this.  And I think that there's probably a strong argument for creating a federal insurance regulator as well.

I have to admit, though, my lane is the futures markets and the securities markets and exchange-related affairs.  You know, as one person of a small agency, I wasn't able to think of the entirety of the regulatory system and all the different ramifications of that, but certainly, there's going to be strong consolidation within that regulatory framework.  And I know that's something near and dear to your heart, but I think there has do be, just like there has to be on the market side as well.

HEIMANN:  Well, the main point is when you talk about regulatory reform, you have to take in the whole system.

LUKKEN:  Everything.  You have to take in everything.

HEIMANN:  So where would you put hedge funds in all of this?

LUKKEN:  Well, I think hedge funds -- they may be a variety of places.  Certainly they have -- large ones have systemic risk problems where the systemic regulator may be interested.  But there are certain safety and soundness issues with hedge funds as well -- as well as if they're dealing with fund-to-funds may be dealing with customer protection issues.

So you're not necessarily pigeonholed in one regulatory framework versus another -- just like you're not today -- but you're going to -- and I think that's important to recognize.  I mean, I think people think if you throw it under one roof, these tensions that are inherent between securities and futures and banks and all this will disappear.

Well, that's just not true.  The tension will be there, but it's just going to be in-house and you're still going to have to figure out a way to manage the mission tensions that exist.  For example, one of our primary missions is protecting the integrity of the futures markets.  So we do everything we can -- segregate funds, a way to protect the futures markets.  But there are times when, on the securities side, they want to protect shareholders or investors that may rub with that protecting of the overall integrity of the markets.

And so that will have to be managed no matter what box you put it in, under the new regulatory system, just as you have to manage it today in the current regulatory system.

HEIMANN:  Well, and one of the -- those who favor reform of the regulatory system have proposed quite actively, and going over some period of time, the merger of the OTS, the Office of Thrift Supervision with the OCC.  And the second was the one you mentioned before, the merger of the CFTC with the OCC.

Now, Chairman Cox of the SEC is in favor of that, and most of the past heads of the SEC are in favor of that.  You mentioned you're opposed to it.

So let me -- I'd like to elicit more reasons as to why, in this following framework, reform of the financial system, whether it is your proposal or any one of the others that have been made, will take a long time.

Now, whether it's nine months or two years, I don't know -- it depends on the Congress, and I don't want to comment on the Congress this morning -- the idea of these two mergers will, in the short run, improve the system.  So why would you -- are you opposed to that short-term fix, which certainly will be commingled into the long-term solution?

LUKKEN:  Well, I would say it's not a short-term fix.  You know, it's just -- for example, we've tried to coordinate our efforts with the SEC, and Chris Cox and I have made this a priority of ours.  But just to hammer out an MOU on information sharing took us six months.  That's information sharing.  I mean, that's easy stuff, you know, to get down to the details.

So you're talking about, you know, merging, you know, a 3,500-person agency with a 500-person agency, different missions that conflict, and, you know, different jurisdictions of Congress.  And so to say oh, this is a quick, easy step we can take to get us to long-term reform, you know, I have to chuckle because it's -- this would take a very long time and a lot of political capital expended on trying to get to where we need to be to merge the agencies.  And is there going to be anything left in the tank to get us to the long-term reform?  And I would say no; the impetus will be gone at that point.

So rather than waste our time and effort on this interim step, let's think about long-term reform, a game plan to do it.  I've suggested if you want to buy time is formalizing some sort of unified regulatory board with the head of the Fed, the head of the SEC and the head of the CFTC.  Give us joint rule-making and exemptive authority so we can align our regulatory authorities ourselves.  And there'll be a tie-breaking mechanism with the Fed, there, to sort of say okay, credit default swaps may go to you, or may go here, and we can work things out through this three-person board.

That would help us to buy some time to get us to where we need to be, and I think the beneficial thing of this unified regulatory board, it would give the Fed the ability to start working as systemic risk regulator immediately, because they'd start receiving securities market data, futures market data.  They'd have the bank over-the-counter data to begin looking at.

So I think this could be a helpful interim step that would be simple, in the keep-it-simple model versus a merger of the agencies.

HEIMANN:  Well, I don't want to be argumentative --

LUKKEN:  Oh, yeah, go ahead.  Yeah.

HEIMANN:  -- and I'll leave that to the people on the floor for questions and answers.

But to point out that the crisis that we've had has really been a collective failure to manage risk in the financial sector, due to expansion of credit, excessive leverage, et cetera and so forth, all of which everyone knows, including the credit derivatives markets, because after all, derivatives are an extension of credit, just under a different name.

And you cannot even think of having a temporary board over the financial system unless it includes the banking regulators as well as the securities regulators, or the product regulators.

So I would just say that if you -- the short-term board that you're talking about would have to, importantly, include certainly the OCC, the FDIC and other agencies, so it'll never -- can't be a three-person board, I don't think.

But one thing that has been mentioned in all of this, which was mentioned very importantly and now has dropped by the wayside because people don't know what to do about it, and that's the rating agencies.

And what is your view on the rating agencies and where they fit in the structure and what should be done about them?

LUKKEN:  Well, you know, that's something a bit out of our lane currently, and the SEC has worked hard to try to remove conflicts with the rating agencies over a period of time.  They certainly form a function and there needs to be strong independence and oversight on credit rating agencies.

I'm not exactly sure where in particular that small part of the markets would fit in that regulatory framework, but certainly there needs to be strong oversight over that element of it.  And that's something the SEC has taken, I think, steps to try to improve.

HEIMANN:  All right.  Well, then, following on that, I would like to say the time has come to open it up to questions and answers from the floor.

Let me just make a few comments.  Do we have microphones, or can everyone hear without them?  Oh, we do have microphones.

If you are asking a question, please wait until you get the microphone, and then please identify yourself by name and affiliation.  When you stand, do that.  And then try to limit yourself to one question, and no speeches -- or, if it is a speech, a very small speech.  (Laughter.)

QUESTIONER:  Ted Kamman, Jones Day.

I'd be particularly interested in your comments on insider trading.  There seems to be a lot of it, and there seems to be an extraordinary opportunity to insider trade in credit default swaps, various forms of derivatives that fall outside of the SEC's regulatory authority.

So I'd be interested to understand what the CFTC actually does with regard to insider trading, what enforcement staff it has and mechanisms it has in that regard, how it works with the SEC, and from a broader point of view, where you'd put that in the regulatory scheme that you have in mind.

LUKKEN:  Well, that's another interesting aspect.  The CFTC, or the futures markets, actually in some ways encourage insider trading.  Not on the securities side of the equation, but definitely on the commodities side.

You know, if I'm Cargill or ADM or somebody who's going to buy grain, I have inside knowledge of purchases I will make in the future, I can go in and hedge.  That's the whole point of our markets, is to allow information to come to the markets for price discovery to occur -- that, indeed, expectations of what the price will be in the future will be reflected in prices.

And so our mandate on insider trading, in particular to securities, is very small.  That rests with the SEC.  And we work closely with them on sharing information, if there's something on the equities side, to share that with them.

But I think if I step back a bit, I think what you're suggesting is what we've discovered over this period of time is that things outside our regulatory focus can influence the regulated aspect of the markets.

So somebody could use the CDS markets to drive down the price of a listed security, and benefit as a result of that.

We've seen this on the energy side of the equation.  We saw with Amaranth, the hedge fund that imploded on itself.  What it did on the New York Mercantile Exchange here in natural gas was that it would -- in the closing range, the last half-hour of trading when the price is set based on a weighted average of that last half-hour, it would come in very big.

It would come in and dump a lot of product on the market, driving the prices down.  And it would have held a very large short position somewhere else in the over-the-counter markets that it could profit from.  And so -- and then we found also that there are actually electronic markets happening over the counter that could drive the NYMEX price the opposite direction.

And so what we said is, look, if you're going to -- if there's going to be a significant price discovery effect on the regulated marketplace, we're going to require more transparency, more regulation, more oversight.  There is a public interest in that.

And so I think that model, if you think about it, could work on anything.  It could work for credit default swaps.  When you say, look, if you're going to -- if you have the ability to either price-discover so people are quoting what the spread is on credit default swaps, people are utilizing that somehow in interstate commerce.  There's a public interest there.

Or, if credit default swaps are linked so closely with the underlying single security that it can -- you know, the tail wag the dog, well, there's certainly a public interest there, and more transparency and oversight might be necessary.

So that -- the trigger mechanism that's worked well in our over-the-counter markets, the energy markets, I think would work very well in the equity markets to prevent this sort of insider trading from occurring.


QUESTIONER:  Hunter Smith with Bunge.  If you think about the credit default swap market, it does not have the fundamental characteristics of a well-functioning derivatives market because there's no symmetry between the interests of potential buyers of the derivative and potential sellers of the derivative.

You have no open-interest concept, no commercial-versus-spec concept, et cetera, et cetera.  You have the ability to write multiple insurance policies on the same house, which eventually aligns the incentive with the arsonist rather than with the homeowner.  (Laughter.)

Given all of that, what is a centralized clearinghouse going to do to bring sellers to the market?  If you can't bring sellers to the market, there's -- the market won't function.

LUKKEN:  You mean commercial entities that have a interest in the underlyings?  Is that what you're referring --

QUESTIONER:  The big seller in the market was AIG --

LUKKEN:  Yeah.

QUESTIONER:  -- so today the biggest seller in the market is the U.S. taxpayer.

HEIMANN:  Right.

LUKKEN:  Well, no, I think -- we're looking at it from a risk point of view.  Whether there's a need for the product going into the future, that's something the markets will determine.  I think there's obviously been a large fall-off in the credit default swap markets.  There are not as many being written.

What we're trying to do with the Federal Reserve and the SEC is those assets that are sitting on the books right now, to make sure that we can untangle, sort of, these daisy-chain credit default swap webs that have been developed over time.  And a clearinghouse does that very effectively.

Instead of having multiple counter parties that you don't see who your counter parties might be, the clearinghouse steps in to be the buyer of every seller.  And certainly Bunge knows this very well.  But what we were trying to do is really address the risk aspect of this.

But I think you might be right.  I think as people recognize this and understand that maybe there's not a need for this product going forward, we may see the amount of credit default swaps being written fall way off into the future.

But our focus, laser focus at the moment, is trying to take care of the 58 trillion (dollars) that's sitting on the books right now and make sure that there's not a systemic event related to that.

QUESTIONER:  Can I just follow that up, just quickly?  Who do you see has the responsibility of looking forward on all of these products, rather than the market today?  But looking forward, what does that mean to the system as a whole?  What risks does it create?  Who would do that, in your view?

LUKKEN:  You mean, who would regulate the market going forward?

QUESTIONER:  You can use the word regulate or supervise.  It's really who will be thinking in terms of the products that are coming to the market and what the -- the effect they may have on the markets over time, especially their excessive use, in some way?

LUKKEN:  Yeah.  I guess I've always envisioned the systemic risk regulator as somebody who would be looking at sort of all these markets, getting the information, similar to what BIS does, collection of data in the over-the-counter markets, but seeing, if it becomes of a size that's important enough and large enough that it could have systemic effects on the markets, that again, this trigger mechanism -- that it's large enough, it's creating -- it's causing price discovery, that there would be a trigger that the government would ask for more information and more oversight.

So, you know, again, we're in a free market society.  Products will develop; people -- most of them will fail, but we want innovation.  We're not throwing innovation out with all this -- hopefully, we're not -- but we still want -- you know, some of these products work very well and they function very well, but we want to make sure that the risks are aligned with the oversight, and that's what we're trying to do.

HEIMANN:  Well, we can't forget that circumvention is the father of innovation.

LUKKEN:  That's right.  We'll see some of that.   Sir?

QUESTIONER:  John Beatty from UBS.

One of the advantages of a principles-based system is the flexibility it gives to the regulators.  What -- from the regulated's perspective, however, one of the disadvantages of a principles-based system is the lack of guidance that might ensue from the so-called flexibility.

How would you ensure that a principle-based system not only gives regulators sufficient flexibility to address systemic risk but, at the same time, give market participants sufficient guidance as to what is or is not permitted?

LUKKEN:  Right.  Well, I think you've laid out perfectly the trade-off between the two systems.  And the CFTC actually is a principles-based regulator.  We've been doing that since the year 2000.

So we have, for all registered entities in our markets -- for example, exchanges -- they have to abide by 18 core principles, under our law.  But those core principles don't stand on their own.  They are accompanied by acceptable practices and guidance which, in essence, are rules.

So you have to provide guidance for the legal certainty that you talked about in order to understand how you are in compliance, that you have a safe harbor, that you're meeting the core principle that's being expected of you.  So it's this balance you have to find between the two.

And you don't want -- unfortunately, you don't want a rules-based system and a principles-based system sort of on top of each other, but you really have to make sure that the spirit of the law is being adhered to as well as the letter of the law.  And that's the balance that you always try to find.

But we've, I think, done it very successfully at the CFTC.

HEIMANN:  Let me just follow that up and ask -- you have 18 principles.  How many pages of rules and regulations support the 18 principles.

LUKKEN:  We've got a rulebook about that thick.  (Laughter.)  I can't tell you.  But no -- it's significant, but we are always mindful.

And the other thing that we do -- and I think this is helpful as well -- is we allow the industry to submit to us acceptable practices.  So rather than us -- sort of a top-down regulatory approach, the industry itself could say look, we've invented a better mousetrap, and here's a better way to meet your Core Principle 5, and here it is.  And we can reject it, accept it, but at least organically the markets themselves could say this is a more efficient, effective way to meet the core principle, and here it is.

So that's, I think, been a useful thing as well.

HEIMANN:  I would just point out that the financial services authority in the U.K. is a principles-based approach, and they have now over 10,000 pages of rules and regulations.

LUKKEN:  Right.  And Hector Santos is --

(Cross talk)

LUKKEN:  -- he's said that he wants to have that, if possible.  But you're right, it's -- they have --


No, Mickie -- the gentleman behind you, then you'll be next.  Okay?

QUESTIONER:  Marshall Sonnenschein, Sonnenschein Partners.

My question relates to levels and extent of disclosure concerning the $58 trillion beast.

Whatever the ultimate blueprint and focus on systemic risk, we know that the $58 trillion beast has exacerbated and accelerated financial shock risk throughout the system.

And whatever the clearing corporation ultimately will do will help, but the real question, it seems to me, is to what extent are we prepared now in Washington to take the position that positions in credit default swaps -- which often tower over in size the underlying debt markets to which they relate -- need to be disclosed, so that whether you are a shareholder in a bank and you have no idea what's on that bank's balance sheet, as it turns out, or whether you are a shareholder in an insurance company or a policyholder with the same problem, or a pension or endowment or other publicly sponsored tax beneficiary-oriented investor, or even in a hedge fund which you may have signed up for.

Whatever your position is, should investors in the marketplace have the right to know what the positions of financial institutions in which they are key investors or constituents have in this $58 trillion market?  Are we prepared to go there and say disclose what you've got?

LUKKEN:  Well, I'm not a securities regulator, but my view is why not?  I think the investor should know what the risks might potentially be, if they're investing into -- in a company that may have exposure there.  No, I certainly think that that's important.  Transparency's helpful.

I think -- so as far as, and this is coming from the CFTC side of things, right now we receive in our markets the positions of every trader that happens in our markets of size.  And so if you're in our markets, whether you're a hedge fund and completely unregulated, if you step foot in our markets, we ask you what are your positions, how many Treasuries you hold, how many Eurodollar futures you hold.

We see it all, which has been very helpful, because we could see if somebody's able to hold a controlling position in our markets, they could try to push around the price.  And that's been very effective.

And I think -- I wouldn't be surprised if other regulators aren't a bit jealous of that, and may ask for that type of information going forward, whether you're on the securities side of the ledger or even the over-the-counter, that we need more information -- information, especially if it's kept private among regulators, is certainly useful for us, overseeing and deterring illegal behavior.

HEIMANN:  Mickie?

QUESTIONER:  I would like to see --

HEIMANN:  You have to introduce yourself.

QUESTIONER:  Oh.  Muriel --

HEIMANN:  I know who you are.

QUESTIONER:  -- Muriel Siebert, Muriel Siebert and Company.  I would like to see global securities and commodities regulations.  For a while I know there was -- the attitude is it will never happen, but I think with the disasters and the responsibilities that have been shown, where the Bank of England takes over the Bank of Scotland, some of these places might be more inclined to accept a global system.

I'd also like to comment on the margins.  I believe the margins are much lower, trading commodities.  Now, they were started so a bread company could buy grain the year before and lock in their cost, which is very -- a legitimate reason.  How do we -- how can we justify the oil speculators having a very low margin?  If you buy stocks, you buy them on 50 percent.  Why can't we take the speculators, those people that are not buying the futures, commodity futures, to produce a product -- why can't we take the speculators and give them the same margins?  That would bring down the speculation probably substantially.

LUKKEN:  Well, that's a very good question.  This is something we talked quite a bit about over the summer.  I think part of it is there's confusion on margin versus -- in the securities markets versus margins in the futures markets.  They're different animals.  Securities is obviously a loan, a down-payment on the purchase of the security.  In the futures markets it's meant to cover a one-day price move in the underlying commodity.  No one is going to buy the underlying commodity when you enter the futures markets.  It's meant to be an insurance bond that you're going to pay at the end of the day.  And in fact, we mark-to-market every day in the futures markets twice to make sure that the winners are paid by the losers and there's no risk in the system.  So that is what margin in our world is meant to protect, is the integrity of the marketplace.

But you're right.  I mean, there is concern that speculators are too large.  You know, actually the level of speculation -- directional bet speculation over time -- has remained very constant.  What has grown is the level of pension money investment, those people on the commodity index side, and spread trading, which is an interesting phenomenon, or people taking long and short, offsetting positions in some ways, one month versus the next month, thinking that there is some relationship that they can try to predict.  That actually has improved the curve of our markets out into the future.  Instead of our markets, the crude oil markets, you used to be able to only hedge a year or two out of the curve on crude oil.  Now you can go eight years out because of speculators, because they're able to provide liquidity out the curve on some of this.

So I think you're exactly right.  We certainly have controls on speculators right now.  They can only hold a certain amount of positions during certain months.  We tried, through transparency.  We see everybody's positions to make sure no one is manipulating the markets.  But we also have to recognize that speculators provide needed liquidity when these markets need them, especially during times of crisis when markets may dry up.

So we're always trying to find that balance, but certainly raising margins is something that's been kicked around on Capitol Hill and is something we've considered.

HEIMANN:  Yes, Fritz, sorry.  You're next, the guy -- you're next, the fellow in the shirt.

QUESTIONER:  Thanks.  I'm Fritz Link from Davis Polk & Wardwell.  And following on Mr. Sunshine (sp) and Mrs. Siebert, there was a proposal in 1990, put forward by your predecessor, to actually have registration of over-the-counter derivatives, and to -- at least on a discussion basis -- to have some kind of margin requirements or oversight because the one put option has not required margin except in extremis has been the CDS.  Do you think we'd be better off now if the proposal had gone through, or if some proposal had gone through and we now had a comprehensive register of financial guarantees and some kind of supervision of the margin?

LUKKEN:  Well, I'm not exactly sure of the proposal you're talking about, but, no, I think the regulatory system did not keep pace with the growth of the over-the-counter market certainly, and that we didn't evolve quickly enough.  We underestimated both the interconnectedness and size and the problems that could happen if this started to unwind.  So that's something that I think we're trying to address.  But certainly one of the problems with the CFCD is we have exclusive jurisdiction, and anything that's under our exclusive jurisdiction has to be on a futures exchange or it's a voidable contract.

And so that is a legal issue that we deal with and have dealt with for 35 years because if we plant our flag in a type of product immediately, especially an over-the-counter product and a $58 trillion over-the-counter product, all those contracts could be, theoretically, voidable in a court of law.  I'm not sure that brings -- that lessens systemic risk potentially in the over-the-counter market, so it's always something -- and because it's off-exchange it would be, you know, voidable as well.  So we have to think about these things.

And the other thing, as I mentioned, exclusive jurisdiction.  If we have jurisdiction, we push everybody out.  I believe, especially in the over-the-counter markets, that this should be a coordinated effort among several regulators, the Fed and the SEC and ourselves, to try to tackle this very large animal.

HEIMANN:  The gentleman in the shirt has been waiting a long time.

QUESTIONER:  Matt Leisen (ph) with Bloomberg News.  As the only federal regulator with experience in the swaps market, why didn't you guys more forcefully say that you should take over the CDS oversight rather than the Fed?  And I guess the overarching question is, was there political pressure for the Fed to take the lead there?

LUKKEN:  No, I think -- you know, I've always been a strong advocate that, you know, if the markets decide to come to a futures exchange to do this business, that we should be the principal exclusive regulator of that.  We do a very good job.  We've been regulating and clearing over-the-counter products since 2002 when the NYMEX here in New York started to clear energy swaps on its ClearPort facility.  We have very good experience doing it.  We certainly can do the credit default swap product as well.

But we also have to recognize that there are other interests in the federal government in these products.  And, again, we would be the exclusive regulator of these products, pushing out other regulator interests.  So I think we've tried to coordinate with the Fed.  There's certainly systemic risk, monetary policy issues here, as well as the SEC.  I mean, a lot of this credit default swap market has large unintended consequences on the securities, the underlying securities markets.  So we recognize those interests.  But certainly we've been very forceful that we can do the job, we will do the job, and we expect that there will be a futures market solution approved in the coming weeks.

HEIMANN:  This lady right here on the aisle.

QUESTIONER:  Thank you.  Merit Janow, Columbia University.  Could you speak a bit further about how you see this mutual recognition system evolving?  And what I'm wondering is, in the absence of harmonization of the underlying approaches, what do you see is the benefits of mutual recognition, and do you see any competitive disadvantages for American institutions?

LUKKEN:  Well, mutual recognition -- and this something the SEC has started as well with Australia, but the idea is that when people are trying to access your markets -- they may be foreign entities coming in -- that rather than require all those foreign registrants to again register around the world -- so you may have to register in 100 nations around the world that you want to trade -- that you could develop some system of passporting into those nations, as long as those nations abide by high regulatory standards.  And that's something that we've been doing for about 10 years on the exchange side and about 20 years on the firm side.

But what we do as an agency, when somebody wants -- for example a London exchange, fully regulated by FSA, wants to offer its products, put its trading screens here in the United States and allow, you know, firms here in New York to trade a London product, how do you do that?  You know, is that enough to require the London exchange to come here and have to register with the CFDC as a full-blown exchange?  And we say, well, no.  I think what we do is we recognize that the FSA has already done its job, and it's doing its regulatory job to make sure that there's not manipulation, they had financial controls in place, that all these people are not felons, you know, all the things that we do, and rather than do that twice, we're going to look at the regulatory system of FSA, make sure it's high standards, make sure that we have all the information we need.

That's the other thing that's important with mutual recognition is there's strong information sharing between the governments, so that if some violation of our law occurs, we have the information and the ability to go after those actors as a result of that.  So it's this balance of home host-country regulator that we're always trying to find.

HEIMANN:  I was just going to say, in the banking industry you do have the home host country ConcordDot (ph) that works around the world.  It would be the same thing.


QUESTIONER:  Glenn Stevens with GAIN Capital.  The question really regards -- as you're an advocate of reform going forward -- how do you see the role of someone like the NFA in this where they seem, under scrutiny, somewhere in between the regulator and kind of the associations attached to it?

HEIMANN:  Excuse me, who's the MFA?

QUESTIONER:  The NFA, the National Futures Association.

HEIMANN:  Okay, I'm not sure everybody understood what that was.

QUESTIONER:  Sorry.  But even if not specifically the NFA, an entity like that.  Do you see that as a role that should be part of the reform going forward, or even currently?

LUKKEN:  Well, absolutely.  This is dealing more broadly with self-regulatory organizations, like FINRA is the securities self-regulatory organization.  The National Futures Association is our self-regulatory organization, but most of our exchanges as well have a public self-regulatory role.  As a small federal government agency, 500-person -- or even a large one, the SEC, for example -- it's important to have the front line self-regulatory organizations that complement your efforts.  And I think no matter whether it's under this regulatory structure -- and SROs developed to meet the federal structure, so there's a futures SRO, there's a securities SRO.  But even under my reform proposal, where there's a systemic market integrity and customer protection regulator, my guess is the SRO functions would complement that, that they would develop to meet what the federal regulatory structure might look like.

But, no, I think going forward there has to be strong self-regulatory organizations that help complement federal regulatory oversight.


QUESTIONER:  Ares Clear (ph), Tiger Management.  You spoke about financial innovation, and it's hard to argue against innovation.  Surely innovative products have done good things in financial markets.  At the same time I think part of the problem with the whole mess is that, particularly with some of these structured product derivatives, the heads of even very, very major financial institutions in this country have not really understood how they've worked.  And the proof that they haven't understood how they've worked is the mess, because if they've really understood the risk, we wouldn't be here.

My question to you as a regulator is, you know, given the complexity in some of these derivative instruments and how they really work, how well do you think you and the kind of key people in your agency that you rely on really understand these products?  And is the kind of nature of your understanding robust enough to, you know -- in your agency and elsewhere in the government -- to give you confidence that they can be effectively regulated?

LUKKEN:  Well, I think everybody didn't understand -- I mean, Nobel Laureates didn't understand the products and the impacts potentially of this all unraveling.  So I think collectively we all underestimated the problems that may develop.  I think the things that as regulators going forward have to think about, obviously transparency.  I mean, I think you've got to sort of open the windows here and say, if you're going to get involved in these complex instruments that may be risky, we have to know a lot more about who's doing it, what they're doing, you know, how they're connected to each other.  I think going forward that's going to be the response to that.

I think the second thing is going to be a revisiting of capital charges for firms that hold these instruments.  You know, right now a lot of this was being run through unregulated affiliates that didn't have the proper capital charges imposed on them, and so that's something -- and this is, again, something the CFDC is not directly involved in, but Basel and the banking side I think are going to have to revisit this.  And John may know more about this than me, but I think that's an important aspect is that the capital should reflect the risk, and hopefully we've learned something about what the risks may be over this period of crisis, and it could better account for that.

HEIMANN:  Well, transparency -- you know, the phrase is in transparencies you get what you see; lack of transparency, what you don't see gets you.


QUESTIONER:  Guy Erb from LECG.  In the context of that last answer, I want you to return to your earlier answer to the question that John asked about what the regulators have done well, and look back at not so much the renewed efforts of coordination that are taking place now, but look back into the full eight or 10 years that you're familiar with these issues and what was done well that might serve as a contribution to the reform effort.

LUKKEN:  Well, I think, you know, Congress, in 2000, for us in particular -- so I'll talk about our own experience -- but the principles-based regulatory system I think has worked well for us, this idea of giving more flexibility to the regulator so that we're not hamstrung by prescriptive rules, and that was talked about earlier.  So I think that's something -- there needs to be more flexibility in the system, complemented by guidance and very clear rules.  So that I think has been helpful.

I think this idea -- and this is something that the President's Working Group in 2000 thought about, but is this idea of trying to get this over-the-counter business on to clearinghouses?  Unfortunately the markets never took that advice and that legal path to do that.  We in the futures markets after Enron saw that, but it seems like it was only after a crisis that people would then, when there was concerns about counterparty risk, that people would turn to clearinghouses.  After Enron, when the energy swap markets dried up, the only way that people could trust counterparties was to come to a clearing facility where there was a guaranteed buyer for every seller and seller for every buyer.  So I think that's something I think that has worked well.

But I think, you know, what we're going to see going forward is sort of the golden era of the regulated exchanges in clearinghouses.  I think a lot of this is going to come back to clearinghouses and people are going to seek the certainty and the transparency and the price discovery of regulated exchanges, and the size of the over-the-counter markets, a lot of that may shift on exchange.  And we, as regulators, have to make sure that there's proper sticks and carrots.  I don't think we should shut down the over-the-counter market.  There are some that have said that.  Senator Harkin has introduced a bill saying let's put it all on exchange, but basically everything off-exchange would be illegal at that point.  I'm not sure I'm there.  I think we should develop a system that allows for innovation off-exchange, that in essence this is an on-ramp to a more regulated transparent environment where innovation -- the incubator model in the over-the-counter market is going to allow for innovation, and as these things become more standardized, they can go on an exchange where they're more transparent.

So I'm not sure that answered your questions very well.

HEIMANN:  I think off-exchange is really a laboratory for innovation.


HEIMANN:  We have time for one short question and then we have to stop.  So this gentleman.

QUESTIONER:  Gerald McLaughlin (sp) -- (inaudible).  False rumors interfere with the integrity of the price discovery process.  How do you in the exchanges deal with those in your markets?

LUKKEN:  Well, you know, false reporting is illegal under our act, and so certainly we go after that strongly on the enforcement side.  This is sort of after the effect -- after the fact that this has occurred.  We saw this actually significantly in the energy space after Enron, where people were reporting to Platts -- you know, Platts would do reports of -- they would compile all the pricing of the different products happening in the over-the-counter markets and then report at the end of the day.  Well, there was no verification or checks happening and people would just call up and lie.  There were just, like you said, a rumor.  This is what I -- you know, they were just completely false statements.  And so we strongly went after that, collected about half a billion dollars of fees and penalties against those people who did that.

I'm not sure there's any way to prevent that sort of thing except through deterrence, just going after those actors, partially in going after them strongly as an enforcement agency.

HEIMANN:  Well, thank you very much, Walter.  It's been an interesting session, and I think everyone agrees, so what's left is for us all to thank you very heartily for your presentation.

LUKKEN:  Thank you very much.  (Applause.)








Top Stories on CFR


The consequences of the COVID-19 pandemic and the rise of China have prompted renewed debate about the U.S. government’s role in shaping the economy.

United States

Progress on President Biden’s climate agenda will slow with a split Congress. But with federal efforts dulled, state-level action could supply added momentum.

International Organizations

The 2022 FIFA World Cup has kicked off in Qatar, and billions of fans worldwide are tuning in to the world’s most popular live event. And yet as in years past, the Qatar Cup is transpiring under the shadow of controversy.