In 2000 Congress passed the Commodity Futures Modernization Act (CFMA) which, in addition to lifting the ban on single stock futures, introduced the concept of principle based regulation. It was hugely popular but came during a different era. It was passed in a business friendly administration with a competitive threat pushing it —the London Financial Futures and Options Exchange (Liffe) was about to list single stock futures on U.S. equities— and with a much more business friendly administration about to take over.
It came amid many reforms that lifted some supposed antiquated Depression era regulations—like Glass-Steagall— and when exciting innovations were opening up a new world of derivatives trading.
The CFMA was received very well by the industry and was credited with rapid growth in futures markets. Even after the Enron implosion (Enron received some special benefits from the CFMA) it was still viewed positively, if in need of a couple of a few tweaks.
Principle based regulation replaced proscriptive rules and allowed exchange and brokers to create products and services in a more efficient manner. It took away some of the time consuming aspects of complying with regulations and sped up the ability for domestic and non-U.S. exchanges to list futures contracts in the United States and amazingly the Commodity Futures Trading Commission (CFTC) under the leadership of James Newsome was making it happen.
Today, however, we are in another world. Countless scandals, frauds and abuses in the banking and trading world has turned the regulatory environment 180 degrees.
The CFMA has been made the scapegoat for a lot of problems that occurred and principle based regulation has in some respect become synonymous with that Laissez-faire era that led to the financial and banking crises of the last decade. Is that fair?
I don’t think so. And I don’t think principle-based regulation should be thought of as regulation light. In some respects it can provide tougher standards than proscriptive rules that can allow for technical loopholes. It certainly can produce more efficient regulation, which is what is needed. Too often regulation is looked at in black and white terms. Pro or anti-government. Regulation is supposed to enhance whatever industry or business it covers because it, when it plays its proper role, creates greater confidence in that industry or business. That greater confidence increases business and more than offsets its cost.
Many of the flaws in the CFMA had to do with the wholesale exemption of certain products from regulation not failures in principle based regulation.
I bring this up because the CFTC just released its Concept Release on Risk Controls and System Safeguards for Automated Trading and will be addressing that and other things at a public forum on Thursday.
The regulator has move away from principle based regulation in its long painful slog towards writing rules for over-the-counter swaps. It seems to me that a principle based approach would have made this process easier and the constant horse trading over certain thresholds to define who will come under certain rules and definitions does not provide confidence. Former CFTC Chairman Phil Johnson noted at the beginning of this that swaps are futures and the CFTC should just declare it so and though go about providing appropriate exemptive relief. That would have saved some time in the process.
The constant innovation in algorithmic trading makes the prospects of specific rules troublesome as it will only push quants to build systems to take advantage of rules. Better to set forth broad concepts that must be adhered to: such as every order must be exposed to risk, and high frequency algorithms can’t run faster than the risk controls employed by that trader.
The CFTC should only consider rules if there is a clear consensus of a problem. They did not always do this in the position limit debate when they wrote an expensive regulatory regime–which couldn’t pass a court challenge–despite no clear consensus on their authority based on the Dodd-Frank Act. It wrote rules despite no clear consensus on the problems being addressed and now are looking to rework that rule.
I must admit that I have not read through the entire 137-page concept release but I was somewhat concerned that it came out amid a flurry of activity from the regulator including the announcement of a public forum where it will be addressed later this week.
The CFTC should not duplicate its wasted and expensive efforts on position limits. It should set out broad principles to be followed and engage the industry to find the best way to meet those principles.