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The World According to Brooksley Born

Less than six months after she became the seventh Chairperson of the Commodity Futures Trading Commission, Brooksley Born discovered that a number of powerful congressmen wanted to dramatically limit her power to regulate the futures markets. The most controversial aspect of the new legislation sponsored by Senator Richard Lugar and others-and supported by the Chicago exchanges-is a proposal that would allow the exchanges to create "professional markets" that would be free of federal regulation.

In the last few weeks, Born has plunged into an active round of lobbying to save her agency and the cause of futures regulation. She is no stranger to Washington power plays. Before joining the CFTC, Born was a partner at heavyweight D.C. law firm Arnold & Porter, where she specialized in representing institutional and corporate clients in futures regulation matters. She speaks as a woman who knows the power of words and chooses them carefully. The interview took place in March with Editor Joe Kolman.

We present a number of differing viewpoints on the professional markets exemption in the Roundtable Section.

Derivatives Strategy: You've said that sophisticated institutional traders don't need the same degree of protection that retail investors do. But that begs the question: what protections do they need?

Brooksley Born: I do think they need protection against fraud and manipulation in these markets. Currently the CFTC conducts market surveillance and oversight over all the futures exchanges. We have people on the floor of the exchanges watching for trading violations. The exchanges are required to keep detailed records of trading, and we get reports from the exchanges and from traders on the markets, showing what the position of large traders is, for example. None of those things would be available as to professional markets under the proposed legislation. The federal government would not have an oversight role at all.

There are standards in the statute and the regulations that deal with trading practices and that are designed to prevent and deter abuses on the floor of the market-such as the audit trail requirement that allows us to see whether floor brokers are trading in front of their customers. There are standards prohibiting trading in front of the customers, wash sales, other kinds of illegal transactions-all that would be eliminated.

There are rules about the fitness of people who represent customers on the floor of the exchanges or act as intermediaries or FCMs (futures commission merchants). These include prohibitions against convicted felons doing this work. There are ethics training requirements, net capital requirements and requirements for segregation of customer funds. All of those requirements would be eliminated if the professionals restricted their activities to exempted markets.

DS: The exchanges would argue that all these things-audit trails, registration, fitness-would still operate under their own self-regulatory regimes. Why don't you believe them?

BB: I think it would be likely that some exchanges would do more than others. We already have difficulties that result in bringing enforcement actions because of misbehavior on the floor of exchanges. Right now all the exchanges impose standards on their own markets that were adopted in the statutory scheme. Under the legislation, those standards would be eliminated. The exchanges also impose some of their own standards. But that doesn't mean we don't have a very active enforcement program for abuses or that we don't work very closely with the exchanges to make sure they're complying with their self-regulatory responsibility.

DS: So you're saying the current self-regulatory efforts are simply not enough

BB: I believe there is a need for federal oversight to ensure compliance with those self-regulatory standards, and I think there should be federal standards for self-regulation. These standards would be totally eliminated in exempt markets by the proposed legislation.

DS: Under the professional market exemption legislation, exchanges would be able to determine which of their pits would become professional-and thus exempt from federal regulation. Are you afraid that the exchanges would turn most of the pits into professional markets?

BB: The exchanges say that more than 90 percent of the volume of trading on the exchanges today would be eligible for the professional markets exemption. I am concerned that the reason the exchanges are pushing so hard for this pro markets exemption is that they want to use it to eliminate federal oversight of their markets.

Another thing to remember is that trading in futures on U.S. government securities and foreign currency could be exempt under these bills, not only under the pro markets exemption but also under the Treasury Amendment's provisions. If so, they would even be exempt from the federal prohibition against fraud and manipulation. The Treasury Amendment revisions in the two bills would allow for the complete elimination of any applicability of the Commodity Exchange Act to futures markets in government securities or foreign currency, as long as the participants in those markets were somewhat more restricted than "the general public." What that means hasn't really been elaborated on.

DS: What kind of fraud do institutional investors have to fear if there were no regulatory controls?

BB: Suppose, for example, a floor broker who was assigned to execute an order on the floor of the exchange didn't do so at all, but instead made a private deal with one of his friends off the floor. We bring cases against that now

DS: ...despite the best efforts of the exchanges themselves. I suppose your argument is that exchanges may be trying their best now but an outside authority is necessary to really do the job properly.

BB: Yes, and also the exchanges, of course, are required by law to do their best. But under the legislation, they would no longer have that legal requirement. There would only be self-interest at work in terms of the motivation of the exchanges to maintain a well-designed and effective self-regulatory regime.

DS: And as a government regulator, you think that really isn't enough...

BB: Historically it certainly has not been enough in the futures and options markets.

DS: The exchanges argue that under the law, the CFTC would still be able to demand records and prosecute trading violations after the fact.

BB: We would be able to bring actions for fraud and manipulation, but the provisions relating to other trading abuses that are presently in our statute would not be applicable.

DS: What kind of trading abuses are we talking about?

BB: Things like wash sales or noncompetitive trading. We would have to be able to prove that trading actually involved fraud on a customer. That might be a much heavier burden of proof than we have today in many cases. But beyond that, there would be no guarantee that we would have the records available for our enforcement people since there would be no record-keeping requirements under the act.

Right now, the people who trade on the floor have to keep records, and the exchanges have to keep records. Under the proposed elimination of federal oversight, the record-keeping requirements would be gone. So if fraudulent traders on the floor wanted to, they could decide not to keep records or destroy their records. And they would not violate any federal law unless we actually had a subpoena out for them. It would also be harder to detect these abuses early on. So it would only be likely that we would find out about them if there either was a tremendous upheaval on the market or a customer came to us with a complaint. That might be substantially later than when we typically get involved now.

DS: So if someone wanted to corner the market in silver again or if they wanted to try it with the S&Ps, under the legislation you would be relegated to the sidelines, unable to prevent anything from happening.

BB: We would probably not have early warning of it. In the silver cases, for example, the commission did have large trader reports from the Hunts and other market participants that alerted the commission to the fact that large positions were being accumulated. We would no longer have that information until there was such a dramatic impact on the price of silver that it was clear that some improper behavior was occurring.

DS: But is there any evidence that the exchanges actually have plans to totally eliminate the record-keeping you need to do your job?

BB: The CBOT wrote me a letter at the end of January saying it believed it was entitled to the same elimination of federal regulation the OTC market enjoys. It said that the undue regulation to which it was subjected under the act included a number of things, and it started the list with record-keeping and reporting and ended with having to deal with federal enforcement officers.

DS: So that leads you to believe that if this bill passes, exchanges will take advantage of the legislation to the fullest.

BB: Usually the reason interest groups press for legislation is because they want to use it.

DS: Are you as afraid of abuses on existing exchanges as you are of new exchanges being formed that might become a sort of a lawless Wild West of trading?

BB: I'm not sure whether under the Senate bill any entity other than an existing futures exchange would have the advantages of creating an exchange free of regulation. The Futures Industry Association in its testimony on the Senate bill in February said that the Senate bill should be broadened so that anyone, including futures commission merchants, would be free to create a market in a futures contract and not have any provision of the act applicable to it.

DS: Some people fear a scenario in which the legislation passes and there are suddenly all these unregulated trading systems-perhaps on the Internet-where caveat emptor is the only rule that applies.

BB: If you are going to have unregulated exchanges, it's difficult to justify limiting the unregulated exchanges to a small group of entities. The futures exchanges seem to be saying that they don't want federal oversight or regulation but they do want the antitrust exemptions that have allowed them to have a monopoly on exchange trading. I'm not sure you can justify that kind of monopoly if there isn't significant regulation.

DS: So if the current regulatory environment ends, it's conceivable that a legal case would challenge certain protections that these exchanges have right now.

BB: Under the act, they also are protected from certain state laws. They also have protection from private rights of action that might otherwise exist.

DS: So is it conceivable that state gaming laws would become applicable to trading on the CBOT or Merc?

BB: I think that's an issue that probably would be explored.

DS: The exchanges have been vociferous in their complaints about the competitive edge that they are losing to the OTC market. You don't put much stock in these complaints. Why?

BB: Largely because the exchanges have experienced such healthy growth in the last decade. They have more than doubled their trading-an increase of 130 percent in the last 10 years.

DS: But the OTC market is up 500 percent.

BB: That's because it's gone from nothing to become a very substantial market. The CBOT has just had its best year and is the largest futures exchange in the world. Its profits were up 26 percent last year over 1995. It is true that the U.S. futures exchanges are experiencing competition and have been experiencing it in the last 10 years-probably for the first time in any significant way-from the OTC market and from exchanges being established abroad. On the other hand, I think they are doing quite well competitively. These other markets have grown up because they provide additional services-not because our futures exchanges are too heavily regulated.

DS: In certain cases-the listed currency markets are most obvious example-the OTC market clearly has advantages that have allowed it to take over much of the volume from the currency pits.

BB: The OTC cash market in foreign currency has always been much larger than futures exchange trading in foreign currency. There was an enormous interbank market in OTC foreign currency transactions in 1974 when the statute was first extended to foreign currency futures exchange trading. So I'm not sure that's really a significant change in circumstances.

DS: You said you were surprised by the positions of the FIA and the exchanges on this legislation. They've always complained about undue regulation. What was so unexpected?

BB: I didn't say I was surprised by the exchanges' position. It seems to me the exchanges see a self-interest in having federal regulation eliminated the way most industries would see some self-interest in that. I was surprised by the Futures Industry Association because it's essentially an association of commodities professionals-futures commission merchants and others who make their profits representing customers on the futures exchanges. It surprised me that they took the position that they would support pro markets in their Senate testimony.

I was surprised because these people rely on customers who have confidence in the fairness and safety of these markets in terms of being willing to commit funds to them. I imagine that there could be a significant diminution of that confidence if our markets became the least-regulated in the world. All other countries with established futures markets would have significantly higher levels of regulation than our pro markets.

DS: A final question about the OTC market: What anti-fraud and anti-manipulation powers do you think the CFTC should have over the OTC market, and is there any new role you foresee in this area?

BB: We have traditionally maintained fraud and manipulation prohibitions and enforcement capabilities over those markets to the extent those markets involve futures and options operations, and we think those powers should continue.