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Lukken remarks - Successful traits in global futures market regulation

15 July 2021

FIA President and CEO Walt Lukken made the following remarks at the 13th Lujiazui Forum International Symposium on the Rule of Law in the Financial Sector in Shanghai, China:

I appreciate being invited to speak at this prestigious forum. For many years, I have been a supporter and admirer of the opening of China’s markets for the benefit of China and the world. Open markets promote economic growth, raise standards of living, and keep costs affordable. I applaud the recent publication of the Draft China Futures Law as a significant step in achieving this goal.

In 2005, as a commissioner of the US Commodity Futures Trading Commission (CFTC), I delivered a speech in Shanghai on the opening of China’s markets entitled “Crossing the River by Feeling for Stones.”  I was referencing Deng Xiaoping’s pragmatic philosophy on how China needed to approach its economic opening in a cautious but intentional way. In that speech, I highlighted the importance of legal certainty, international cooperation, and regulatory flexibility in developing safe and growing futures markets.

Since my speech 16 years ago, China has made steady but significant progress in crossing that river. In that time, China has loosened restrictions on its currency to increase the renminbi’s prominence on the global stage. China has opened ownership of Chinese firms to foreign participation and allowed foreign financial institutions to open offices on the mainland. China has liberalized the ability of foreign and domestic companies to make investments cross-border. It has also listed futures contracts open to foreign participation and established exchange “connect” pipelines to provide cross-border access to financial products.

The publishing of a Draft China Futures Law is the latest step in crossing this river and will bring legal certainty and transparent rules to market participants wanting access to the Chinese derivatives markets. While FIA has submitted a comment letter offering specific recommendations for the Draft China Futures Law, today I want to highlight certain foundational characteristics needed in building a strong regulatory framework.   

In my speech in 2005, I shared some of the reforms that the United States had implemented with the passage of its then new futures law, the Commodity Futures Modernization Act of 2000. That law implemented principles-based regulations for exchanges and clearinghouses to provide clear but flexible requirements on these regulated entities. It allowed exchanges to self-certify new products without regulatory approval to quicken the listing of innovative financial instruments. It provided legal certainty for over-the-counter derivatives that allowed for the clearing of these instruments for the first time. It also clarified the jurisdictional lines between the CFTC and Securities and Exchange Commission (SEC) for certain stock futures index products.

This legislation laid out clear rules and a legal foundation for these markets that enabled an explosion of innovation and growth. Over the next twenty years, volumes on US futures exchanges grew by almost ten times, from 491 million contracts in 2000 to 4.4 billion in 2020. Equally important, the amount of customer funds held by futures brokers in the US rose by almost five times, from $60 billion in 2002 to $290 billion at the end of 2020. That is a testament to the confidence that customers have in both the legal foundation of this industry and the quality of its regulation. 

Legal Certainty is Key

While there are many reasons for this ensuing growth, it would not have occurred without the legal certainty brought by the new law. When rules are vague or enforced haphazardly, market participants tend to avoid trading for fear of running afoul of the law or losing their investment. Today’s global financial institutions have sophisticated compliance programs that are designed to flag these risks and avoid such uncertainty. Given the economic stakes as well as the reputational risks, many firms will pass over markets that do not have clear and enforceable rules. 

The Draft China Futures Law will provide a comprehensive legal framework for the futures markets in China, forming a solid legal foundation for international financial institutions, investors, and end-users to participate in the Chinese financial markets. These markets already rank among the largest in the world in terms of trading volume but have lacked transparent legal standards and rules that are critical for deeper institutional participation. The Draft China Futures Law, once passed, will provide important legal certainty that will incentivize greater international participation.

Crucially, the Draft China Futures Law also clarifies the availability of close-out netting for certain offsetting derivatives instruments, including close-out netting arrangements for futures clearinghouses. Derivatives contracts, by their nature, are hedging instruments that must be offset against each other during a default to mitigate further losses. Close Out Netting has always been a topic of great importance to market participants, given its impact on the capital treatment of firms. The importance of close-out netting has also been recognized by global regulatory bodies like the Basel Committee on Banking Supervision and IOSCO, who have developed capital and margin rules that provide advantages for firms in jurisdictions where netting is legally enforceable. We applaud China for addressing these legal clarifications around close-out netting and have suggested further clarifications in FIA’s comment letter to mitigate the risks surrounding this issue.

Regulatory Cooperation is Critical

Derivatives markets are global in nature. Transactions, clearing and settlement often take place in different countries and across different time zones and continents. Ultimately, market participants benefit from the deep pools of liquidity that form in these global markets.

The enhanced legal and risk management framework underpinning the Draft China Futures Law brings the Chinese markets better in-line with international standards and places Chinese exchanges on a stronger footing to seek recognition by foreign regulators to allow more foreign customer participation.

The Draft China Futures Law will be key when seeking equivalence and authorization for market infrastructure in other countries. Equivalence determinations require the benchmarking of laws and regulations against global standards. The final publication of the Draft Futures Law would greatly aid standard setting bodies, like IOSCO, or national authorities, as they look to deem China’s laws equivalent.

Global listed and cleared derivatives markets today are grappling with the challenge of market fragmentation due to inconsistent and overlapping regulatory frameworks. Fragmentation reduces liquidity and competition in derivatives markets by creating barriers to market access and increasing the complexities of compliance. It also undermines the resilience of the clearing system by making it more difficult for clearing firms to operate on a global basis.

The regulatory recognition and deference model has been the foundation of the futures industry for years. Reliance by regulatory authorities on agreed international standards and supervision by fellow regulators in other jurisdictions is the best way to prevent market fragmentation and ensure deep, efficient, liquid, and competitive derivatives markets. We strongly encourage China to support this recognition and deference model in tandem with the final passage of its Draft Futures Law.

Regulatory Flexibility Promotes Responsible Innovation

While clear rules of the road are important, markets are constantly evolving, and regulators must have flexible tools to keep pace with market changes. Most global regulators have specific authority to provide exceptions to rules as unique circumstances present themselves. These tools come in various forms, including “no action” letters, forbearance authority or exemptive authority, and typically have administrative procedures that accompany them to ensure fairness and transparency in the process. Regardless of form, they allow a pathway for market participants to request regulatory relief when circumstances justify an exception. I can tell you firsthand that the US CFTC utilizes these tools frequently to help market participants stay in compliance with the law and allow for evolution in the marketplace. FIA also requested that the European Securities and Markets Authority (ESMA) receive similar forbearance authority during its recent European Supervisory Authorities (ESA) Review. Given the pace of innovation and technological change, it would be helpful to have greater legislative clarity around the authority of Chinese regulators to grant exemptions under the Draft Futures Law.

Closing: 

In closing, I want to congratulate China policymakers and the CSRC on the significant strides they have made in opening the Chinese markets to the world over the last two decades. I look forward to even more progress and development in the years ahead. Thank you.

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