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For Release on Delivery 1-00 p.m E D.T May 2, 1990 Remarks by Alan Greenspan Chairman, Board of Governors of the Federal Reserve System before the Joint Conference of the Commodity Futures Trading Commission and the Futures Industry Institute Washington, D.C. May 2, 1990 It is a pleasure to be here today to discuss some of the issues that confront our financial markets I was heartened to observe that in the title of this conference, "Futures and Options Markets in the 1990's — Innovation, Regulation and Jurisdiction," innovation took priority over regulation and jurisdiction This being Washington, a greater portion of our time and energy will be devoted to the latter subjects, my own remarks included I think it appropriate that innovation be an important consideration in regulatory discussions has heated up The debate over jurisdiction The outcome could affect the long-term health of our markets, including the ability of domestic markets to maintain their role as a leader in creating innovative products For that reason, it is important to examine our goals for regulation and the regulatory structure that will best achieve those goals Consider first what we would like financial market regulation to accomplish Most fundamentally, we want to ensure that the financial system efficiently allocates capital resources and that financial disturbances do not spill over to the real economy Achieving these goals requires that investors be well informed of risks and generally have confidence in the contractual terms of their investments It also necessitates limiting systemic risks within our financial markets, a matter of particular interest to the Federal Reserve objective was embodied in the Act that created the Fed Indeed, this By systemic risks, I refer to problems that, because they potentially affect a broad range of markets and market participants, threaten the overall stability of the system It is important to distinguish between these risks and -2- the risks faced by individual market participants Regulatory actions and the design of regulatory structures should not be directed toward preventing the failure of individual firms Rather, the focus should be on reducing the potential for such a failure to endanger other market participants The recent dissolution of Drexel Burnham Lambert might be viewed as a case in point Although several problems encountered during the wind-down threatened to have broader ramifications, the failure of this major securities firm did not precipitate other failures Some believe that another objective of regulation is to prevent excessive price volatility Specifically, they have argued that differences in the regulatory treatment of margins in securities and derivative markets have contributed to increased volatility in securities markets and that a more consistent treatment of margins would reduce volatility As I have discussed in recent Congressional testimony, I remain skeptical of such assertions The objective of margin regulation should be to protect the integrity of financial market participants The role for oversight is to ensure that margins are set at levels covering potential losses of clearing houses or creditors under a wide variety of economic circumstances Oversight of margins is particularly important because margins have implications for systemic risk In particular, I have been concerned about the tendency for clearing organizations to lower margins in periods of price stability to such a degree that margins must be raised during periods of heightened volatility The practice has the potential for compounding liquidity pressures on market participants and payment systems in times of stress In this area, I have reluctantly -3- come to the view that private market decisions may not always fully reflect systemic concerns. Another goal of regulatory policy is to ensure competitive balance among market participants While the need for competitive balance is widely recognized for its role in fostering efficiency, what is not always recognized is the importance of competitive balance in fostering innovation If some markets or their participants are disadvantaged by regulation, they may be hampered in generating and introducing products Alternatively, their innovative efforts may be channeled in unproductive directions, or innovation may shift offshore This is not to imply that a single regulatory agency necessarily fosters innovation because it can achieve competitive balance Unified regulation may stifle innovation in other ways, a topic that I will turn to later Rather, looking at the issue broadly, competitive balance implies an equal opportunity for firms and markets to develop and trade new products. These goals of regulation provide a context for evaluating the current debates over jurisdiction they first develop Many markets may be unregulated when The recognition of some problem, or market failure, prompts the imposition of regulation regulations and regulators But markets are more dynamic than Markets change, and as they change, the legislative response has been to graft new regulatory authority onto the existing structure This response generally is to be expected because developments in markets are incremental They accumulate with time, however, and it is sometimes necessary to review regulatory structures in a wider perspective Now is such an occasion Re-evaluations of -4- regulations should include the benefits and coats of existing regulations as well as new regulations We should be as open to the possibility that some regulation should be relaxed as we are to the possibility for additional regulation Different regulatory structures allow us to approach our regulatory goals in different ways In the past, we have focused on entities trading or offering particular types of products as a way of structuring our regulation However, the possible ways of organizing regulatory regimes are limited only by the number of products, markets, and firms that exist. An alternative approach that has gotten quite a bit of attention recently is one that would base regulation around closely related product lines The current system results in different regulators for banks, broker-dealer firms, and futures commission merchants Under this framework, each exchange is regulated by a single authority, the one that also regulates the firms trading on them It is not surprising that much of our regulation is organized in this way because financial firms and exchanges traditionally undertook specialized activities. The regulation of a bank or broker-dealer, for example, focused on a type of firm offering a well-defined set of products. Institutional regulation recognizes the common characteristics of firms offering similar products and exploits the specialized knowledge about institutions that a regulator can build over time Perhaps even more important, institutional regulation recognizes the interdependence of firms trading on the same exchanges and using the same clearing organizations Despite the often diverse nature of the products traded on an exchange -5- or the business of individual firms, institutional regulation looks through these differences to the common features and financial responsibilities of exchanges and firms In contrast, products connected through a pricing mechanism could be regulated by a single entity even though such a structure might result in more than one regulator for an exchange or clearing organization Stock-index futures, stock-index options, stocks, and options on individual stocks would be an example of a cluster of products connected through a single pricing mechanism Similarly, Treasury securities along with options and futures on Treasuries, and foreign exchange along with foreign exchange derivatives, represent other product clusters Participants in futures and options markets have long been aware of the relationship between derivatives and their underlying instruments The conclusion of the studies of the 1987 stock-market plunge that stocks, stock-index futures, and stock-index options are, in effect, one market undoubtedly had long been understood by market participants. The organization of regulation around groups of related products recognizes this economic reality. The two regulatory structures that I have sketched out are by no means the only viable alternatives Nonetheless, I think these two models provide interesting contrasts, for they are at the heart of regulatory and jurisdictional issues currently being debated The most obvious limitation of institutional regulation arises from the increasing diversification of financial institutions No longer are banks solely in the business of making commercial loans and brokers-dealers solely in the business of underwriting and trading -6- securities Even when banks, broker-dealers, and futures commission merchants are not offering precisely the same products, they are offering products that functionally substitute for each other Once such product diversification occurs, the consistent application of regulations across similar products is difficult Differences in regulatory treatment may have consequences for competitive balance among market participants. In this regard, having a common regulator of a pricing mechanism or product group has appeal However, such an approach also has its limitations More than one regulator would have responsibility for products trading on a single exchange, implying a need for coordination among the regulators of exchange and clearing house rules Problems also may arise in the practical implementation of this approach Just as stocks, stock-index futures, and stock-index options are linked, other financial products are linked with varying degrees to this cluster of instruments. For example, if contracts on foreign stock indexes are included in this pricing process, foreign exchange contracts also might be a part of the pricing mechanism. Absent a single regulator, it will be necessary, legislatively or, one fears judicially, to draw lines around product clusters, and substantial coordination among regulators will still be required The choice between regulatory schemes based on an institutional approach or on a pricing mechanism approach is not an obvious one way of evaluating these alternatives is to measure them against the goals of regulation The institutional approach to regulation recognizes the financial interdependences of the firms within an A -7- exchange or other organization The pricing approach recognizes the financial interdependencies of participants in one product or market on the outcomes of trading in closely connected markets. Both of these interdependencies are important from a systemic standpoint because interdependence is at the core of systemic risk For my part, I have come out slightly in favor of having a common regulator of equity products, the common products approach Such a regulatory structure would mean, for example, that prudential margin requirements across cash and derivative instruments were based on the same assessment of price volatility This approach would avoid competitive imbalances that might arise when different regulators have different outlooks and different concerns margins A single regulator, of course, does not imply equality of Instead, it would imply consistency of prudential standards. Having one regulator responsible for other aspects of prudential regulation would seem reasonable as well One way to avoid the tradeoffs in a choice of types of regulation is to have a single regulator for all products and firms This entity could look at both firms and exchanges as single units, functioning as an institutional regulator, and could look at products connected through their prices Such unified regulation would have several advantages over our current system more quickly, with less debate Decisions might be reached This would be particularly true if the regulator were structured with a single individual at its head rather than a board or commission Problems that we have currently, such as discussion among regulators over where particular products should be traded, would arise less frequently In principle, issues of -8- competitive balance also could be resolved across instruments and exchanges, at least within national boundaries. Although this unified, even monolithic, regulation could lead to more simple and consistent regulation, I am not convinced it would lead to the best regulation The process of discussion among regulators better ensures that relevant issues surface and are addressed. Also, having different regulators of products that are functionally similar provides more scope for regulatory experimentation and innovation A unified system, in contrast, likely would be more sluggish and more vulnerable to entrenched interests, possibly leading to a less responsive regulatory system To some extent, regulatory competition in the future will be provided by foreign authorities unified system domestically domestic regulation Some argue that this justifies a more No doubt competition abroad will constrain Nonetheless, it is unlikely that we would get as much innovation, or innovation of the same kind, as we would with multiple domestic regulators Competition can prove as effective a tool in government regulatory organizations as in other areas of human affairs We would be shortsighted to ignore its potential benefits Impediments to innovation, of course, can exist in any structure. Under our current system, the so-called exclusivity provision of the Commodity Exchange Act prevents competition among types of exchanges and firms that offer products having an element of futurity While once reasonable, this provision may now be more costly than beneficial. In essence, all financial instruments have an element of futurity in them because their value depends on future events. A -9- broad interpretation of contracts having elements of futurity thus serves to discourage the development of financial products offered outside of futures exchanges Index participations are frequently cited as an example of how this provision has halted the trading of a product In addition, concerns about the application of the exclusivity provision to swap contracts reportedly has led to a more cautious approach to developing new products A way to deal with this impediment to innovation is to end the single regulation of products with futures attributes The exclusivity provision was created to prevent fraudulent activity and this objective could still be met, perhaps by exemptions of transactions subject to other federal regulatory safeguards, by exemptions for sophisticated traders, or by more stringent fraud liability Such a system would allow products with similar attributes to be traded on a variety of exchanges or regulatory regimes It is unlikely that all products would succeed, but the decision regarding the success or failure of a product would be determined not by the judiciary but by individual market participants through their investment decisions The choice among regulatory structures is a difficult one Each of the alternatives has significant drawbacks One choice with which I feel uncomfortable is the concentration of regulatory authority in a single agency I am concerned that the costs could well outweigh the benefits from a simpler decision-making process Once we have determined that a regulatory system involving competing interests is desirable, we still are left with the issue of how that system will be organized. Both regulation along institutional -10- lines and along common pricing mechanisms have strengths and weaknesses, which I have tried to identify evident The choice between the two is not self- As I noted, I come down slightly in favor of the pricing mechanism approach, although some operational difficulties still need to be addressed Whether the system adopted follows institutional or product lines, however, substantial coordination will be required among regulators As we resolve these very difficult issues, we should do so with an eye toward the future Substantial competition is developing abroad, and the development of new instruments proceeds apace Our regulatory system must be one that is flexible, encompassing and encouraging changes in our markets, and at the same time, providing safeguards that minimize systemic risk
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