TESTIMONY OF

DANIEL J. ROTH, VICE PRESIDENT
GENERAL COUNSEL AND SECRETARY
NATIONAL FUTURES ASSOCIATION

BEFORE THE SENATE COMMITTEE ON AGRICULTURE, NUTRITION AND FORESTRY

My name is Daniel J. Roth, and I am the General Counsel of National Futures Association. NFA has been operating for fifteen years now, and in that time we have had many occasions to testify before this Committee but never on issues that were more important than those addressed in your proposed legislation. Your bill addresses the tough issues facing the industry head-on and I am sure that all of us applaud the Committee for the exhaustive efforts which have been committed to this process.

NFA certainly welcomes the opportunity to express our views on these issues, but I would like to remind you that our perspective is a little bit different than most of the other witnesses you will hearing from. Like the exchanges, we are a self-regulatory body, but, unlike the exchanges, we operate no marketplace and do not directly face the types of competitive issues which confront exchanges. Like the trade associations, we are a membership organization, but we are not a lobbying organization. We are first, foremost and finally a regulatory body. Our 4,000 Members include futures commission merchants ("FCMs"), introducing brokers ("IBs"), commodity pool operators ("CPOs") and commodity trading advisors ("CTAs"). We regulate not only our Members' dealings with the public but also the activities of the 55,000 registered account executives who work for those Members. We do that job with a staff of approximately 280 people and a budget of less than $30 million, all of which is paid by the futures industry.

To truly understand NFA's perspective, it's important to understand NFA's roots. Fifteen years ago, NFA's founders offered this Committee a promise -- a promise that the industry itself would fund a regulatory body which would both ensure that all market professionals were subject to self-regulation and allow the Commission to focus on its oversight responsibilities:

     The number of non-exchange member FCMs had mushroomed and without any form of self-regulation these FCMs were foundering. In the ten years before NFA began operations, more than $9 million were lost due to FCM insolvencies. In NFA's first ten years customer losses were down by 80% and no customer funds have been lost due to an FCM insolvency in the last seven years after NFA increased the capital requirements for FCMs. CPOs and CTAs represented another burgeoning segment of the industry with no form of self-regulation and, as a result, these firms were seldom, if ever, subject to audits. Since then, NFA has performed over 4,800 CPO and CTA audits. These firms are audited on an average of once every three years, far more often than comparable firms in other industries.
      The Commission was swamped with the labor intensive effort of processing thousands of registration applications each year, sapping the Commission's resources and glutting the registration process. The Commission has now delegated almost all of its registration functions to NFA. By computerizing the entire process, NFA can now grant temporary licenses to eligible applicants within seconds.
     Boilerroom operations, some with nationwide branch office networks and hundreds of salesmen, plagued the industry. These dens of high-pressure, fast-talking con artists generated over 1,000 reparations cases each year. Again, these problems predominantly involved non-exchange member firms. As a result of the CFTC's and NFA's joint efforts, we have made tremendous strides in the fight against fraud. NFA's telemarketing rules dealt with rogue brokers before the term became fashionable. Customer complaints filed in arbitration and reparations are down by over 60% since NFA began operations and the number of APs with checkered employment histories has dropped y 75%.
     Given the volume of cases in reparations, the public needed an alternative forum for the resolution of disputes which would be fair, inexpensive and prompt. NFA's arbitration program is just that. Statistics show that customers in NFA arbitrations fare as well as or better than those in reparations, and the average turnaround time is 7.5 months. In addition, NFA provides fully subsidized mediation in the vast majority of cases.
     There was a continuing need to educate the public on the risks involved in the futures markets and registrants on their regulatory responsibilities. NFA has filled that need by producing a wide variety of pamphlets for the investing public. Over 3 million copies of these pamphlets have been distributed through the Consumer Information Center in Pueblo, Colorado.

In short, after fifteen years and over $300 million in expenditures, NFA stands now as a promise fulfilled. I know that we are not here for a trip down memory lane, but I mention what's happened in the past because I think it's relevant to the decisions you have to make for the future. NFA is further proof that self-regulation works. As you consider the overriding question of how to provide our markets with the most effective and most efficient regulation in the world, bear in mind that NFA is a proven resource which stands both ready and able to take on any assignment that the Congress or the Commission may deem appropriate. We strongly support and appreciate the bill's suggestion that the Commission consider further delegations to NFA.

Some of the other issues dealt with in the bill do not impact NFA directly, but are of vital interest to the industry and to the public. Over the last several years no issue has generated more confusion, more concern and more legal fees than the Treasury Amendment. There are really two issues which have to be dealt with in this context. First, what is the appropriate level of regulatory protection for retail customers trading in futures and options currently covered by the Treasury Amendment. Second, what is the appropriate level of regulatory protection for markets that are available only to sophisticated, institutional market participants.

With respect to the protection of retail traders, we should all focus on certain basic, unassailable points:

     First, there can be no real question that the current level of retail participation in off-exchange futures or options covered by the Treasury Amendment is and always has been minute. For the most part, the Treasury Amendment has done what it was intended to do -- it has allowed a marketplace of sophisticated, institutional participants to grow and develop, unencumbered by regulatory protections intended for less sophisticated customers.
     Second, the last thing Congress wants to do is tamper with that portion of the Treasury Amendment which has produced the intended result.
     Third, in the almost fifteen years that NFA has been fighting boilerrooms with the CFTC, there has been one phenomenon we have witnessed over and over. Scammers always seek the least regulated niche in which to ply their trade. That s why they ve been leaving the futures industry in droves. Most of the problems we see in our day-to-day surveillance of retail sales practices involve non-Members -- firms that are required to be registered but aren't. Although we do not have jurisdiction over these firms, we always have and always will help in any way we can in such cases. However, if the Treasury Amendment is ultimately interpreted to exempt the retail sales of certain types of futures contracts from CEA regulation, Congress may as well declare open season on unsophisticated customers. Quick-talking con artists will flock to this newfound haven.
     Finally, that result most definitely was not what Congress intended when it adopted the Treasury Amendment and it cannot be, must not be, what Congress intends today. Congress must act now to clarify that the retail public needs and deserves the type of regulatory protections afforded under the Commodity Exchange Act, regardless of the type of futures or options contract they are trading.

I know that defining the term "retail public" may sound easier than it is. But whether that definition is developed by Congress or the Commission, the fact is there is no shortage of models to choose from. The existing definitions for "accredited investor," "appropriate persons," and "qualified eligible clients" all address the same basic questions, and I am sure that reasonable people can sit down and determine the most appropriate customer profile to use in this context.

The second question which comes up regarding retail customers is what agency will provide the regulation necessary to protect them. To the extent that these products are offered by a bank, for example, should the bank be subject to regulation by both its primary regulators and by the CFTC? We have worked quite closely with the Commission in fighting sales practice fraud, and those joint efforts have produced the dramatic results I referred to earlier. Though we recognize and respect the Commission's proven expertise, in our view the important question is what regulatory protections will be provided, not who will enforce them. Congress recognized precisely the same principle when it adopted the Telemarketing and Consumer Fraud and Abuse Prevention Act in 1994. Congress directed the FTC to adopt customer protection regulations to govern telemarketing but at the same time recognized that the CFTC and SEC already provide comparable protections in their respective regulatory regimes. Congress realized that it didn't need the FTC to do what the SEC and CFTC were already doing and effectively exempted their registrants from the FTC rules. Congress can and should take the same approach here.

Our understanding is that the bill is intended to do just that. We read the bill to exempt from the Act firms which market futures or options subject to the Treasury Amendment if those firms are subject to comparable federal or state regulation. We feel, however, this point could be further clarified. The bill's definition of the term "board of trade" in this context includes "unsupervised entities engaged in the systematic marketing" of foreign currency transactions to the retail public. Another paragraph in this section describes the types of agencies whose authority would not in any way be affected by the Treasury Amendment. We assume that "unsupervised entities" refer to firms not subject to regulation by such agencies. Some further guidance on the meaning of "unsupervised entities" could prevent confusion on this point.

The other aspect of the Treasury Amendment controversy is whether exchange traded products marketed solely to sophisticated institutional participants should be subject to more regulation than OTC products aimed at the same participants. Actually, this issue comes up in both the proposed changes to the Treasury Amendment and in Section 6 of the bill -- the Exemption for Professional Markets. In both contexts, my understanding is that the bill does not intend that markets limited to institutional and sophisticated participants should be unregulated. To the contrary, those markets would be subject to pervasive regulation -- the same sort of self-regulation which has served our markets since they were first developed over 150 years ago. Certainly, the exchanges have a powerful economic incentive to maintain the integrity and reputation of their markets and will continue to carefully scrutinize the activities of their members. Industry professionals who act as intermediaries in these pro-markets and are not exchange members would also, we assume, be subject to some form of self-regulation.

While self-regulation should continue to be the first line of defense in these markets, it would, in our view, be a mistake to eradicate the government's general oversight role. In this regard we note that the bill expressly applies the anti-fraud and anti-manipulation provisions of the CEA to these professional markets and preserves the Commission's authority to act in emergency situations. These measures provide at least some assurance that the federal government will continue to provide a further check on the effectiveness of the self-regulatory process. Congress should also consider requiring the Commission to report back to Congress after an appropriate period of time on the overall effectiveness of the self-regulatory process in these markets.

In sum, NFA strongly supports the concept that markets which are limited to sophisticated, institutional participants should be regulated differently than those which are not so limited. This bill endorses that concept and would allow the exchanges to compete with OTC markets on a more even playing field. Given the vital role of our futures markets, changes of this magnitude should not be made lightly or hastily. These hearings will provide all interested parties with an opportunity to state their concerns and will allow this Committee to make carefully considered and fully informed decisions in this critical area.

Another important issue addressed by this bill is the approval process for new contracts developed by the exchanges. We have all seen the U.S. market share in international futures dropping like a stone in recent years. In addition, the exchanges face intense competition from OTC products. Like any other marketplace, success in this one is often determined by who is the first to develop and implement a bright new idea. For the exchanges, though, building a better mouse trap is only the start of the process. Obtaining approval for that mouse trap is the real key and the real disadvantage in dealing with OTC and foreign competitors who do not have to clear that hurdle. Competitive pressures, however, should never cause us to enter a "race to the bottom," to eviscerate important regulatory protections, to risk long-term harm for a short-term gain. However, when you consider the mortality rate of new contracts, it's clear that the marketplace is ruthlessly effective and efficient in its own "contract approval process." By allowing the exchanges to get new products to the marketplace quickly while preserving the Commission's authority to act if necessary, the bill will go a long way toward ensuring a more competitive environment, to everyone's advantage.

The bill also addresses the approval process for exchange rules not related to new contracts. Section 17(j) of the Act currently sets out the process for the Commission's approval of NFA rules and incorporates the same timeframes set forth in Section 5a(a)(12) for exchange rules. NFA certainly agrees that the approval process for both exchange and NFA rules needed to be expedited but we see no reason whatsoever why NFA and exchange rules should not continue to be accorded similar treatment. The current symmetry between Section 5a(a)(12) and Section 17(j) should be maintained and whatever changes Congress ultimately makes to one it should make to the other as well.

I would also like to mention a number of issues involving minor amendments to the Act. Since NFA is purely a regulatory body which operates no markets, the legislative issues which directly impact us tend to be more technical and, to most, less compelling in nature. These issues are nevertheless important to NFA because we feel their resolution will enable us to do a better job of protecting the public.

In NFA's fifteen years of existence, the exchanges have always been fully supportive of our regulatory activities in every way possible. In fact, I believe that the communication and coordination among SROs in the United States sets an example for the world to follow. The current wording of Section 8c, however, has at times made it more difficult for the exchanges to be as helpful as they would like. Section 8c(2) provides that exchanges must make the results of their disciplinary proceedings public but may disclose the underlying evidence for those actions only to the disciplined member or to the Commission. We certainly agree that such information should not be publicly available, and, in fact, we would recommend an amendment to Section 17(b)(8) to make clear that NFA disciplinary actions should be afforded the same treatment. However, we feel that an exchange should not be restricted in its ability to provide information regarding its disciplinary proceedings to other self-regulatory organizations.

We have also identified a number of quirks in the statutory disqualifications set forth in Sections 8a(2) and 8a(3) which could be corrected with minor changes to the Act. Section 8a(2)(D) provides for disqualification based on convictions less than ten years old of felonies involving fraud, theft and other various forms of dishonesty. No mention is made of guilty pleas to such felonies. Section 8a(3)(D) disqualifies persons who have pleaded guilty to or were convicted of felonies not specified in Section 8a(2)(D) or who were convicted of an 8a(2)(D) felony more than ten years prior. The absence of reference to guilty pleas in Section 8a(2)(D) seems to be an oversight which at times creates problems. NFA routinely reviews applications of persons who as part of pre-trial sentencing diversion programs have pleaded guilty to 8a(2)(D) felonies with adjudication withheld and no resulting convictions. Such persons are not disqualified by the provisions of either Section 8a(2)(D) or 8a(3)(D).

This anomaly appears to be inadvertent and not representative of congressional intent since a person would be disqualified based upon a guilty plea to a less serious 8a(3)(D) felony but not based on a guilty plea to the more serious 8a(2)(D) felony. To correct this, NFA would propose amending both sections to provide for disqualifications based upon guilty pleas to 8a(2)(D) felonies.

Section 8a(3)(H) disqualifies persons who have pleaded nolo contendere to charges of felonious conduct or who have been convicted in state, military or foreign courts of conduct which would constitute a felony under federal law. As with Section 8a(2)(D), no mention is made of guilty pleas. The omission of guilty pleas in this section is inconsistent with the provisions of other sections dealing with criminal conduct. NFA proposes adding guilty pleas to Section 8a(3)(H) to remedy this inconsistency.

Section 8a(2)(B) provides that a denial of registrations based on a Section 8a(3) disqualification within five years is itself a basis to deny future applications. Oddly, though, a denial based on a more serious Section 8a(2) disqualification within five years does not create an additional statutory disqualification. This also appears to have been an inadvertent omission. NFA suggests that Section 8a(2)(B) be amended to include Section 8a(2) denials.

The proposed bill addresses each of these technical issues and we appreciate you and your staff's attention to these technical amendments.

In closing, Senator Lugar, let me again state that NFA is proud of its accomplishments and proud of our close working relationship with the CFTC. We are confident that in the years ahead we can continue to contribute to the goal of efficient and effective regulation that all of us share, and we are willing to help in that effort in any way that Congress or the Commission deems appropriate.