Just over a year ago, we acquired AI surveillance startup Neurensic, which led to our TT® Score trade surveillance and compliance offering. TT Score helps our users stay fully compliant with market regulations by leveraging machine learning to identify trading behavior that might prompt regulatory inquiries. The move into technology for trade surveillance and regulatory compliance has been a fascinating one for us—and it has provided us with an even greater appreciation for regulatory organizations such as NFA.
NFA is the industry-wide, self-regulatory organization for the U.S. derivatives industry, providing innovative and effective regulatory programs. Designated by the CFTC as a registered futures association, NFA strives every day to safeguard the integrity of the derivatives markets, protect investors and ensure Members meet their regulatory responsibilities.
I sat down with NFA President and CEO Tom Sexton at our Tech Tap to learn more about NFA and how the organization deals with a variety of issues we all face. Below is part one of our conversation.
– Rick Lane, CEO
Rick: Tom, first of all, thanks for agreeing to speak with me. We interview traders, heads of trading firms, and other technology companies, but it’s not often that we get to sit down with folks in the regulatory space. I’m sure there are lots of people who are eager to hear what you have to say. For those who aren’t familiar with NFA, would you give a quick overview, touching on history of and NFA’s regulatory responsibilities?
Tom: Sure. We’re entering our 36th year—we opened in 1982. And obviously the organization is much different today than it was in ‘82.
In 1974, Congress established the Commodity Futures Trading Commission, or CFTC. The same legislation also authorized the creation of registered futures associations, giving the industry the opportunity to create a self-regulatory organization. NFA’s founding fathers wanted us to be committed to the self-regulation of futures. In 1981, we were formally designated as a registered futures association by the CFTC, and we officially opened our doors in 1982.
We’ve shifted significantly over the last 36 years. We started off as a self-regulatory organization for only the futures industry.
Over time, the CFTC’s jurisdiction has expanded to include additional trading instruments—retail forex, for example, and swaps—in light of Dodd-Frank, so we’ve broadened our regulatory responsibilities.
Today, we have several key functions.
- Registration. The Commodity Exchange Act (CEA) requires certain firms and individuals that conduct business in the derivatives industry to register with the CFTC. CFTC regulations also require, with few exceptions, CFTC-registered firms to be NFA Members.The CFTC initially delegated the registration responsibility to NFA over 30 years ago. On behalf of the CFTC, NFA registers firms and market professionals after a thorough investigation to determine if they meet the fitness standards set forth in the CEA. NFA conducts all background checks and, where appropriate, initiates proceedings to deny or revoke registration. We process approximately 800 individual and 60 firm registration applications monthly.
- Rulemaking. The essence of self-regulation involves identifying industry best practices in certain areas, then mandating those practices for the industry.
- Compliance. NFA’s largest departments monitor Members for compliance with NFA rules and CFTC regulations by monitoring financial and other reports and performing examinations. We also investigate possible violations. If material violations are noted, the offending firm may be subject to a disciplinary process.
Additionally, we provide education to Members and investors. NFA develops and delivers ongoing education to help Members understand their regulatory requirements. NFA also offers investor education tools, including BASIC, which is an online, searchable database of registration, disciplinary and financial information about firms and individuals currently or previously in the derivatives industry.
NFA also offers an affordable and efficient arbitration program to help customers and Members resolve futures-related and forex-related disputes.
In addition, NFA’s Market Regulation department performs trade practice and market surveillance services on behalf of SEFs and DCMs.
Rick: How long have the outsourced regulatory services, combined, been around?
Tom: We began offering this sevice to electronic futures exchanges in the early 2000s. We now provide market regulation services to the vast majority of SEFs, in light of Dodd-Frank.
Rick: Is that all public information, by the way?
Tom: Yes. The DCMs and SEFs are ultimately responsible for what occurs on their markets, but they outsource regulation to us, and we work closely with them.
Rick: You mentioned there’s an education component, too. Has that been around for a while?
Tom: It has. Our philosophy is always to help Members comply with regulatory requirements. That’s a key aspect of what we do. We aren’t in the business of playing “gotcha” with our Members. We’re here to explain all regulatory requirements to Members and answer their questions. The vast majority, 95% or more, want to comply with their regulatory requirements. As an SRO membership organization, we think it’s important to provide education and guidance when we think further clarification of the regulations is necessary.
Rick: To what extent will you help decipher or decode other regulations that fall outside of the NFA? How does NFA decide to create new rules or interpretive guidance?
Tom: So, this is how the regulatory arm works as far as our rulemaking. New rule initiatives can come from any number of sources. We might find common deficiencies during examinations and start asking questions about why firms have difficulty complying. Our Board can also request clarification on certain rules. Rules can be Member-initiated as well, or at times, customer-initiated. If further clarification is needed, we work closely with our advisory committees and trade associations and have informal conversations with the CFTC. Staff then puts together draft proposals, which go to our Executive Committee and the Board. Finally, the CFTC approves our rules.
In terms of other regulations, if we adopt by reference, for example, certain CFTC rules, and think further clarification is necessary, we’ll work very closely with the CFTC on what we propose because they ultimately approve it. But we can, by providing guidance in certain areas, clarify CFTC requirements.
Rick: What are some recent rules that are particularly of interest or merit?
Tom: We try to use technology and address technology issues as much as we can in our rulemaking. For example, given the sensitive nature of customer data that Member firms possess and the growing risks associated with cyber breaches, in 2015, NFA developed guidance requiring Members to adopt and enforce procedures to secure both customer data and access to their electronic systems. NFA’s Information Systems Security Program Interpretive Notice, which became effective on March 1, 2016, requires all Member firms to adopt and enforce an information systems security program appropriate to its circumstances.
Because our guidance applies to all Members, which range in size and complexity of operations, our guidance establishes general requirements, but leaves the exact form of the ISSP up to the Members. We recently amended this guidance to provide clarification on common questions related to training obligations and ISSP approval posed by Members to NFA, and impose a narrowly drawn notification requirement to ensure that Members notify NFA of certain cybersecurity incidents related to a Member’s commodity interest activities. The amendments will become effective on April 1.
Another important customer protection initiative that utilized technology was the development of a system to perform a daily confirmation of customer segregated funds. In December 2012 (post MF Global and PFG), NFA and the CME Group developed and implemented a system to electronically confirm daily balances in customer segregated and secured fund accounts directly with banks, clearing firms and clearinghouses. The system automatically compares FCM reports to the depositories’ daily confirmations to identify suspicious discrepancies.
Rick: Interesting. It’s one thing to build a system like that, but it’s another to actually get all of those pieces to integrate. That must have taken a long time.
Tom: It took far less time than we thought it would, especially given that the system required daily information from thousands of accounts and hundreds of banks. Quick delivery was critical—the industry needed to increase confidence in our markets, and this addressed that need.
That’s one characteristic of self-regulation—it can often enforce rules quicker than the government regulatory process.
For example, if the CFTC were to implement the daily confirmation requirements, a notice and comment period would be needed, followed by adjustments based on the comments, and more. For NFA, in a period of about six months, after working with the Board and the CFTC, we were prepared to put this important customer safeguard in place. We can act very nimbly when we need to, and adapt quickly to step up and address issues.
Another key rulemaking initiative was in response to the launch of virtual currency derivatives. In late 2017, a number of CFTC regulated trading venues launched virtual currency derivatives, including Bitcoin. During the past year, NFA has taken measures to protect investors and oversee its Members, including issuing an investor advisory, imposing additional reporting requirements for NFA Members dealing with virtual currency products, and issuing guidance establishing disclosure requirements for Members that engage in activities related to virtual currencies or virtual currency derivatives. We want to make sure that investors know that, among other things, NFA doesn’t regulate the underlying virtual currency product, with the limited exception of investments in commodity pools. So there are various disclosures Members must provide to enhance customer protection. This interpretive guidance became effective in October 2018.
The last technology initiative I’d like to mention has to do with data from NFA swap dealers. It’s an ongoing process to develop a swap dealer risk profiling system that identifies firms that may pose heightened regulatory risk and then allocate resources accordingly. To enhance its swap dealer risk profiling tool, NFA recently developed a plan to collect monthly market and credit risk data from swap dealers. Understanding a swap dealer’s market and credit risk exposures provides NFA with insight into a swap dealer’s risk profile. Working with the swap dealers, NFA’s Swap Participant Advisory Committee, the CFTC and relevant trade associations, NFA identified a list of metrics related to market and credit risk that provides important information for swap dealer risk monitoring, without imposing undue burdens on SDs. Swap dealers began electronically filing this data last January.
For the second half of this interview, see Keeping Score of Trade Compliance: A Regulator’s Perspective from Tom Sexton, NFA CEO, Part 2.